Lesson 2: Understanding the 3 Main Investment Vehicles

I.                    Stocks

a.       Common Stock – Corporations are a form of business that offer ownership in the company to the general public through the issuance of stock.  A company “goes public” by organizing itself as a corporation (in accordance with the business laws of the country in which it operates) and issuing shares of stock on a stock exchange through an Initial Public Offering (IPO).  The largest stock exchange in the U.S. is the New York Stock Exchange (NYSE) located on Wall Street in New York City.  All of the major U.S. corporations, along with many major foreign corporations, list their stock on the NYSE.  This stock exchange is so famous that it has become synonymous with the words “Wall Street”.  Stock (ownership) in a corporation is purchased through buying shares of the company’s stock through traders on the stock exchange where the company is listed.  The money raised by issuing shares of stock can be used by the corporation to fund its operations or pay its obligations.  Once issued, the price per share of a company’s stock rises and falls based on many things including;  market conditions, number of company shares on the market, competition, public opinion, the company’s financial condition, etc…  Corporations are legal entities that are separate from their owners.  Corporations are owned by their shareholders.  However, corporations can own property, incur debt, sue and be sued separate from the owners.  This unique quality of a corporation to operate independent of the owners (shareholders) protects the owners from damages related to issues such as legal liability and the solvency of the corporation.  If the corporation is found culpable in a legal battle, or is unable to pay its debts or other obligations the shareholders are not held liable.  The only loss the shareholders incur related to legal obligations of the corporation, or if a corporation goes bankrupt or out of business, is the loss of the value of the stock held by the shareholders. 

All of a corporation’s shares that have the same rights are known as “common stock”.  Ownership of common stock provides you with certain rights in relation to the operation of the corporation such as; 

1.       ownership of a nonredeemable security (share of company stock)

2.       the right to offer your nonredeemable security (company stock) for sale at any time and for any price

3.       the right to limited liability (as discussed in the paragraph above)

4.       the right to receive a copy of the company’s annual report

5.       the right to attend shareholder meetings

6.       the right to vote to elect the company’s board of directors, and to vote on other matters that come before the board of directors (the number of votes is equal to the number of shares of common stock owned)

7.       the right to examine some of the company’s financial and other records

8.       the right to receive a share of any dividends declared by the company’s board of directors

9.       the right to share in the assets of the company upon dissolution or liquidation

b.      Preferred Stock – Preferred stock can be thought of as a hybrid between common stock and corporate bonds.  They are like bonds in that the return on the investment is fixed and usually limited.  They are like common stock in that they do not mature (expire) and the holder is an owner not a creditor.  They are also in the middle with regard to access to corporate assets upon dissolution or liquidation.  In general bond holders receive first right to corporate assets upon dissolution or liquidation, preferred stock holders receive second right to the assets and common stock holders receive third right.  Preferred stock holders also receive preferential right to corporate dividends over the common stock holders.  However, they rank behind corporate bonds with respect to dividends because the corporation has a legal requirement to pay interest on bonds whereas there is no such legal requirement to pay dividends to preferred stock holders.  The actual rights of the preferred stock holder are found in the company’s charter.  Preferred stock is issued in many different forms including cumulative¹, participating², redeemable³ and convertible⁴.  Because the return on preferred stock is limited to that declared when the stock is issued the growth possibilities are generally not as good as with common stock.  Also, the return on preferred stock is normally tied to a percentage of the dividend declared on the stock and as such the return could be deferred, or eliminated if the board of directors defers dividends or defaults on the dividend.  Preferred stock holders normally cannot vote in company elections unless the dividends are in default.

II.                  Bonds

a.       A bond is formal evidence of a debt owed.  Bonds are issued by corporations, federal, state and local governments as a means to finance certain activities and/or projects or to fund ongoing operations.  When a corporation or government issues a bond they are offering the holder of the bond a promise to be paid a specific amount of interest at specific intervals and for a specific duration (term or maturity).  When the bond matures (expires or finishes it term) the corporation or government promises to repay the bond holder the amount of money originally paid for the bond (the principle). 

b.      As an investment bonds are fairly easy to understand because generally the maturity (duration), interest rate, and interest payment schedule are published with the bond so it is very clear what you are buying.  However, there are a vast variety of different types of bonds so understanding what type you are buying can get a bit confusing.  For example; bearable bond⁵, callable bond⁶, convertible debenture⁷, discount bond⁸, first mortgage bond⁹, registered bond¹⁰ and serial bond¹¹ are a few of the different types of bonds available on the market. 

c.       In general the interest rate paid on a bond is proportional to the risk associated with the issuer of the bond.  The U.S. Treasury bill (T-bill) is considered the safest and most marketable security in the world and therefore merits the lowest interest rate.  The U.S. Treasury also issues savings bonds, Treasury bonds and Treasury notes that all merit ultra-low interest rates because they are considered to be virtually “risk free” as they are backed by the full faith and security of the U.S. Federal government.  The U.S. Federal government has never defaulted on payment of its bond obligations.  Bonds issued by state and local governments (municipal bonds) are also considered low risk (albeit not zero risk as there have been examples of school districts, cities and even states defaulting on their bonds). The risk associated with corporate bonds varies widely based on the credit rating of the company issuing the bonds.   Federal, municipal and corporate bonds are rated by many domestic and international rating agencies.  The three major U.S. rating agencies are:  Moody’s¹², Standard & Poor’s (S&P)¹³ and Fitch Group¹⁴.  As stated before the U.S. T-bill is considered the safest and most marketable security in the world and as such the U.S. Federal government has historically held the highest possible rating by all three major U.S. rating agencies (Aaa by Moody’s, AAA by S&P and Fitch).  However, on August 5, 2011 the S&P rocked the domestic and international investment markets by downgrading the U.S. Federal government from AAA (outstanding) rating to AA+ (excellent) rating.  Moody’s and Fitch did not downgrade the government but each did issue a negative outlook in 2011 for the government retaining the highest rating.  Fitch has since removed its negative outlook in March of 2014. 

d.      In general the amount of interest a government or corporation must offer in order to attract buyers to their bonds increases as their credit rating decreases.  Bonds with a rating of “BB” by S&P and Fitch, or “Ba” by Moody’s are often referred to as “junk” or “high-yield” bonds as they are considered high risk, speculative or below investment grade and therefore carry much higher interest rates (yields) than bonds from issuers with higher credit ratings.  Bond prices generally fluctuate inversely with market interest rates (i.e. when interest rates rise bond prices fall and when interest rates fall bond prices rise)¹⁵.  Municipal bonds have the added advantage of paying interest that is normally free from federal taxes.

III.                Cash

a.       Savings accounts (passbook accounts), Certificates of Deposit (CDs) and interest bearing checking accounts are the primary examples of “cash” investments.  The interest paid on such “cash” accounts are, in general, lower than the other types of investment vehicles described above and for the past several years have been at near zero (below zero when adjusted for inflation).  However, in terms of security, as long as the money is placed in an institution that is insured then the principle is guaranteed up to the limit of the insurance on the account.  Also, in terms of liquidity, or ease of access to the funds, cash accounts are considered the most liquid investment because funds can be withdrawn at any time, normally without penalty (except in the case of early withdrawal from a CD).  It is always a good idea to have a certain amount of cash on hand to cover emergency needs, but in the current ultra-low interest environment on cash accounts it is advisable to keep cash to a minimum.

IV.                Risk vs return

a.       The primary risk associated with ownership of corporate common stock is the decrease in stock price.  If you must sell your shares and the per share price of the stock is less than when you bought the shares you will suffer a loss on the sale.

b.      In general, the larger the potential return on an investment, the higher the risk.  Below is a table that compares the general risk vs return of the three main investment vehicles discussed in this lesson:

Investment Vehicle	Risk	Return
Stock	High	High
Bond	Low/high (depending on type of bond)	Low/High (depending on type of bond)
Cash	Low	Low

Foot Notes

¹ Past, omitted dividends are paid to preferred shareholders, then to common shareholders.

² The stock holder has the right to the normal preferred dividend rate plus a bonus dividend based on a predetermined condition.

³ The issuer of the stock can buy it back and retire it.

⁴ The stock holder has the option, past a certain date, to convert the shares into a number of common shares.

⁵ A bond on which the owner’s name is not registered with the issuer.

⁶ Also known as a redeemable bond, the issuer can redeem this bond before it reaches maturity. Usually, the bond owner is paid a premium when the bond is called.

⁷ A company-issued loan that the bond holder, or sometimes the issuer, can convert into stock. This allows for a lower interest rate paid by the issuer.

⁸ A bond issued, or currently trading in the secondary market, for less than its par/face value.

⁹ A bond backed by real property or real estate owned by the issuer.

¹⁰ The company records (registers) the bond owner’s name and contact information in order to pay the correct person.

¹¹ Multiple bonds issued at the same time and quoted by their yield that mature at regular intervals until all the bonds have matured.

¹² This corporation provides credit ratings, research, tools, and analysis for transparent and integrated financial markets. It is the parent company of Moody’s Investors Service (credit ratings and research on debt instruments and securities) and Moody’s Analytics (software, advisory services, and research on credit and economic analysis and financial risk management).

¹³ This rating service provides an opinion on the general creditworthiness of an obligor.

¹⁴ This service provides financial information through Fitch Ratings (credit ratings and research), Fitch Solutions (credit market data, analytical tools, and risk services), Fitch Learning (learning and development solutions for the global financial services industry), and Business Monitor International (country risk and industry analysis specializing in emerging and frontier markets).

¹⁵ If interest rates drop (to 5% for example), higher return rates (such as 9%) are more attractive. Therefore, more people buy those bonds, increasing the price until the yield matches the dominant interest rate (5%). If interest rates increase (to 9%), the lower return rates (5%) become less attractive, forcing the bond prices to decrease to attract demand and increase the yield.