Chapter 2: Securities: Types, Features and Concepts of Asset Allocation and Investing

Taxonomy of Securities in the Capital Market

Securities are categorized into broad asset classes based on the nature of the legal claim, return profile, and priority of cash flow distribution:

1. Equity Securities: Ordinary equity shares representing residual fractional ownership in the enterprise.
2. Debt Securities: Debentures, bonds, commercial paper, and government debt representing borrowed capital with a contractual obligation for interest payment and principal redemption.
3. Hybrid Securities: Preference shares, convertible debentures, warrants, REITs, and InvITs combining equity upside potential with fixed-income characteristics.
4. Derivative Contracts: Futures, options, and structured products deriving their economic value from an underlying security, index, commodity, or currency rate.

Issuer Perspective: The Choice between Equity and Debt Financing

Corporate issuers choose between equity and debt financing based on strategic corporate finance considerations:

Fundamental Features of Equity Capital

• Residual Claim on Cash Flows: Equity shareholders stand at the absolute bottom of the corporate cash-flow hierarchy. They receive dividends only after all operational expenses, vendor liabilities, statutory taxes, senior debt interest, and preference dividends have been fully discharged.
• Limited Liability: The liability of an equity shareholder in a company limited by shares is strictly capped at the unpaid face value (if any) on the shares subscribed. Personal assets cannot be attached to settle corporate debts.
• Perpetual Capital: Equity capital is permanent. A company cannot return capital to shareholders except through a statutory capital reduction or a court-approved / board-approved share buyback under Section 68 of the Companies Act, 2013.
• Differential Voting Rights (DVRs): Under Indian regulations, companies can issue equity shares with Differential Voting Rights (e.g., higher dividend with fractional voting rights, or superior voting rights for promoters), subject to prescribed regulatory safeguards.

Statutory Rights of Equity Shareholders

Under the Companies Act, 2013, holding equity shares confers vital corporate rights:

1. Right to attend, speak, and vote at general shareholder meetings (AGMs and EGMs).
2. Right to receive audited annual financial statements and director/auditor reports.
3. Right to vote on major corporate actions: mergers, acquisitions, debt ceilings, and related-party transactions.
4. Pre-emptive right to subscribe to fresh share issuances via Rights Issues (Section 62).
5. Right to petition the National Company Law Tribunal (NCLT) against oppression and mismanagement.

Concepts of Equity Price, Value, and Fundamental Ratios

In equity investing, Price is what you pay on the stock exchange, whereas Value is the intrinsic worth of the underlying operating business.

• Book Value per Share (BVPS): $$\text{Book Value per Share} = \frac{\text{Net Worth (Equity Capital + Reserves & Surplus)} - \text{Intangibles}}{\text{Total Number of Outstanding Equity Shares}}$$
• Earnings Per Share (EPS): $$\text{EPS} = \frac{\text{Net Profit After Tax} - \text{Preference Dividend}}{\text{Weighted Average Number of Equity Shares Outstanding}}$$
• Price-to-Earnings Ratio (P/E): $$\text{P/E Ratio} = \frac{\text{Current Market Price per Share}}{\text{Earnings Per Share (EPS)}}$$ Indicates how many rupees investors are willing to pay for every rupee of current earnings.
• Price-to-Book Ratio (P/B): Compares market capitalization to accounting book value.
• Dividend Yield: $$\text{Dividend Yield} = \frac{\text{Annual Dividend per Share}}{\text{Current Market Price per Share}} \times 100$$

Fundamental Anatomy of a Debt Instrument

A debt instrument is a formal contract between a borrower (issuer) and a lender (investor) incorporating specific legal terms:

• Face Value (Par Value): The nominal principal amount stated on the instrument (commonly Rs. 100, Rs. 1,000, or Rs. 10 Lakhs for institutional bonds), upon which interest is calculated.
• Coupon Rate: The nominal annual interest rate payable by the issuer, expressed as a fixed or floating percentage of face value.
• Maturity Date (Tenor): The contractually specified date on which the issuer must repay the principal face value to the investor.
• Trust Deed & Debenture Trustee: In India, public and private issues of debentures must be secured by a Debenture Trust Deed, with an independent SEBI-registered Debenture Trustee appointed to protect the legal rights of debenture holders and enforce security charges upon default.

Structural Variations of Debt Instruments

• Zero-Coupon Bonds (ZCBs) / Deep Discount Bonds: Issued at a significant discount to face value and redeemed at par on maturity. The entire investor return originates from the discount accretion without intermediate coupon cash flows.
• Floating Rate Bonds (FRBs): Coupon is reset periodically against a transparent benchmark rate (e.g., RBI Repo Rate, 91-day T-Bill yield, or MIBOR) plus a spread.
• Callable Bonds: Grants the issuer the legal right (but not the obligation) to redeem the bonds prior to maturity at a specified call price. Beneficial to issuers when market interest rates decline.
• Puttable Bonds: Grants the investor the legal right to demand early repayment of principal prior to maturity at a specified put price. Beneficial to investors when interest rates rise.

Bond Yield Concepts

1. Coupon Yield: Nominal coupon divided by face value.
2. Current Yield: $$\text{Current Yield} = \frac{\text{Annual Coupon Payment}}{\text{Current Market Price of Bond}} \times 100$$
3. Yield to Maturity (YTM): The single internal rate of return (IRR) that equates the present value of all future scheduled coupon payments and the final principal redemption cash flow to the bond's current clean market price: $$P = \sum_{t=1}^{n} \frac{C}{(1 + \text{YTM})^t} + \frac{M}{(1 + \text{YTM})^n}$$ Where $P$ is current price, $C$ is coupon, $M$ is maturity value, and $n$ is periods to maturity.

The Inverse Price-Yield Relationship and Bond Risks

Fundamental Theorem of Bond Pricing: Bond prices move inversely to prevailing market interest rates. When interest rates rise, existing fixed-rate bond prices fall; when interest rates decline, bond prices rise.

• Interest Rate Risk: The risk that fluctuations in market interest rates will depress bond prices. Measured by Modified Duration (percentage price change for a 100 basis point parallel shift in yield curve).
• Credit (Default) Risk: The risk that the issuer fails to meet contractual interest or principal obligations. Assessed by Credit Rating Agencies (CRAs: CRISIL, ICRA, CARE, India Ratings).
• Reinvestment Risk: The risk that intermediate coupon cash flows must be reinvested at lower prevailing interest rates.
• Liquidity Risk: The difficulty of selling the bond in the secondary market without suffering substantial price discounts.

Hybrid Securities Architecture

Hybrid instruments blend equity characteristics (long tenor, potential capital appreciation) with debt characteristics (fixed income, priority of claim).

1. Preference Shares

Preference shares possess dual characteristics:

• Preferential Right to Dividends: Must be paid fixed dividends before any dividend can be distributed to equity shareholders.
• Preferential Return of Capital: Upon liquidation, preference shareholders have priority over equity shareholders in capital repayment.
• Non-Voting: They carry no general voting rights unless preference dividends remain unpaid for a period of two years or more (Section 47 of Companies Act).
• Redeemable: Under Indian corporate law, companies are prohibited from issuing irredeemable preference shares. Maximum tenure is capped at 20 years (or up to 30 years for specified infrastructure projects).

2. Convertible Debentures

• Fully Convertible Debentures (FCDs): The entire face value of the debenture is automatically converted into equity shares at a pre-agreed conversion price or ratio on specified dates.
• Partly Convertible Debentures (PCDs): A portion of the face value is converted into equity shares, while the non-convertible portion continues as a regular debt instrument until redemption.
• Optionally Convertible Debentures (OCDs): The investor (or issuer) retains the option to convert the debt into equity or seek cash redemption at maturity.

3. Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs)

• Concept: Specialized trust structures registered under SEBI regulations that pool capital to invest in income-generating commercial real estate (offices, tech parks, malls) or operational infrastructure assets (highways, power transmission grids, gas pipelines).
• Mandatory Distribution Norms: SEBI mandates that REITs and InvITs must distribute at least 90% of their Net Distributable Cash Flows (NDCF) to unitholders semi-annually (or quarterly).
• Dual Return Profile: Provide regular, high cash dividend/interest yields (typically 6.5% - 8.5% pre-tax) combined with capital appreciation from long-term real estate asset revaluations.

Commodities as an Alternative Asset Class

Commodities encompass physical goods traded on recognized commodity derivatives exchanges (MCX, NCDEX, BSE, NSE):

• Asset Categories:
  • Precious Metals: Gold and Silver (viewed globally as stores of value and safe-haven assets during geopolitical turmoil).
  • Base Metals: Copper, Aluminum, Zinc, Lead, Nickel (industrial economic indicators).
  • Energy: Crude Oil, Natural Gas.
  • Agricultural Commodities: Cotton, Soybeans, Chana, Spices, Guar Seed.
• Role in Portfolio Diversification: Commodities exhibit low or negative correlation with traditional equity and fixed-income assets, providing an effective hedge against unexpected inflation and currency depreciation.

Introduction to Derivatives

A derivative is a financial contract whose value is derived from the performance of an underlying asset, index, or benchmark:

• Underlying Assets: Equity shares, equity indices (Nifty, Sensex), interest rates, currencies (USDINR, EURINR), and physical commodities.
• Primary Market Participants:
  1. Hedgers: Seek to eliminate or reduce price risk associated with their existing commercial assets or liabilities.
  2. Speculators / Traders: Assume price risk to profit from anticipated future market price movements.
  3. Arbitrageurs: Exploit temporary price discrepancies between cash and futures markets (or across different exchanges) to lock in riskless profits.
• Contract Types:
  • Forwards: Over-The-Counter (OTC) bilateral agreements customized to specific dates and sizes; subject to counterparty default risk.
  • Futures: Exchange-traded, standardized contracts with daily mark-to-market (MTM) settlement and clearinghouse novation.
  • Options: Asymmetric contracts granting the buyer the right (without obligation) to buy (Call) or sell (Put) at a pre-agreed strike price, while the seller/writer assumes the contractual obligation in exchange for receiving a non-refundable option premium.

The Principle of Asset Allocation

Asset allocation is the process of distributing an investment portfolio among different asset categories (equities, bonds, real estate, gold, and cash) according to an investor's goals, risk tolerance, and investment horizon.

• Empirical Reality: Academic studies (e.g., Brinson, Hood, and Beebower) demonstrate that over 90% of portfolio return variability over time is determined by the strategic asset allocation decision, rather than individual security selection or tactical market timing.
• Diversification and Modern Portfolio Theory (MPT): Harry Markowitz established that combining assets with low or negative correlation ($ ho < 1$) significantly reduces overall portfolio variance without proportionately sacrificing expected returns.

graph LR
    A[Define Financial Goals & Horizons] --> B[Assess Risk Capacity & Tolerance]
    B --> C[Formulate Strategic Asset Allocation]
    C --> D[Select Vehicles: Mutual Funds, Direct Stocks, Bonds]
    D --> E[Execute Portfolio Implementation]
    E --> F[Periodic Review & Corridor Rebalancing]
    F --> C

Steps in the Investment Advisory Process

1. Client Financial Profiling: Analyzing age, income, expenditure, assets, liabilities, tax bracket, and dependents.
2. Goal Definition and Time Horizon: Quantifying near-term goals (< 3 years), medium-term goals (3 to 7 years), and long-term goals (> 7 years).
3. Determining Risk Profile: Evaluating Risk Capacity (financial ability to take loss) versus Risk Tolerance (psychological comfort with volatility).
4. Formulating the Investment Policy Statement (IPS): Drafting the formal guiding roadmap containing target asset allocation, return hurdles, liquidity buffers, and permitted instruments.
5. Portfolio Construction & Execution: Selecting specific cost-effective vehicles (direct mutual funds, exchange-traded funds, G-Secs, corporate bonds).
6. Monitoring and Rebalancing: Implementing systematic rebalancing whenever market movements cause asset weights to breach predetermined tolerance bands (e.g., $\pm 5%$).