A portfolio is a collection of different investment alternatives. By considering potential options of investments, a better set of portfolio can be developed that can generate reasonable returns for the investors. Following are certain investment alternatives of the capital market that are useful in developing & managing portfolio effectively.
Investment Alternatives of Capital Market
Fixed Income Securities
- Fixed Income Securities:
Fixed Income Securities the first investment alternatives that include the bonds which are long term debt instruments that show the contractual obligation of the issuer. In simpler terms, the issuer of a new corporate bond sells that bond to a purchaser for a certain fix amount that will be returned back to the purchaser on the maturity date. The issuer of the bond further pays certain interest payment to the purchaser for the borrowed money. Bond is considered as fixed income security because the interest payments and the principal amount repayment for normal bond are fixed in advance for the entire life of the bond. The purchaser of the bond knows in advance all the future cash flows for purchasing and holding the bond till maturity. The issuer of the bond set the time intervals for receiving the payments in the shape of interest as well as the repayment of the principal amount at the maturity date. However if the purchaser of the bond make decision to sell the bond before its maturity date, then the receiving price will be base on the currently prevailing interest rates.
Characteristics of the Bond:
The face value (or par value) of the bond is that amount which is printed on it and is equal to the borrowing money which is repaid at the maturity date. There are additional coupon payments associated with bond which are interest payments and paid on semi-annual basis generally.
Types of Bonds:
In United States, there are four main types of bonds on the basis of the involved issuer and these are
- Government Bonds
- Federal Agency Bonds
- Municipal Bonds
- Corporate Bonds
The US government has its Treasury Department which issues many notes and bonds with greater than one year maturity period. Because the US government has the power to print money so it is considered as the safest credit risk. This means that the investors do not think the likelihood of the risk of default for this type of bond. When investors buy US government bonds, they expect to receive consistent stream of interest payments along with receiving of the par value of the bond at maturity date with full assurance.
Federal Agency Bonds:
There are many federal agencies designed by federal government since 1920’s for the assistance of the different sectors of the economy through either guarantee of private loans or direct loans. There is competition of funds in the marketplace among these federal agencies and for this purpose these agencies sell government agency securities. Federal Agencies and Federally-Sponsored Credit Agencies are two types of federal credit agencies which are legal part of the federal government and their securities are completely guaranteed by the Treasury.
The bonds which are issued by the states, countries, cities and other political entity other than federal government and its agencies are considered as municipal bonds. The risk and the marketability of these municipal bonds vary greatly but their default rate is quite favorable as compared to the municipal bonds.
There are two types of municipal bonds which are
- General Obligation Bond which are secured by complete trust & credit of the issuer
- Revenue Bonds which are return back from the revenues produced by the project, whose financing makes the selling of these bonds.
Corporate bonds are sold by the corporations which reflect long term debt securities of various kinds. Most of the large size companies issue bonds as an assistance in financing their operations. Some important corporate bonds are as follow
- Senior Securities
- Direct Access Notes (DANs)
- Convertible Bonds
- Junk Bonds
These are debt securities which have priority of payment over common & preferred stocks in case of liquidation. These are generally considered as corporate bonds.
Debenture is that kind of corporate bond which is not secured by any security and it is only backed by the general credit worthiness of the company.
Direct Access Notes (DANs):
The notes which is issued at par and does not have any premiums, discounts or accrued interest is called Direct Access Notes (DANs). These are sold by highly credit quality companies in order to make bonds more accessible to individuals. The coupon rates of these bonds are fixed and their maturity range between 9 months to 30 years.
The convertible bonds have option to be converted into shares of common stock of the same company at the holder option. The conversion feature is built-in in these convertible bonds through which the holder of the bond can convert the bonds into specified number of shares whenever they desire. Convertible bond act as dual securities simultaneously by acting as fixed income security that pays certain interest payments and a claim on the common stock whose value increases on the basis of the increase in the price of the underlying stock. This shows that the prices of the convertible bonds can fluctuate over reasonable wide range on the basis of either these bonds currently are traded to show the price of the underlying common stock or these are traded like other fixed income securities.
Junk bonds contain high risk & high return which are categorized as ratings of Ba (Moody’s) or BB (S&P) or lower, with higher returns correspondingly. The high yield debt market is alternatively used to describe this area of bond market.
In order to express the relative likelihood of default, rating agencies assign letters of alphabet to the bonds. Risk of default is associated with many corporate bonds being issued. These rating agencies like Moody’s Investors Service Inc, standard & Poor’s (S&P) Corporation and Fitch Inc. give different bond ratings to the investors. The judgments on the relative advantages of these securities are provided objectively by these independent rating agencies.
- Equity Securities:
The another types of investment alternatives is equity shares. The ownership interest in the company is represented by the equity security. This category of security gives a residual claim on the income & assets of the company after payments of all obligations to the fixed income claims. Equity securities are of two kinds which are
- Preferred Stock
- Common Stock
Although preferred stock is technically a hybrid security because it features are similar to both fixed income & equity instruments. Preferred stock pays dividends and has infinite life while acting as equity security. Similarly preferred stock acts as fixed income security in such a way that its dividend is fixed in advance in terms of amount which generally makes it a stream of fixed payments just like bond. The main difference is that there is long life continuity of the stream unless the issue is retired or called. The preferred stock has generally more price fluctuations than the bond.
In case of liquidation of the company, holders of preferred stock are paid before the common stockholders but after the bondholders regarding the priority of payment of income. The board of directors of the company must vote the dividend of preferred stock on each period although this dividend is not legal binding. Usually the non-payment of these dividends in certain year transferred them to the next year and the cumulative dividends must be paid before payment of dividend to common stockholders.
Mostly the dividend rate for the preferred stock is variable rate which means that dividend rate is connected to the prevailing market interest rates. Auction rate is another trend in preferred stock which reflects the floating rate preferred in which the dividend is developed by auction after each period of 49 days. Another latest category is convertible preferred stock, which are automatically converted into common stock at a specified ratio. These stocks are mostly traded on the New York Stock Exchange (NYSE) offering attractive fixed monthly or quarterly dividends.
The ownership of interest of company is represented by the common stock. If few individuals have the shares of the company, than that company is regarded as Closely Held. On the other if there are large no of shareholders of a company than that company is said to be Public. Mostly the public company lists itself to the any one or more stock exchanges. In case of liquidation of the company, the common stockholders have the last claim on the assets & income of company after paying all other claims of fixed income security holders and preferred stockholders.
The common stockholders have right to elect the board of directors of the company and having voting power on serious issues of the company. The company must held annual general meeting which should be attend by the shareholders, where they give their votes on serious issues of the company. The shareholders have limited liability which means that they can only lose according to their share in the company. The personal property of the shareholders is protected from paying out the claims of the outsiders in case of the liquidation of the company. This is the main reason for the success of the companies.