Hybrid security

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Hybrid securities are a broad group of securities that combine the characteristics of the two broader groups of securities, debt and equity.

Stock financial instrument

The stock of a corporation is all of the shares into which ownership of the corporation is divided. In American English, the shares are commonly known as "stocks." A single share of the stock represents fractional ownership of the corporation in proportion to the total number of shares. This typically entitles the stockholder to that fraction of the company's earnings, proceeds from liquidation of assets, or voting power, often dividing these up in proportion to the amount of money each stockholder has invested. Not all stock is necessarily equal, as certain classes of stock may be issued for example without voting rights, with enhanced voting rights, or with a certain priority to receive profits or liquidation proceeds before or after other classes of shareholders.

Contents

Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the holder has a number of options, including converting the securities into the underlying share.

Therefore, unlike with a share of stock (equity), the holder enjoys a predetermined (rather than residual) cash flow, and, unlike with a fixed interest security (debt), the holder enjoys an option to convert the security to the underlying equity. Other common examples include convertible and converting preference shares.

Preferred stock type of stock which may have any combination of features not possessed by common stock

Preferred stock is a form of stock which may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred stocks are senior to common stock, but subordinate to bonds in terms of claim and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the issuing company's articles of association or articles of incorporation.

A hybrid security is structured differently than fixed-interest securities. While the price of some securities behaves more like that of fixed-interest securities, others behave more like the underlying shares into which they may convert.

Examples

Convertible bond

In finance, a convertible bond or convertible note or convertible debt is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features. It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to counter market cornering.

Bond (finance) instrument of indebtedness

In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. The most common types of bonds include municipal bonds and corporate bonds.

Share (finance) single unit of ownership in a corporation, mutual fund, or any other organization

In financial markets, a share is a unit used as mutual funds, limited partnerships, and real estate investment trusts. The owner of shares in the corporation/company is a shareholder of the corporation. A share is an indivisible unit of capital, expressing the ownership relationship between the company and the shareholder. The denominated value of a share is its face value, and the total of the face value of issued shares represent the capital of a company, which may not reflect the market value of those shares.

Important terms

  • Price moves in line with share price (fixed conversion terms e.g. 1 hybrid convert to 1 share)
  • Bond like, price does not move in line with share price (variable conversion terms, face value (usually $100) convert to $100 worth of shares).
  • Cumulative: missed dividend payments are added to the next dividend payment.
  • Non-cumulative: missed dividend payments are forgone.
  • Redeemable: At certain times the holder may have the option to sell the securities back to the company at the face value/issue price.
  • Non-redeemable / irredeemable: The company is not offering to buy the securities back.

Traditional hybrids

Traditional hybrids were usually structured in a way that leads the securities to react to the underlying share price. Although each has individual characteristics, typically:

Note: This fixed conversion ratio means the price of these hybrids react to the movement in the underlying share price. (The extent of the co-relation is sometimes referred to as a delta, and these typically have a delta of between 0.5 and 1) In addition, some of these securities include minimum and maximum conversion terms, effectively giving the holder a put and call option if the share price reaches a certain prices.

Style of hybrids

Most of the hybrid securities issued since 2005 are very bond-like. Although each has individual characteristics, typically:

Usage

Hybrid securities have skyrocketed in popularity since Moody's released a new set of guidelines for treating debt-equity hybrids in February 2005. The new guidelines establish a "debt-equity continuum" and allow institutions to classify part of the hybrid security as equity and part as debt (in a shift from the previous policy, that counted the entire amount as debt). This change allowed companies to issue hybrid securities at a time of record low interest rates (and thus gain access to cheap capital) and then use the proceeds to repurchase equity shares (which have a very high cost of capital). Since only a fraction of the recapitalization would be listed as debt on the balance sheet, hybrids allowed companies to repurchase more shares than previously without negatively affecting their credit rating.

Basket D security

The most popular hybrid among financial institutions (banks and insurance companies) is the Basket D security. Basket D is a reference to a point on Moody's debt-equity continuum scale that treats the hybrid as 75% equity and 25% debt. In order to qualify, the security must give the issuer the right (or even the obligation) to roll-over the security at expiry to an indefinite or long maturity bond and to suspend dividends (effectively coupon payments, but to reflect the equity nature of the security, the term "dividend" is used). Most Basket D issuances have been structured in a way that also preserves the tax deductible nature of their interest payments, avoiding double taxation/customs.

See also

A convertible security is a security that can be converted into another security. Convertible securities may be convertible bonds or preferred stocks that pay regular interest and can be converted into shares of common stock. Warrants are equity convertible securities. They give the owner the option to buy newly issued shares at a determined exercise price and date. Equity capital notes are similar to warrants, except that there is no exercise price.

Monthly income preferred stock or MIPS is a hybrid security created by Eli Jacobson, a Sullivan & Cromwell tax partner, and introduced to the market by Goldman Sachs in 1993. In essence, MIPS is a combination of deeply subordinated debt and preferred stock.

SWORD-financing is a special form of financing invented to help junior biotech companies access institutional capital markets to finance their R&D via establishing a special purpose entity and giving the investors partial rights to the outcomes of the R&D projects that they are funding.

Related Research Articles

Security (finance) tradable financial asset

A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some jurisdictions the term specifically excludes financial instruments other than equities and fixed income instruments. In some jurisdictions it includes some instruments that are close to equities and fixed income, e.g., equity warrants. In some countries and languages the term "security" is commonly used in day-to-day parlance to mean any form of financial instrument, even though the underlying legal and regulatory regime may not have such a broad definition.

Financial capital is any economic resource measured in terms of money used by entrepreneurs and businesses to buy what they need to make their products or to provide their services to the sector of the economy upon which their operation is based, i.e. retail, corporate, investment banking, etc.

Debenture

In corporate finance, a debenture is a medium- to long-term debt instrument used by large companies to borrow money, at a fixed rate of interest. The legal term "debenture" originally referred to a document that either creates a debt or acknowledges it, but in some countries the term is now used interchangeably with bond, loan stock or note. A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest and although the money raised by the debentures becomes a part of the company's capital structure, it does not become share capital. Senior debentures get paid before subordinate debentures, and there are varying rates of risk and payoff for these categories.

Warrant (finance) security that entitles the holder to buy stock

In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed price called exercise price until the expiry date.

In finance, an equity derivative is a class of derivatives whose value is at least partly derived from one or more underlying equity securities. Options and futures are by far the most common equity derivatives, however there are many other types of equity derivatives that are actively traded.

Death spiral financing is the result of a badly structured convertible financing used to fund primarily small cap companies in the marketplace, causing the company’s stock to fall dramatically, which can lead to the company’s ultimate downfall.

Yield (finance) financial

In finance, the yield on a security is the amount of cash that returns to the owners of the security, in the form of interest or dividends received from it. Normally, it does not include the price variations, distinguishing it from the total return. Yield applies to various stated rates of return on stocks, fixed income instruments, and some other investment type insurance products.

Treasury stock

A treasury stock or reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market.

Convertible arbitrage is a market-neutral investment strategy often employed by hedge funds. It involves the simultaneous purchase of convertible securities and the short sale of the same issuer's common stock.

Earnings per share EPS

Earnings per share (EPS) is the monetary value of earnings per outstanding share of common stock for a company.

In finance, a bond option is an option to buy or sell a bond at a certain price on or before the option expiry date. These instruments are typically traded OTC.

Stock dilution, also known as equity dilution, is the decrease in existing shareholders’ ownership of a company as a result of the company issuing new equity. New equity increases the total shares outstanding which has a dilutive effect on the ownership percentage of existing shareholders. This increase in the number of shares outstanding can result from a primary market offering, employees exercising stock options, or by issuance or conversion of convertible bonds, preferred shares or warrants into stock. This dilution can shift fundamental positions of the stock such as ownership percentage, voting control, earnings per share, and the value of individual shares.

An equity-linked note (ELN) is a debt instrument, usually a bond, that differs from a standard fixed-income security in that the final payout is based on the return of the underlying equity, which can be a single stock, basket of stocks, or an equity index. Equity-linked notes are a type of structured products.

A reverse convertible security or convertible security is a short-term note linked to an underlying stock. The security offers a steady stream of income due to the payment of a high coupon rate. In addition, at maturity the owner will receive either 100% of the par value or, if the stock value falls, a predetermined number of shares of the underlying stock. In the context of structured product, a reverse convertible can be linked to an equity index or a basket of indices. In such case, the capital repayment at maturity is cash settled, either 100% of principal, or less if the underlying index falls conditional on barrier is hit in the case of barrier reverse convertibles.

A split share corporation is a corporation that exists for a defined period of time to transform the risk and investment return of a basket of shares of conventional dividend-paying corporations into the risk and return of the two or more classes of publicly traded shares in the split share corporation. Most commonly a split share corporation issues equal numbers of shares from a class of preferred shares and a class of capital or class A shares. The proceeds of the share offering are invested in conventional dividend-paying shares according to the regulations of the split share corporation. The preferred shares typically offer relatively high and secure dividend yield at a fixed coupon rate but with no expectation of capital gain by the time that the split share corporation is wound up. The capital shares often pay a dividend like the preferred shares; in addition, the capital shares offer participation in the leveraged capital gains of the underlying basket of conventional shares.

Perpetual subordinated debt is debt (bonds) with no maturity date for the return of principal, never needs to be redeemed by the issuer, and thus pay coupon interest continually until bought back. Like other subordinated debt, it has claims after senior debt in the event of default.

Hybrid investments, also known as derivatives or just hybrids, are a form of investment that combines equity and debt features, allowing companies to protect themselves against financial risks in securities transactions. This form of investment is essential for traders and investment professionals to branch out their portfolio assets.

References

  1. "Introduction to Canadian Convertible Debentures" (PDF). Voya Vasiljevic, ScotiaMcLeod. March 15, 2009. Archived from the original (PDF) on March 18, 2009. Retrieved March 15, 2009.