This article covers:

• What are Hybrids?

• Hybrid Market in Australia

• The Different Types of Hybrids

• Hybrid Features

• Advantages of Hybrid Securities

• Disadvantages of Hybrid Securities

“With interest rates rising, investors eyeing regular income now have a greater range of investment opportunities to consider than when interest rates were at record lows. However, with inflation at elevated levels, yields need to keep up with inflation in order to avoid a real loss. 

Cash and bonds might be well known fixed income investments, but hybrid securities, or hybrids for short, are another option that seek to provide investors with an income stream.

Read our guide on investing in fixed income here. 

So how do hybrids work? What are the benefits? What should you be wary of? 

What are Hybrids?

Hybrids are a complex type of security that combine the characteristics of debt securities (bonds) and equity securities (shares). Like equity securities, they may be listed on the ASX, and traded as you would with other instruments. Some hybrids are unlisted, which carry liquidity risks.

At their most basic level, hybrids are a method with which companies or financial institutions can borrow funds from investors. In exchange for said funding, an entity issues hybrid securities or notes.

Hybrids typically provide an income stream until a specified date into the future, usually at a higher yield than bonds, albeit without any guarantee as to the timing or amount of payments made. At maturity', investors may have the option to convert their original investment into shares, reclaim the face value, or roll it over into a new security.

Due to their equity characteristics, hybrids can lose significant value, and along with some of their complex features, they are considered a risky product.

The structure of a hybrid security will depend on the type of hybrid in question, as there are various types that involve varying degrees of debt and equity characteristics. We'll touch on these below.

Hybrid Market in Australia

At the end of July, 2022, there were around $42 billion of hybrids listed on the ASX across 57 different products. The majority of these products are convertible preference shares and capital notes ($40.8 billion), whereas other hybrid securities ($950 million) and convertible bonds ($408 million) make up a smaller portion of the market.

In the first seven months of the year, the ASX welcomed six new hybrid listings, all of which bar one were convertible preference shares from the nation major banks - Westpac, Macquarie, NAB, Commonwealth Bank, ANZ. The cumulative size of these hybrid securities was around $7.3 billion, which is nearly 50% higher than the entire amount raised via hybrids throughout 2020.

Apart from the major banks, some of the other companies that have conducted hybrid issues over recent time include Mosaic Brands, Latitude Group, and Suncorp. Corporates, insurers, and diversified financials often tap the hybrid market to raise money for sufficient liquidity on their balance sheets.

The Main Types of Hybrids

The largest and most popular hybrid category on the ASX relates to convertible preference shares and capital notes. 

As far as preference shares, these are equity securities, albeit with some debt-like characteristics. 

They typically pay a specified dividend rate, which is either at a fixed rate, or floating rate. In most cases, like bonds, they may be redeemed for cash at maturity. Preference shareholders generally don't have voting rights, but they rank ahead of holders of ordinary shares for dividends and even recovery of capital in the event of a winding up of the company. 

Capital notes are debt securities that have equity-like features. By and large, there tends to be greater variance in capital notes due to the features of debt securities. 

For example, a perpetual debt security is a debt security with no fixed maturity date. Alternatively, it could be subordinated debt securities, where rights to interest payments and principal repayment fall behind other classes of debt. Finally, they might be knock-out' debt securities, where the issuer or a third-party has the right to treat them as capital and extinguish' (cancel) them in certain cases.

Meanwhile, convertible bonds allow the issuer or investor to convert the instrument into another security at a specified date in the future. Most commonly, this means the hybrid is converted into shares in the issuing entity.

There are potential benefits for both parties here. For issuers, hybrid securities avoid immediate dilution, and they are typically more affordable to service as they tend to be issued at a lower interest rate than bonds. On the other hand, investors typically benefit from downside risk protection and have the prospect of potentially benefitting when they convert to equity in the future.

More information on the types of hybrids and naming conventions for hybrids can be found on the ASX website.

Hybrid Features

Hybrids are valued mostly for the regular interest payments issuers pay to holders. A holder will invest an initial amount, otherwise known as the principal, or the face value of the hybrid. 

Hybrids may trade, either on the public market or privately, but prices are typically derived from the underlying value of the security (capital amount), and the value of all interest accrued since the latter of a security last interest payment, or its original issuance. This means hybrid prices tend to rise until they trade ex-interest payment, when accrued interest resets to zero.

In many cases, the payments offered by a hybrid follow a predetermined rate of return (yield), and they may occur periodically, like every quarter, or semi-annually.

If the rate is not fixed at a regular amount, it may be set as a floating value. Again, however, there are no guarantees regarding the amount and timing of any interest payments. If an issuer runs into financial difficulties, or even based on certain terms of the agreement, they may be able to defer distributions to holders. 

If the issuer is required to make up for any missed payments, this is referred to as a cumulative hybrid, and accrued interest must be paid out at a later date. But hybrids may also be non-cumulative, where no such obligation exists. 

While some hybrids are convertible into shares at a discount, other hybrids provide the issuer with a call option to buy back the security at the issue price, or par value. This could be to the detriment of the holder. 

Perpetual hybrids do not have a maturity date, and continue to trade on an indefinite basis. Most hybrids, however, have a maturity date for the repayment of the face value, or conversion, and this timeframe may span a few years to more than a decade.

Hybrids may also be categorised as redeemable, which gives either party the unilateral right to redeem the securities for a specified value, or non-redeemable, where no redemptions or conversions are possible before maturity.

Investors should also pay close attention to the subordination of the hybrid security in the capital structure of the entity. This determines their rank in the list of creditors should insolvency occur.

Advantages of Hybrid Securities

Some of the advantages of hybrids include: 

• Typically higher yield versus government bonds and cash

• May rank higher than common equity holders to proceeds if a company is wound up

• Some hybrids offer flexible benefits for conversion or redemption

• May be used to generate an income stream over a set period of time

• Can be used to diversify a portfolio by goal, strategy, and asset type

• Hybrids with floating rates benefit from higher benchmark rates as interest rates rise

Disadvantages of Hybrid Securities

Some of the disadvantages of hybrids include but are not limited to:

• Liquidity may be limited, which could make it difficult to sell in a hurry, and spreads or redemptions might be unviable during a market downturn 

• Interest rate movements can inversely influence hybrid prices

• Some hybrids allow the issuer to defer payments to holders if facing financial difficulties, and the hybrid could even be knocked-out' (written off) under some circumstances, leading to losses

• Hybrid issuers may have the unilateral discretion to convert or even terminate securities 

• Rank lower than debt holders to proceeds if a company is declared insolvent

• The issuer could default on payments over what is a long time frame before maturity

• If an issuer does not redeem a hybrid at first call', the redemption period could be extended and lead to depresses trading prices in the security

• Unlike conventional cash deposit products, hybrids are not covered by the Government Guarantee

Please consult a financial adviser, your tax accountant, and any relevant PDS to decide if a particular hybrid security product is right for you.