What is a Hybrid Security?

A hybrid security is one that combines elements of the two main types of security: equity and debt. The best-known examples include a convertible bond and a preference share. By design, a hybrid security combines the advantages of both equity and debt securities. Some argue that it is a form of compromise and thus includes drawbacks from both types as well.

A security is a financial product which can be traded and ultimately exchanged for money, with securities usually classified as either debt-based or equity-based. A debt security is set up so that it will eventually be returned to the issuer in return for cash. The most common debt security is a bond. An equity security gives the holder part-ownership in a company but is not usually returned to the issuer for cash. The most common equity security is stock in a company.

The hybrid security will straddle these two categories. This could mean, for example, that a holder owns some part of the issuing company but can still cash in the security at a later date. This arguably makes the security more desirable.

One example of a hybrid security is a convertible bond. Essentially, this is a traditional bond, meaning that a company issues it to a buyer and promises to repay the purchase price plus interest to whomever holds the bond on a set date. Unlike a traditional bond, the convertible bond allows the holder to exchange it for company stock at an agreed price at any time. Doing so will mean the holder does not receive the cash payment on the bond's originally scheduled expiration date. A convertible bond is particularly desirable as it combines the guarantee of a future payment, as long as the issuing company stays in business, with the option to take advantage if it appears a company's stock price is likely to increase.

Another type of hybrid security is the preference share. This is a form of company stock in which the value will be repaid if the company is liquidated, with this payment made in full before the administrators begin dividing up the remaining assets among other stockholders and creditors. In most cases a preference share will be guaranteed to get any dividend payments ahead of those issued for common stock. This means that the preference share is legally classed as an equity security, giving part ownership of the company, but retains the possibility of getting the face value back in cash as with a debt security.