Do Hybrid Securities Belong in Your Portfolio?

Hybrids are surging in popularity these days, but the attraction has nothing to do with high gas prices. Hybrid securities, not hybrid cars, are what we're talking about. It's worth noting that the reasons for the spike have everything to do with what's good for the offering institutions and little to do with what's good for individual investors. But hybrids have legitimate uses for savvy investors.

Hybrid investments are part equity and part debt, and can take many forms. The most common type is a bond that can be converted into stock, known as a convertible bond. Hybrids are an increasingly cheap way for companies to raise money. Changes by the Federal Reserve and the credit rating services last year gave companies new incentives, allowing them to count hybrids differently for regulatory and credit-rating purposes. So corporate America rushed to make 2006 the year of the hybrid.

In the broadest possible sense, hybrids act like bonds but carry some of the upside (and downside) potential of stocks. They generally kick off an income stream and will have a very long or even perpetual maturity. In the case of convertible bonds, a hybrid will carry a conversion feature allowing the bond to turn into shares of stock at a predetermined price--40 shares of stock, for example, for each $1,000 in bonds. That means that the value of the convertible will rise along with the company's stock, even if it won't be dollar-for-dollar.

Content Continues Below

In any case, there are some significant caveats. Hybrids are riskier than traditional bonds, for one thing, because they rate lower in the case of bankruptcy. They also tend to be callable, meaning your upside potential will be limited. If the stock price rises too high, the convertible will probably get pulled out from under you. Even so, because of the equity upside, you'll probably have to settle for lower interest rates than on traditional debt investments.

Brokers will be working the phones this year to sell more hybrids, so think hard before you take the bait. These should never make up too large a percentage of your portfolio, because the cumulative effect of stock prices, interest rates, and conversion and call features makes it difficult to pin down a value. Buyer certainly beware.