Posted by Anjali Kaur on Jul 01, 2022

Types of Investment

As a dealing representative, it is essential that you have in-depth knowledge about the different types of investments that are available in the financial markets, so that you can effectively match clients with suitable investments.

Building Blocks of Mutual Funds

Mutual funds are collections of different types of investments. The holdings within a given mutual fund are intended to achieve several different investment objectives.

As a dealing representative, your clients will expect you to understand the different investment types held within mutual funds.

Mutual funds are investments that hold a collection of different securities such as equities and bonds. Collectively, the securities in a mutual fund are called holdings. A typical mutual fund can have dozens or hundreds of different securities.

The investment goal of a mutual fund determines which securities are included in the fund’s holdings, as each security plays a unique part in helping the fund reach its goal.

Therefore, to understand the different categories and types of mutual funds, we need to first understand the different securities that form the building blocks of the funds.

Knowledge of the building blocks will help you understand how the underlying securities affect the performance and return of a mutual fund. As a dealing representative, this will help you manage your clients’ expectations and recommend suitable mutual funds.

Investment Objectives Safety and Income

A mutual fund’s investment objectives determine the various types of securities that are held in a given fund. There are three main investment objectives:

  1. Safety of Principal

Mutual funds for which the investment goal is the safety of the principal strive to protect investors from losing any of their original investment. In other words, investors expect to get back at a minimum the amount of money they put into the investment.

2. Income

Mutual funds with a primary investment objective of income provide investors with a regular source of income over the course of their investment time horizon.

Income-oriented investments are typically fixed-income securities, which are essentially debt issued by corporations or governments. The corporations or governments are the borrowers, and they must make regular payments to the lenders, i.e. the investors.

Compared to investments that offer safety of principal, income investments will experience greater price fluctuations. Depending on the situation, investors may find that their investments have either grown or declined in value compared to their original principal. 

3. Growth

Securities with an investment objective of growth have the potential to appreciate over time. Investors purchase growth investments in the hope that the market price of the securities when they sell their investments will be higher than the original purchase price.

Growth investments typically include equity securities that represent ownership in a corporation. The value of an investor’s equity investment is tied to the prospects of the corporation. If the corporation is profitable or has the potential to do well, equity investors will benefit. If the corporation does poorly or is perceived to be doing poorly, equity investors will suffer. Therefore, equity investors will experience greater price fluctuations than safety-of-principal or income investors.

Why Government Issue Securities?

Governments and corporations each issue securities as a means of raising capital. This section looks at the reasons why each type of organization issues securities.

Government

From time to time, governments may need to raise money in order to pay for spending commitments such as health care, defense, or deficit financing.

Governments can borrow money from the public by issuing fixed-income securities, as follows:

Why do Corporations Issue Securities?

One of the ways in which corporations can raise money to grow their businesses is to divide ownership into smaller parts and sell those parts to the public in the form of shares. In exchange for a share, a corporation receives the money it needs, and investors have an opportunity to share in the corporation’s earnings.

Corporations can issue two types of shares, as follows:

  • Common shares—Share ownership that entitles investors to a portion of the company’s earnings and some control of the corporation.
  • Preferred shares—Share ownership that entitles investors to receive a fixed amount of the company’s earnings on an ongoing basis. This type of share ownership typically does not give investors control of the corporation.

If a corporation wants to maintain its current division of ownership, rather than issuing shares, the corporation can borrow from the public and issue fixed-income securities such as bonds. This way, the corporation receives money without increasing the number of owners in the corporation.  The company can issue the following types of fixed income securities:

  1. money market securities, including both bankers’ acceptances and commercial papers
  2. medium- and long-term bonds

A corporation can also borrow money from a bank. However, interest payments required by banks can be very high, which is why some corporations choose to raise funds by issuing either shares or fixed-income securities.

Fixed Income Securities

Fixed income securities are a form of loan in which investors act as lenders, with the borrowers being organizations such as governments or corporations, which need to raise capital.

As a dealing representative it is very important that you are familiar with the different types of fixed income securities, and how they are bundled in mutual funds to meet various investment objectives.

As mentioned, when governments or corporations need money, they can borrow money from the public by issuing fixed-income securities.

Fixed income securities are essentially loans provided by investors. The debt security includes a contractual obligation stating that the issuing government or corporation must pay interest and return the principal (i.e. the investment amount) to the investor (i.e. lender) by the maturity date (i.e. the bond’s expiry date).

Investors tend to purchase fixed income securities with the objectives of the safety of principal and stable, regular income.

Some key concepts when dealing with fixed income securities are:

Money Market Securities

Money market securities are fixed-income investments that typically have a maturity of under a year. The short maturity makes money market securities very liquid, which means they can be converted into cash very quickly and easily.

The price of money market securities does not fluctuate a great deal. This fact added to the short maturity of the securities makes them a relatively stable and safe investment.

Money market securities meet the investment objectives of the safety of principal and stable income. They are also very low-risk investments.

Types of Money Market Securities

There are several types of money market securities. Each type of security involves a different level of risk and a corresponding level of return.

Generally, investments with higher levels of risk compensate investors with the potential for higher return – why else would a rational investor choose a higher-risk investment.

There are four different types of money market securities, as follows:

  1. treasury bills
  2. provincial and municipal short-term papers
  3. bankers’ acceptances  
  4. commercial papers

Treasury Bills

Treasury bills (T-bills) are fixed-income securities issued by the Canadian government to finance their short-term cash needs.

T-bills do not pay periodic interest to investors.  Instead, T-bills are sold at a discount, and then at maturity, the government pays the investor the face value. The interest income is the difference between the face value and the price the investor paid for the T-bill.

For T-bills, the investment objectives are safety of principal and income. T-bills are very low-risk investments since they are guaranteed by the Government of Canada.

T-bills in the Primary and Secondary Markets

T-bills are issued and exchanged in both the primary and secondary markets. The primary market is where new T-bills are issued and sold. The secondary market is where investors can sell their T-bills before the maturity dates.

T-bills in the Primary Market

The Bank of Canada issues T-bills on behalf of the Government of Canada. The Bank of Canada conducts an auction on a two-week cycle where T-bills are sold in large denominations to banks and investment dealers. The terms of maturity offered at the auction are 98, 182, and 364 days.

T-bills in the Secondary Market  

There is a secondary market run by investment dealers where individuals and institutions can buy and sell T-bills. In the secondary market, T-bill prices change in relation to interest rates. When rates increase, T-bill prices decrease. Conversely, when interest rates decrease, T-bill prices increase. If investors sell their T-bills for a higher price than the original purchase cost, they will make a profit. This form of income, from a sale that incurs a profit, is called a capital gain. If investors sell their T-bills for a lower price than the original purchase cost, they will lose money. This form of income loss from a sale is called a capital loss.

Monica buys a 6-month T-bill for $9,850, which will mature at a face value of $10,000.  After three months, the interest rate drops, and the current market price of Monica’s T-bill rise to $9,950. Monica sells her T-bill in the secondary market for $9,950 and realizes interest earned of $75 and a capital gain of $25. The interest earned is calculated as [($10,000 -$9,850) x 3 months/6 months]. The capital gain is calculated as ($9,950 – $9,850 -$75).

On the other hand, if interest rates increase and the current market price of her T-bill after 3 months falls to $9,800, she would realize interest earned of $75 and a capital loss of $125, calculated as ($9,800 – $9,850-$75), if she then sells her T-bill.

T-bill Return Calculation

In order to determine the rate of return for a T-bill, you must calculate the quoted yield. The quoted yield is expressed as a percentage. The formula is as follows:

Provincial and Municipal Short-Term Papers

Provincial and municipal short-term papers are debt securities issued by the provincial or municipal government, in order to raise money to pay for capital spending. Similar to T-bills, these securities are sold at a discount and pay their face value at maturity.

The investment objective of short-term papers is the safety of principal and income. Provincial and municipal short-term papers offer slightly higher interest income than T-bills, but the risk level is also higher.  

Bankers’ Acceptances

Bankers’ Acceptances (BAs) are fixed-income securities that are issued by corporations but guaranteed by a commercial bank. A corporation may find that it wants to borrow money in the short term (typically one to three months), but it finds that by itself, its borrowing costs are too high. However, if the corporation can rely on the credit rating of a major bank, its borrowing costs will fall, meaning it can pay less interest on its debt. If the bank agrees, it advances the corporation in the funds. For a stamping fee, the bank guarantees the corporation’s debt and is ultimately responsible to repay investors if the corporation defaults on its payments.

Similar to T-bills, BAs are bought at a discount, and the difference between the face value and the purchase price is considered interest income. However, BAs typically pay a higher interest rate than T-bills due to their higher risk. In other words, there is a greater chance of default by the bank than by the government.

The investment objectives of BAs are safety of principal and income.

BIZ Corporation is expecting payments from its customers, but in the interim needs to make payroll and other critical payments.  To get the money to make these payments while they are waiting for cash from their customers, BIZ may issue bankers’ acceptances to get the short-term loan they need.

Commercial Papers

Commercial papers (CPs) are issued by corporations seeking to get short-term loans to fund short-term cash shortages. Similar to other money market securities, CPs are purchased at a discount, and at maturity, the issuer pays the face value to the investor. The interest income is the difference between the face value and purchase price.  

CPs typically pay higher rates and are considered higher risk than T-bills and BAs because they are not guaranteed by the government or a commercial bank. Instead, the issuing corporation borrows money under its own name and credit rating. The interest rate will depend on how stable the corporation is, and the likelihood of it repaying the loan.

The investment objectives are safety of principal and income.  

Risks and Returns of Money Market Investments

Each type of money market security has its own risk and return level as shown by the following graph.

Money Market Securities and Mutual Funds

Portfolio managers use money market securities in their mutual fund portfolios either to meet their primary objective of the safety of capital, like in a money market fund, or as a short-term placeholder for cash. Quite often referred to as cash equivalents, money market securities provide a relatively safe and flexible alternative to cash. Portfolio managers require this flexibility to meet redemption requests or to park cash while they are making decisions for longer-term investments.  

Thank You!

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