Types of Hybrid Securities

A hybrid security has the characteristics of both debt and equity. The security is first issued in the form of fixed income such as a bond and later converted to common stock when the company's shares have risen in value. A hybrid security has a lower risk than common stock but the potential to achieve higher returns than a pure debt. Hybrid securities have been widely used in corporate financing, benefiting both companies in need of capital and their lenders and investors.

Convertible bonds are the most common type of hybrid securities. Companies issue convertible bonds to attract investors who want the possibility of higher return but not the risk of owning stock at the outset, explains Investopedia. Holders of convertible bonds are allowed to convert each bond for certain shares of common stock when the stock rises in value. Absent such an upside, investors would continue to receive interest payments, plus the protection of invested principal. Offering convertible bonds also benefits the company. Compared with conventional stock offering, convertible bond issuance is quicker and the new capital does not dilute company earnings, according to information about convertible securities from the SEC website. Moreover, companies pay less interest on convertibles than on regular bonds because issuers are allowing bondholders to potentially benefit from a common stock conversion.

Convertible preferred shares are another type of hybrid security. Similar to convertible bonds, convertible preferred shares also retain a lower risk profile but with the potential for higher return when they are converted to common stock for capital appreciation. For the issuing company, not only do preferred shares not dilute existing common shareholders' value, but they are also considered part of the issuer's core capital for accounting purposes. Core capital is also known as tier 1 capital, especially useful when measuring a bank's capital adequacy. Institutional investors may also choose convertible preferred shares over convertible bonds for tax reasons. IRS permits institutions that pay corporate tax to exclude 70 percent of their received dividends from taxable income, whereas interest earned is fully taxable at the higher ordinary income rate.

Mezzanine financing, as the name implies, is a form of financing that functions by way of two other financing methods. It is a financing agreement in which funds are provided in a traditional loan but the lender can assume an ownership if the loan is not paid back on time and in full. Lenders who provide mezzanine financing particularly look for companies that have the potential to expand successfully if equipped with adequate additional capital. When companies need continued financial support, lenders are willing to take greater responsibility. According to information about business development posted on the Department of Commerce website, mezzanine financing is also advantageous to the company because funds borrowed are treated like equity in the balance sheet, making it easier to maintain favorable debt-equity ratios for other standard bank financing.