Introducing… Hybrid securities

Most people understand debt and equity. A debt is when you owe money; equity is when your asset has increased in value and is now worth more than you paid for it. But what about investment instruments that have the characteristics of both? Introducing hybrid securities…

Hybrid securities: a double-edged investment

A hybrid security, also called hybrid instrument, is a security that has characteristics of both debt and equity, so it cannot be regarded as pure debt or pure equity. Examples of hybrid securities include preference shares and convertible bonds. Although preference shares are legally shares, they provide a fixed return like bonds do. Similarly, convertible debt is debt until converted.

In the sophisticated world of investing, once you go beyond simply buying a stake in a managed fund or a parcel of blue-chip shares a whole new – rather complex – world opens up.

Professional investors or their brokers may consider the following when looking to use hybrid securities:

• Ways of increasing available capital without overly diluting existing equity. An example is the issue of hybrids that qualify as tier one capital according to the criteria for a bank's capital adequacy, but do not share in profits as ordinary shares do.
• Ways to give investors a wider choice of risk, return and tax treatment combinations. The issue of multiple classes of securities by split capital investments trusts that issue multiple classes of shares is one example of how this can be done.

These include income shares, that receive the dividends paid by the trusts' investments, and there may be more than one class of income share with different characteristics; capital shares which do not receive any dividend, but which eventually receive all the capital gains made after paying off any debt and preference shares.

Some funds may have more than one class of share of each type: for example, a higher risk type of "geared" or "ordinary" income share, or "annuity" shares that have a high yield but pay back less when the trust is wound up than the price at which the shares were issued.

What is a spilt capital trust?

The advantages of a split capital trust are:

• Greater returns for investors as the capital value increases, and a choice of capital gain or income depending on their tax situation.
• Income investors get the highest possible income, because they get the dividends paid on a greater amount of capital (the investment made by the holders of capital shares as well as their own) than a non-split income trust would have.
• Growth investors looking for long term capital gains get greater capital gains as they benefit from the capital gains on the capital invested by the holders of income shares as well as their own.
• The other classes of shares provide variants on the above with different balances of risk and return: for example if there are both ordinary income shares and preference income shares, the holders of the latter get a lower return at a lower risk.

Spilt capital: best of both worlds or neither?

A split capital trust has should not be expected to produce better returns for any type of investor, because it has to compromise between the growth investing strategy that would suit the holders of capital shares, the income investing strategy that would suit the holders of the income shares and the conservative strategy that would suit holders of zeros.

The added complexity of how returns are distributed can make it harder for investors to assess how much risk they are exposed to than would be the case with a more straightforward fund.