Investing in hybrids 

A convertible debt security is one that gives either the investor or the issuer the option to convert it into another type of security at a specified date in the future. Often this will be ordinary shares in the issuer. Convertible securities have contained within them an embedded option. This embedded option has value, which from the holder’s point of view, may be positive (where the option is exercisable by the holder) or negative (where the option is exercisable by the issuer).

Securities that are convertible by the holder can be attractive to investors as they typically offer downside risk protection while having a potential ‘equity-kicker’ on the upside. They can be attractive to issuers as they can usually be issued at a lower interest rate than a standard bond due to the value of that potential equity-kicker. This makes them less costly for the issuer to service. These bonds also allow the issuer to raise capital without having to immediately add a large number of shares to their pool of ordinary shares. If the company issues shares rather than convertible notes the sudden addition of more new shares would result in a dilution of its equity. This can be unsettling for existing investors.

Some convertible and converting bonds contain anti-dilution provisions which protect the value of the right of conversion for the investor. If the security does not contain an anti-dilution provision, the value of the right of conversion may be materially affected, presenting a risk for investors.

Unlike ordinary shares, which pay a variable dividend rate as determined by the company, preference shares usually carry a specified dividend rate. It may be a fixed rate or a floating rate. They also usually carry a right to be redeemed for cash at maturity, much like a bond. It is these features that can make them hybrid securities as they may be equity securities that pay debt-like returns.

A preference share is given that name because holders of a preference share rank ahead of holders of ordinary shares for the payment of dividends and recovery of capital. That is, holders of preference shares typically have priority over dividend payments to ordinary shareholders and are entitled to a payment of the face value of the preference shares ahead of any distribution of surplus assets to ordinary shareholders in a winding up. The holders of preference shares generally do not have voting rights except in certain limited and exceptional circumstances.

Capital notes are debt securities that have equity-like features. Examples include:

Perpetual debt securities - with no fixed maturity date. They are generally regarded as hybrid securities because they are a debt security with equity-like features (like a share, they don’t mature).

Subordinated debt securities - whose rights with respect to payment of interest and repayment of principal are subordinated to another class or classes of debt. The subordination may be in favour of the holders of senior debt or to ordinary creditors generally. They are generally regarded as hybrid securities because they are a debt security with equity-like features (like a share, they rank behind certain debts in a winding up).

Knock-out debt securities - give the issuer or a third party (such as a prudential regulator like APRA) a right to extinguish them under certain conditions. They are typically issued by banks or other prudentially-regulated companies and have terms and conditions attached so that they are treated like capital, or given a particular risk weighting, by prudential regulators. They are generally regarded as hybrid securities because they are a debt security with equity-like features (in certain circumstances, like a share, they have no right to a return of capital).