Types of securities



Securities are financial assets which represent ownership in or debt of companies.

Securities refer to both shares and bonds, which are the two most common types.

A share confers on its owner a legal right to the part of the company’s profit. It represents ownership in a company and entitles the owner to participate in the distribution of the company’s profit.

When an investor buys a share, using the services of a specialist company or broker, he or she becomes a shareholder (stockholder) and owns a part of a company.

Shareholders on the other hand, as owners of the company, have no guarantee of their investment. If the company fails, their shares will become worthless. Although because of limited liability, shareholders are not responsible for the company’s debt.

Dividends are paid to shareholders out of profits, which means that if the company has had a weak business performance, no dividends are distributed. The amount of dividend is decided by the Board of Directors and declared at the annual general meeting of the shareholders. It is expressed as a percentage of the face value of the shares.

The common classes of shares are:

  • Ordinary shares (common stock or equities): which have no guaranteed amount of dividend but carry voting rights; traded on stock exchanges and represent one of the most important types of security for investors; fixed unit of the share capital of a company;
  • Preference shares (preferred stock): an intermediate form of security between an ordinary share and a debenture; in the event of liquidation, they are less likely to be paid off than debentures, but more likely than ordinary shares; preference shares may be redeemable at a fixed or variable date; voting rights are normally restricted; owners are entitled to a fixed rate of dividends which is called practically interest.
  • Founder’s shares: shares issued to the founders of a company, who often have special rights to dividends.
  • Deferred ordinary shares: ordinary share, formerly often issued to the founding members of a company, in which dividends are only paid after all other types of ordinary share have been paid; such shares often entitle their owners to a large share of profit.

Shares in public companies may be bought and sold in an open market, e.g. a stock exchange. Shares in a private company are generally subject to restrictions on sale, e.g. they must be offered to existing shareholders first or the directors’ approval must be sought before they are sold elsewhere.

Employee share ownership plan (ESOP): method of giving employees shares in the business for which they work.

A bond is a type of debt issued in certificate form, on which interest is paid over a certain period of time. On the expiration date (date of maturity) the entire face amount is paid to the owner of the bond. Irredeemable or undated securities do not bear a date at which the capital sum will be repaid or redeemed. A company can borrow money from investors by issuing bonds, loans for fixed periods with fixed interest rates.

Bonds may be issued not only by companies, but also by the governments or municipalities.

  • G stocks or bonds (gilt edged securities): also called gilts; used to raise money to finance government projects; gilts are among the safest of all investments, as the government is unlikely to default on interest or on principal repayments; issued for a fixed period of time; receive a fixed rate of interest
  • Local Authority Bonds: issued by local authorities; the money invested represents loan to the authority; usually bought by institutions, but can be bought also by the public; a secure form; pay a fixed rate of interest; there is a  fixed date for repayment.
  • Debentures (járadékkötvény):  are similar to bonds; they are issued by companies and are mostly secured, which means that the company guarantees the owner’s rights over the company’s assets; debenture holders are not involved in the management of the company.

BONDS

Companies finance most of their activities by way of internally generated cash flows. If they need more money they can either sell shares or borrow, usually by issuing bonds. More and more companies now issue their own bonds rather than borrow from banks, because this is often cheaper: the market may be a better judge of the firm’s creditworthiness than a bank, i.e. it may lend money at a lower interest rate. This is evidently not a good thing for the banks, which now have to lend large amounts of money to borrowers that are much less secure than blue chip companies.

Bond-issuing companies are rated by private ratings companies such as Moody’s and Standard & Poors, and given an ‘investment grade’ according to their financial situation and performance, Aaa being the best, and C the worst, ie. nearly bankrupt. Obviously higher the rating, the lower the interest rate at which the company can borrow.

Most bonds are bearer certificates, so after being issued (on the primary market), they can be traded on the secondary bond market until they mature. Bonds are therefore liquid, although of course their price on the secondary market fluctuates according to changes in interest rates. Consequently, the majority of bonds on the secondary market are traded either above or below par. A bond’s yield at any particular time is thus its coupon (the amount of interest it pays) expressed as a percentage of its price on the secondary market.

For companies, the advantage of debt financing over equity financing is that bond interest is tax deductible. In other words, a company deducts its interest payments from its profits before paying tax, whereas dividends are paid out of already-taxed profits. Apart from this ‘tax shield’, it is generally considered to be a sign of good health and anticipated higher future profits if a company borrows. On the other hand, increasing debt increases financial risk: bond interest has to be paid, even in a year without any profits from which to deduct it, and the principal has to be repaid when the debt matures, whereas companies are not obliged to pay dividends or repay share capital. Thus companies have a debt-equity ratio that is determined by balancing tax savings against the risk of being declared bankrupt by creditors.

Governments, of course, unlike companies, do not have the option of issuing equities. Consequently they issue bonds when public spending exceeds receipts from income tax, VAT, and so on. Long-term government bonds are known as gilt-edged securities, or simply gilts, in Britain, and Treasury Bonds in the US. The British and American central banks also sell and buy short-term (three-month) Treasury Bills as a way of regulating the money supply. To reduce the money supply, they sell these bills to commercial banks, and withdraw the cash received from circulation; to increase the money supply they buy them back, paying with newly created money which is put into circulation in this way.