The ability to effectively manage financial instruments defines the success or failure of an economy. The world of securities holds a very significant position in the financial markets. Here’s a look, into the details of securities and their classification.
Any standard dictionary defines security as “the state of being free from danger or threat.” In financial world, if you’re an investor, you will feel secured when you are assured of returns on your investments. So, when extended to the financial world, the definition of ‘securities’ is related to the surety or an assurance of fulfillment of obligations by the companies/firms in the financial market, for your invested money. Hence, securities are a class of investments that promises you some return on your invested money.
In the financial world, securities can be defined as financial instruments that have some financial value, and they can be traded amongst investors, governments and private enterprises. Securities in a financial market are traded legally and are bound by stipulated laws. So, if you buy some securities (say five stocks of a blue-chip company), then you’re entitled to receive the future gains on your investment (from the five stocks in which you have invested your money) under some stated terms and conditions. Further, suppose that you have two billion dollars in your account, and you buy few bonds of the US government. Now, as a legal proof of your purchase (and it happens in any transactions), you’ll be provided with a share certificate or bond, which is nothing but the acknowledgment of your security. Now, we have got some idea about basics of securities. But what are the different types of securities? What are their characteristics? Why it is easy to sell one type of security, while the other aren’t traded frequently? Let us explore more into the concept of securities, that form the foundation stone of world’s financial market.
Characteristics of Securities
Since a security is a financial instrument, it has some characteristic features that make it valuable in the market and it is sold or purchased keeping in mind its basic features. As an investor, the three must-know features of a security are:
Return on Investments (ROI)
It is a human habit to calculate the gains or losses incurred in a transaction. In financial markets, ROI is the factor that motivates people to buy and sell securities.
Risk Inherent in It
All investments carry some degree of risk. Many people stake a significant fraction of their money in stock markets even when they are aware of the risks! If their estimates work, they earn many times their investments but if it fails, they go bankrupt. So, risk in securities is another factor which promotes its buying and selling.
Liquidity of a financial product or asset or financial instrument is the ease with which it is traded in the market. What does it mean for an investor if a security can be traded with ease? It means that there are lots of potential buyers and sellers who’re interested in that particular security and so, it can be traded frequently, thereby, increasing the scope of negotiation in price (value) of the security. Generally, investors prefer to have assets with high liquidity!
Did You Know
Generally ‘assets’ and ‘securities’ are used interchangeably. However, there are small differences between the two. Assets are often classified as ‘hard’ and ‘soft’ assets. When we talk about hard assets, we are actually referring to physical investments like oil, metals, real estate, natural gas, diamonds, gold, etc. Soft assets, on the other hand, are financial products or the rights exclusively stated in official documents like credit balances, patents, trademarks and financial contracts, to name a few. Securities are distinctively soft assets in the form of bonds or stocks of a company. The noteworthy point is that hard assets can be transformed into soft assets to facilitate the trade in structured financial markets.
A. Marketable Securities
Stocks, bonds or any other types of securities which can be traded easily in organized financial markets or between two investors with the help of brokers, are known as marketable securities. The chief feature of marketable securities is that it is easier to trade them and they can be converted into cash whenever required by the investor. From the figure given below, it can be observed that marketable securities are classified into four types- money market securities, capital market securities, derivatives, and indirect investments. Each of these four marketable securities comprise several trade and financial instruments. We will discuss all of these in detail.
1. Money Market Securities
One of the most reliable and highly liquid assets, money market securities are short-term bonds issued by governments or large financial corporations. Transactions are generally very large, to the tune of US$100,000 and the maturity period is one year or less. Since transactions of very high value are involved in these, only major financial institutions are able to trade in such securities. For investors with limited risk potential, such securities can be accessed by investing in mutual funds. Let us know in more detail about what constitutes these securities.
- What are They: Short-term securities issued by the government.
- Issued By: Governments
- Risk Factor: Least Risky
- Face Value: $1,000 – $1mn
- Maturity Period: 3, 6 months or yearly
- What are They: Short-term promissory note
- Issued By: Corporations
- Risk Factor: Safe
- Face Value: $100,000
- Maturity Period: 270 days or less
- What are They: Deposits in Non-US banks or banks outside U.S.A., denominated in US$
- Issued By: Financial Institutions
- Risk Factor: Not totally risk-free
- Face Value: Varies
- Maturity Period: Short-term
- What are They: Certificates of deposits
- Issued By: Commercial Banks
- Risk Factor: Low risk
- Face Value: $100,000 or more
- Maturity Period: 14 days to 1 year
- What are They: Same as treasury bills, short-term credit investments, bank guarantee
- Issued By: Non-financial firms
- Risk Factor: Least Risky
- Face Value: $100,000
- Maturity Period: 30 – 180 days
- What are They: Selling the security with an agreement with the seller to repurchase them later at a fixed time
- Issued By: Securities dealers
- Risk Factor: Residual credit risks
- Face Value: Varies
- Maturity Period: Very short-term (overnight!)
2. Capital Market Securities
The common stocks in which we trade in the open market are classic examples of a capital market security. In such securities, the maturity period is greater than one year and for some securities (for example, stocks), there is no defined maturity period. Let us know more about several capital market securities.
Fixed Income Securities: These are investments that promise guaranteed income on the amount invested, though at a lower rate of return. Suppose you invest US$100 in a bond at 10% fixed interest annually. So, it will give you a $10 return every year until maturity when you would receive the US$100 back.
Bonds: They are a form of fixed-income securities, and payments are made as per the time and depending on the conditions mentioned in the deal. The investor can sell the purchased bond before maturity, depending on the market conditions and how that particular bond is rated.
Treasury Notes and Bonds: Another types of fixed-income securities are treasury notes and bonds, that are issued by the US government for longer maturity periods (10-30 years). The terms of treasury notes are usually between 1 to 10 years while for the treasury bonds, it is between 10-30 years. These securities offer higher interests, and they also repay the principal on maturity.
Federal Agencies Securities: To raise funds for carrying out public infrastructure related tasks, the federal agencies securities are issued by the federal government and by Government-Sponsored Enterprises (GSEs). While the bonds issued by federal agencies are backed by the US government, the bonds of GSEs are not backed by the same guarantee by US government. So, while buying bonds of GSEs, don’t forget to check the credential of the sponsored agencies. Investment in these bonds generally, starts from US$10,000.
Municipal Bonds: These are tax-exempted investments and hence, one of the most sought after bonds issued by the government. To raise funds for public work several counties, states and municipalities issue bonds. If you buy these bonds, you will not only be entitled tax exemption, you will also be able to get back your invested money, along with the interest at a good rate.
Corporate Bonds: These are almost similar to the treasury bonds with the major difference that they are issued by corporate entities, so the risk of default is higher.
Common Stocks: Most of us must know about stock investments. Stocks are divided into two types- preferred stocks and common stocks. The general trading we see in stock markets is done in common stocks. Stocks in essence, represent a share of ownership in the companies, and they are also a proportionate claim on profit of the corporations. However, suppose if a company shuts down or goes broke, common stock shareholders are the last investors to get compensated. Dividend, if it is distributed at all, first goes to creditors, bondholders, and preferred shareholders. With preferred stocks, you may have a larger share of the profit but your ownership rights are very limited.
These class of marketable securities represent those investments values of which are dependent on the performance of several other securities. That means, their values are derived from the value of other investment instruments and hence, the name derivatives.
Options: It is an interesting security that provides the holder the right, but not obligation to buy or sell securities at some fixed point of time in the future. Now, the buying is typically known as ‘a call option’ while selling is popular as ‘a put option’. In case, the holder doesn’t carry the transaction within the specified time constraints, the deal expires. The point to be noted is that stock options are very speculative and hence, are not for everyone. It is only ideal for sophisticated investors.
Futures: Futures securities are just like options, however, the major difference between the two is that in future securities, the buyer is obligated to fulfill the terms of contract unlike the options. The futures market is extremely liquid, risky and very complex. Again, this is not for investors do not like to take risks.
Rights and Warrants: Similar to options and futures are rights and warrants that grant the shareholders some rights of ownership and profit from the company’s performance. Rights and warrants are issued by the companies for raising money. By issuing rights, these companies allow shareholders to buy more of their shares at a price lower than the original share price. It thus favors, to the existing shareholders. Warrants are further attached to rights or preferred issues to make them more attractive trading prospects for the shareholders. What differentiates rights and warrants? Rights are generally for short-term and expire within a week, while warrants may be traded for one to a few years.
4. Indirect Investments
Investments in securities that are made by purchasing shares of an investment company, are known as indirect investments. Just like any other company, even an investment company tries to diversify its portfolio and generate funds for its business purposes. Three popular indirect investments are:
Unit Trusts: A unit trust functions under a trust deed and is looked after by fund managers. Also known as open-ended investments, the value of a unit trust depends on the number of units issued and the price of each unit. The cost of fund management (fee of the fund managers, costs incurred in running the company) is adjusted to the inflow of funds. The success of a unit trust depends on the expertise and experience of the fund managers handling it. Unit trusts can be purchased from fund managers.
Investment Trusts: One of the most popular investment instruments are the mutual funds. Investment trusts, like mutual funds, also known as open-end investment companies sell shares of the companies even after the Initial Public Offering (IPO) gets over. Mutual fund companies pool money from investors, and it is then invested in a variety of investment options like stocks, bonds, short-term assets, etc. All investors of a mutual fund have a proportionate ownership in the company. Another type of marketable securities are in the form of closed-end investments. These are the companies under trusts that don’t sell the shares after the IPO of a company gets over. The initial shares that have been purchased by investors are the ones which are later on traded in stock market.
Hedge Funds: One of the most popular funds that have gained attention of financial wizards and investors are hedge funds. Since these marketable securities are traded aggressively, and are limited to a few accredited investors, they are not ideal for average investors. The private capital pooled in hedge funds is generally, very large and is invested by few sophisticated investors. Here’s a word about hedge funds from the official website of the US Securities and Exchange Commission – Hedge fund is a general, non-legal term used to describe private, unregistered investment pools that traditionally have been limited to sophisticated, wealthy investors. Hedge funds are not mutual funds and, as such, are not subject to the numerous regulations that apply to mutual funds for the protection of investors – including regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interests, regulations to assure fairness in the pricing of fund shares, disclosure regulations, regulations limiting the use of leverage, and more.“
B. Non-Marketable Securities
Now that we know the definition of marketable securities, it is easier to define non-marketable securities. Securities that are difficult to trade in a normal financial market are generally called non-marketable securities. It is difficult to get a potential buyer for non-marketable securities and hence, some of the financial instruments that comprise non-marketable securities are traded in private transactions. Although these securities can’t be traded easily, they from a significant portion of an investor’s portfolio. These securities are traded between investors and large financial institutions like commercial banks, so it is a risk-free and safe investment. Different types of these securities are as follows.
As we all know, savings accounts are a common mode of deposits in banks. They are a form of non-marketable securities that earn an interest over a period. The interest rates and maturity period depends on the banks. Withdrawing money is possible at any point of time, however for the account to function, investor needs to maintain some minimum balance as per the directives of the bank. It is a safe and simple form of investment although, the returns are not very high.
b. Government Savings Bonds
Those government bonds that can’t be traded in the open market, constitute a part of government savings bonds. These government debt instruments are traded amongst investors and financial institutions (banks) indirectly. These bonds earn interest only when they are redeemed.
c. Non-negotiable Certificates of Deposits (CDs)
CDs are promissory notes (the bearer is promised some return on investment with interest) that are issued by commercial banks. CDs are insured by the Federal Deposit of Insurance Corporation (FDIC), so they are relatively a safe investment. CDs have a maturity period of one month to five years and any withdrawal prior to maturity attracts penalty. To understand it more closely, let us say, you buy a $100 CD with an interest rate of 10%, compounded annually and a term of one year. At the end of the year, you will earn $110 ($100 plus 10% of 100, i.e. $110).
d. Money Market Deposit Accounts (MMDAs)
MMDA securities are another type of savings account, but with very high interest rates along with some restrictions. For instance, in MMDAs, an investor is allowed a limited number of transactions every month. In some of these accounts, it is also mandatory to maintain a minimum balance that is normally higher than that in normal savings account. The minimum balance criteria differs from bank to bank.
So, this was all about classification of marketable and non-marketable securities. As you can observe, each topic in these classifications can be a subject of PhD. If you have investment related concerns, it is best to contact professionals in this field.