Debt And Equity: What Securities Can You Invest In?

Securities are financial instruments that represent ownership or debt owed by an entity. The two main types of securities are debt securities and equity securities. Debt securities are loans made to an entity, such as corporate or government bonds, where the borrower is legally required to make interest payments to the lender. Equity securities, on the other hand, represent ownership interests in a company, such as stocks or shares of a mutual fund. When an individual buys a stock, they become a partial owner of the company and can profit through dividends and capital gains. Understanding the difference between these two types of securities is crucial for investors when making informed investment decisions based on their financial goals and risk tolerance.

Debt securities

The most common example of a debt security is a bond, which can be issued by governments or corporations. These securities are purchased by investors and pay out a stream of income in the form of interest payments. At the bond's maturity, the issuer buys back the bond from the investor.

Other examples of debt securities include:

• Certificates of deposit (CDs)
• Collateralized securities, such as collateralized debt obligations (CDOs) and collateralized mortgage obligations (CMOs)
• Municipal bonds
• Preferred stock
• Mortgage-backed securities (MBSs)
• Zero-coupon securities

Equity securities

If you own an equity security, your shares represent part ownership of the issuing company. In other words, you have a claim on a percentage of the issuing company's earnings and assets. For example, if you own 1% of the total shares issued by a company, your ownership piece of the controlling company is equivalent to 1%.

Other assets, such as mutual funds or exchange-traded funds (ETFs), may be considered equity securities as long as their holdings are composed of pooled equity securities.

The main types of equity securities are common stocks, preferred stocks, and convertible securities. Common stocks offer voting rights and profit sharing. Preferred stocks provide fixed dividends and priority in liquidation. Convertible securities can be exchanged for a predetermined number of common shares.

The main advantages of equity securities are the potential for high returns, dividend income, and voting rights. The disadvantages include higher risk due to market volatility, no guaranteed returns, and dilution of ownership when new shares are issued. They balance reward potential with risk exposure.

Mutual funds

The two main types of mutual funds are equity and debt mutual funds. Equity mutual funds invest in shares, bonds, and other securities, while debt mutual funds primarily invest in debt securities such as government and corporate debt. Equity funds tend to be more volatile than debt funds, but they offer higher returns because of the higher risk involved in equity investments.

Equity mutual funds are the most common type of mutual fund in India and are also known as open-ended equity funds. They provide investors with an opportunity to invest in listed and unlisted companies, allowing them to buy or sell equity shares at any time. The returns on these funds depend on the performance of the underlying stock market indices, as well as other factors like government policies and regulations. Equity funds usually invest in large, mature companies with high market capitalisation, making them suitable for long-term investors.

On the other hand, debt funds are highly recommended for investors with lower risk tolerance. They are also a good option for short-term investors (3-12 months) who want to earn higher returns than regular savings accounts, and for medium-term investors (3-5 years) who are looking for low-risk investments. Debt funds often have higher expenses than equity funds due to their diversification and periodic risk management requirements.

Before investing in mutual funds, there are a few factors to consider, such as the size of the fund, the expense ratio, and the risk-reward ratio. The expense ratio is particularly important as higher fees can make it difficult to make a profit. The risk-reward ratio will determine the performance of the fund over time, with high-risk investments potentially losing money and offering little to no returns.

In summary, mutual funds are a popular investment vehicle that offers diversification, higher returns than individual stocks, and the opportunity to invest in both equity and debt securities. They are suitable for investors with different risk tolerances, investment horizons, and financial goals.

ETFs

Exchange-traded funds (ETFs) are investment funds that are traded on stock exchanges. ETFs are similar to mutual funds in many ways, except that ETFs are bought and sold from other owners throughout the day on stock exchanges, whereas mutual funds are bought and sold from the issuer based on their price at the end of the day. ETFs are also more transparent than mutual funds since their holdings are generally published online daily. ETFs are subject to securities laws such as the Investment Company Act of 1940 and the Securities Exchange Act of 1934 in the United States.

The largest ETFs, which passively track stock market indices, have annual expense ratios as low as 0.03% of the amount invested, although specialty ETFs can have annual fees of 1% or more of the amount invested. In the United States, there is $5.4 trillion invested in equity ETFs and $1.4 trillion invested in fixed-income ETFs. ETFs can be actively or passively managed. Actively managed ETFs include active management, whereby the manager executes a specific trading strategy instead of replicating the performance of a stock market index.

Options, including put options and call options, can be written or purchased on most ETFs – which is not possible with mutual funds, allowing investors to implement strategies such as covered calls on ETFs. There are also several ETFs that implement covered call strategies within the funds.

Bonds

Corporate bonds are another type of bond issued by companies to raise capital for various projects or ventures. These can be high-yield or investment-grade, depending on the credit quality and default risk of the issuing company. High-yield corporate bonds, also known as junk bonds, carry a higher risk of default but offer higher interest rates.

It is important to note that bonds can be sold before their maturity date in the secondary market, but this may result in a loss if interest rates are higher at the time of sale. Overall, bonds provide investors with regular and predictable income, making them a solid investment option for those seeking stability.

Frequently asked questions