An investor can invest his surplus funds in different investment alternatives like shares, stocks, bonds, and debentures depending upon the investment environment, availability of funds, and expected rate of return considering the risk factors involved therein. The ultimate objective of an investor is to learn how to construct an optimal portfolio of investments.
In order to accomplish this, an investor will have to be aware of the various investment alternatives available and be able to make estimates of the returns he expects to get from the individual securities in the portfolio as well as their risk.
Securities are marketable financial instruments that bestow on their owners the right to make specific claims on particular assets. Individual security provides evidence of either creditorship or ownership depending on whether it is a bond or stock respectively.
Different Types of Investment Alternatives
Debt Instruments:
Debt instruments include all types of fixed-income securities promising the investors that they will receive specific cash flows at specific times in the future. Securities generating one cash flow are known as pre-discount securities or zero-coupon securities.
On the other hand, it may involve multiple cash flows. If all the cash flows are of equal amount, they are generally referred to as coupon payments.
The date beyond which the investors will no longer receive Cash flows is known as the maturity date. On this date, investors will receive the principal along with the last coupon payment.
Although these cash flows are promised, they may not be received due to the risk associated with such investments. Financial assets issued by the government, firms, and individuals often take the form of IOUs calling for fixed periodic payments, termed interest, and the repayment of the amount borrowed, termed principal. Debt instruments represent money loaned rather than ownership to the investors.
Deposits and Contracts
Currency, in real sense, is a government IOU. Money and savings accounts referred to as demand and time deposits are loans to banks and other financial institutions.
Demand and savings and other time deposits cannot be withdrawn without notice, although financial institutions provide this advantage to deposit holders.
Savings accounts draw interest, and some forms like certificates of deposits (CDs) have specific maturities. CDs pay higher interest than normal saving accounts do.
Government Securities
Government securities are those securities that are issued by the government to finance a deficit in the budget when revenues fall short of expenditures. Government securities are all most invariably bond issues of various types.
These bonds are issued by the government at all levels. Because it can print money, the securities of the government are not subject to default. The government securities are riskless, default-free, and earn a fixed rate of interest income.
Issued government debt securities differ in quality, yield, and maturity. In the national and international financial market, we usually find the government’s securities as mentioned below:
Treasury Bills:
Treasury bills are short-term notes that mature in three months, six months, nine months, and a maximum of one year from the date of issue. These securities can be redeemed only at maturity.
Treasury bills can be easily sold in the money market at prices that reflect prevailing interest rates and on a discount basis before maturity.
The discount to the investors is the difference between the less-than-face-value price they pay and the face value they receive at maturity.
Treasury Certificate:
Certificate of indebtedness differs from Treasury bills because they are issued at par value and pay fixed interest rates. These fixed interest rates are called coupon rates.
Every bond issue of this type promises to pay a coupon rate of interest that is printed on the bond and never changes.
The bond investor collects this interest income by tearing perforaled coupon slip off the edge of the certificate and cashing the coupons at the banks and post offices or other government-approved authorities. The Treasury certificate matures within one year from the date of issue.
Treasury Notes:
Treasury notes are similar to the treasury certificate accepted with regard to time of maturity. Notes typically have a maturity of one to ten years when they are newly issued.
Like treasury certificates, however, they are sold at face value in the money market and pay fixed coupon interest payments, each year of their life.
Treasury Bonds:
Treasury bonds make up the smallest segment of government debts. Bonds differ from notes and certificates with respect to maturity bonds mature and repay their face value within a period from ten to thirty years from the date of issue. Some bond issues are callable or redeemable prior to maturity.
Private Issues:
Private debt securities are issued by corporations and/or both financial and non-financial institutions that run the spectrum in quality and yield.
The categories of these types of securities are furnished below:
Corporate Bonds:
When corporations go to the capital markets to obtain money for all corporate purposes, the single most important source of funds is through the sale of debt, and securities. It is a long-term written promise to pay under seal a certain sum of money at a certain time for a specific rate of interest.
Bondholders have the right to receive a fixed rate of interest payable before any dividends may be distributed to the equity owners. In addition, the bondholders have what is termed as a fixed claim on the assets of the firm.
This means that when the bonds mature, or in the event of liquidation of the firm, the bondholders are entitled to receive a stated amount and this claim has priority over any of the claims of the equity owners.
A corporate bond is a long-term debt security issued by corporations help to finance their operations. It is similar to other kinds of fixed-income securities in that it promises to make specific payments at specified times and provides legal remedies in the event of default.
Different names are often used for the same type of bond, and occasionally the same name will be used for different bonds. However, the following types of bonds are available in the financial market:
Debentures:
Debentures are general obligations of the issuing corporation and thus represent unsecured credit. Their claim is fixed but based only on the firm’s ability to generate cash flow.
To protect the holders of such bonds, the indenture will usually limit the future issuance of secured debt as well as any additional unsecured debt.
Income bond:
All interest on bonds must be paid before any dividends are distributed to the shareholders. An income bond is a security on which interest is paid only if earnings are sufficient. These are infrequently sold to raise new capital because of the residual nature of interest payments.
In some income bonds, the interest payment must be approved and declared by the board of directors as much the same way as dividends are paid on preferred stocks. If the interest on bond is not paid, it may be cumulative and payable at a later time. Income bonds are still debt instruments but they are closely related to stock in the essential characteristic of interest payment.
Mortgage bond:
Mortgage bond represents a debt that is secured by the pledge of the subject security. In case of default, the bondholder is entitled to obtain the property and sell it to offset his claims on the firm.
Equipment trust certificate/bond:
Any way in which the principal of a bond issue is secured through the pledge of equipment. The title to the property or machinery usually remains in the hands of the trustee until the debt is repaid.
The corporation receives the title to the equipment only when all scheduled payments are made. Each six months after the purchase of equipment, a principal and interest payment would be paid to the trustee.
The trustee in turn would retire some of the equipment trust certificates and pay the interest on the outstanding debts.
Convertible bond:
The convertible bond provides the holder with an option to exchange his bond for a predetermined number of common shares at any time period to maturity.
Convertible bonds offer the promise of sharing capital growth. If the stocks increase in value, the bonds also will increase. If the stock remains at the same price, the bonds will still provide a good yield.
Callable bond:
The callable bond gives the issuing firm to retire the bonds at a stated call price. The call option usually becomes operative after a stated period of call protection which is usually either five or ten years after original issuance.
The call price usually begins at a value close to the sum of the principal plus one annual interest payment and steadily declines to the value of the principal at maturity. The promise to redeem bonds at maturity can be altered or modified by what is called call future providing the benefit for the issuer.
Putable bond:
A putable bond gives the holder the option to exchange his bond for cash equal to the face value of the same.
Registered bond:
One other safeguard might be indicated in the indenture which assures the basic security of the bond. A bond may be registered to protect the owners from loss. When the bond principal is registered the name and address of the bondholders are recorded with the issuing company.
The registration of the principal does not guarantee that the bondholder will receive principal repayment at maturity, but it does provide him with protection from loss should the bond certificate be lost or destroyed.
Collateral trust bond:
Some bond issues pledge stocks or bonds as additional security for the money borrowed. This type of bond is referred to as a collateral trust bond.
The collateral is usually the personal property of the corporation that is issuing the bond.
Sinking fund:
A sinking fund is a specific type of security issued for the benefit of the investors. A part of the principal of the debt is paid each year reducing the amount outstanding at maturity.
A sinking fund operates by having the corporation transmit cash to the trustee who can then purchase bonds in the open market.
Receivers certificates:
Receivers’ certificates are debt instruments that arise out of reorganization. When a corporation in reorganization needs capital, the receivers or the trustees have the power to raise additional funds.
The securities issued are known as receivers certificates and the principal value of these claims takes precedence over any other debt outstanding. This priority places them in a superior position with respect to other debts.
Bond indenture:
The special promises that are made to the bondholder are set forth in the bond indenture. It is an agreement between the corporation issuing the bonds and a corporate trustee, usually a commercial bank or trust company who represents the bondholder.
The usual items that are found in the bond indenture are: the authorization of the issue, the exact wording of the bond, the interest or coupon rate, the trustee’s certificate, the registration and endorsement, the property pledged as security if any, and the agreements, restrictions and remedies of the trustee.
Commercial Papers:
Commercial paper is an unsecured short-term promissory note issued by both financial and nonfinancial companies. These securities are issued to supplement bank credit and are sold by companies of prime credit standing.
Commercial papers representing short-term unsecured promissory notes are generally issued by large firms of unquestionable financial soundness.
Banker’s Acceptance:
A banker’s acceptance is a time draft drawn on and accepted by a bank that has agreed to do so for an importer or a holder of merchandise, thus substituting bank credit for commercial credit. Such instruments are widely used in foreign trade.
The buyer of the goods may issue a written promise to the seller to pay a certain amount within a short period of time the maturity of which is less than one year. This written promise offering liability to both the bank and the buyer of the goods is termed as the banker’s acceptance.
Certificates of Deposits:
Certificates of deposits (CDs) are special types of interest-bearing deposits at commercial banks or savings and loan associations.
Time deposits of large corporations in commercial banks are often of certain minimum amounts for a specified time period. Unlike time deposits, these certificates of deposit are negotiable.
Eurodollar Certificates of Deposits:
In the world of international trade and finance, large short-term certificates of deposit denominated in dollars and issued by banks outside the United States are known as Eurodollar certificates of deposit (henceforth Euro CDs). Euro CDs are negotiable.
Eurodollar Deposits:
Dollar-denominated time deposits in commercial banks outside the United States are commonly known as Eurodollar deposits. Eurodollar deposits cannot be traded and thus they are not negotiable.
Repurchase Agreements:
A money market instrument may be traded between two investors. The seller of such an instrument may agree to repurchase it for an agreed-on price at a later date. This agreement is like a collateralized loan from buyer to seller.
