What’s it: Securities are tradable certificates or financial assets, which we can buy for regular income or sell later for a profit when the price goes up. They have many variations. Equities and bonds are the most popular examples. While bonds represent debt, equity represents ownership rights in the issuing company. And then, certain securities offer debt and equity features – called hybrid instruments. Convertible bonds are an example.
Holding securities offers several advantages to financial market investors. Capital gains come first. We profit by selling at a price higher than the purchase price. In addition, we have the potential to get dividends when holding company shares. Or, when holding debt securities, we can earn regular income from coupons. Some securities offer diversification while making a profit, as mutual funds offer. Then, derivatives offer us instruments to speculate or hedge our investments.
What are some examples of securities?
Stocks, bonds, and mutual funds are probably the most popular securities. We might almost find them in financial markets all over the world. Meanwhile, other instruments emerged when financial markets developed, such as asset-backed securities, exchange-traded funds, and derivative contracts.
How are they traded? There are two categories. The first is public securities. We can find them widely because they are usually listed on public markets such as stock exchanges. They come from various companies, which must adhere to strict regulations and standards.
The second is private securities. They are only purchased by qualified investors. For example, a startup issues securities in its funding round to raise capital. Unlike those available on exchanges, these securities are sold to investors on a limited basis. Only eligible investors can buy. The securities can be equity, debt, stock options, convertible instruments, or membership interests.
Equity represents ownership rights in a company. So, when we buy it, we become shareholders of the company. So what are the advantages of buying shares?
Buying shares allows us to have voting rights, depending on how significant our holdings are. In addition, we are also entitled to receive dividends. And when stock prices rise, we have the potential to get capital gains.
Equity securities include three categories:
- Common stock
- Preferred stock
Common stock offers us voting rights. Thus, we can participate in corporate decision-making or elect management at shareholder meetings. In addition, we are entitled to receive dividends when the company distributes them.
However, our right to receive dividends is only after preferred shareholders receive them first. Likewise, we have the last priority to claim assets when the company goes bankrupt. Assets will be distributed to other parties, such as creditors and preferred stockholders, before being distributed to common stockholders.
Preferred stock has a higher priority than common stock to receive dividends. Likewise, preferred stockholders have a higher right to claim assets when the company is liquidated. They receive it after creditors, but before it is distributed to common stockholders.
Unlike common stock, preferred stock usually does not carry voting rights. Therefore, when we buy it, we cannot influence the decision-making in the company at the shareholders’ meeting.
Warrants offer the holder the right to buy common stock at a predetermined price or before the expiration date. It is a stock derivative instrument and can be traded and redeemed into shares.
Companies often issue warrants as a bonus when issuing new shares to attract investors. Or they publish it to raise capital for a new project. Because the price has been set, when the company’s stock price exceeds the strike price, we can buy shares below the market price.
As the name suggests, fixed-income securities offer us regular cash inflows. Bonds are an example. Bond issuers pay coupons regularly, usually twice a year. In addition to coupons, we also have the potential to obtain capital gains when selling them at a higher price than when purchased.
However, in specific cases, bonds may not offer coupons. An example is a zero-coupon bond. When you buy it, you only get income from capital gains. So why is it attractive compared to conventional bonds? Issuers will usually sell zero-coupon bonds at a discount to attract investors.
Fixed-income securities types
Debt securities are the most popular example of fixed-income securities. Debt securities have several variations, such as bonds, notes, and bills, which all three differ because they have different maturities. Bonds mature for more than 10 years. Meanwhile, notes mature in 10 years or less. Bills have the shortest tenor and maturity of less than one year.
Unlike stocks, debt securities do not represent ownership in the company. Rather, they represent obligations. The issuer will pay off the debt at maturity and regularly pay the coupon.
Who issues debt securities? The company is one of them. They issue it to raise funds, usually to finance capital investments. Issuing debt securities is usually cheaper than borrowing from a bank. Companies can take on long-maturity debt, which may not be provided through bank loans since it carries high risk.
In addition to companies, the government may also issue them. For example, you may have heard of sovereign bonds and municipal bonds. The former are issued by the national government, while the latter is issued by the local government.
Compared to corporate bonds, government bonds are considered less risky. For this reason, investors often use them as a benchmark to determine the corporate bonds’ fair price by adding a premium.
In addition to the debt securities above, other fixed income securities are:
- Certificate of deposit (CD)
- Commercial paper
- Repurchase agreement (repo)
Certificates of deposit (CD) represent savings accounts. The issuer sells it to investors to raise a certain amount for a certain period. And when we redeem the CD, we will get the money we invested plus interest.
Commercial paper is a debt instrument and usually matures in less than one year. Companies usually issue them for short-term funding, such as working capital.
Meanwhile, a repo is a short-term instrument with a promise to buy it back at a higher price. It is similar to a loan secured by securities and is common for transactions involving government securities dealers. For example, a dealer sells government securities to a counterparty overnight and will buy them back the next day at a slightly higher price.
Then, there are convertible bonds. It is a bond issued by a company but has a conversion feature into common stock. When the issuing company executes it, each convertible bondholder is entitled to receive a certain number of common shares. So, after the conversion, they become shareholders. When was it converted? It can be done any time as long as it is not due.
Unlike stocks and bonds, pooled investment vehicles collect funds from investors and use them to purchase the underlying asset. Take mutual funds as an example. Investment managers mix portfolios and sell them as mutual funds. Their portfolio may contain stocks, bonds, or other instruments, according to the investment objectives stated in the prospectus.
They then sell the mutual fund shares to investors. The bigger the investor buys, the bigger the fund managed under the mutual fund. In addition, the money under management also gets bigger as the underlying assets continue to rise in price.
Buying mutual funds offers investors several advantages. And diversification is its biggest advantage. Take a stock mutual fund as an example. They contain stock investments in several companies. So, when we buy a mutual fund, we are essentially buying a portfolio, not individual stocks.
Exchange-traded funds (ETFs) are another example of pooled investment. It is similar to mutual funds. Only, it is traded on an exchange, much like a stock. In addition, there are hedge funds, Real Estate Investment Trusts (REITs), and Unit Investment Trusts as examples of pooled investments.
Then, there are asset-backed securities (ABS), which are collateralized by the underlying asset pool. For example, issuers pool assets such as receivables, student loans, and mortgages and package them into securities – securitization. Mortgage-backed securities (MBS) are an example where it uses a mortgage as the underlying asset.
Financial derivatives are another example of securities. Generally, they are purchased for speculative purposes or to hedge investments.
These securities derive their value from the prices of underlying assets such as stocks, bonds, commodities, or currencies. Thus, financial derivatives will also move along when the underlying asset fluctuates in price.
Collateralized debt obligations (CDOs) and credit default swaps are examples of financial derivatives. Other examples are forwards, futures, mortgage-backed securities (MBS), and options.
Generally, derivatives are traded over the counter. However, some may also be traded on exchanges. In addition, derivative contracts may be settled in cash. Or some may require physical delivery, such as commodities.