Investors may notice that wedged between the daily share price and bond market data in most newspapers is a growing list of so-called hybrid securities, or hybrids.

Broadly, a hybrid security is anything that combines the characteristics of debt (fixed interest) and equity (shares).

They are issued by companies as a way of raising money and generally pay a predictable (fixed or floating) rate of return or dividend for a set period, usually until a maturity or conversion date. Investors may then have the option of converting the securities into the underlying share or cash, or resetting for another term. The company issuing the security will determine the specific terms of the conversion.

The most common types of hybrids are income securities and convertible and converting preference shares.

Some issues will be similar to pure debt and others very similar to pure equity but there is a lot in between, says Steve Johnson, head of research at The Intelligent Investor. He says changes to what a company can classify as debt as well as strong investor demand for income-generating securities has led to substantial growth in the sector.

"Hybrids are attractive to many investors because they offer a regular income stream and a bit more security than an ordinary [share]," he says.

That said, they do come with their own risks. The key to these investments is the quality of the asset, which will be reflected by the credit rating and the financial abilities of the company to repay the interest payments as well as the capital on maturity or conversion.

In the event of a company collapse, hybrids rank behind senior debt investors but above equity investors.

Income securities

When it comes to labelling, the marketing departments of many of the companies issuing income securities appear to have had some fun in generating acronyms. Examples are the Santos Ltd FUELS (franked, unsecured, equity-listed securities) and the Ramsay Health Care CARES (Convertible Adjustable Rate Equity Securities).

Few issues will be identical but some of the characteristics will be similar, including: franking (whether the company has paid any of the tax on the dividend); converting or convertible; fixed or floating; resettable; cumulative or non-cumulative, redeemable; secured and a discount on conversion to ordinary shares.

The terms convertible or converting relates to whether an income security becomes another form of stock, usually an ordinary share, at fixed points in time. Often it will be five years after the instrument is issued.

Converting means that at the maturity date (or conversion date), the security will convert into ordinary shares. Convertible means the investor or the company issuing the security has the option of redeeming to cash or converting to shares.

Fixed or floating refers to the interest rate applying to the payments you receive on your investment, similar to your home loan or bank deposits.

A reset feature means the fixed interest rate will be reviewed at the end of a set period (usually every five years) to take account of interest rate movements.

Cumulative refers to what occurs to any payments that are missed if the issuing company is under financial pressure.

If the security is cumulative, any missed payments will have to be paid before ordinary shareholders get a cut. If non-cumulative, any missed payments are gone forever.

Some income securities are secured over specific assets, or sometimes the entire company.

As with any secured loan, the investor is likely to receive a lower payment as a trade-off for the additional security.

Redeemable refers to whether the issuer has a right to buy back or redeem the instrument at a future time at a set price.

"Redeemable is a very important point as often the price that the instrument can be redeemed at is less than the current price," says Johnson.

Risk

No investment is totally without risk. In the case of hybrids, two important considerations are the impact of rising interest rates and default risk. The market price of traded hybrid securities or other debt instruments is sensitive to movements in interest rates as well as other factors dealing with the creditworthiness of the issuer and the underlying equity or share.

When interest rates rise, hybrid securities may see a weaker market price. As fixed rates rise for a particular investment term, the underlying price of the security will fall so that the overall return to an investor is equivalent to the new higher rates in the marketplace.

As we are seeing in the current debate about whether the Reserve Bank will act to rein in inflation, expectations about inflation are a powerful influence on interest rates. Expectations of higher inflation pull interest rates higher and vice versa.

Another important consideration is issuer default. The best measure of default risk is the credit quality of the issuer, where the higher the rating (by agencies such as Standard & Poor's and Moody's) the better. The higher the credit quality of the issuer, the lower the perceived risk of issuer default.

Confidence returns

Recent turmoil in the financial markets has not been lost on the hybrid security sector, with many issues particularly vulnerable to the tight credit markets.

However, with the overseas financial markets showing signs of calm and new offers returning to the market, hybrids may again be on the radar of income focused investors.

John Wong, investment analyst with researcher van Eyk, points to the recent Suncorp preference share offer - with a yield of close to 11 per cent - as an example of restored confidence in the sector.

He expects other banks to start issuing hybrids, such as income securities, which can pay tax effective returns of up to 3 percent above the official cash rate. He says access to franking credits and companies with investment grade credit risk has made many hybrids an attractive option for income investors.

The hype

PROS

- Higher income yields compared with bonds reflecting the higher risk associated with these securities.

- Opportunity to participate in the company through the share conversion option.

- Some downside protection if an option for cash back at issue value is offered.

- Potential tax benefits from franking credits.

CONS

- Ranks behind traditional debt obligations but ranks ahead of equity.

- The issuer's capacity to meet its financial obligations and other balance sheet fundamentals must be a consideration.

- Interest rate movements may affect the value.

- Price movements of the ordinary share may have a positive or negative impact.