Alternative Strategies of Marketable Securities, Choice of Securities
Alternative Strategies of Marketable Securities
Marketable securities are investments that can easily be bought, sold or traded on public exchanges. The high liquidity of marketable securities makes them very popular among individual and institutional investors. These types of investments can be debt securities or equity securities.
Types of Marketable Securities
Though there are numerous types of marketable securities, the most common types of equity and debt securities are, relatively, stocks and bonds.
Stock represents an equity investment because shareholders maintain partial ownership in the company in which they have invested. The company can use shareholder investment as equity capital to fund the company’s operations and expansion.
In return, the shareholder receives voting rights and periodic dividends based on the company’s profitability. The value of a company’s stock can fluctuate wildly depending on the industry and the individual business in question, and so investing in the stock market can be a risky move. However, many people make a very good living investing in equities, using short- and long-term strategies.
Bonds are the most common form of marketable debt security and are a useful source of capital to businesses that are looking to grow. A bond is a security issued by a company or government that allows it to borrow money from investors. Much a like a bank loan, a bond guarantees a fixed rate of return, called the coupon rate, in exchange for use of the invested funds.
The face value of the bond is its par value. Each issued bond has a specified par value, coupon rate and maturity date. The maturity date is when the issuing entity must repay the full par value of the bond.
Because bonds are traded on the open market, they can be purchased for less than par (referred to as the discount) or for more than par (also called the premium), depending on their current market values. Coupon payments are based on the par value of the bond rather than its market value or purchase price, and so an investor who can purchase a bond at a discount still enjoys the same interest payments as an investor who purchases the security at par value.
Interest payments on discounted bonds represent a higher return on investment than the stated coupon rate. Conversely, the return on investment for bonds purchased at a premium is lower than the coupon rate.
There is another type of marketable security that has some of the qualities of both equity and debt. Preference shares, also called preferred shares, have the benefit of a fixed dividend, much like a bond.
Unlike a bond, however, the shareholder’s initial investment is never repaid, making it a hybrid security. In addition to the fixed dividend, preferred shareholders are granted a higher claim on funds than their common counterparts if the issuing company goes bankrupt and must liquidate assets to pay off its liabilities.
In exchange, preferred shareholders give up the voting rights that ordinary shareholders enjoy. The guaranteed dividend and insolvency safety net make preference shares a more enticing investment to those who find the common stock market too risky but don’t want to wait around for bonds to mature.
Marketable securities can also come in the form of money market instruments, derivatives and indirect investments. Each of these types contains several different specific securities.
Indirect investments include hedge funds and unit trusts. These instruments represent ownership in investment companies. Most market participants have little or no exposure to these types of instruments, but they are common among accredited or institutional investors.
Derivatives are investments directly dependent on the value of other securities. In the last quarter of the 20th century, derivatives trading began growing exponentially. Many types of derivatives can be considered marketable, such as futures, options and rights and warrants.
The most reliable liquid securities fall in the money market category. Most money market securities act as short-term bonds and are purchased in huge quantities by large financial entities. These include Treasury bills (T-bills), banker’s acceptances, purchase agreements and commercial paper.
Common Characteristics of Marketable Securities
The overriding characteristic of marketable securities is their liquidity, or the ability to convert them into cash and use them as an intermediary in other economic transactions. A security is further made liquid by its relative supply and demand in the market and the volume of its transactions. Because marketable securities have short maturities, and can be sold easily with price quotes available instantly, they typically have a very low rate of return, paying less interest than other instruments. But they are usually perceived as low-risk as well.
From a liquidity standpoint, investments are marketable when they can be bought and sold easily. If an investor or a business needs some cash in a pinch, it is much easier to enter the market and liquidate common stock than, say, a nonnegotiable certificate of deposit (CD).
This introduces the element of intent as a characteristic of “marketability.” And in fact, many financial experts and accounting courses claim intent as a differentiating feature between marketable securities and other investment securities. Under this classification, the marketable security must satisfy two conditions. The first is ready convertibility into cash; the second condition is that those who purchase marketable securities must intend to convert them when in need of cash. In other words, a note purchased with short-term goals in mind is much more marketable than an identical note bought with long-term goals in mind.
Marketable Securities and Working Capital
In accounting terminology, marketable securities are classified as current assets, and, therefore, are often included in the working capital calculations on corporate balance sheets. (It is often noted if they are not; the definition of adjusted working capital, for example, considers only operating assets and liabilities, excluding any financing-related items, such as short-term debt and marketable securities.) Businesses that have conservative cash management policies tend to invest in marketable securities instead of long-term or riskier securities, such as stocks and other fixed-income securities with maturities longer than a year. Marketable securities are typically reported right under the cash and cash equivalents account on a company’s balance sheet at the current assets section.
An investor who analyzes a company may wish to carefully study the company’s announcements that make certain cash commitments, such as dividend payments before they are declared. For a company that is low on cash and has all its balance tied in marketable securities, an investor may exclude the cash commitments that management announced from its marketable securities, since this portion of marketable securities is earmarked and spent on something other than paying off current liabilities.
The Bottom Line
It’s important to note that there are liquid assets that are not securities, and there are securities that are not liquid assets. Every marketable security must still satisfy the requirements of being a financial security: It must represent interest as an owner, creditor or rights to ownership, carry an assigned monetary value, and be able to provide a profit opportunity for the purchaser.
Choice of Marketable Securities
Factor # 1. Marketability:
The prime requisite of highly liquid and profitable investments is that they can be liquidated as and when required to replenish cash. This means that only those securities should be chosen for investment which is easily saleable even for large amounts without appreciable reduction in their price.
Such securities can be depended on to meet cash shortages. Government and municipal bonds as well as port trust securities meet the test of marketability as they can be disposed off in fairly big lots without forcing down their market prices, but general industrial and the like shares, except those of a few reputed companies, are not easily marketable and when it is desired to sell particularly for cash, a large block of such shares at a time of pressure, it proves difficult to do so without considerable price reduction.
Factor # 2. Safety:
Safety in investment here means free from credit risk i.e., risk arising from default of the debtor in the payment of principal or interest. The credit risk is a product of the character of the debtor, the economy which supports the obligations and the borrowing power of the debtor.
Securities of the Central Government are regarded as gilt-edged securities, as they are free from credit risk because of the great tax and borrowing powers and the greatness of the economy from which it derives its funds for the repayment of obligations.
State Government and Local Self Government securities are also risk free. The greater the degree of credit risk inherent in securities, the higher should be their interest rate to attract venturesome investors who would like premium on such securities to compensate for high financial risk.
Factor # 3. Maturity:
Besides credit risk, investments are also subject to money rate risk. Money rate risk arises from change in market price consequent upon interest rate fluctuations. If the market rate of interest tends to shoot up and the bondholders want to dispose off bonds, the price of the bond will go down because the bonds carry the rate less than the prevailing rate of interest. Money rate risk is intimately related with maturity of securities.
The shorter the maturity, the more stable the price and the vice-versa. This is essentially because one of the factors influencing the market price of a bond is the future payments computed on an annual basis. Therefore, the longer the maturity the greater is the influence of future income payments that are reflected in the price of the bond.
If, for example, the market rate of interest moves from 3 to 4 percent, the price of a 20-year, 3 percent bond would drop to Rs. 86.32; but a 5-year, 3 percent bond would drop to only Rs. 95.51. This is a sizeable difference and it explains why short-term securities are preferred against long-term obligations.
It should be noted here that money rate risk arises only when securities are disposed off before their maturity period. Where a firm can meet its cash shortages by liquidating a portion of its investment, funds should be invested in securities of different maturity pattern.
Thus, the firm should stagger its investment portfolio in such a way that a certain amount of securities mature at regular intervals. If funds released as a result of the maturity of a particular bond are not needed, they can be reinvested in those securities that best fit into the firm’s investment portfolio. This will help the firm to improve its earnings and make the cash resources available as and when needed.
Factor # 4. Taxability:
Market yield of securities is also affected by tax factor. There are certain categories of securities which are exempted from levy of income tax and wealth tax. For example, in India interest on treasury saving deposit certificates, post-office cash certificates, 12-year national plan savings certificates and such other certificates issued by the Central Government are exempted from income tax.
Similarly, certain securities viz., Ten-year saving deposit certificates, Fifteen-year annuity certificates, Twelve-year National defence certificates, Post- office certificates. Post-office National defence certificates, Post-office cash certificates, Post-office National savings certificates, 61/2 Gold Bonds 1977 and 1979, Gold Bonds, 1980 and National Defence Gold Bonds, 1980 are exempted from wealth tax.
In view of the differential tax treatment, yields of different securities differ. Tax exempted securities are sold in the market at lower yield than other securities of the same maturity. Tax factor should, therefore, be considered while choosing securities for the secondary reserves.
It is worth stressing that the above factors affect each other and are functionally interdependent. Therefore, all these factors must be considered simultaneously while evaluating a security to test its suitability.