Hybrid securities (also known as hybrids, convertibles or preference shares) are securities that combine both ‘equity-like’ and ‘debt-like’ characteristics. They can pay a fixed or floating rate of return, which can be in the form of interest or dividends. When you buy or subscribe for a hybrid security, you are investing money in a corporation or other entity, known as the issuer.
Hybrid securities promise to pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the holder or issuer has a number of options including converting the security into the underlying share or even repaying the security early.
Unlike a share (equity), the holder has the promise of a 'known' cash flow and unlike a traditional debt security (bond) there is an embedded option element, which may include conversion into the underlying equity. More common examples are capital notes, convertibles and preference shares.
It is important to look beyond the name given to hybrid securities and to consider the specific terms attached to a hybrid security, as set out in the prospectus or product disclosure statement (PDS) for the security. These can be very different from each other. A number of terms are sometimes used interchangeably when describing different types of hybrid securities. As such, special care needs to be taken when considering if the investment is suitable for your investment objectives.
There are two broad types of hybrid securities – convertibles and preference shares. Each type has different characteristics, benefits and risks.
Your first choice for more information should be the ASX online courses on interest rate securities, which includes a section on hybrids. You can also download the ASX education brochure Understanding interest rate securities or listen to an Investor Hour podcast on hybrids to learn more.
The Australian Securities and Investments Commission (ASIC) has also produced a short guide to hybrid securities emphasising that hybrid securities are complex products with higher risks than other types of securities. For more information from ASIC on hybrid securities and other investing topics, please see ASIC's MoneySmart website.
Benefits of investing in hybrids
Hybrids can provide several benefits including:
- pay a defined income stream
- may in some instances return their face value at maturity
- enable you to diversify your investments with the opportunity (sometimes mandatory) to convert into the underlying equity at a future point in time
- are bought and sold on ASX
- may offer tax advantages.
The distinguishing characteristics of hybrid securities
Hybrid securities are considered 'hybrid' because they combine the features of more than one type of security. For example, a convertible bond could look like a debt security for a time, but contain features that convert it to another type of security during its term. The simple rule to remember is that if the security contains any feature that enables it to be changed into a different security, amend the payment structure, rate or term, change its security ranking or downgrade its credit worthiness, then the security is a considered a hybrid security.
Finding a broker
If you’re already using a broker to buy and sell shares, they may also advise on hybrid securities. However if your existing broker is not active in the hybrid market, you may need to find a specialist broker in this area.
Hybrid securities are typically complex securities and have risks that investors should be aware of before investing. Some of these risks include:
- the company may be unable to pay the promised distributions, or repay the face value at maturity (issuer risk);
- your income may be affected by an unfavourable movement in market interest rates (interest rate risk);
- the value of your hybrid security may be affected by changes in the company's share price. This means that the value of your security could fall sharply if the company’s share price also falls;
- many hybrid securities have an implied maturity often much shorter than the legal term with investment performance potentially suffering from events beyond the issuer’s control (regulatory risk); and
- you may not be able to sell your hybrid security for a fair price (liquidity risk).
This is not an exhaustive list of all the potential risks from investing in hybrid securities. Hybrid securities are often very complex instruments which can make understanding of the product more difficult. You should obtain independent advice from a professional adviser prior to making any final investment decision.