Characteristics of hybrid securities: convertibles, warrants, and preferred stock

Hybrid Securities

In basic terms, hybrid securities have features that easily distinguish them from other kinds of securities. In their most basic form, they have characteristics of both equity and debt. For this reason, they cannot be classified as either debt or equity. The three hybrid securities I concern myself with below are convertibles, warrants, and preferred stock.

Preferred Stock

In the words of Carey and Essayyad (2001), "preferred stock is a security which pays fixed dividends" (p.89). When seeking to raise capital for growth or expansion, companies can issue two kinds of stock, i.e. common and preferred stock. As is the case with common stock, investors who buy preferred stock provide the company with money in exchange for the corporation's shares. For this reason, preferred stock can be likened to equity. It is however important to note that preferred stock could in some instances be likened to bonds. This is particularly the case given that they pay a regular dividend. Unlike common stock which does not guarantee investors a regular stream of income, preferred stock could be seen as a fixed income-security. In the event of liquidation, preferred stockholders have a claim on the assets of an entity before common stockholders (but after holders of corporate bonds) and for this reason, many view preferred stock as being safer than common stock (Carey and Essayyad, 2001). Companies could use preferred stock as a way of regulating control of the business. This is particularly the case given that holders of this kind of stock lack voting rights.

Convertibles

In basic terms, convertible securities according to Carey and Essayyad (2001) offer those who invest in them a number of fixed-income security advantages while at the same time offering the said investors an opportunity to benefit from changes in stock price. Convertible bonds - yet another hybrid security that has features similar to those of an ordinary bond -remain the most popular convertible securities. Another equally popular convertible is convertible preferred stock. With regard to convertible preferred stock, holders of the said stocks can elect to convert them into common stock. When it comes to convertible bonds, investors have the option of cashing out on maturity or converting the said bond to company stock. In addition to owning a piece of the company, stockholders also regularly share the earnings of a company. They are therefore seen as having an equity interest in an entity. By virtue of lending money to the company, bondholders are usually paid a certain amount of interest until the maturity date of the said bond. For this reason, bonds largely represent debt. With that said, holders of convertible bonds (unlike holders of traditional bonds) have an option of being paid in cash on maturity or taking up company shares. Companies could use convertibles as a way of deferring common stock dilution.