A hybrid is anything that is made by combining two or more things. The idea is simple: Take two financial products and smush them together into a single product. Some work more effectively together than others; sometimes the traits of each component of the hybrid function separately, not really creating any benefit other than having two financial products rather than one.
The more successful hybrids are those where the traits of each component complement each other in some way.
The mixed-interest class of hybrids
Whether you’re talking about investments (for example, bonds, money markets, annuities, or any other income-generating investment) or loans (such as mortgages, business loans, credit cards, and so on), these mixed-interest hybrids combine aspects of both fixed-rate and variable-rate financial products.
A mixed-rate bond, for example, guarantees a minimum rate of return that also matches interest rates if they go over a certain level, giving you the best of both a variable- and fixed-rate bond. A typical mixed-rate bond may include a minimum guaranteed fixed 3 percent interest rate with the potential to increase above 3 percent if interest rates rise above that level.
This sort of hybrid interest rate is partially pegged to some other indicator, such as interest rates or some index.
Another type of mixed-rate is time-dependent. Many mixed-rate mortgages include something called teaser rates, wherein the interest on a mortgage remains fixed for a period of time before switching to a variable rate. These types of mortgages have come under fire recently as a form of bait-and-switch, hidden in a mountain of legal and financial jargon.
They can be quite beneficial under the right circumstances, but the reality is that these circumstances can be extremely difficult for even professionals to predict, much less someone who’s less versed in financial modeling and forecasting.
For example, a circumstance wherein one expects interest rates to fall in the future would benefit someone considering a time-dependent mixed-rate loan. Still, a market exists for these types of loans, even if it’s smaller than many lenders would like to believe.
Single asset class hybrids
In addition to hybrids that mix fixed- and variable-rate investments and loans, there are hybrids that combine different types of a single asset class.
Convertible bonds, for example, are bonds that have the option to be converted into a fixed number or value of shares of common stock. Convertible preferred shares of stock also have the option to be converted into a fixed number or value of shares of common stock per share of stock.
This form of hybrid doesn’t provide the same sort of simultaneous benefits of each component as other forms of hybrids do, but the option to choose which traits you have available to you in your investing is still a valuable benefit for strategic and portfolio investing.
Furthermore, a number of hybrids combine completely different types of asset classes. Packaging different types of investments together with options, either call or put, is a particularly popular option. In cases of equity, debt, and even money market investments, hybrid investments are now available that include, by default, put options that allow you to sell your investment at a given rate or price.
Contracts are available to purchase an asset with a call option to purchase more on or before a certain date at a given price. These vehicles can be particularly useful for people managing strategic investment portfolios, which often supplement with risk-hedging strategies. They’re also quite handy as stand-alone investments for corporations that are more risk averse than the underlying investment alone can accommodate.
One hybrid investment utilizes several of the previous hybrids discussed to create something of a chimera; something that has been combined with so many different things that it barely resembles its original form anymore. This is called the index-backed CD with a put-option hybrid.
To create this monstrosity, you start with a standard certificate of deposit, which is a timed deposit that works similar to a savings account, except that it includes an obligation to maintain the principal balance for a minimum period of time.
Now, combine that with a variable-rate security that’s pegged to an equity index, so that the interest rate floats with the index. Now, tack on a put option that allows the investor to sell her stake in the CD for a set return that’s usually based on the present value.
This particular investment shows that the development of new forms of hybrid financial tools is just beginning, and that brand new types of transactions that no longer resemble anything known today may easily evolve from these innovations. Like securitization, this trend in financial engineering is only just beginning.