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Sometimes referred to as hybrids, hybrid securities are investment opportunities that blend the features of debt and equity securities. This creates a situation where the hybrid type of security will pay some sort of identifiable return up to a certain date in the maturation process. After that date, the security is likely to undergo some sort of change, such as converting from a bond into shares of the underlying stock associated with the bond issuer. Securities of this type are often considered relatively low risk, since investors can choose to retain control of the security up to the point of conversion, then sell it if projections for the future performance of the investment do not meet expectations.
One common example of hybrid securities is the convertible bond. Many bonds of this type pay either a fixed rate or a floating rate for the first portion of the bond’s life. With the fixed rate approach, the investor knows exactly what rate of return to expect during this phase. Even with a floating rate, the investor can have a good idea of how much return will be realized before the bond undergoes some type of conversion.
Hybrid securities like the convertible bond undergo some type of change from being a floating or fixed interest security to some other form, at a time specified in the terms of the bond issue. The bond may become a straight bond, in which case it will pay a fixed or floating rate until it matures. At other times, the convertible bond may become an option that allows the investor to secure shares of stock issued by the entity that first issued the bond. In either situation, the investor has the option of holding on to the investment or selling it to another interested party.
There are other types of hybrid securities in common use today. An income security combines elements of both stocks and bonds, usually paying interest on the bond portion, while the stock portion issues regular dividends to investors. A payment in kind, or PIK loan, which does not require payment until the maturity date or the date of refinancing, may include what is known as a detachable warrant. This type of warrant is simply the assurance that the investor can choose to buy relevant shares of stock for a particular price during a specified time period of the loan, such as the refinace date.
While there are differences in the structure of different types of hybrid securities, many share a core group of attributes. The purchase price on a hybrid security is usually relatively low in comparison to other types of investments. Most have a set dividend rate that will be in effect for up to five years, making it easy for investors to have a good idea on the anticipated rate of return. An investor always has the option of selling the security as a slightly lower price if necessary, but can choose to hold onto the investment until the reset date, then determine whether to sell, or retain the security and go with the conversion.