One term that’s essential to understand when it comes to investing is ‘financial security.’
But what exactly are they? In layman’s terms, financial securities are simply negotiable instruments that you can buy or sell, and hold a monetary value for a certain amount of time.
Sound interesting? Well, in this article, we’re going to break down exactly what financial securities are, and give you the lowdown on the different types out there.
We’ll also talk about why it’s important to diversify your portfolio with various securities, and the benefits of investing in them.
Financial Security Starter
Are you familiar with the Securities Act of 1933? This important piece of legislation was the first to regulate the stock market at the federal level in the United States.
It’s a law that ensures that any company or individual wishing to sell investment contracts to the public must disclose certain information, including details about the proposed offering, the company making the offering, and the individuals behind the company.
This is all to protect the public from any deceptive or misleading practices.
The Securities Act
The Securities Act of 1933 also created the Securities and Exchange Commission (SEC) which is responsible for enforcing these regulations. But what exactly is considered a security under the law?
You might associate the term ‘securities’ with stocks and bonds, but the U.S. Supreme Court gives the term a much broader interpretation.
In a famous case, Howey vs. SEC (1946), the court found that an investment in land and agricultural services was considered an “investment contract” under the securities laws, even though it didn’t involve traditional stocks or bonds.
This case established the four-prong Howey Test, which states that an investment can be regulated as a security if:
- there is an investment of money,
- the investment is made into a “common enterprise,”
- the investors expect to make a profit from their investment
- any expected profits or returns are due to the actions of a third party or promoter
This means that under the securities law, any kind of investment offering can be considered a security, whether it’s formalized with a legal contract or not.
In fact, over the years, courts have enforced securities provisions on some unexpected assets, like whiskey, beavers, and chinchillas.
Securities can be broadly categorized into two distinct types: equities and debts. However, some hybrid securities combine elements of both equities and debts.
1. Equity Securities
In simple terms, equity securities represent ownership in a company, partnership, or trust. This ownership is represented by shares of capital stock, which can include both common and preferred stock.
As an owner of equity securities, you’re not typically entitled to regular payments like you would be with debt securities, however, you may still receive dividends.
The main benefit of holding equity securities is the potential for capital gains if you sell them for a higher price than what you paid.
2. Debt Securities
Debt securities represent borrowed money that must be repaid. These loans come with specific terms that outline the size of the loan, the interest rate, and when the loan must be repaid or renewed.
Debt securities come in many forms, such as government and corporate bonds, certificates of deposit (CDs), and collateralized securities (like CDOs and CMOs).
When you hold a debt security, you’re typically entitled to regular interest payments, as well as the repayment of the principal at a later date.
Debt securities are usually issued for a fixed term, at the end of which the issuer has the option to redeem the debt.
They can also be either secured or unsecured, where secured debt is backed by collateral. In the case of a bankruptcy, secured debt is typically prioritized over unsecured, subordinated debt.
3. Hybrid Securities
Hybrid securities, as the name implies, have elements of both debt and equity securities. These securities offer investors a combination of benefits, with the characteristics of both types of securities.
Examples of hybrid securities include equity warrants, which are options issued by the company allowing shareholders to purchase additional stock within a certain timeframe and at a fixed price.
Convertible bonds are another example, which are bonds that can be converted into shares of common stock in the issuing company at a later date.
Preference shares are company stocks that have priority in terms of interest, dividends, or other returns of capital over other stockholders.
4. Derivative Securities
A derivative is a financial contract whose value is based on the performance of an underlying asset, such as a stock, bond, commodity, or currency. This means that the price of the derivative is derived from the value of the underlying asset.
Derivatives come in many forms, but some of the most common ones include options. A call option is a derivative that gives the holder the right, but not the obligation, to purchase a specific underlying asset at a fixed price on or before a specific date.
If the underlying asset increases in value, the call option will also increase in value. On the other hand, a put option is a derivative that gives the holder the right, but not the obligation, to sell a specific underlying asset at a fixed price on or before a specific date.
If the underlying asset decreases in value, the put option will increase in value.
5. Assets Backed Securities
An asset-backed security represents a part of a large basket of similar assets, such as loans, leases, credit card debts, mortgages, or anything else that generates income. Over time, the cash flow from these assets is pooled and distributed among the different investors.
Regulation of Securities
In the United States, the government agency in charge of regulating the sale of securities is the SEC (Securities and Exchange Commission). All securities that are offered and sold to the public must be registered and reported to the SEC, as well as to state securities departments.
There are also organizations in the industry that take on some regulatory responsibilities such as National Association of Securities Dealers (NASD) and the Financial Industry Regulatory Authority (FINRA).
To determine what a security offering is, the Supreme Court made a decision in 1946 that established the definition of a security based on four factors – It has to be an investment contract, a common enterprise, the promise of profits by the issuer, and the promotion by third party.