FMDQ Learning: Introduction to securities markets (1)

Asecurity represents a means by which governments, companies, commercial enterprises etc. can raise capital, as well as an investment aimed at redistributing funds from those with excess to those in need of funds.

The decision to raise capital could be for a number of reasons, such as, an organisation looking to expand its operations; the government looking to raise capital for infrastructural projects to build hospitals, schools or roads and entrepreneurs starting up new businesses.

Whilst going directly to a bank to obtain a loan is also an option to raise capital, organisations decide to access the capital market in order to raise capital for various reasons and are faced with the decision of either raising the funds via issuing debt or equity securities.

What is a Security?

A security is a financial instrument issued by a business entity or government, which gives the buyer an ownership position or share in the earnings of the organisation, a right to interest payments or creditor relationship with the corporation or government. The entity that issues the security is known as the issuer.

Securities are typically categorised into: Debt and Equity

Debt securities, also known as fixed income securities, are instruments used by the issuers of the securities as a source to borrow money, and include bonds, commercial papers, debentures etc. An entity looking to raise funds can sell (or issue) debt securities into the securities market instead of going to the bank to obtain a loan.

Once these securities are issued, the issuing entity becomes indebted to the buyers of the securities. Essentially, a debt security represents money that is borrowed which must be paid back.

The entity typically pays the investors a fixed rate of interest and the principal is payable at maturity, along with other contractual rights under the terms of issue. Debt securities are not centrally traded but are bilaterally traded OTC.

Equity securities refer to an instrument that signifies an ownership position in a corporation. An example of an equity instrument would be a common stock or a share, such as those traded on a stock exchange. Ownership in the company is determined by the number of shares a person/entity owns divided by the total number of shares outstanding, and therefore called equity.

The shares give the shareholders the right to participate in the decision-making process of the company. If the company is profitable, the shareholders may receive dividends, a decision which is taken at a General Meeting of the Shareholders. The table below details the key differences between debt and equity securities.

Key differences between Debt and Equity Securities

Debt Securities holders do not gain ownership in the issuing entity or have claims over their future profits but only receive interest and repayment of the principal from the issuer; while Equity Securities (shares) holders gain ownership of the entity whose shares they hold and have claims on future earnings of that entity.

Debt Securities are considered to be less risky investments than equity securities investments as the debt market returns are less volatile than the stock market returns’ equity securities are considered to be riskier than debt securities as returns generally fluctuate and are more volatile.

Debt Securities have a date of maturity in which borrowed funds are returned to the holders of the securities; equity securities have no period of expiry.  Debt Securities require mandatory interest payments and capital repayments are made to the holders of the securities; while holders of equity securities may get paid dividends however this is not a mandatory requirement.

In the case of bankruptcy, holders of these debt securities are paid first; in the case of bankruptcy, holders of equity securities are the last to be paid and share only in residual interest after all obligations have been paid out to creditors.

Holders of debt securities are not entitled to any form of control of the company and do not have any voting rights; while holders of equity securities are entitled to some control of the company/entity and maintain voting rights. They also have rights to any capital gains and profits of the company/entity.