Debt Vs. Equity Securities
You know you should be saving and investing. Saving seems pretty simple. You just put some of your money in an interest-bearing account at the bank where you can get to it when you need it. Investing might seem a bit more daunting, because there are so many investment options to choose from. Among the options are debt securities, which are effectively loans that pay out interest over time, and equity securities, which confer ownership in a company.
Debt securities are essentially a stake in a loan to a company, government agency or other organization. Equity securities, such as stock shares, represent an actual ownership interest in a company.
Understanding Debt Securities
Businesses, municipalities, states and the federal government all need money to operate. When they don't have enough ready money to do the things they need to do right now, they borrow money from investors. In exchange for the investment, the issuer promises to repay the face amount of the loan and to pay a set rate of interest until the debt is repaid. Debt instruments can take on a number of forms, ranging from short-term commercial paper to long-term bonds.
Either way, they generally pay out a rate of interest over time based on terms set at the time the securities are issued. Debt with a higher risk of default generally pays a better interest rate.
Exploring Equity Securities
Equity refers to ownership. If you have a mortgage on your home, you are probably familiar with the concept of equity. The value of your home, less the amount you still owe on your mortgage loan, is your equity. That's how much of your home represents an asset that adds value to your net worth. Equity securities are similar.
When you buy an equity security, rather than receiving an IOU as you do with a debt instrument, you become a part owner of the investment. Your upside is potentially higher, since rather than the fixed return of a debt instrument, the company's potential growth is unlimited. But the risk is also greater, since the venture could fail altogether, and in a bankruptcy or liquidation, the owners are the last to be paid. Equity securities can take on a number of forms ranging from a real estate partnership to common stock in a corporation.
Evaluating Current Income
Both debt instruments and equity securities can produce current income. Debt instruments, such as corporate and municipal bonds, typically make regular interest payments. Equity securities don't pay interest, but some types of equity securities offer different types of income.
For example, if a company earns a profit, its board of directors might choose to return a portion of those profits back to its stockholders in the form of a dividend. If you own an equity stake in a real estate partnership that invests in apartment complexes, you might received a pro rata share of the rents.
In general, bonds are usually seen as less volatile, safer investments than stocks, but also often have less lifetime earning potential.
Capital Gains and Losses
Both equity securities and debt instruments may be traded in the secondary market, where the market price can fluctuate. The forces that drive market prices for different kinds of investments include movements in prevailing interest rates, supply and demand, the state of the economy, current events and a multitude of other factors.
If the market price of your stocks or bonds increases, you might sell them for a profit and earn a capital gain. The market price of your investments might also decrease, resulting in a potential capital loss.
It's worth noting that capital gains from securities and many other investments you hold for a year or more are taxed at a different, usually lower rate than your other income. Most taxpayers pay a 15 percent rate on long-term capital gains, while some pay 0 or 20 percent based on income. Capital losses are deductible from capital gains and, to a limited extent per year, from ordinary income.
Investing in Funds
Rather than investing in securities like stocks and bonds directly, you can invest in funds that pool investor money to invest in bundles of such securities. You can invest in some funds by working directly with the organizations that manage them and others, called exchange-traded funds, you can buy and sell through exchanges similar to buying and selling stock.
So what's the difference between an ETF and stock? Buying shares in an ETF puts your money into a fund which invests it on your behalf for a fee, usually in multiple securities, while buying stock puts your money into one company.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.