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SECURITIES: TYPES, FEATURES AND CONCEPTS OF ASSET ALLOCATION AND INVESTING

SECURITIES: TYPES, FEATURES AND CONCEPTS OF ASSET ALLOCATION AND INVESTING

SECURITIES: TYPES, FEATURES AND CONCEPTS OF ASSET ALLOCATION AND INVESTING (Part 1)

  • Definition: Securities are investment instruments that are pre-defined for their features, issued under regulatory supervision, and are liquid in the secondary markets.
  • Types of Securities: There are two broad types of securities:
    • Equity: Represents ownership in a company, confers voting rights, and entails a higher level of risk and potential return.
    • Debt: Represents a loan to a company, offers a fixed rate of return, and entails a lower level of risk.

Key Concepts

  • Equity vs Debt Financing: The choice between equity and debt financing depends on factors such as:
    • Ability to pay periodic interest: Businesses with stable profits may prefer debt financing.
    • Willingness to dilute ownership: Existing equity holders may prefer debt financing to avoid diluting their stake.
    • Ability to give collateral as security: Businesses with assets can offer collateral for debt financing.
    • Time period for which capital is required: Short-term needs may be met with debt capital, while long-term needs may require equity capital.
  • Hybrid Instruments: Combine characteristics of debt and equity, such as:
    • Commodities: Investments in real assets like gold, silver, or agricultural produce.
    • Derivatives: Contracts to buy or sell underlying assets, suitable for sophisticated investors.
    • Mutual Funds: Investment vehicles that pool funds from multiple investors, suitable for retail investors.
    • Structured Products: Pre-packaged instruments linked to traditional investments, suitable for high net worth investors.
    • Distressed Securities: Securities issued by companies in financial distress, suitable for sophisticated investors.
  • Characteristics of Equity Capital:
    • Nature: Provided by owners willing to take risks, with variable profits.
    • Denomination: Denominated in equity shares with a face value.
    • Inside and Outside Shareholders: Equity capital can be provided by promoters (inside shareholders) or institutional investors (outside shareholders).

SECURITIES: TYPES, FEATURES AND CONCEPTS OF ASSET ALLOCATION AND INVESTING (Part 2)

  • Equity Capital: Represents the ownership of a company, with shareholders having a claim on the company's assets and profits.
  • Features of Equity Capital:
    • Part Ownership: Equity shares represent a proportionate ownership of the company.
    • Variable Return and Residual Claim: Equity investors receive a periodic dividend that is not pre-determined and have a residual claim on the company's assets.
    • Net Worth: Retained profits become part of the company's reserve funds, enhancing its net worth and the value of equity shares.
    • Management and Control: Shareholders have voting rights, with large shareholders potentially having a significant influence on the company's management.
  • Types of Equity Capital:
    • Ordinary Shares: Full voting rights and participation in profits.
    • Equity Shares with Differential Voting Rights (DVR): Separate the right to participate in profits from the right to vote, with investors enjoying a higher rate of dividend but having lower voting rights.
    • Preference Shares: Pay a pre-defined rate of dividend, with some features of equity and debt instruments, but without voting rights.
  • Risks and Returns from Investing in Equities:
    • Returns: Depend on the company's future residual cash flows and can be in the form of dividends or capital appreciation.
    • Risks: Future benefits are not assured, and equity returns are volatile and subject to market fluctuations.
  • Characteristics and Role of Debt Securities:
    • Instrument Types: Debentures, bonds, commercial papers, certificates of deposit, and pass-through certificates.
    • Floating Rate of Interest: Interest payments vary based on a pre-decided interest rate benchmark.
    • Credit Rating: Evaluates the company's ability to service debt and provides a rating to assure lenders.
    • Priority: Interest payments are made before taxes and distributions to equity investors.
    • Security: Lenders may require security, such as a mortgage on assets, to protect their rights.
    • Control: Lenders may place restrictions on the company's decisions to protect their interests.
    • Conversion: Some debt instruments may be convertible into equity shares.

SECURITIES: TYPES, FEATURES AND CONCEPTS OF ASSET ALLOCATION AND INVESTING (Part 3)

  • Debt Instruments: Lenders may seek a conversion of their debt into equity through the issue of convertible debentures, which can be converted into equity at a specific date, price, and time.
  • Features of Debt Instruments: Debt capital can be created by borrowing from banks and other institutions or by issuing debt securities, which denote a contract between the issuer and the lender with pre-determined terms, including:
    • Principal: The amount borrowed by the issuer, with each investor owed a portion of the principal represented by their investment.
    • Coupon: The rate of interest paid by the borrower, usually specified as a percentage of face value, depending on factors such as the risk of default, credit policy, debt maturity, and market conditions.
    • Maturity: The date on which the contract requires the borrower to repay the principal amount, after which the bond is redeemed or repaid and ceases to exist.

Key Concepts

  • Types of Debt Securities: Examples include debentures, bonds, commercial papers, treasury bills, and certificates of deposits, with the terms "bonds" and "debentures" often used interchangeably.
  • Secured and Unsecured Debt: Secured debt securities give investors rights over the assets of the issuing company, while unsecured debt does not provide this option.
  • Listed and Unlisted Securities: Some debt securities are listed on stock exchanges, allowing them to be traded in the secondary market, while unlisted securities must be held until maturity.

Debt Instrument Structures

  • Plain Vanilla Bond: A simple debt security with a fixed interest rate and principal repayment at maturity.
  • Variations in Bond Structures: Modifications to the plain vanilla bond structure, including:
    • Zero Coupon Bond: A bond issued at a discount to face value, with no intermediate coupon payments, and redeemed at face value.
    • Floating Rate Bond: A bond with an interest rate that is re-set periodically based on a pre-decided benchmark rate.
    • Callable Bond: A bond that allows the issuer to redeem the bond prior to its original maturity date.
    • Puttable Bond: A bond that gives the investor the right to seek redemption from the issuer before the original maturity date.
    • Amortizing Bond: A bond in which the principal is repaid over the life of the bond, with periodic payments including both interest and principal.

Classification of Debt Instruments

  • By Type of Borrower: Securities can be divided into those issued by governments and those issued by non-government agencies.
  • By Tenor/Maturity: Securities can be classified as short-term, medium-term, and long-term, with maturities up to one year considered part of the money market and longer maturities part of the capital markets.

Money Market Securities

  • Definition: Instruments for raising and investing funds for periods ranging from one day up to one year.
  • Examples: Repos/reverse repos, certificates of deposits, treasury bills, and commercial papers, all of which are issued at a discount and redeemed at par, with a zero coupon structure.
  • Participants: Banks, primary dealers, financial institutions, mutual funds, provident and pension funds, companies, and the government.
  • Purpose: To enable institutions and companies to meet short-term funding needs by borrowing and lending from each other.

SECURITIES: TYPES, FEATURES AND CONCEPTS OF ASSET ALLOCATION AND INVESTING (Part 4)

  • Repo and Reverse Repo: A repo is a transaction where one participant borrows money at a pre-determined rate against eligible security collateral for a specified period. A reverse repo is a lending transaction, with the borrower's repo being the lender's reverse repo.
  • Eligible Collateral: Central and state government securities and select corporate bonds are used as collateral for repos and reverse repos.
  • Tri-party Repo: A tri-party repo transaction takes place on the electronic platform of the Clearing Corporation of India (CCIL) or the Exchanges, providing a settlement guarantee for trades in return for margins.
  • Certificates of Deposits (CDs): CDs are short-term tradable deposits issued by banks to raise funds, involving the creation of securities and allowing for transferability before maturity.
  • Treasury Bills: The central government issues short-term debt securities called Treasury bills (T-bills) for maturities of 91 days, 182 days, and 364 days through an auction process managed by the RBI.
  • Commercial Papers: Companies raise short-term funds in the money market through the issue of commercial paper (CP), which are unsecured corporate loans with a limited secondary market.
  • Government Securities (G-secs): G-secs are issued to fund the fiscal deficit of the government, with a fixed coupon rate, semi-annual interest payments, and redemption at par.
  • Sovereign Gold Bonds (SGBs): SGBs are government securities denominated in grams of gold, providing a fixed semi-annual coupon of 2.5% on the initial investment, with the amount receivable on maturity linked to the market price of gold.
  • Corporate Bonds and Debentures: The market for long-term corporate debt consists of bonds issued by public sector units (PSU) and private corporate sector, with PSU bonds categorized as taxable and tax-free bonds.
  • Masala Bonds: Masala bonds are corporate bonds issued outside India by Indian companies, denominated in Indian rupees, and advantageous to the Indian issuer as payments are made in rupees.
  • Green Debt Securities: Green debt securities are issued to raise funds for sustainable projects and assets, such as renewable energy, clean transportation, and climate change adaptation.
  • Bharat Bond ETF: An exchange-traded fund (ETF) that tracks the Nifty Bharat Bond Index, investing in AAA-rated bonds of Public Sector Undertakings (PSUs), with a defined tenure and low expense ratio.
  • Benefits of Investing in Debt Securities:
    • Fixed Income: Debt securities provide a fixed coupon rate, making them less risky than variable return securities.
    • Fixed Tenor: Debt is held for a limited period, with capital tied up only for the tenor of the instrument.
  • Risks of Investing in Debt Securities:
    • Inflation/Purchasing Power Risk: Returns from debt securities may be lower and riskier after adjusting for inflation.
    • Credit Risk: The risk of default by the issuer, affecting the investor's ability to receive interest and principal payments.

SECURITIES: TYPES, FEATURES AND CONCEPTS OF ASSET ALLOCATION AND INVESTING (Part 5)

  • Risks Associated with Debt Securities: Investment in debt securities is vulnerable to various risks, including:
    • Inflation Risk: High inflation can reduce the purchasing power of fixed income from debt securities.
    • Default/Credit Risk: The risk that debt issuers may default on interest and/or principal payments.
    • Reinvestment Risk: The risk that investors may not be able to reinvest interest payments at the same or higher rate.
    • Call Risk: The risk that the issuer may exercise the option to call the security earlier, forcing investors to reinvest at lower rates.
    • Liquidity Risk: The difficulty in selling debt securities in the secondary market, making it hard for investors to profit from price rises or switch to higher coupon bonds.
  • Choosing between Debt and Equity Investment Avenues: Investors consider the following factors when choosing between debt and equity:
    • Need for Regular Income vs. Growth: Debt securities are income-oriented, while equity securities are growth-oriented.
    • Time Horizon: Debt instruments are suitable for short-term investments, while equity investments are more suitable for long-term investments.
    • Risk Appetite: Debt instruments are relatively more stable in value, but carry default risk, while equity investments carry higher risk and potential for higher returns.
    • Frequency of Review: Investors who prefer active management of their risk may prefer equity investments.

Hybrid Instruments

  • Convertible Debentures: Debt instruments that can be converted into equity shares of the company at a future date, offering features of both debt and equity.
    • Advantages: Lower coupon rate for the issuer, and potential for capital appreciation for the investor.
    • Disadvantages: Dilution of existing shareholders' stakes, and potential loss of principal for the investor.
  • Depository Receipts (DRs): Financial instruments that represent shares of a local company but are listed and traded on a stock exchange outside the country.
    • Types: American Depository Receipts (ADRs), Global Depository Receipts (GDRs), and Indian Depository Receipts (IDRs).
    • Benefits: Wider investor base, access to international markets, and potential for capital appreciation.
  • Foreign Currency Convertible Bonds (FCCBs): Foreign currency denominated debt raised by companies in international markets, with the option to convert into equity shares before maturity.
    • Benefits: Lower interest rates, faster fundraising, and potential for capital appreciation.
    • Regulations: Subject to regulatory provisions, including listing requirements and conversion guidelines.

SECURITIES: TYPES, FEATURES AND CONCEPTS OF ASSET ALLOCATION AND INVESTING (Part 6)

  • Foreign Currency Convertible Bonds (FCCBs): FCCBs are regulated by RBI notifications under the Foreign Exchange Management Act (FEMA). The issue of FCCBs should be within the limits specified by RBI from time to time.
  • Expenses: The expenses shall be limited to 4 percent of the issue size in case of public issue and 2 percent in the case of private placement.
  • Maturity: The maturity of FCCB shall be not less than five years.

Key Concepts

  • Warrants: Share warrants are options issued by a company that give the holder of the warrant the right but not the obligation to subscribe to a specific number of equity shares of the company at a predetermined price and on or after a predetermined date.
  • Characteristics of Warrants:
    • Warrants are beneficial for a company when the exercise price is higher than the current share price.
    • Warrants permit an investor to lock in a predetermined price for buying the shares on the future date by paying only 25 per cent of the total price.
  • Commodities as an Asset Class: Commodities are ‘real’ assets or assets which are consumed or used in the manufacturing process.
  • Classification of Commodities:
    • Soft commodities (agricultural commodities such as sugar, tea, coffee, cocoa, corn, wheat, soya-bean etc.)
    • Bullion (gold and silver)
    • Base metals (copper, zinc, aluminium, nickel and other metals used for industrial purposes)
    • Energy (crude oil and natural gas)
  • Features of Commodities as an Investment:
    • Storage and insurance costs: Investment in physical forms of commodities involves storage and insurance costs.
    • Specialized knowledge: Investment in commodities requires the investor to track fundamental factors affecting demand and supply of commodities.
  • Role of Commodities:
    • Protection against inflation: Commodity prices are usually higher during periods of rising inflation.
    • Low correlation to equity and debt: Commodities have a low correlation with equity and debt investments, making them an efficient means of diversification.

Derivatives

  • Definition: Derivatives are financial instruments whose value depend upon or are derived from the value of other, more basic underlying variables.
  • Types of Derivatives:
    • Futures contracts: Agreements between a buyer and seller to buy or sell the underlying asset at a predetermined price and quantity on a predetermined date.
    • Options: Contracts that give the holder of the option the right (but not the obligation) to buy or sell the underlying asset at a predetermined price and in a specified quantity at or before a predetermined date.
  • Features of Exchange-Traded Derivatives:
    • Contract specifications are approved by the regulator.
    • Derivatives are under-funded instruments, requiring only a small percentage of the entire value of the underlying asset as margin.
    • Derivatives are leveraged instruments, allowing investors to gain exposure to the entire value of the underlying asset by depositing only a fraction of its value.
    • Derivatives markets are often more liquid than the spot markets or cash markets.
  • Role of Derivatives:
    • Facilitate the process of ‘price discovery’.
    • Allow the transfer of risk from those who wish to avoid risk to those who have the ability and willingness to bear the risk for a price.
    • Permit efficient diversification of a traditional debt plus equity portfolio by enabling retail investors to participate in alternative asset classes such as currencies and commodities.
  • Features of Equity Derivatives:
    • Equity derivatives traded in India comprise futures and options contracts on stock indices and individual stocks.
    • Equity futures and options can be traded on stock indices such as Nifty and Bank Nifty and on specified individual stocks.
  • Features of Currency Derivatives:
    • Currency futures and options are available both on Indian rupee (INR) pairs (USDINR, EURINR, etc.) and cross-currency pairs (EURUSD, etc.).

Securities: Types, Features and Concepts of Asset Allocation and Investing (Part 7)

  • Currency Derivatives: Contracts such as EURINR, GBPINR, and JPYINR, as well as cross-currency pairs like EURUSD, GBPUSD, and USDJPY, are cash-settled in Indian rupees and useful for hedging currency risk.
  • Commodity Derivatives: Futures and options on commodities like gold, industrial metals, crude oil, and agri-commodities are traded on nation-wide commodity derivatives exchanges, allowing users to hedge against price fluctuations and speculate on price changes.
  • Interest Rate Derivatives: Interest rate futures (IRF) and options (IRO) are available on government securities, treasury bills, and MIBOR, enabling users to hedge against interest rate risk and speculate on interest rate direction and volatility.

Asset Allocation and Diversification

  • Definition: Asset allocation involves creating a portfolio with a mix of assets to balance return and risk, while diversification means combining investments to reduce risk by ensuring that not all assets rise or fall together.
  • Benefits: Asset allocation and diversification help reduce portfolio risk, stabilize returns, and increase potential for long-term growth.
  • Investment Objectives and Suitable Investments:
    • Growth and Appreciation: Equity shares, equity funds, real estate, gold
    • Regular Income: Deposits, debt instruments, debt funds, real estate
    • Liquidity: Cash, bank deposits, short-term mutual fund schemes
    • Capital Preservation: Cash, bank deposits, ultra-short term funds

Understanding Investment Process

  • Managing Return and Risk: Asset allocation and diversification are crucial in managing return and risk requirements, with investments like mutual funds providing an easy way to diversify.
  • Aligning Investment Horizon: Selection of investment products should be aligned with the investor's horizon, with younger investors ideally investing more in equities and older investors in debt.
  • Aligning Portfolio Features to Investor Needs: Portfolios may require focus on growth, income, and liquidity at different stages, with the ability to rebalance investments as needed.
  • Ease of Investments and Exits: Investments should be convenient, allowing periodic investments and easy exits when needed.
  • Flexibility in Investments: Investments should be flexible to suit specific requirements, such as choosing a mutual fund Monthly Income Plan (MIP) for lower risk.
  • Information and Updates: Investors should have access to regular information about their investments to assess performance and suitability.

Investing in Equity: Price and Value

  • Intrinsic Value: The estimated value of an equity share based on future earning potentials, which may differ from the market price.
  • Market Price: The price at which the share trades in the stock market, reflecting various estimates of intrinsic value and market forces of demand and supply.
  • Price Discovery: The process by which equity markets gather intrinsic value estimates to arrive at an equilibrium market price, with episodes of inefficiency and chaotic price reflection of underlying information.

SECURITIES: TYPES, FEATURES AND CONCEPTS OF ASSET ALLOCATION AND INVESTING (Part 8)

  • Intrinsic Value: The true value of a share, which may not always be reflected in its market price. If the intrinsic value is perceived to be more than the market value, the scrip is said to be undervalued. If the intrinsic value is perceived to be less than the market value, the scrip is said to be overvalued.
  • Equity Investing Process: Involves:
    • Security Selection: Choosing the right stock to invest in, based on factors such as business, future prospects, profit forecasts, and expansion plans.
    • Market Timing: Periodically reviewing the portfolio to sell low-return stocks and buy shares with potential higher returns, taking into account economic cycles and growth phases.
    • Sector and Segment Weighting: Combining different segments of the equity market into a portfolio, considering risk and return.
  • Commonly Used Terms in Equity Investing:
    • Price Earnings Multiple (PE Multiple): A valuation measure that indicates how much the market values per rupee of earning of a company. It is computed as Market price per share divided by Earnings per share.
    • Price to Book Value (PBV): Compares the market price of the stock with its book value, computed as Market price per share divided by Book Value per share.
    • Dividend Yield: The ratio of dividend per share to market price per share, indicating the return on investment.
  • Equity Research:
    • Buy-side Research: Done by institutional investors to select stocks to invest in, focusing on questioning the model and business case to understand downside risks.
    • Sell-side Research: Done by broking houses to track sectors and stocks, creating earning models and generating sector and stock reports.
  • Equity Analysis and Valuation:
    • Fundamental Analysis: A study of financial statements and information to estimate the future potential of a stock.
    • Technical Analysis: A study of price and volume patterns to understand how buyers and sellers are acting on existing price information.
    • Equity Valuation: Involves using extensive information to estimate future cash flows, modeling variables into a logical valuation framework, and understanding sources of risk.
    • Discounted Cash Flow (DCF) Models: Theoretical constructs that estimate value by looking into information about the business itself, its earnings, growth, and dividends.
    • Relative Valuation Models: Try to find the pricing of something similar to the asset being valued, using peer group averages, sector averages, and other commonalities.

SECURITIES: TYPES, FEATURES AND CONCEPTS OF ASSET ALLOCATION AND INVESTING (Part 9)

  • Introduction to Debt Securities: Debt securities are investments where an investor loans money to a borrower, with the expectation of receiving regular interest payments and the return of their principal investment.
  • Time Value of Money:
    • Definition: The concept that a rupee in hand today is more valuable than a rupee obtained in the future.
    • Details: This is because today's money can be invested to earn a return, making it more valuable than the same amount received in the future.
  • Key Concepts in Debt Securities:
    • Yield and Price: The bond price is the present value of cash inflows from the bond, discounted by the market yield. So, bond price, coupon rate, and yield are all connected.
    • Current Yield: Current yield compares the coupon of a bond with its market price.
    • Yield to Maturity (YTM): The rate which equates the present value of future cash flows from a bond with the current price of the bond.
  • Debt Investing Process:
    • Security Selection: The selection of the investment product depends on the risk appetite and liquidity needs of the investor.
    • Market Timing: Debt investments need to be timed properly, requiring an understanding of the interest rate outlook and credit outlook.
    • Determining Weights: An investor must decide the proportion of funds to be invested in each type of product, depending on their risk appetite and liquidity needs.
  • Important Terms:
    • Credit Spread: The difference in yields between corporate bonds and government bonds with the same maturity.
    • Dynamic Bond Funds: Funds that invest in bonds and have the flexibility to adjust their portfolio in response to changes in interest rates.

SECURITIES: TYPES, FEATURES AND CONCEPTS OF ASSET ALLOCATION AND INVESTING (Part 10)

  • Pricing of Securities: Securities can be priced in various ways, including:
    • At a price that reflects its credit risk
    • At a price below face value
  • Top-Down Approach:
    • Definition: A method of investing that starts with analyzing macro factors such as economic trends and market conditions.
    • Details: This approach involves identifying macro trends and then selecting sectors and stocks that are likely to benefit from these trends.
  • Statement Evaluation: The statement "Top down approach begins at macro factors and identifies sectors and stocks based on the identification of macro trends" is:
    • True, as it accurately describes the top-down approach to investing. The correct answer is: a. True
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