This is a guest post by Luke Fitzpatrick. Connect with him on LinkedIn.
Fixed-income securities with attributes of both equities and debts, hybrid securities are single investment vehicles with potential benefits for both issuers and income-oriented investors alike.
Investing in hybrid securities
Hybrids typically rank lower than other debts and higher than vanilla stocks and usually have perpetual or longer-dated maturities. While they have no voting rights, their rates can be structured as fixed or fixed-to-floating, and are generally callable 5 to 10 years from their issue date. Just like most other fixed-income investments, hybrids can either be sold via the stock exchange or transferred between investors or dealers.
While a mark-up or commission is commonly charged when processing the initial purchase or sale transaction of these securities, dealers will usually make a profit on the transaction by trading them at a net cost plus an additional percentage of the spread.
Features and characteristics
Hybrid securities are a combination of both equity and bond securities, with returns based on the performance of underlying assets. To fully understand how they work, there’s a number of important features and characteristics you need to know.
A popular option for investors looking for trades with regular income sources, hybrid securities generally offer monthly or quarterly payments in the form of dividends or interest. While there are some circumstances where issuers can defer these payments, they are always paid out to investors as a priority before any common stockholders can receive their dividends.
Most hybrid securities have deferrable distributions and maturities of at least a minimum of 30 years. Because of the higher risks attached to hybrids, they typically enable investors to generate much higher yields than with more traditional debt securities.
Fixed or fixed-to-floating dividend rates
Hybrid securities can either have fixed or fixed-to-floating dividend rates. Fixed-rate securities pay a set amount for the life of security, whereas fixed-to-floating rate securities pay a set amount until a specific date when it starts paying a floating rate until it’s called in by the issuer. It’s important to note that fixed-to-floating rate securities are less vulnerable to interest rate instability as their duration is shorter than fixed-rate securities.
Cumulative vs. non-cumulative hybrids
Hybrids with a stated maturity are cumulative, whereas any hybrid without the cumulative feature is non-cumulative. Companies that fail to distribute their accumulated dividends to cumulative hybrid shareholders are required to pay them in full before any deferred dividend payments can be made to common shareholders. Alternatively, companies without stated maturities are not required to pay missed dividends to shareholders with non-cumulative hybrids before paying common dividends.
Associated risks with hybrids
Just like any other securities with fixed incomes, hybrids also have a number of risks that can have an effect on the market price and yield of the investments. That being said, most hybrids will also generally have higher yields in order to compensate for these increased risks.
Most commonly associated with many fixed-income investments, credit risk occurs when an issuer becomes unable to meet their obligations to make interest payments to investors due to difficulties with their financials.
Because market prices move with interest rates, there is always a risk of volatility. So hybrid securities can end up being worth more or less than their purchase price. Especially if investors decide to sell their hybrid before they mature.
Issuers of hybrid securities can typically defer the distribution of income payments at any time they’re having financial difficulties. The only requirement is that they must also stop all other dividends to stockholders, as well as any other security payments lower than the hybrid.
When a company fails to make scheduled payments of principal interest or debt as specified in legal agreements, the default will have an effect on a hybrid’s market price.
Many hybrid securities are issued with call features that allow issuers to redeem them at a specific date before it matures. Subsequently, any principal which was then reinvested elsewhere would most likely reduce their income stream as it would be at a lower interest rate.
There’s a wide variety of events that may affect the debt repayment obligations of a company, such as poor management, volatile markets, changing regulations, new competition, rising costs, and many more.
The bottom line
While hybrid securities can be a valuable addition to your portfolio, you should always assess everything before making any investment decision. Not only is it important to review your current financial situation, but you should also revisit your investment objectives, diversification needs, risk tolerance, and liquidity objectives.