EQUITY SECURITIES: Overview and Types

equity securities

Whether you invest primarily in equity or fixed-income securities, most of us are familiar with the more common names used to describe traditional investment securities. Such names are stocks, bonds, exchange-traded funds (ETFs), mutual funds, and so on. However, specialized terms can sometimes leave the average investor perplexed or uncertain. ‘Equity securities’ is one of these terms. This article will define securities and discuss the various types, with an emphasis on equity securities.

What Is a Security?

The term “security” refers to any fungible, negotiable financial instrument with monetary value. It represents stock ownership in a publicly traded corporation; a creditor relationship with a governmental body or corporation represented by owning that entity’s bond; or ownership rights represented by an option.

Securities are typically classified into two types: equities and debts. Some hybrid securities, on the other hand, combine aspects of both equities and obligations.

Equity Securities

Equity security is a share of capital stock that reflects the ownership stake held by shareholders in an entity. Such an entity could be a business, partnership, or trust. Shares of capital stock comprise both common and preferred stock.

Holders of equity securities are normally not entitled to monthly payments (though equity securities frequently pay out dividends). However, they can profit from capital gains when they sell the securities (provided the value has improved).

Through voting rights, equity securities do provide the holder with some pro-rata control of the corporation. In the event of bankruptcy, they only receive residual interest once all obligations to creditors have been met. They are sometimes presented as a form of payment in kind.

Types of Equity Securities

There are four major types of equity securities:

#1. Common Stock.

The most common sort of equity asset issued by firms is common stock. These are also known as common shares, ordinary shares, or voting shares. A common share is a company’s ownership interest. Common shares are issued with no maturity dates and have an indefinite life. A par value may or may not be assigned to common stock. When firms issue common shares with par values, they generally set the par value extremely low, such as Rs.10 per share in India. It is crucial to remember that, even at the time of issuance, the par value of a common share may have no relationship to its market value.

For example, a shareholder may be granted a common share with a par value of Rs. 10 for Rs. 50. By market value, common shares account for the lion’s share of equity securities. Large corporations frequently have a large number of common owners. Each of these owners holds a part of the company’s total shares. Investors can purchase common stock in both public and private companies. Shares of publicly traded corporations are often traded on stock exchanges, which facilitate share trading between buyers and sellers. Private corporations are often significantly smaller than public corporations, and their stock does not trade on stock markets. The capacity to sell common shares of public corporations on stock exchanges allows potential shareholders to trade when and at what price they desire.

#2. Preferred Stock 

Businesses may also issue preferred stock (also known as preferred shares or preference shares). Preferred stocks are hybrid securities because they have the characteristics of both debt and equity investments.

Preference stockholders have both benefits and drawbacks. On the plus side, they receive dividend payments before common stock shareholders. On the other hand, they do not have the voting rights that regular shareholders possess.

As a result, preferred stockholders typically receive dividends before common stockholders. They also have a stronger claim on the company’s assets than common shareholders if the company goes bankrupt. In other words, preferred shareholders get special treatment in various ways.

Preferred shares are usually issued with a par value. This par value, along with a stated dividend rate, establishes the amount of the yearly dividend promised to preferred shareholders. Preferred share conditions may include the right of the issuing firm to buy back preferred stock from shareholders at a predetermined price, known as the redemption price. In general, the pre-specified redemption price equals the preferred share’s par value. The par value of a preferred share is also often the amount the shareholder would be entitled to receive in the event of a liquidation, provided there are sufficient assets to fulfill the claim.

Although it is not a legal obligation of the corporation, preferred shareholders often get a predetermined dividend. If the company does well, the preferred dividend will not be increased. When the firm performs poorly, the board of directors is frequently hesitant to lower preferred dividends.

#3. Convertible bonds 

Companies may issue convertible bonds to raise finance. A convertible bond is a bond issued by a firm that allows the bondholder to convert the bond into a set number of common shares. Although a convertible bond is debt security prior to conversion, the fact that it can be converted to common shares makes its value partially dependent on common share prices. Convertible bonds are so classified as hybrid securities. Hybrid securities combine the characteristics and linkages of equity and debt securities.

The conversion ratio is the number of common shares that the bondholder will get after converting the bond. The conversion ratio may remain constant throughout the life of the security or it may change over time. A convertible bond’s conversion value (or parity value) is the value of the bond if it is converted to common stock. The conversion value equals the conversion ratio multiplied by the share price. The bonds are retired (no longer exist) at the time of conversion, and common shares are issued.

Because the conversion feature benefits the bondholder, a convertible bond usually has a lower fixed annual coupon rate than a comparable bond without a conversion feature (a straight bond). Convertible bonds have an expiration date. If the bonds are not converted to common stock before maturity, they will be paid off and retired like any other bond on the maturity date.

#4. Warrants

A warrant is equity-like security that entitles the holder to purchase a predetermined amount of the issuing company’s common stock at a predetermined per-share price (called the exercise price or strike price) prior to a predetermined expiration date. Warrants may be issued by a corporation to investors to raise capital or to employees as a form of compensation. Warrant holders may choose to exercise their rights before the expiration date.

A warrant holder will only exercise his or her right if the exercise price is equal to or less than the price of a common share. Otherwise, buying the stock on the market would be less expensive. When a warrant holder exercises his or her right, the corporation creates a certain number of new shares and sells them to the warrant holder at the exercise price.

Warrants usually have expiration dates that are several years in the future. In rare situations, firms will attach warrants to a bond or preferred stock issue to make the bond or preferred stock more appealing. Warrants are known as sweeteners when issued in this manner. This is because their inclusion often permits the issuer to provide a lower coupon rate (interest rate) on a bond issue or a lower annual fixed dividend on a preferred stock issue.

Warrants may also be issued to employees as a form of remuneration. In this case, we refer to them as employee stock options. When warrants are utilized as employee remuneration, the purpose is to connect the employees’ goals with the shareholders’ goals. Many organizations pay their top management salary as well as some type of equity-based compensation, such as employee stock options.

Restrictions on Equity Securities 

It may be permissible to sell shares to a third party, depending on the restrictions mentioned on the front or back of a stock certificate. When a company is privately held, several constraints apply. Alternatively, the limits are enforced within the first few months following an initial public offering to ensure that insider sales do not have a negative influence on share prices.

Who Has the Authority to Issue Equity Securities?

Only firms issue equity securities. Non-profit organizations, partnerships, and sole proprietorships do not issue them. It is substantially easier for a major publicly traded firm to issue equity securities since the shares may be easily sold on a stock exchange.

Debt Securities

A debt security is borrowed money that must be repaid, with terms specifying the loan amount, interest rate, and expiration or renewal date.

Debt securities, which include government and corporate bonds, certificates of deposit (CDs), and collateralized securities (such as CDOs and CMOs), generally entitle their holders to regular interest payments and principal repayment (regardless of the issuer’s performance), as well as any other contractually stipulated rights (which do not include voting rights).

They are usually granted for a set period of time, after which they can be redeemed by the issuer. Debt securities can be secured (backed by collateral) or unsecured, and when secured, they may be legally prioritized over other unsecured, subordinated debt in the event of bankruptcy.

Hybrid Securities

As the name implies, hybrid securities combine some of the characteristics of both debt and equity securities. Equity warrants (options issued by the company that gives shareholders the right to purchase stock within a certain timeframe and at a certain price), convertible bonds (bonds that can be converted into shares of common stock in the issuing company), and preference shares are examples of hybrid securities (company stocks whose payments of interest, dividends, or other returns of capital can be prioritized over those of other stockholders).

Although the preferred stock is legally an equity investment, it is sometimes treated as debt security due to its “bond-like behavior.” Preferred shares are a popular product for income-seeking investors since they provide a fixed dividend rate. It is essentially a fixed-income investment.

Investing in Securities 

The entity that develops the securities for sale is referred to as the issuer, and those who purchase them are known as investors. Securities, in general, are an investment and a tool for towns, corporations, and other commercial entities to raise new cash. Companies can make a lot of money when they go public, for example, by selling stock in an initial public offering (IPO).

Municipal bond issues are used by city, state, and county governments to raise funding for specific projects. Depending on a company’s market demand or pricing structure, raising capital through securities may be a better option than a bank loan.

Buying securities with borrowed money, sometimes known as buying on a margin, is a common financial strategy. In essence, a firm may deliver property rights to another entity, either from the outset or in default, in the form of cash or other securities. These collateral arrangements have recently grown in popularity, particularly among institutional investors

In Conclusion,

If you own an equity investment, your shares represent a portion of the issuing company’s ownership. In other words, you have a stake in the issuing company’s earnings and assets. If you own 1% of the total shares, or security stocks, issued by a corporation, you own 1% of the controlling company.

Other assets, such as mutual funds or exchange-traded funds, may be classified as equity securities if their holdings are made up of pooled equity securities.

Equity Securities FAQs

What is the difference between equities and securities?

Equity is a type of ownership in a corporation that is obtained by investing funds or acquiring stock in the organization. Securities, on the other hand, encompass a broader range of financial assets such as banknotes, bonds, stocks, futures, forwards, options, swaps, and so on.

Is a mutual fund an equity security?

Mutual funds, like stocks, are considered equity securities because investors purchase shares that correspond to an ownership stake in the fund as a whole.

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