Accounting for corporate finance: hybrid debt: what is hybrid debt?
What is hybrid debt?
In the context of this guidance, the term ‘hybrid debt’ means debt instruments which have features of both debt and equity. An example is non-voting, fixed rate convertible preference shares. The holders of these shares get a return which is indistinguishable from debt, but the convertible element allows the instrument holder to subscribe for equity shares. Another example is subordinated debt which gives the holders a higher reward but which will be repaid after other types of debt, perhaps ranking only above ordinary shares.
The two main types of hybrid instruments are asset-linked securities and debt which is convertible into the equity of a company. Where the conversion right relates to the equity of the issuing company the debt is termed ‘convertible’. If the right relates to the equity of another company, usually a subsidiary of the issuing company, it is termed ‘exchangeable’.
Asset-linked securities are those linked to the performance of some underlying asset.
The advantage of a hybrid instrument is that it can allow a lender to participate in the success of a growing entity, while having more protection than ordinary shareholders if things go wrong. For the borrower, the right to convert may be given in exchange for a lower interest rate, which could help a developing business, and there will be less risk of the lender taking a short-term view. But in the case of convertibles, the existing equity of the business will be diluted if the conversion takes place.