Many people wondering what securities are may not realize that they're likely already familiar with this investment category. The most common examples include stocks and bonds.
Along with commodities, securities offer investors a way to grow the value of their money. Securities can increase or decrease in value because of a variety of factors. This can be most clearly seen in the day-to-day volatility of the Dow Jones Industrial Average.
Let’s review the different types of securities and how they make—and occasionally lose—money for investors.
What are securities?
A security is a financial investment with some monetary value. It entitles the holder to ownership of a part of a publicly traded company, such as a stock, or a debt obligation, such as a bond.
Securities are listed on the stock exchanged and can be bought, sold, or traded on the secondary market.
Types of securities explained
Securities are broadly categorized as either an equity or a debt. In simple terms, equity securities are stocks, and debt securities are bonds. Each one behaves differently and has its own risk profile that determines how much an investor can make.
Equity securities
Equity securities are most often shares of a publicly traded company stock. They offer a way for companies to grow beyond securing private funding. When a company declares an Initial Public Offering (IPO), it starts selling stocks on the open market (also known as the secondary market).
By selling stocks which represent shares of ownership for the investor, the company can raise capital to grow the business or repay debt obligations. As an investor, you make money by buying the stock and selling it at a higher price or through dividends.
Dividends are a way for the company to share profits with investors. Stocks that pay out dividends are more volatile and thus riskier.
Debt securities
“Debt securities” most often refers to bonds. When a company or a government entity wants to borrow money, it can either get a loan or issue a bond. But bank loans to fund big projects are difficult to secure.
This is where bonds come into play. The company can issue a debt security called a bond to raise money. When investors buy bonds, they are lending the company money. It entitles them to getting their money back with interest once the bond matures.
Let’s look at an example. If a school district wants to build a new school, they can issue a bond to fund the project. Investors who buy the bond will lend money to the school district while expecting to get paid back through interest.
This arrangement works well both for investors and companies issuing bonds. Bonds are less volatile than stocks, helping balance out investment portfolios. The company issuing the bonds also gets the loan to meet its financial needs.
Marketable securities
Marketable securities are a way for companies to make money on their cash reserves. These types of securities are liquid with an expiration term of less than a year. They offer lower returns in exchange for liquidity.
Companies keep cash on hand to make payments or take advantage of opportunities. Instead of parking the money where it won’t earn interest, they invest a portion of the cash into short-term liquid securities. These investments can be sold quickly if the business needs the cash.
There are two types of marketable securities: marketable equity securities and marketable debt securities. Marketable equity securities are usually shares of common stock or preferred stock traded on the stock exchange. Marketable debt securities include corporate bonds and government bonds.
Mortgage-backed securities
Mortgage-backed securities or MBS for short, are investments secured by mortgages. Here’s how they work: An individual gets a mortgage from a bank or a mortgage company. The bank or mortgage company turns around and sells the loan to an investment bank to generate liquidity for new loans.
Investment banks bundle these mortgages based on common characteristics and sell them as mortgage-backed securities. When the mortgages are bundled into MBOs, they can be moved off the books to free up more money for lending.
The MBS bundles can be sold on the secondary market to institutions, corporations and individuals. When you buy an MBS, you have the right to a portion of the value of the bundle. This includes part of the monthly mortgage payments and principal for the entire pool.
Mortgage-backed securities played a big role in the stock market crash of 2008 and the financial crisis that began in 2007. As home values increased, investors wanted a piece of the pie, and mortgage-backed securities delivered.
However, when the real estate bubble burst, the value of these MBS bundles plummeted as more people walked away from their mortgages, causing mass losses for investors and institutions.
The Federal Reserve stepped in to create a market for unloading MBS bundles through the Troubled Asset Relief Program (TARP). This injected capital back into banks who were struggling under the weight of the overvalued MBSs.
Fixed-income securities
A fixed-income security is an investment that pays out on a regular schedule. The interest payments are fixed in value and paid out periodically until maturity when the principal is returned.
One of the most common types of fixed-income securities are bonds. Governments or corporations issue bonds to fund projects. Bonds come with different ratings assigned by credit-rating agencies.
These ratings tell investors how likely it is for a corporation or a government to repay a bond. Bonds are divided into investment grade and non-investment grade, also called junk bonds.
Investment grade bonds are issued by companies and governments at a low risk for default with corresponding lower returns. Junk bonds offer higher returns to account for the higher probability of default by the issuers.
Some of the most popular types of fixed-income securities are Treasury notes, Treasury bonds, Treasury bills, municipal bonds and dividend stocks.
Treasury notes or T-notes for short, are issued by the U.S. Treasury. They come with different maturities ranging from two to 10 years. Their value and semiannual interest payments are backed by the U.S. government,
T-bonds are another type of fixed-income security backed by the U.S. government. They mature in 30 years and are sold on auction on TreasuryDirect.
T-bills are the short-term version of government-backed fixed-income securities. They mature within one year and don’t pay interest. Investors make money by buying T-bills at lower than face value. They are paid out the value when the bill matures and make their money on the difference between how much they paid and received for the T-bill.
Local governments issue municipal bonds to fund capital projects such as building hospitals and schools. Interest earnings are exempt from federal income tax and may also be exempt from state and local taxes.
The role of securities in the economy
Securities are a way for investors to make money by lending them to companies and governments. By buying a share or a bond, an investor is voting for that company’s future growth. Securities inject money into the economy, helping both the investor and the issuer. However, they also cause the stock market to fluctuate, sometimes wildly.
Most investors will do well with a diversified mix of low-fee assets such as Wealthsimple Invest. This offers a consistent return that spreads the risk over different sectors and types of investments.
Some investors purchase securities based on a hot stock tip and not proper research. Putting too much of their money into one stock or investment product can cause big losses. This is one issue that precipitated the Great Depression in 1929 when many lost all of their savings.
Another example is derivative investments such as mortgage-backed securities. In the 2000s, many investors bought these because they considered them less risky. As investment banks went further down the subprime mortgage rabbit hole, this was no longer the case.
When the housing bubble burst, many were left with MBSs they couldn’t sell. The Federal Reserve had to step in and offload the derivatives to pull financial markets back from the edge of collapse.
This was one of the precipitating factors that caused the global financial crisis and resulting Great Recession in 2008.
Pros and cons of investing in securities
Investing in securities, such as stocks and bonds, has its positives and negatives. Historically, the stock market has gone up, helping investors grow their money over time and beat inflation.
However, that’s not the whole story. As the Great Depression of 1929 and the Great Recession of 2008 show, markets are prone to steep declines. Investors can just as easily lose money buying securities.
Here are the pros and cons of investing in securities:
Pros
A good hedge against inflation over the long run
Takes advantage of economy growth
Easy to buy and sell
Provide many ways to make money from dividend stocks to bonds
Cons
Come with the possibility of losing your entire investment
Subject to stock market ups and downs, which can mean an emotional roller coaster for an investor
Require a lot of research
Bottom line: securities offer a good hedge against inflation, but you need to be careful not to risk more than you can afford to lose.
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