Information for Investors

What are the different types of capital instruments

Different types of capital market instruments

What are shares?

A share is a security which represents a portion of the owner's capital in a company. Shareholders are the owners of the company. They share in the success or failure of the business of the company. This can be measured by the amount of dividends that they receive and by the price of the share, quoted on the stock market.

The different types of securities that are traded include:

a. Ordinary shares

Also called equity securities (in the US ordinary securities are referred to as common stock) and this is the risk capital of a company. Ordinary securities give holders the rights of ownership in the company, such as the right to share in the profits, the right to vote in general meeting and to elect and dismiss directors. Holders receive dividends which vary in amount in accordance with the profitability of the company and recommendations of directors. Obligations of ownership are also conferred and this may result in the loss of an investor's money if the company is unsuccessful. Ordinary securities usually form the bulk of a company's capital and have no special rights over other securities. In the event of liquidation, ordinary securities rank after all other liabilities of the company.

b. Preference shares

As an alternative to ordinary securities, companies may issue preference securities. Holders have certain preferential rights, mainly relating to the entitlement to a dividend.

Preference securities generally carry no voting rights, but voting rights may be made contingent upon failure to pay dividends on preference securities for a certain period of time.

In the unlikely event of a company not being able to pay a dividend to all shareholders, the preference shareholders get paid first. That's why they are called preference securities. Dividends are payable at a fixed rate and therefore offer more certainty than dividends from ordinary securities. But since well-run companies tend to increase their dividends faster than the rate of inflation, preference shareholders still get the same fixed income.

As a result they do not share in the long-term growth of the company. Preference securities are low-risk compared to ordinary securities.

There are various types of preference securities:

i. Participating preference securities are entitled to participate in the profits beyond the fixed dividends, by way of an additional fluctuating dividend if the company is successful.

ii. Cumulative preference securities are preference securities which, apart from having a preferential right to receive a fixed dividend ahead of ordinary securities, also carry the right of any arrears of the preference dividends which may have built up.

iii. Non-cumulative preference securities are preference securities which are not entitled to any arrears in dividends.

iv. Redeemable preference securities may be redeemed by the company at a stated redemption price on advance notice of a period of time.

v. Convertible preference securities are preference securities which carry the right of conversion to another class of securities, normally into ordinary securities.

How to make a good investment

How to make a good investment in the stock market

Investing in securities is like investing in a business. The objective is to get a good return. This could be either to get a regular income by way of dividends or to get a profit by way of capital appreciation of the securities or both.

An investor who is interested in getting regular dividends from the company must look at the company's dividend policy carefully. Where a company has not stated their dividend policy they could make an assessment of this by analysing the company's past dividend record and its pattern of payment.

There are several ratios that may be used in investment analysis. Most commonly used ratios are as follows:

Calculating the dividend yield on the basis of the last annual dividend can give an investor an idea of what the percentage return he could expect by way of dividend (Dividend yield = dividend per share / market price of a share x 100).The dividend cover is a guide to the company's financial background indicating the total dividends covered with respect to available earnings (dividend cover = profit / dividends). Dividend payout ratio is also useful to ascertain whether the company is retaining sufficient funds for future development and growth. A high ratio indicates that a shareholder is receiving a large part of the earnings and that the company is not retaining much by way of reserves. This may mean that a shareholder cannot expect much by way of capital appreciation (Dividend payout ratioc=cdividend per share / earnings per share x 100).

The earnings per share (EPS = profit of the company/total number of securities issued) may be calculated for the last five years and should ideally show an upward trend (or an overall trend that is continuing to rise). An increase in earnings should ideally be accompanied by an increase in dividend when analysed over a period of five years. The price earnings ratio indicates the expectation about the future of the company. It is a measure of investor confidence. Higher the PE ratio the more popular the share. (PEratio = market price per share / earnings per share).

Be aware of the risks ....

All investors must be aware of the risks attached to investing in securities. The securities of a company could fluctuate in value due to the business risks as well as financial risks.

Business risk may arise from fluctuation of profits due to changes in demand (new and better products coming into the market, competitors increasing its strength, the overall economic activities) or supply (new methods of production, varying costs of labour or raw materials).

Financial risks can be measured by the return to shareholders and the probability of the company having to go into liquidation brought about by the inefficient use of borrowed funds or by borrowing more than what the company could service. The higher the proportion of borrowed funds the higher the capital gearing. This gearing ratio (gearing ratio = borrowed funds / total funds) must be considered along with the current ratio (current ratios=acurrent assets / current liabilities). If this is also high then the risk is greater.

If the company has not made profits the Directors will not be able to declare a dividend.

An investor may minimise the risks by making a fully informed decision. He could obtain the advice of his broker or else he could make a decision himself by reading the annual reports of the company carefully and in addition considering the following factors: economic factors of the country and future trends, performance of the industry, quality of the company's management, reputation of the board of directors, company's current trading position, strengths and weaknesses of the company and the business risks involved. An investor must not be guided by rumours.

To minimise risk, he may invest in securities of several companies, preferably operating in different industries.

Investors should invest in securities only after having considered all of the above factors. By investing in securities traded on the stock market there is a possibility of getting a higher return by way of dividends and/or capital appreciation. Therefore to increase your income, trading in securities on the stock exchange may be advantageous.

Debentures

What are debentures?

A debenture is an instrument where the issuing company undertakes to pay the holders interest periodically at a specified rate known as the coupon rate. This rate will depend on the prevailing interest rates in the market for securities with similar risk features. Unlike securities debentures usually have a limited life of say 3 to 5 years. The principal amount is repaid at the end of the life of the debenture which is known as maturity. Maturity refers to the date on which the issuer has promised to redeem the issue by repaying the principal value. The number of years until the date of redemption is referred to as the term, the term- to- maturity or the maturity period. A graph which shows the relationship between the coupon rate and maturity is known as the Yield curve. The securities which are used in the construction of a yield curve are similar in all respects, except maturity. A debenture is similar to a share in the sense that it can be traded on the Securities Trading Floor. However, unlike a shareholder, a debenture holder is not an owner of the company.

The rights of the debenture holders are specified in a document known as a Trust Deed. Therefore if the issuing company fails to honor periodic interest payments or the repayment of the capital at maturity, then the debenture holders will represent matters to the Trustee who will act on behalf of the debenture holders to protect their interests in accordance with the terms of the trust deed. If the company does not pay interest or repay the principal value, the debenture holders may, as a last resort, force the company into liquidation to recover their capital and interest.

The debentures differ in type depending mainly on the protection afforded to holders. The common types are as follows:

A secured debenture is a debenture in which the promised obligations are secured by specific assets. The investors will have recourse to the assets in the event of default.

A third party, usually a financial institution, may guarantee the payment of interest and/or principal in the event the issuer fails to honor payment. Such debentures are known as guaranteed debentures.

A convertible debenture gives the investor the option to convert it into a specified number of common securities of the issuer at a specified time.

A subordinated debenture is an issue in which, in the event of winding-up, the claims of debenture holders rank after all claims of secured and unsecured creditors of the issuer but in priority to the claims and rights of shareholders. Otherwise the claims of debenture holders will rank equally with claims of other creditors.

Some issuers of debentures may choose to obtain a credit rating for the debenture. Credit rating is an assessment of the issuers ability to service the interest and principal on a timely basis. This work is carried out by independent companies known as credit rating agencies.

Some issuers may wish to have the right to retire the debenture, fully or partly, at a pre-specified price before maturity. This is known as a call option. Some other issuers may give the investor the right to sell the debentures back to the issuer at a specified price and time. This is known as a put option.

A debenture holder need not wait till maturity to get back his investment. He may sell the debenture on the Securities Trading Floor. The investor will make a capital gain or loss depending on the interest rates of the bank deposits and the government securities. If the interest rates have moved down, then the investor will make a capital gain. Otherwise he will make a capital loss. The sale price will be determined by the yield to maturity which is a measure of the total rate of return of a debenture. This yield is calculated assuming the debenture is held to maturity and the interim cash flows are reinvested at the same rate as the coupon rate.