Updated: Jun 21, 2020
I’m now twelve posts in to my blog, which roughly equates to two articles per week since inception – something that I’m quite proud of. However, it’s come to my attention that a large proportion of my posts have been more niche and advanced than I intended when I first set out creating this blog. The target was always to capture the interest of students, regardless of their level of investment knowledge – to even inspire those with no previous background knowledge to become fascinated with the financial world. Therefore, to keep on track with this target, I’ve decided to create a series of posts under the heading of ‘Investing 101.’ The content and language used may seem fairly basic, but that was always my initial intention – to inspire and educate other students, and to give them an easily accessible insight into the financial world. I hope you enjoy reading, and as always, if you have any questions, comments, or feedback, I’d love to hear them!
What are Securities?
According to Investopedia, the term “security” is a fungible, negotiable financial instrument that holds some type of monetary value. It represents an ownership position in a publicly-traded corporation.” In short, a security is effectively a small part of a company that is sold by an “issuer” to an “investor.”
The following are the three main types of securities:
Have you ever heard of someone buying stock in a company. It could be Facebook, Apple, Tesco, or any publicly-traded company. This means that they have been on the investor end of an equity deal. An equity security represents ownership held by shareholders in an entity (a company, partnership or trust), in the form of shares of capital stock. which includes shares of both common and preferred stock. But, we wont talk about preferred stock just yet!
Holders of equity securities are typically not entitled to regular payments. Nevertheless, equity securities sometimes do pay out dividends (a typically annual sum of money that is paid to shareholders out of a companies’ profits). Regardless, those who invest in equity best profit from capital gains. Capital gains is the assumption that one will purchase shares in a company when the stock price is low, and sell the shares when the price has risen, thus creating capital gains for the investor.
Equity securities provide the shareholder with some control of the company via voting rights. A voting right is the right of shareholders to vote on matters of corporate policy, including decisions on the makeup of the board of directors, issuing securities, initiating corporate actions and making substantial changes in the corporation’s operations.
You may be wondering how an investor obtains an equity security. Well, when a company decides to trade publicly, it has an Initial Public Offering (IPO), where it raises funds by selling equity. But again, IPO’s will be covered in further articles.
2. Debt Capital
Picture this: Just Eat, the food delivery/takeaway company, are launching a campaign to promote their new, improved delivery service. They need to raise money to be able to fund the marketing for this campaign, but don’t want to give away equity (a stake) in their company. So instead, they may offer a corporate bond, a form of debt capital. What this means is that they will sell a ‘bond’ (think of it as an IOU) to an investor. However, Just Eat will have to pay back the amount of this bond, with a pre-agreed amount of interest, on a set date. So, Just Eat can pay for their campaign through raising debt, and without giving away any ownership of the company. Likewise, investors know that they are 100% guaranteed to earn interest on their bond at the end of the bond agreement (the maturity date). So, it is beneficial for both parties.
To give you a better understanding, here is the same example, with figures included:
Just Eat PLC needs to raise £500 million for a new campaign
They offer bonds to investors, with each one costing £10
The maturity/expiry date of the bond is 5 years, and the annual interest rate is 5%
If an investor buys one bond for £10, he will receive that £10 back at the end of 5 years, as well as 5% interest from each year (5% of £10 is 50p, so he will get 50p*5 years’ worth of interest repayment).
Even if Just Eat doesn’t perform well, and its campaign fails, it must return the bond payment, and stick to the prearranged interest rate of 5%.
Thus, in total, a bond of £10 will return £12.50 in total to the investor at the end of 5 years.
This type of security is known as debt capital.
3. Hybrid Securities
Most securities are either debt or equity. However, some securities take on traits of both, or are a fascinating spin on both. These are known as hybrid securities. One example of a hybrid security is preferred shares, mentioned above.
If I invest in Apple, I can buy regular shares in equity. They will give me a dividend, or a payment, maybe once or twice a year, depending on how well the company is doing. However, I could instead invest in preferred shares, which would give me a bigger dividend. Also, the dividend would not change, regardless of Apple’s performance. This is good for investors, as it gives them some sort of certainty about the future of their investments. And, what’s more, I’d receive my dividend before normal (equity) shareholders received their payment. Sounds pretty good right? Well, here’s the downside(s).
Preferred shares don’t come with as high a claim to assets as bonds. I.E. if Apple goes bankrupt, people who bought bonds will be more likely to get their money back than those who invested in preference shares.
The income stream can be suspended by the company if it chooses. Ouch!
Preferred shares tend not to hold any voting rights in firm decisions.
As the dividends from preference shares are fixed, you won’t benefit from any increases in a company’s profits, although you will be protected if a company’s profits fall.
So, now that you know the three main types of securities and what they do, which do you think makes the most sense for investors? I’d love to hear your opinion!
Thanks for reading!