Equity vs Debt

Imagine for a moment that you are a small business owner. You have been running your widgets company quite successfully, employing a small staff and enjoying the profits rolling in. So why would you share these profits with literally thousands of people?

The answer is simple: in order to grow, a company needs to either go into debt, sell a part of the company in order to raise money. So you can either finance that growth by borrowing from the bank, or by issuing bonds. This is called debt financing. So while you own 100% of the company, you owe a lot of money.

On the other hand, you could sell stock in the company. No interest payments, no money to pay back. Only the promise that the shares will be worth more some day. Of course, now these new shareholders now can lay claim to the assets and profits of the company. This is called equity financing.

An IPO is an Initial Public Offering is the first sale of a companies stock that is issued from a private company.

From an investors point of view, there is a large difference between investing in debt versus investing in equity. By investing in a debt instrument such as a bond, you are guaranteed the principal of the bond, plus any interest that is owing. However, for equity investors, you become an owner. As such, you also take on the risk of the company not being a success. Just as a small business owner has no guarantee of success with each new venture, neither is a shareholder. If things don't turn out well, you get to claim the assets of the company, but only after the creditors have been satisfied, which is usually nothing. As a shareholder, if the company is successful, you stand to make a lot of money. On the flipside, you stand to lose a lot of money if the company is less than successful.

Risk Vs Reward

Its important to understand the risk that is inherent with investing in stocks. There are no guarantees or obligations. Some companies will pay out a dividend, while others will not. There is no obligation for a company to pay a dividend, or even increase a dividend. If there is no dividend paid out, then the only way for an investor to make money is through the increase in share price on the stock market. If the shares decrease, the shareholder value is lowered. If the company goes bankrupt, your investment is worthless.

Risk should always be balanced out with reward. By taking on more risk, you should be compensated with the potential for a greater return. This is why small caps have historically outperformed large caps and why the return on investment in stocks in general have more than doubled that of bonds or savings accounts. The stock market over the last 50 years has returned over 12% per year.

However, that return is not without its risk.

Think you know the basics of stock market investing? Stocks vs bonds? Think again. Learn the truth about stock market investing

Understanding Debentures and Bonds

Understanding Debentures and Bonds.

Investors looking for regular fixed income through the payment of interest can invest in debentures and in bonds. They are both fixed income instruments put out by borrowers wishing to raise capital for various business purposes.

In finance, a bond is a debt security, in which the approved issuer owes the holders a debt which they are obliged to repay at a later date. This later date is termed the maturity. The obligation is to repay both the principal and interest (the coupon). It is simply a loan in the form of a security with different terminology. Bonds and debentures enable the issuer to finance long-term investments with external funds.

So what are the differences?

Debentures and bonds are debt instruments with different types of risk exposure. Generally bondholders are secured by access to the underlying asset in case of default by the issuer. In contrast, debentures are unsecured and holders do not have recourse to assets if the debenture issuer defaults.Debentures are backed only by the general creditworthiness and reputation of the issuer.

A bond price fluctuates according to the market interest rates. If the interest rates go down the value of the bond goes up whereas the reverse applies if the interest rates rise. The varying price becomes important when the bond is being traded but not much of a concern if holding to maturity. Liquidity is possible during the term of the investment, unlike debentures which do not tend to be traded. Debentures may be broken at a penalty rate.

The interest rate offered on bonds depends on a number of factors, including the maturity and the credit rating of the issuer. Normally the longer the time frame of the bond, the higher the offered return. The better the credit rating of the issuer, the lower the interest rate that is offered. Interest rates on debentures tend to be higher to reflect the higher risk.

The main International Rating Houses for bonds are Moody's, S&P and Fitch. They each have their own rating scale but are very similar using 'A A A' as the top tier. When you were at school you no doubt thought a B was not too bad, in fact pretty good, but when applied to a bond or debenture this is not the case. This is more of a speculative rating meaning there is a one in five chance of default over five years. It is important to note that ratings will not always predict default perfectly. Failure is a possible outcome for even a highly rated institution. Bond issues come with a rating whereas some companies offering debentures may apply to be rated but this is not always the case.

Lyn Bell has been in the finance industry for more than 30 years and is a Certified Financial Planner. She has helped many clients achieve their financial goals. Sign up to get Lyn's free newsletter SoundFinance News and receive a free gift.

What Is Bond Market?

What Is Bond Market?

A bond is a debt obligation or security, where the the holder or buyer expects the holder to repay the principal and interest at maturity (a date in the future). The bond market is a financial market where these bonds are bought and sold. To get an estimate of the size of these debt securities markets you should bear in mind that the international bond market is approximately $45 trillion and the size of U.S. bond market debt is about $25.2 trillion.

How are these markets structured?

Quite different from the stock, futures and options markets, most of the trading volume in bond markets takes place between brokers and large financial institutions in an over-the-counter market. But, a couple of bonds, primarily corporate ones, are listed on exchanges. This is partly due to the differences in bonds.

What are the various types of bond markets?

The Securities Industry and Financial Markets Association(SIFMA) classifies the bond market into the following categories:

1) Corporate

In simple terms, corporate debt securities are IOU's issued by corporations so that they can use this cash to support their day-to-day operations and generate greater profits in the future. All sorts of corporations issue corportate debt. These could range from industrial, financial companies to service-related ones.

2) Government and Agency

As the name suggests, government and agency debt is issued by different government-sponsored enterprises (GSEs). These entities have been created by Congress to fund loans at affordable rates to certain kinds of borrowers (such as students, farmers and homeowners). GSEs mostly rely on debt financing for their daily operations. Some examples of GSEs in this regard - Fannie Mae, Sallie Mae, Federal Farm Credit System Banks etc.

3) Municipal

Municipal securities are debt securities issued by counties, cities, states, and other governmental entities to raise money to build/maintain infrastructure such as highways, schools, hospitals, and drainage systems. This is perhaps the the state and local governments in the United States finance their cash flow requirements. One great appeal of investing in municipal bonds is that the interest on these securities is exempt from the federal income taxes.

4) Mortgage Backed Securities and Asset-Backed Securities

Financial institutions issue mortgage debt securities to those interested in ownership of mortgage loans. These are loans that are used to finance the borrower's purchase of homes or other real estate. As the underlying loans (mortgages) are being paid off, the investors receive interest payments in addition to their principal being paid off.

Some examples of agencies that issue these debt securities are - Ginnie Mae (Government National Mortgage Association), Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation).

Asset-backed securities (ABS) are similar in mortgage securities in that they represent an interest in a variety of assets such as auto loans, auto leases, home equity loans, or credit card receivables. The investors in these debt securities receive interest payments in addition to their principal as the underlying loan is being paid off.

In summary, you have learnt what bond markets are, the different types of bond markets and the different players in these markets.