Equity securities vary in many ways from debt securities. Both are financial securities but are different from each other in their features, examples, and many other ways. Below are some of the differences between both financial securities.
- Debt securities depict a loan issued to a company or corporation intending to raise funds towards meeting its objectives like funding a project. In contrast, equity securities describe the shares and claims a company owns regarding its assets, capital stock shares, and earnings.
- Debt securities have a date when they are set to mature because it shows that on that date, the investors expect to receive their principal alongside the agreed interest rates. This is when the investor's money to the entity that purchased the security expects to receive the money they gave to the entity as a loan. However, equity securities do not depict a maturity date because they are in the form of stocks that do not really mature. Equity securities are merely a representation of the shares of an organization or business entity, and therefore no maturity date is attached to an entity's shares.
- Debt securities have their returns in the form of interest payments where the buyer of the security pays the investor a higher rate than the principal or borrowed amount, which acts as the interest rate. Conversely, equity securities have dividends and capital gains as their mode of payment, where shareholders receive their investment funds in dividends paid periodically as agreed.
- Debt securities do not provide for voting rights in which the buyer of the bond can have rights to the decision-making pattern of the security and vice versa. In contrast, equity securities provide voting rights where shareholders have the capacity to make decisions regarding the company's operation.
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- Maturity date. The maturity date describes the time when the security issuer is bound to repay the borrowed amount and the attached interest. It is categorized into short and long term, where securities maturing in a year are deemed to be of short-term maturity. Long-term maturity describes securities maturing in more than three years. The securities that mature between one and three years are deemed to be of medium-term maturity. Long-term maturity securities allow investors to demand more returns from the investment and vice versa.
- Yield to maturity. The yield to maturity is an annual expression of the rate of return that an investor expects to receive at the security maturity. YTM is important in its ability to enable investors to differentiate and compare securities and their respective expected returns.
- Coupon rate. The coupon rate is the interest rate that an investor expects to receive as income upon maturity of the security they are holding. The coupon rate is usually fixed upon issuance of the debt security. It is calculated by performing a division between the summation of the coupon payments through the period and the par value. However, the coupon rate may not always be fixed throughout the security's life but may vary based on prevailing economic conditions.
- Issue date and issue price. The issue price is the monetary value attached to the debt security or the amount at which investors purchase the security on the issued date. On the other hand, the issue date is the day when the security is purchased or sold.
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Securities are categorized into two distinct forms; debt and equity. Debt securities are subdivided into government, corporate, and municipal bonds. Government bonds are loan grants or financial obligations that the national government provides for use as a source of funding for the expenses of the government. Government bonds have the backing of the federal government in full faith and credit, which means that the government pledges to pay the obligation on time. Government bonds usually depict lesser interest in comparison to corporate bonds because of the minimal default risk. Examples of these are treasury notes, treasury bills, zero-coupon bonds, municipal bonds, and treasury bonds.
Corporate bonds describe the securities that corporations issue to willing buyers. Corporate bonds depict higher interest rates than U.S government bonds due to the higher risk of default associated with them. The credit rating determines the interest rate to be charged because it shows the subsequent default risk. Examples of these are convertible bonds, callable bonds, junk bonds, and investment-grade bonds.
Municipal bonds fall under the category of government bonds because they are issued by both state and local governments. The risk associated with them is higher in comparison to the federal government's bonds. However, the expected yield is usually higher than that of the federal government bonds.
On the other hand, equity securities are categorized into mutual funds, certificates of deposit, and stocks. Stocks are further divided into preferred stock and common stock. Preferred stock describes the shares of stock in a particular company that shareholders receive as dividends. In contrast, common stock is the share of ownership in a company where shareholders have voting rights or a platform to contribute to the entity's decision-making. Therefore, preferred stock has fixed dividends with no voting rights, unlike common stock.
Certificates of deposit are savings accounts in which account holders deposit a fixed amount of money for a fixed period, and the bank pays interest to the customer in return. Banks prefer that customers deposit their money in certificates of deposit and not in the usual savings accounts because the customers can only invest in CDs for a fixed period so that the bank can use the money for fractional banking.
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Debt securities are beneficial to investors because they provide repayment of what they initially invested, the principal amount, and additional interest when the security matures. Additionally, debt securities enable investors to diversify their portfolios hence mitigating risk effectively. Debt securities also act as a steady flow of income to investors because they guarantee consistent interest payments as repayment for their initial investment.
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Debt securities are associated with default risks whereby the bond issuer fails to meet their debt obligations on time by making the agreed interest payments and the principal amount. Though some entities may come up with ways of managing default risks, they are bound to take time and costs while following up on the proceedings.
Debt securities are also faced with the interest rate risk, which refers to the abrupt change in interest rate in the market hence affecting the expected return by investors.
The reinvestment rate risk is also another risk affecting debt securities. It describes the instance when the interest rate falls and makes it impossible to reinvest the investment proceeds in the form of interest and coupon returns.
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Debt securities are described as financial obligations where investors buy the securities and expect to receive periodic payments in the form of interest and the principal amount after a particular period known as the maturity date. Debt securities are characterized by a yield to maturity, maturity date, coupon rate, and an issue price and date. Securities are grouped into debt and equity. Examples of debt securities are government bonds and corporate bonds. Government bonds portray a lesser interest rate than corporate bonds because they have little or no default risk because they are backed by the credit and full faith of the federal government. An example of a government bond is the municipal bond which is granted by both local and state governments. Debt securities are beneficial because they provide a stream of income to investors through regular interest payments. They also aid in the portfolio diversification by investors hence mitigating risk. However, these securities are faced with default risks, interest risks, and reinvestment rate risks.
Examples of equity securities are certificates of deposit and stocks. Certificates of deposit are the savings accounts in banks where customers store a fixed amount of money for a fixed period. Banks prefer them to simple savings accounts because they can use them to generate money through fractional reserve banking and later pay the customers with interest. Stocks are further subdivided into preferred and common stocks, which differ in the aspect that preferred stocks have fixed dividends and have no voting rights, but common stocks have voting rights where shareholders can influence the decisions of the company, including the due dividends.
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Video Transcript
Debt Securities
Gabe is looking for investment options that offer consistent payments and higher interest payments than he would earn by leaving his money in a savings account. Debt securities are one option that Gabe can utilize to grow his money.
Debt securities allow an institution to borrow money from investors and repay the loan with interest. When institutions such as banks, corporations, or governments need to raise money to conduct business, they have two primary means of doing so. First, they can sell equity in the company in the form of common stock, whereby investors share in the ownership of the company. Another option is to create debt securities.
Bonds
Gabe knows a little bit about bonds, primarily from receiving a few savings bonds from his grandparents as gifts when he was younger. Bonds come in a variety of forms and are largely distinguished by the issuing institutions, which promise to make periodic interest payments until the value of the bond is repaid in full at a future date. Government bonds are issued by the federal government. They often act as a benchmark for the interest rates on debt securities and are backed by the credit and full faith of the U.S. government. This makes the risk of default highly unlikely, since the government can always raise taxes or cut spending in order to make the payments.
Municipal bonds, or muni bonds, are issued by state and local governments and might have a higher interest rate since there's more risk involved. Corporate bonds are issued by companies to raise money to fund their operations. Like municipal bonds, they too may be associated with more risk and therefore offer a higher interest rate.
If Gabe is making an investment that's riskier than depositing money in a savings account or even a federal government bond, he expects a bigger return. The more risky the security, the higher the interest rate needs to be in order to attract investor dollars.
Preferred Stock
Instead of creating pure debt securities, a corporation can instead create shares of preferred stock. The corporation raises money by selling these equity shares, which also attract investors such as Gabe who want guaranteed payments. Preferred stock are different from common shares in that, unlike common stock, they come with a fixed dividend payment. The result is a combination of debt and equity, as the shareholders not only own equity in the company but also are entitled to the fixed dividends periodically paid out by the company.
Certificates of Deposit
Banks use certificates of deposit to encourage customers to put money in the bank. Certificates of deposit can be bought for as little as $25 and as much as hundreds of thousands of dollars. Unlike a savings account, where a customer can withdraw money any time, with a CD the bank gets to keep the money for a specified amount of time. Otherwise, the customer has to pay a penalty fee. This allows a bank to hold onto the money for a given period of time and make loans backed by CDs. In exchange, Gabe earns an interest rate that's slightly higher than those offered by a savings account. In general, the longer the deposit period, the higher the interest rate.
Lesson Summary
Let's review. Large institutions can use debt securities to finance operational activities. Unlike equity, or shares, debt securities are based on the premise of borrowing money and then repaying that money with interest under specified terms. The U.S. federal government borrows money by selling government bonds, which act as a benchmark for the interest rates on debt securities and are backed by the credit and full faith of the U.S. government. Municipal bonds, or muni bonds, offered by state and local governments to generate funds, have a higher interest rate since there's more risk involved.
Banks offer interest earning certificates of deposit, which must be held for a given period of time; early withdrawals result in a penalty. Companies offer corporate bonds to fund their operations, which, like municipal bonds, may be associated with more risk. Benefits include a higher interest rate. Another option for corporations is to sell preferred stock, or a type of hybrid security. Unlike common stock, they come with a fixed dividend payment.
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