You were given a paper certificate or note of some kind if you made an investment before the electronic era. It served as proof of your purchase. It outlined the terms of the investment. These papers were called "securities." Paper securities could be bought and sold, just as we buy and sell stocks or bonds or shares of mutual funds today.
The term "security" now refers to just about any negotiable financial instrument, such as a stock, bond, options contract, or share of a mutual fund. Securities fall into three broad groups: debt, equity, or derivative.
A business will first borrow using a traditional means, such as from a bank, when it needs money to grow. Banks don’t want to take too much risk, so they will only lend so much. A business must go to the capital markets and issue a debt security called a "bond" when the bank option is exhausted.
You are lending your money to a company or municipality when you buy a bond from an issuer. They must pay it back with interest. These interest payments are called "coupons." They're often issued twice a year.
A business can either find private investors or go to the capital markets and issue securities in the form of publicly traded stock when it takes on more owners in order to grow. Equity represents ownership. You are buying a share in a company when you purchase a stock. As the company makes a profit, you will share in that profit in one of two ways.
Either the company will pay you a dividend, which you should receive every three months (sometimes six), or it will use their profits to grow the business further. You should see your stock rise in value if the business grows.
You have the right to trade other securities at pre-agreed upon terms with derivative securities, rather than owning something outright, like shares of a stock. Options contracts are a type of derivative security. They give you the right to buy or sell shares at a certain price by a certain date. You pay for that right. The price you pay is called the "premium."
Suppose Widget stock is trading at $50 per share. You buy an option contract that gives you the right to buy it at that price, because you feel sure it is going to $60, but you don’t want to be out the full cost of $50 just in case it doesn't.
Your option costs $1 per share. Widget does go to $60. You exercise your option and flip the stock, making an instant $9 per share: $10 profit minus a $1 premium cost.
The Securities Market
The securities market is much the same as the real estate market. Just as the housing market is composed of millions of people who all dream of owning a home, the securities market is made up of thousands of business owners who all have a vision of building and growing a thriving business.
Most of these large businesses would never be able to reach their level of success without borrowing or raising money in some way, just as most of us would not be able to own a home without first taking out a mortgage.
Every business needs capital. It's used to build the infrastructure to grow.
The owners have enough money to fund the business themselves in rare cases. The company will remain privately owned in that case, and the owners get to keep all the profits. The owners can either borrow or take on more owners who have capital if the business doesn't have the money it needs to expand.
That is where you, the investor, come in. When businesses issue securities in the form of stocks and bonds, investors buy them. The income provides the company with the capital it needs. These securities can then be traded on the secondary market once they have been issued.
The securities market is regulated by the Securities and Exchange Commission in the U.S.
How Securities Get Issued Through Capital Markets
A business will hire an investment banking firm when it has to go on the capital market. The firm looks at the financials of the business and the total amount of money it needs to raise. The bank then advises the business as to the best way to raise that money, by issuing either stock or bonds. It helps it put together and sell a public offering of the securities.
The newly issued stocks and bonds are offered to public investors through a network of brokerage firms.
Frequently Asked Questions (FAQs)
How do you invest in mortgage-backed securities?
Why do pension and mutual funds invest in debt and equity securities?
Pension and mutual funds have different goals, but they generally fall into a few basic categories like capital gains, passive income, and capital preservation. In other words, securities help pension and mutual funds grow wealth, secure steady income streams, counter inflation, or some combination of those goals.
Which type of bond mutual funds invests in tax-exempt securities?
Municipal bonds may be tax-exempt at the federal, state, and local levels. Bond investors who want to reduce their tax liability should consider municipal bond funds, but double-check to ensure that a specific fund will receive favorable tax status in your area.