Legal Definitions - hybrid security

A hybrid security is a type of financial instrument that combines characteristics of two or more different traditional securities, most commonly blending features of both debt (like bonds) and equity (like stocks).

Instead of being purely a loan that must be repaid with interest, or purely an ownership share in a company, a hybrid security offers a mix of benefits and risks associated with both. This structure allows companies to raise capital in ways that can be more flexible or appealing to a broader range of investors.

• Example 1: Convertible Bonds

  Imagine a technology company issues bonds to raise money for a new product launch. These aren't just regular bonds; they are convertible bonds. This means that while they function like traditional bonds by paying regular interest to the bondholder and promising to return the principal amount at maturity (a debt feature), the bondholder also has the option to convert these bonds into a fixed number of the company's common shares at a predetermined price (an equity feature). If the company's stock price rises significantly, the bondholder can convert their bonds into shares and potentially profit from the stock's appreciation, much like a shareholder. This blend of guaranteed interest payments (debt) and the potential for capital gains from stock ownership (equity) makes convertible bonds a classic example of a hybrid security.

• Example 2: Preferred Stock

  Consider a large manufacturing corporation that issues preferred stock. Unlike common stock, which typically grants voting rights and fluctuating dividends based on company performance, preferred stock usually does not come with voting rights. However, it often pays a fixed dividend amount, similar to the interest payments on a bond (a debt-like feature). Furthermore, if the company were to go out of business, preferred stockholders would be paid back their investment before common stockholders, but after bondholders (another debt-like priority). While it represents an ownership stake in the company (an equity feature), its fixed dividend payments and priority in liquidation give it characteristics often associated with debt instruments, thus classifying it as a hybrid security.