Fixed Income and Equity are two most common financial instruments investors use to make the most out of their money. However, fixed income and equity are both made up of many smaller instruments, each with different characteristics, expectations of returns and risks, and suitability. Investors need to know the similarities and differences not only between these two types of asset classes, but also across different asset classes in the same category. Once you understand fixed income and equity thoroughly, you will be able to construct a well-founded investment portfolio for your money.
1.1. What is Equity?
Definition: Equity is an investment that allows you to have a partial ownership of the issuing company. For example, if you buy one share issued by Amazon, you own an ownership stake in Amazon with value equivalent to the value of the stock you buy at the market price. Equity investors choose to invest in a company’s stake with the expectation that it will rise in value in the future (if they sell their investments) and/or generate dividends.
1.2. What are the Types of Equity Investments?
Equity investments come in two forms: common stocks and preferred stocks.
Common stocks are the most common securities. Common stocks allow investors to have a stake in the company they choose to invest in, receive dividends, and vote at shareholders’ meetings. This means that as a shareholder, you are entitled to receive dividend payouts if the issuing companies decide to do so. To illustrate the voting rights point, if you own one percent of a company, you would be able to cast a one percent vote at that company’s corporate meetings.
For a company to issue stocks, it must begin with the initial public offering (IPO) process. IPO is a way for companies to expand their financial position by seeking additional capital. They will work with an underwriting investment banking company who will help them with the due diligence and pricing of the stock. After an IPO is complete, the public can start buying and selling shares of that company in stock markets where its shares are listed. Major stock markets in the world include the New York Stock Exchange (NYSE), London Stock Exchange and the Tokyo Stock Exchange.
Preferred Stocks are pretty much similar to common stocks, but preferred shareholders have priority over common stockholders as they often receive bigger dividend payouts on a monthly or quarterly basis. In addition, if a company is struggling, preferred stockholders can receive payments in arrears before dividend can be resumed for common shareholders. Another difference between preferred stockholders and common stockholders is that if a company is liquidated, preferred stockholders have a prior claim on the company’s assets before common stockholders. However, their claims come later than the claims of bondholders or creditors.
In terms of voting rights, preferred stocks do not carry voting rights. In terms of values, preferred stocks are less likely to appreciate substantially. Some companies allow their preferred stockholders to convert their preferred stocks into common stocks. In this case, those stocks are convertible. The convertibility of the stocks can be decided by the board of directors or by the date specified at which they automatically convert.
|Common Stocks||Preferred Stocks|
|Dividend Entitlement||Yes||Yes (prioritized over commons stocks)|
|Claims on companies after liquidation||Yes||Yes (prioritized over commons stocks)|
|Value Appreciation||More sustantial||Less sustantial|
|Riskiness||More risky||Less risky|
Other less common types of equity investments include stock options and convertible bonds. These are different from common stocks in that they require certain events to take place before they can be converted into an equity investment. Another increasingly popular type of equity is equity mutual funds and ETFs. These funds are managed by financial institutions that pool many equity investments together. Investors can participate by purchasing the shares of the respective mutual or ETF funds.
1.3. Risks and Returns Consideration of Equity Investments
When it comes to assessing the risks of equity investments, we can break the risks down into two parts: systematic risk and unsystematic risk.
Systematic risk, also known as market risk, refers to the various volatility that macroeconomic situations cause to the stock market. Unsystematic risk, on the other hand, refers to the risks inherent in or associated with the operations of individual companies. Unsystematic risk, because of this nature, can be minimized by diversification, while systematic risk is market-wide and unable to be defeated through diversification. For that reason, equity investments can be risky, but they also yield higher returns than almost any other investing instruments. That said, how would you calculate the expected value of an investment?
Identify alternative outcomes of the investment. For example, a 2x magnitude of outcome means that you get twice for each dollar you invest. A 0.5x magnitude of outcome means you only get half of each dollar invested.
Estimate the probability of occurrence for each outcome. You will answer the question: what is the probability of that outcome occurring?
Compute the expected value of each outcome by multiplying the magnitude of outcome by the probability of outcome.
Compute the expected value of the investment by adding together the expected return from each outcome.
The return on your equity investment is the difference between the expected value of investment and the actual price you pay for the investment.
2. Fixed Income
2.1. What is Fixed Income?
|Definition: The fixed-income market, also known as the debt securities market or bond market, is a class of asset that pays investors fixed interest or dividend payments until its maturity date. Fixed income instruments are not typically traded on exchanges. Investors can purchase these debt securities traditionally over the counter at auctions, such as the U.S. Treasury department’s bill auctions or directly from the issuers. However, some bond investors also make their purchases in the secondary market where investors buy and sell from one another.|
2.2. What are the Types of Fixed Income?
There are three types of fixed income securities:
- Fixed-rate bonds: the borrowers make a fixed payments to the lender on the coupon rates
- Floating rate bonds: the interest payments are made based on the market rates in that period
- Zero-coupon bonds: borrowers do not make any interest payments over the life of the security. Investors will receive the principal amount and interest payment in lump sum at the maturity date.
2.3. How to Price Fixed-Income Securities?
How much should you pay for a bond? The price you pay for a bond is the present value of the future interest payments (coupon payments) and the principal amount.
From the formula above, there are three scenarios when you purchase a bond:
- Par bond: when the coupon rates specified in the bond are similar to the yield-to-maturity (interest) rate
- Discount bond: when the coupon rates specified in the bond are less than the yield-to-maturity (interest) rate
- Premium bond: when the coupon rates specified in the bond are more than the yield-to-maturity (interest) rate
2.4. Risks and Returns Consideration of Fixed-Income Investments
Contrary to equity investments, fixed-income investments are less risky and less profitable. In assessing the risk of fixed income, investors pay most attention to default risk – the risk that the issuers will not meet the payment obligations. Government-issued securities are often safest, as the default rate of the governments, especially of developed countries, are relatively low. Other risks include interest rate risk and credit risk.
Inflation risk is especially a concern for investors who primarily seek interest payment. The risk of rising inflation means that you gain less from interest payments, and your purchasing power coming from bond income falls. Interest rate risk occurs when interest rate is affected due to negative economic and market conditions. When interest rate falls, bonds are less attractive in the primary market because interest payments are low. However, in the secondary market, bond prices appreciate, allowing investors to make a gain due to price appreciation. On the other hand, when interest rate rises, bond prices in the secondary market declines, while conservative investors who gain from interest payments benefit in the primary market.
Returns on fixed-income securities are easier to calculate than equity investments. The expected return on a bond can be calculated with the formula:
Expected return = (F-P)/P
Where RETe is the expected rate of return
F = the bond’s face (or par) value
P = the bond’s purchase price
The bigger the difference between a bond’s face value and the purchase price, the higher the return investor can earn from their investments.
3. Equity vs. Fixed Income
|Equity Investment||Fixed Income Investment|
|Definition||Equity is an investment that allows you to have a partial ownership of the issuing company.||Fixed income is an investment that pays investors fixed interest or dividend payments until its maturity date.|
|Issuer||Corporates, financial institutions||Governments, financial institutions, corporates|
|Risk||High risk||Low risk|
|Returns||High returns||Low returns|
|Types of investors||Risk-seeking investors||Risk-averse conservative investors|
|Claims on asset|
Common shareholders have the last claim on asset.
|Bondholders are prioritized over common shareholders.|