Hybrid products mix debt and equity stakes to blend an investor’s risk.
Specifically, a hybrid product is a single financial security that combines two or more different financial instruments. Hybrid securities, often referred to as ‘hybrids’, generally combine both debt and equity characteristics. They are bought and sold on an exchange or through a brokerage and may give investors a fixed or floating rate of return, and may pay interest or dividends. The issuer of the hybrid may have to repay the face value to the holder when they mature.
The most common type is a convertible bond that has the debt-like features of an ordinary bond. It is heavily influenced by the price movements of the stock into which it is convertible at some point in the future.
Another hybrid is the convertible preference share, which pays dividends at a fixed or floating rate before common stock dividends are paid, and can be exchanged for shares of the underlying company’s stock.
Pay-in-kind toggle notes are another type of hybrid security where the issuing company can attach the payment of interest to the additional debt owing to the investor, meaning the company will owe the investor more debt but not pay interest immediately. The interest deferral allows the company to keep cash flowing.
Advantages and disadvantages of hybrids
Each type of hybrid security has unique risks and rewards.
- Convertible bonds offer greater potential for appreciation than regular bonds, but pay less interest than conventional bonds, and are therefore cheaper for the business.
- They will not be available to all businesses.
- Hybrids face the risk that the underlying company could perform poorly. They can also fail to make coupon payments and not be able to repay the bond’s face value at maturity. Fear of that happening could precipitate a situation for a business that has issued hybrids.
- Convertible securities offer greater income potential in the long-term than regular securities, so in the long-term can be more expensive. However, that is because the individual elements of them will not be available to a business at that point in time, or will not be appropriate.
- Because of their complex nature, corporate finance advice on hybrids is absolutely necessary.
- Market price volatility can prove an issue for the business that has issued the hybrids.
- Despite taking advice businesses can struggle to understand exactly how hybrids will perform in different circumstances.
- Think through the impacts of major change in your particular market and your business as a result of COVID-19 - A contingency plan, where you’re going to be most effective or changes you can make in your business and what the consequences might be for your need for finance.
Stephen Pegge, Managing Director, Commercial Finance, UK Finance