Stocks, Bonds, and Mutual Funds

What are Stocks, Bonds, and Mutual Funds?

Stocks represent ownership in a company, offering the potential for capital appreciation and dividends. Bonds are debt securities issued by governments or corporations, providing fixed interest payments.

Mutual funds pool investments from multiple investors to buy a diversified portfolio that professionals manage.

In brief,

• Stocks represent ownership in a company and can potentially yield capital gains
• Bonds are debt securities issued by entities, offering fixed interest payments and return of principal
• Mutual funds pool investors' money to invest in diversified portfolios of stocks, bonds, or other assets managed by professionals, providing diversification and convenience

People invest in various assets depending on their goals and risk profiles in the hopes of better future returns. Historically, people have often invested in tangible assets such as real estate and gold.

Let us have a look at these instruments in the section below.

What is a Stock?

A stock, also known as equity, is a token representing a fraction of a company.

Suppose a company is worth $ 1 million and has 100 shares; then each stock will represent 1/100th ownership of the company and will be worth

$1,000,000/ 100 = $10,000

Many companies are publicly traded on exchanges; this is where equity in companies can be bought and sold.

These markets are called equity markets. Common stockholders participate in bid-and-ask pricing when buying or selling stocks on exchanges. The other levels of membership are for brokers and market makers.

These markets involve brokers facilitating trades between buyers and sellers and dealers who may buy or sell shares to maintain market liquidity.

What is a Bond?

These are fixed-income financial assets. Each bond represents a specific loan given to the issuer.

Companies use bonds to raise funds for their operational expenses. Once a company issues bonds, they are made available for purchase by investors through the primary market.

The capital raised funds the issuing company's activities, and investors receive a fixed income in return.

Bonds can have fixed, variable, or hybrid interest rates, with the specific rate determined by factors such as prevailing market conditions and the issuer's creditworthiness. They are traded on fixed-income markets. 

What Are Mutual Funds?

Mutual funds are a pool of diverse shares and other securities. The mutual fund collects money from the investors(or clients) and invests that pool of money in various securities.

The profits or losses from mutual funds are distributed among participants based on the proportion of their investment in the fund.

 Investors often seek various investment vehicles based on factors such as exposure, return expectations, and risk tolerance. Each financial instrument has different types/strategies to meet those needs. Investors aim for the best risk-adjusted returns.

Let us look at these financial instruments in detail.

Types of Stocks

Each type represents unique investment opportunities and risks tailored to different investment goals, time horizons, and risk tolerances.

Let us have a look at different types of stocks.

1. Common Stock

They are the most commonly publicly traded financial instruments. They give the right to vote during the board meetings. Each stock is equivalent to one vote. The gains from these shares are majorly dependent on the increase in company valuation. 

However, dividends for common stocks are not guaranteed and can vary in frequency and amount. Therefore, some of them can also be non-voting. 

2. Preferred Stock

Many companies issue preferred stocks alongside common stocks. These shares can be traded like common ones and provide guaranteed dividends. Preferred stockholders receive higher dividends than common stockholders. 

They have a higher priority in compensation than common stockholders but lower than the company's bondholders in case of bankruptcy or solvency. 

3. Class A stock and Class B stock

Some companies issue shares of different classes, which aims to retain decision-making power with the key investors. 

For example, in 2004, Google was planning to go public. However, Larry Page and Sergey Brin were a little skeptical as the public was new to this technology, and giving them decision-making powers could prove fatal for the company. 

Hence, Warren Buffet advised using these shares, where the voting power of Class B shares is 1/10 that of Class A shares. Therefore, though Larry Page and Sergey Bin own about 11.4 % of Google, their votes account for more than 51 %. 

Types of Bonds

They provide investors various options based on their financial objectives, risk tolerance, and desired maturity terms.

Let us have a look at its different types:

1. Municipal

Municipal bonds are also known as munis and are issued by the local government. Municipal bonds are of two types - general obligation and revenue.

• General obligation bonds allow local governments to use taxpayers' money or other resources to repay the due loans
• In the case of revenue ones, the government can repay loans only from the revenue generated from the concerned project

As we can see, revenue securities carry a higher risk than general obligations because of the narrower revenue stream available for loan repayment. Hence, they have higher interest rates.

2. Corporate

Corporate bonds are financial instruments used to fund corporations or businesses. They account for a tiny percentage of the bond market. They have low liquidity compared to government/municipal securities.

Corporate bonds can further be divided into six types:

1. Senior secured: A senior secured bond is debt security(please note it is a security, not a loan). These are backed by securities such as gold loans, automobile loans, etc. They are the first ones to be paid in case the corporation defaults
2. Debentures: Corporations issue these for long-term activities, and they are a form of secured financial instrument. Therefore, in case of default, investors won't be able to claim any company assets. Due to the uncertainty linked with these instruments, debentures have a high-interest rate
3. Subordinated debenture: Subordinated debentures are also known as subordinated debt. They are unsecured financial instruments. The subordinate term indicates that they are lower or junior debt forms. They are even riskier than debt and hence have a higher interest rate. They are the last ones to be paid in case of bankruptcy
4. Income: Similar to revenue securities, these are paid from the company's revenue. They follow variable interest rates, the value of which is based on a project's income. Interest can be cumulative, which indicates that if the firm cannot pay the loan in a particular period, the payment will be added to the next cycle and is not a default. These unpaid interests are classified as interest in arrears
5. Convertible: As the name suggests, these can be converted into company shares or equity. But, again, these numbers of shares are pre-determined. They offer lower interest rates because, with the safety of fixed interest, the bond can be converted into a common stock
6. Debentures with warrants: Warrants are like options to convert a bond into equity after a specified period (European style). Debentures with warrants have a fixed number of warrants attached to them.

Let's take a look at the International bonds. These can be classified into:

1. Eurobond: A Eurobond is issued in a country in a currency denomination from another country. A suffix is added based on the currency denomination where they are issued. For the US, these are called Eurodollar bonds
2. Yankee: They are issued in US dollar denomination in the USA by a company from another country. Yankee is for the US; Samurai is for Japan, and Bulldogs are from the United Kingdom
3. International domestic: These are domestic bonds with international investors

Types of Mutual Funds

Mutual funds are the easiest way to create diversified portfolios. There are various types of mutual funds, each catering to different investor needs. Let us look at the different types of funds and who and how they cater to investor needs.

Types of investment funds are:

1. Money market funds
2. Bond funds
3. Common stock funds
4. Balanced funds

Types of mutual funds are:

• Open-ended funds: Open-ended funds are liquid mutual funds that allow investors to enter or exit according to their preferences
• Close-ended funds: Unlike open-ended funds, closed-ended funds have a fixed maturity date. However, closed-ended funds often have an initial offering period known as the New Fund Offer (NFO) period, during which investors can subscribe to the fund

Further classification includes:

1. Equity or growth schemes

These include:

• Sector-specific funds: As the name suggests, sector-specific funds invest in a specific sector or segment. The sector can be either in the tech, real estate industry, etc. The level of risk and associated returns vary based on the sector
• Index funds: Index funds aim to replicate the performance of a specific index, such as the NASDAQ index. However, returns and losses may not be identical to the index due to factors like tracking errors and expense
• Tax-saving funds: Some countries have tax-saving funds that offer tax benefits to investors. However, these types of funds have a lock-in period

2. Money market funds

These types of funds invest in high-quality short-term debt securities. They typically have a low-risk portfolio similar to current or savings bank accounts with higher returns.

Money market funds are considered liquid investments because they invest in high-quality short-term debt securities with high liquidity.

3. Fixed income funds

As the name suggests, most money is invested in fixed-income financial instruments. The returns and risks are low since they are invested in fixed-income instruments. 

The types of risks involved are credit risk and maturity risk. These are also known as debt mutual funds.

4. Balanced funds

Balanced funds balance equity and debt, i.e., the portfolio has a mixture of equity and debt investments. As a result, they have moderate returns with low risk. 

5. Hybrid/Monthly Income Plans

Monthly income plans, mutual funds, or MIPs are a type of balanced fund; however, the focus is on debt investments for stability, and equity investments are just enough to provide an advantage over debt investments.

6. Gilt funds

Gilt funds are low-return, low-risk mutual funds that invest exclusively in government securities. The only risk in these funds is the high-interest rate risk.

Stocks Vs. Bonds Vs. Mutual Funds

To clear out the distinction between these terms, let's take a look at the table below:

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Bond Pricing
• Bonds vs Stocks
• How to Invest in Stocks
• Mutual Funds