Stocks, Bonds, and Mutual Funds

Some common and most liquid forms of investments.

Some common and most liquid forms of investments are stocks, bonds, and mutual funds. Stocks are fractional ownership of a company; bonds are instruments organizations use to raise funds; investors are paid interest, and mutual funds are pools of various financial instruments. 

Stocks Bonds Mutual Funds

People invest in various assets depending on their goals and risk profile. The investment takes place in the hopes of better returns in the future. For ages, people have been investing in tangible assets like real estate, gold, etc.

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

What are Stocks?

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. In equity markets, common stockholders receive only representative prices, not bid and ask prices. The other levels of membership are for brokers and market makers.

These markets are primarily broker and dealer markets. Broker because a third party tries to match buyer and seller price and dealer market as sometimes the third party needs to buy/sell excess shares for the market's continuity. 

What are Bonds? How do these financial assets work?

These are fixed-income financial assets.

Each bond represents a specific amount of loan given to the issuer. Companies use them to raise funds for their operational expenses. 

Once a company issues bonds, investors buy those bonds, and the capital raised is used to fund the issuing company's activities and, in return, get a fixed income. Interest rates on these can be fixed, variable, or a mixture of both. 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 according to their investment size.

Investors have been trying to find new investment vehicles according to their exposure, return expectations, etc. Each of the financial instruments has different types/strategies under its umbrella to meet those needs. They aim for the best risk-adjusted returns.

Let us look at these financial instruments in detail: 

Stocks

Let us have a look at different types of shares.

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, some companies may also provide dividends in some quarters, which is not guaranteed. Therefore, some of them can also be non-voting. 

Preferred Stock:

Few companies issue preferred stocks; these types of shares can be traded like common ones and provide guaranteed dividends. Preferred stockholders get 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. 

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 bin 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 %. 

Shares are also divided based on the size of the company; this classification helps filter shares based on risks and returns.

Large-Cap:

These are companies with significant market value. For a company to be qualified as a Large-cap company, its valuation should be greater than $ 10 billion. In addition, these have steady growth, providing low returns at low risk.

Mid-Cap:

These are companies with valuations between $ 2 billion and $ 10 billion. The volatility associated with mid-cap companies is higher. However, the associated risk is also higher.

Small-Cap:

These companies have a market capitalization value of less than $ 2 billion but greater than $ 300 million. The possible returns can be very high, but the associated risks with small-cap investing are also higher.

Growth:

These are companies' equity expected to grow at a rate higher than the market rate. The probability of these companies giving dividends is also low since they reinvest in their business to keep up with the high growth rate.

Value:

These are the underpriced equities trading on the market. They are identified based on their ratios and have a low price-to-book ratio or low P/E ratio, intrinsic value, and other factors.

International:

These are the equity of foreign companies. Many times, the economic condition of a country might be better than in other countries. 

Investing in companies from different countries helps diversify portfolios and hedge against the risk of economic slowdown.

Dividend:

These shares, as the name suggests, provide regular dividends. Apart from the fixed income, sometimes dividends are eligible for tax benefits. They are classified as long-term capital gains instead of regular income, hence the tax benefit. 

There are few programs like DRIP or Dividend reinvestment programs

IPO

IPO or Initial Public offering shares are the new shares recently listed on an exchange. Most investors invest in IPOs for listing gains. However, there is always a possibility of shares opening below their lot price. 

Cyclical:

These are the shares that follow the economic cycles. For example, these shares grow when the industry or sector is booming and are down during the economic slowdown.

Defensive:

Unlike cyclical, defensive ones are not affected by economic cycles. There is a commonly used sector rotation, where investors invest in cyclical during an economic boom and then return to the defensive during a recession

Volume

Blue-chip:

They provide steady returns along with dividends. Generally, these are large-cap companies with a constant growth rate. These are for risk-averse investors.

Penny:

They are generally classified as speculative shares because the company is in financial trouble. These investments are hazardous. These are low-valued companies with very low liquidity. 

ESG:

These are the companies that show responsibility towards the environment. These companies are filtered based on third-party scoring systems.

Bonds

Issuance

Let us have a look at it's different types

Municipal:

They are also known as munis. Local governments issue these. They 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. 

Interest earned from these municipal securities is exempt from income tax.

Corporate:

These are financial instruments for funding 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; however, unlike other securities, debentures are not a secured form of 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. These are unsecured forms of financial instruments. The subordinate term indicates that these are lower or junior debt forms. 

These are even riskier than Debentures 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 revenue generated by the company. They follow variable interest rates. The interest rate's value 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 it is not a default. These unpaid interests are classified as interest in arrears.

5. Convertible:

As the name suggests, these can be converted into shares or equity of the company. But, again, these numbers of shares are pre-determined. They offer lower interest rates because, with the safety of fixed interest, there is also the option of converting the bond into 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. Warrants are detached after the expiration date.

7. International:

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. 

Mutual Funds

Mutual funds are the easiest ways 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:

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

Types of mutual funds:

1. Open-ended funds:

Open-ended funds are liquid mutual funds that allow investors to enter or exit according to their preference. 

2. Close-ended funds:

Unlike open-ended funds, closed-ended funds have a fixed maturity date. However, even for entering these funds, there is an initial period known as New Fund Offer or NFO period. 

Trading

Further classification:

1. Equity or growth schemes

A. 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. 

B. Index funds:

Index funds have portfolios similar to a particular index. For example, an index fund might follow the NASDAQ index; in that case, returns will be identical to the Nasdaq index, and losses will also be limited to the failure in the index. 

They have a medium level of returns.

C. Tax saving funds:

Some countries have Tax saving funds that offer tax benefits to the 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. Since these are short-term investments, they are also called liquid funds.

3. Fixed income funds:

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

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

4. Balanced funds

Balanced funds maintain a balance between 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 plan mutual funds or MIP 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. 

They are also known as marginal equity funds because of the proportion of equity funds in the portfolio.

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 risk associated with a high-interest rate.

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Research & Authored by Punit Manjani | LinkedIn 

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