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

1Equity, debt and the other choices

Businesses raise capital in two basic forms:

• Equity: stays with the business as long as it needs it, has no fixed return and no promise to repay. Equity investors are owners, take part in management and get all the leftover (residual) benefit.
• Debt: must be repaid after a fixed period, pays a fixed interest rate and gives no say in management. Debt investors are lenders.

Equity is risky, long-term and growth-oriented; debt is lower-risk, income-oriented and usually shorter term. Splitting money between them is asset allocation.

Other avenues: hybrid securities (part debt, part equity); commodities (real assets such as gold, metals, farm produce; retail investors usually use commodity ETFs and funds); derivatives (contracts on an underlying, suited to sophisticated investors); mutual funds (pooled, best suited to retail investors); structured products (a bond or similar with an embedded derivative, complex and illiquid, for high-net-worth investors); distressed securities (issued by companies near or in bankruptcy, bought at deep discounts by specialists such as hedge funds); Electronic Gold Receipts traded on a Gold Exchange, with vault managers regulated under the SEBI (Vault Managers) Regulations, 2022; and Zero Coupon Zero Principal instruments issued by not-for-profits on a Social Stock Exchange, which promise a social return, not money.

Example A company borrows at 12% and earns 14% on the assets it buys. Lenders still get only 12%; the extra 2% belongs to the shareholders. If the assets earn only 10%, the shareholders bear the shortfall.

Remember

• Equity = owner, residual claim, no fixed return.
• ZCZP instruments pay no interest and no principal; the return is social.

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2How an issuer chooses between equity and debt

Short-term needs (working capital, salaries) are met with short-term debt. Long-term needs can use equity or debt; governments only issue debt. The issuer weighs four factors:

1. Ability to pay regular interest: steady profits favour debt; uneven profits favour equity.
2. Willingness to dilute ownership: owners who do not want to share control prefer debt.
3. Collateral: service businesses with few assets find it hard to borrow and lean towards equity.
4. Period of need: short-term needs favour debt; long-term needs that lenders will not fund favour equity.

Remember

• Dilution worry → debt. No collateral or unstable profits → equity.

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3Features of equity capital

• Equity shares carry a face value (commonly ₹1, ₹2, ₹5 or ₹10). Companies funded this way are joint stock companies.
• Inside shareholders are promoters and early investors such as venture capitalists; outside shareholders are the public who invest later.
• Ownership is proportional to shares held (the stake). Owning 5,100 of 10,000 shares is a 51% majority stake. ESOPs give employees a small stake.
• Equity is raised in perpetuity. Dividends are not fixed and come only after costs, interest and tax.
• Shareholders rank last for profits and in liquidation (after government, lenders, employees and preference shareholders): a residual claim.
• Profits not paid out become retained earnings and go to reserves, which belong to the equity shareholders and raise net worth. Equity is also called risk capital.
• In large companies, ownership and management are separate. The board of directors oversees management; independent directors look after small shareholders. Each share carries one vote, cast at general meetings, by postal ballot or e-voting.

Example 10,000 shares of face value ₹10 = equity capital of ₹1,00,000. With face value ₹2 it would be ₹20,000.

Remember

• Reserves belong to equity shareholders.
• Equity holders are last in line for profits and assets.

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4Types of equity: DVRs and preference shares

• Differential voting rights (DVR) shares separate profit rights from voting rights: usually a higher dividend but fewer votes. Promoters can raise capital without losing control.
• Preference shares pay a fixed rate of dividend, paid before ordinary shareholders but after all other payments. They have no voting rights (in normal course) and rank ahead of equity in getting capital back on winding up.

How preference shares differ from debentures: a preference holder is a shareholder, a debenture holder a creditor; debentures are usually secured, preference shares are not; debenture interest is an expense before tax, while preference dividend is paid out of profit after tax.

Cumulative preference shares carry unpaid dividends forward to later years. Preference shares are rarely listed and offer little capital appreciation.

Exam trap Preference shareholders get a fixed dividend only if there are enough profits; it is not a guaranteed interest payment.

Remember

• DVR: more dividend, fewer votes.
• Cumulative = unpaid dividend carried forward.

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5Risk and return in equity

Equity returns come from dividends and capital appreciation in the secondary market. Both depend on future residual profits, which are uncertain. Prices are "noisy" because many investors keep reacting to new information. Over time, prices mirror how well a company, sector or the economy is doing.

Remember

• Two sources of equity return: dividend + price rise.

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6Features of debt securities

Debt is raised through debentures, bonds, commercial paper, certificates of deposit and pass-through certificates. Each has a tenor and a coupon, quoted as a percentage per year of face value.

• Principal (face value), coupon (interest rate and frequency) and maturity (repayment date, after which the bond is extinguished) are the basic terms.
• Floating rate debt resets the coupon periodically against a benchmark such as MIBOR.
• A credit rating gives lenders an outside view of the issuer's ability to pay.
• Interest is paid before tax and before shareholders; missing it is a default. In liquidation, lenders are paid before employees and shareholders.
• Secured debt is backed by a charge on assets that lenders can sell if unpaid.
• Lenders do not manage the company but may impose covenants (no unrelated diversification, limits on more borrowing, more equity from owners).
• Convertible debt turns into equity on set terms; interest is paid until conversion.

Splitting a ₹100 crore loan into one crore bonds of ₹100 each lets many investors lend small amounts. By convention, government and PSU borrowings are called bonds and private company borrowings debentures, but the terms are now used interchangeably. Listed debt can be traded; unlisted debt must be held to maturity.

Remember

• Interest is a legal obligation; dividend is not.
• Lenders rank ahead of shareholders.

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7Bond structures

A plain vanilla bond pays fixed interest and repays at par. Variations:

• Zero coupon bond: no interest during its life; issued at a discount and redeemed at face value (or issued at par and redeemed at a premium). Long ones are deep discount bonds.
• Floating rate bond: coupon reset against a benchmark, e.g. 1-year G-sec yield + 50 basis points every six months.
• Deferred interest and step-up bonds lower the interest burden in early years.
• Callable bond: the issuer may repay early, typically when rates fall. Good for the issuer, bad for the investor who loses a high coupon.
• Puttable bond: the investor may demand early repayment, useful when rates rise.
• Amortising bond: principal is repaid over the life, as in home and car loan instalments; "maturity" means the last payment.

Exam trap Call option = issuer's right. Put option = investor's right.

Remember

• Zero coupon: return = redemption value minus issue price.
• Amortising: each payment has interest and principal.

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8Classifying debt: money market, G-secs and corporate bonds

Debt is classified by borrower (government or non-government) and by tenor. Up to one year is the money market; longer is the capital market.

Money market instruments are issued at a discount and redeemed at par:

• Repo / reverse repo: borrowing against eligible collateral (G-secs, some corporate bonds). A repo for the borrower is a reverse repo for the lender. Tri-party repo is cleared through a central counterparty (CCIL or the exchange's clearing corporation), which guarantees settlement and collects margins. Exchanges offer basket repo contracts of 1 to 7 days on corporate bonds.
• Certificates of deposit: tradable short-term deposits issued by banks.
• Treasury bills: issued by the central government for 91, 182 and 364 days, through RBI auctions.
• Commercial paper: unsecured, rated short-term borrowing by companies, up to 364 days; 90 days is the most common.

Call money, term money and inter-corporate deposits are money market transactions but create no security.

Government securities fund the fiscal deficit, are auctioned by the RBI under a half-yearly calendar, and range from 1 to 40 years. Most are dated securities with fixed semi-annual coupons. G-secs are treated as free of default risk (the government can tax, borrow or print money) and set the benchmark: other borrowers pay a spread over the G-sec yield. G-secs make up over 90% of trading in the long-term debt market, concentrated in benchmark maturities.

Corporate bonds: PSU bonds (taxable or tax-free), capital gains bonds under Section 54EC (NHAI and other notified issuers), and private corporate bonds. The extra yield over G-secs is the credit spread: higher rating, lower spread. Others:

• Masala bonds: rupee-denominated bonds issued abroad; the foreign investor bears the currency risk.
• Green debt securities: raise money for sustainable projects; part of ESG investing. India has issued sovereign green bonds.
• Bharat Bond ETF: tracks an index of AAA-rated PSU bonds, has a fixed maturity, a very low expense ratio and is taxed like a debt fund.

Company fixed deposits are rated but unsecured and are not securities, so they have no liquidity.

Exam trap T-bills are issued by the central government only; companies use commercial paper; banks use certificates of deposit.

Remember

• T-bill tenors: 91, 182, 364 days. CP: up to 364 days.
• Credit spread = corporate yield − G-sec yield.

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9Benefits and risks of debt

Benefits: a legally promised fixed income and a fixed tenor.

Risks:

• Inflation risk: fixed coupons lose real value if inflation exceeds the coupon.
• Default (credit) risk: zero for central government securities; lower for secured debt; reflected in ratings.
• Reinvestment risk: interest taken out may have to be reinvested at lower rates. The cumulative option avoids this.
• Call risk: the issuer calls the bond when rates fall, forcing reinvestment at lower rates.
• Liquidity risk: thin secondary markets mean most retail investors hold to maturity and cannot easily profit from falling rates or switch when rates rise.

Remember

• Five debt risks: inflation, default, reinvestment, call, liquidity.

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10Choosing between debt and equity as an investor

Four considerations: need for regular income versus growth (retirees lean to debt); time horizon (short periods → debt; long periods → equity); risk appetite (equity can lose the whole amount); frequency of review (active investors prefer equity; debt investors tend to buy and hold).

Remember

• Debt = income; equity = growth.

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11Hybrid instruments

• Convertible debentures pay interest and later convert into shares on set terms (date, ratio, price, proportion). Fully convertible (FCD), partly convertible (PCD) or optionally convertible (OCD), where the holder decides. The issuer pays a lower coupon and may not have to repay cash, but existing shareholders are diluted on conversion.
• Depository receipts represent shares of a company listed on a foreign exchange: ADRs in the USA, GDRs elsewhere, IDRs when foreign companies list receipts in India. Shares are lodged with a custodian and a depository bank issues the receipts. DR holders get dividends and price gains but no voting rights. Using existing shares is a sponsored issue. Two-way fungibility allows conversion between shares and DRs. IDRs are open to resident Indians, not FPIs.
• FCCBs are foreign-currency bonds convertible into shares, usually at a premium to the market price. Interest and principal are paid in foreign currency. Regulated by RBI under FEMA; minimum maturity five years; issue expenses capped at 4% (public) or 2% (private placement). A company not eligible to raise equity in India cannot issue FCCBs.
• Warrants give the right, not the obligation, to buy shares at a set price on or after a set date. Issued by the company with a long life (exchange stock options are short-lived). Investors pay 25% upfront; if they do not exercise, that amount is forfeited.

Example 4,00,000 warrants at ₹220 → upfront payment = 25% × 4,00,000 × 220 = ₹2.2 crore.

Remember

• DRs: no voting rights. FCCB: minimum 5 years.
• Warrants: 25% upfront, forfeited if not exercised.

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12Commodities as an asset class

Commodities are real assets: soft (agricultural), bullion (gold, silver), base metals (copper, zinc, aluminium, nickel) and energy (crude oil, natural gas). Physical holding brings storage and insurance costs, and investors need specialised knowledge of weather, inventories and demand.

Their roles: a hedge against inflation and low correlation with equity and debt, which makes them good diversifiers. Buying shares of a steel company is not a pure play on steel prices because company-specific risks come with it. Direct exposure comes through commodity ETFs, commodity funds or commodity derivatives.

Remember

• Commodities protect against inflation and diversify a portfolio.

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13Derivatives in brief

A derivative's value comes from an underlying asset. Exchange-traded derivatives in India are futures (an obligation to buy or sell at a set price on a set date) and options (a right, not an obligation; call = right to buy, put = right to sell, at the strike price until expiry). Contracts are designed by exchanges and approved by the regulator.

Key traits: they need only a margin (underfunded), so they are leveraged; they are often more liquid than the cash market; leverage magnifies both gains and losses. Roles: price discovery, risk transfer (hedging) and diversification into currencies and commodities.

• Equity derivatives: on indices (cash settled) and selected stocks (physically settled).
• Currency derivatives: INR pairs (USD, EUR, GBP, JPY) and cross-currency pairs, all cash settled in rupees.
• Commodity derivatives: commodity options are options on futures, because SEBI regulates futures while State governments regulate spot markets.
• Interest rate derivatives: futures on G-secs, T-bills and MIBOR; options on G-secs; cash settled.

Example With a 10% margin, ₹100 of margin controls shares worth ₹1,000: 10 times leverage.

Remember

• Stock F&O: physical settlement. Index F&O: cash settlement.
• Commodity options settle into futures positions.

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14Asset allocation and diversification

No single investment gives growth, regular income, liquidity and capital safety together, so investors combine assets. Equity, real estate and gold suit growth; deposits and debt suit income; cash and short-term funds suit liquidity and capital preservation. Concentrating in one asset is risky: all-real-estate is illiquid, all-savings-account loses to inflation, all-equity is volatile, all-gold gives no income, all-FDs fails as expenses rise.

Asset allocation spreads money across asset classes; diversification then spreads money within each class (for example, shares from different industries) so that not everything falls together. Someone near retirement holds more debt; a young high earner with distant goals holds more equity.

Remember

• Allocation across classes is the first level of diversification.

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15Matching investments to the investor

Good investment choices balance return and risk; match the horizon (equity for long periods); suit the stage of life (growth while accumulating, income after retirement); are easy to invest in regularly and exit; are flexible (for example, a growth option when income is not needed); and provide regular information. Mutual funds make diversification possible even with small amounts.

Remember

• Younger investors with no near-term needs can hold more equity.

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16Price versus value in equity

Intrinsic value is the present (discounted) value of the future benefits from a share. Market price is what it trades at. If intrinsic value is above price, the share is undervalued; below price, overvalued. Markets are not perfectly efficient, so gaps appear, but prices cannot stay far from value for long. That anchoring is what separates investing from gambling.

Example Analysts value a share at ₹50 and it trades at ₹35: undervalued.

Remember

• Buy undervalued (value > price); sell overvalued.

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17The equity investing process and key ratios

Equity investing involves security selection, market timing (economic and business cycles affect sectors differently) and sector and segment weighting (large or small, growth or dividend stocks).

Formula P/E ratio = Market price per share ÷ Earnings per share (EPS = profit after tax ÷ number of shares)

A higher P/E means the market expects higher growth; analysts focus on prospective P/E. For the market index, a P/E around 22x or more is often seen as overvalued and 12x or less as undervalued.

Formula Price to book value = Market price per share ÷ Book value per share (book value = net worth ÷ shares)

A P/BV below 1 may indicate undervaluation. Book value uses historical cost, so it may not reflect the realisable value of assets.

Formula Dividend yield = Dividend per share ÷ Market price per share

Dividends are declared as a percentage of face value. Dividend yield moves inversely to price: it falls in bull markets and rises in bear markets.

Example A 40% dividend on a ₹10 share = ₹4 per share. At a price of ₹200, dividend yield = 4 ÷ 200 = 2%.

Remember

• Dividend % is on face value; dividend yield is on market price.

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18Equity research, analysis and valuation

Buy-side research is done by institutional investors for their own portfolios (analysts tend to be generalists). Sell-side research is done by brokers, with sector specialists who build earnings models, meet managements and publish reports.

Fundamental analysis studies financial statements and business information to estimate intrinsic value. Technical analysis studies price and volume patterns, support, resistance and trends. The economy–industry–company (EIC) framework can be applied top-down (macro first, then sectors and stocks) or bottom-up (stock first, then checked against industry and macro). Information comes from audited accounts, management meetings and plant visits, industry reports and government publications.

Valuation approaches: discounted cash flow models (rigorous, driven by cash flow and discount rate assumptions) and relative valuation (comparing with peers or sector averages: easier, but can inherit market pricing errors).

Remember

• Top-down starts with the economy; bottom-up starts with the company.

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19Bond maths: time value, yield and price

Money today is worth more than the same amount later because it can earn a return. To value a bond, discount each coupon and the redemption amount at the market yield and add them up. The further away a cash flow is, and the higher the yield, the lower its present value.

Example 5-year bond, face value ₹100, 10% annual coupon, market yield 8%. PV = 10/1.08 + 10/1.08² + 10/1.08³ + 10/1.08⁴ + 110/1.08⁵ = ₹107.98. The bond is worth more than face value because its coupon beats the market yield.

Price and yield move in opposite directions. Bought below face value, yield is above the coupon; bought above face value, yield is below the coupon.

Formula Current yield = Annual coupon ÷ Market price

Example 12% coupon bond priced at ₹109.50: current yield = 12 ÷ 109.5 = 10.95%.

Yield to maturity (YTM) is the discount rate that makes the present value of all future cash flows equal to today's price. Market yield quotes usually mean YTM.

Exam trap If market interest rates rise after issue, an existing bond's price falls below face value.

Remember

• Price up ⇔ yield down.
• Current yield ignores time value; YTM includes it.

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20The debt investing process

Debt investing needs more macroeconomic knowledge. Security selection depends on risk appetite and liquidity needs (retail investors favour FDs, small savings and short-term funds; institutions use G-secs, money market and corporate bonds). Market timing follows the interest-rate and credit cycle: buy long-dated G-secs when rates have peaked to lock in high yields. Credit spreads widen in recessions and narrow in booms, which can offer bargains in highly rated bonds. Investors who cannot track rates can use dynamic bond funds.

Remember

• Lock in long bonds at the peak of the rate cycle.
• Credit spreads widen in slowdowns.

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