A hybrid security is a single financial security that combines two or more different financial instruments. Following the budget 2023, hybrid instruments held for longer than a year are now more tax advantageous than debt funds because they are subject to a 20% tax rate and may even be eligible for an indexation benefit. Contrarily, the sale of debt mutual funds is subject to a slab rate of taxation that can reach 30%. Hence, here’s how can you lower your higher tax liability by investing in hybrid funds based on a discussion with multiple industry experts.
Hybrid securities, often referred to as “hybrids,” generally combine both debt and equity characteristics. The instruments in this category fall into several capital instruments, which combine certain characteristics of equity and certain characteristics of debt. Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the holder has several options, including converting the securities into the underlying share. The most common type of hybrid security is a convertible bond that has the features of an ordinary bond but is heavily influenced by the price movements of the stock into which it is convertible. Other common examples include convertible and converting preference shares. Each has a particular feature, which can be considered to affect its quality as capital. Where these instruments have close similarities to equity, in particular when they can support losses on an ongoing basis without triggering liquidation, they may be included in Tier II capital.
Following are some of the popular Hybrid Securities:
Convertible Bonds: A convertible bond is a bond issued with the option to be converted into shares. Typically, these securities have a set interest payment until the conversion. The convertible security holder determines if and when to convert the bond to equity based on that company’s common stock price. In other cases, the company retains the right to determine when the conversion occurs. Convertible bonds are popular especially when there is a volatile equity market.
Preferred stock/Preference Shares: Preference shares of company stock with dividends that are paid out to shareholders before common stock dividends are issued. Preferred stock gives the investor a higher dividend than the company’s common stock (closer to the rate of the company’s bonds) and places the investor before the common shareholder in bankruptcy. However, owning preferred stock typically does not give the holder voting rights in the company. In addition, preferred stock can be callable, giving the company the option to repurchase the shares back from the preferred shareholder. If the company enters bankruptcy, preferred shareholders are entitled to be paid from company assets before common shareholders.
REITs and InvITs are classified as hybrid securities and they are relatively new investment instruments in the Indian context but are extremely popular in global markets. A REIT comprises a portfolio of commercial real assets, a major portion of which is already leased out, InvITs comprise a portfolio of infrastructure assets, such as highways and power transmission assets.
Real estate investment trusts (“REITs”) allow individuals to invest in large-scale, income-producing real estate. A REIT is a company that owns and typically operates income-producing real estate or related assets. These may include office buildings, shopping malls, apartments, hotels, resorts, self-storage facilities, warehouses, and mortgages or loans. Unlike other real estate companies, a REIT does not develop real estate properties to resell them. Instead, a REIT buys and develops properties primarily to operate them as part of its investment portfolio.
An Infrastructure Investment Trust (InvITs) is like a mutual fund, which enables direct investment of small amounts of money from possible individual/institutional investors in infrastructure projects. Also, as the fund managers manage mutual funds, InvITs are managed by the designated managers.
Hybrid Mutual Funds: To provide investors with a diverse portfolio, hybrid mutual funds are a form of investment vehicle that typically invests in a blend of stocks, bonds, and other assets. Securities like mutual funds that have debt or equity proportions exceeding 35% but below 65% are considered hybrid securities.
Key risk factors:
Hybrid debt instruments are considered as ‘subordinate debt’. In the event of bankruptcy or liquidation of the debtor, subordinated debt can only be paid if any assets are left after the claims of secured creditors have been met. The other two important risk factors are Credit Risk and Interest Risk. These risks are quite small as the paper of hybrid issuers is normally rated Investment Grade, their rating is not very volatile.
Originally posted on November 7, 2018, updated and reposted on 03.12.2023