Overcoming hybrid insecurities

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Jemima Joseph is a financial writer at Dimensional Fund Advisors.

A focus on investing for income has led some investors to turn to hybrids, financial instruments that combine the characteristics of both debt and equity capital.

While these instruments present an alternative source of income, typically offering returns above cash, they also come with additional risks, structural complexities, and in many cases, exceptionally long-dated contractual maturities.

As such, hybrids require careful analysis to determine whether the return provided is sufficient compensation for the risks investors bear.

This brief paper provides a broad overview of hybrid securities with a specific focus on the riskiness of these complex financial instruments.

Firstly, back to basics

A hybrid security is a financial instrument that combines characteristics of both debt and equity capital. For companies that issue them, hybrids are another way to raise the capital required to fund their businesses.

Typically, the debt characteristics of hybrids relate to the issuer committing to pay a pre-determined interest rate. The equity characteristics relate to the fact that many hybrids have a very long or perpetual maturity and the interest payments can stop without the issuer defaulting.

Hybrids come in many forms, but common examples include:

- Perpetual income securities: These have no maturity date and coupon payments are paid out indefinitely. However, payments can be ceased or deferred at the discretion of the issuer. These securities are redeemable only at the issuer's discretion; and

- Perpetual step-up securities: These are similar to perpetual income securities, with the exception that the coupon payment increases (steps up) if the issuer does not redeem the security on a certain date. The rationale behind the increased interest rate is to compensate investors for non-payment.