Hybrid security

Securities

Securities Banknote Bond Debenture Derivative Stock
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Bonds by coupon Fixed rate bond Floating rate note Inflation-indexed bond Perpetual bond Zero-coupon bond Commercial paper
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Derivatives Forward Futures Option Swap Warrant Credit derivative Hybrid security

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

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 a share of stock (equity) the holder has a 'known' cash flow, and, unlike a fixed interest security (debt) there is an option to convert to the underlying equity. More common examples include convertible and converting preference shares.

A hybrid security is structured differently and while the price of some securities behave more like fixed interest securities, others behave more like the underlying shares into which they convert.

Examples

A convertible bond is a bond (i.e. a loan to the issuer) that can be converted into common shares of the issuer. A convertible bond can be valued as a combination of a straight bond and an option to purchase the company's stock.^[1]
An income security is a hybrid between a stock and a bond. The bond portion pays interest, and the stock portion pays dividends. Income securities are popular in Canada.
A PIK loan may carry a detachable warrant (the right to purchase a certain number of shares of stock or bonds at a given price for a certain period of time) – the loan is the debt (Bond), while the warrant is the equity
The important hybrid instruments are:
- Preference shares
- Convertible/exchangeable debentures/bonds
- Debt with attached warrants

Important terms

Returns: Predictable dividend, often franked therefore possible tax advantage to the holder
Capital price:

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).

Discount: A discount is usually offered to the share price at the time of conversion.
Reset/resettable: At the reset date the terms of the security (dividend rate, next reset date) may change. The holder can elect to accept the new reset terms or convert into shares.
Cumulative/non-cumulative This refers to the event of missed dividend payments.

Cumulative: missed dividend payments are added to the next dividend payment.
Non-cumulative: missed dividend payments are forgone.

Redeemable/non-redeemable

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:

they have a set dividend until conversion
the conversion might occur at a number of dates
they are usually issued at a similar price to the underlying share
they convert at a set ratio. e.g. 1 hybrid converts into 1 underlying share

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:

they have a set dividend rate for a 5-year period ('reset' period)
are issued at $100
the holder has the ability to take the new 'reset' terms, redeem the face value or convert
the holder can convert into the shares at a discount to the current ordinary share price e.g. 5%
the conversion ratio is into a dollar amount of shares. e.g. $100 worth of the underlying equity Note: This 'variable' conversion ratio means the price of these hybrids does not react to the movement in the share price, and they therefore behave in a similar way to fixed interest securities (this lack of co-relation with the underlying shares is sometime referred to as a zero delta).

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.

References

↑ "Introduction to Canadian Convertible Debentures" (PDF). Voya Vasiljevic, ScotiaMcLeod. March 15, 2009. Retrieved March 15, 2009.

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