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INVESTING IN STOCKS, BONDS AND TREASURY BILLS
Shares, or stocks are securities that represent ownership
in a company; so when you buy a share you become part owner
of the company. When the company does well, you receive a
portion of its profits. But if the company experiences financial
difficulty, you also share in its losses.
There are two (2) types of shares, (i) ordinary shares also
called common shares, and (ii) preferred shares. Common shares
give the shareholder a vote in the selection of directors,
and a proportionate but unspecified claim on the company’s
profits. These profits may be distributed to shareholders
as dividends declared by the company’s directors from
time to time, and paid out as either cash or additional shares.
Since profits will vary as a business thrives or declines,
so too will dividend payments. In fact a company might not
pay dividends in years in which it made little or no profit.
Preferred shareholders are entitled to certain preferences
not enjoyed by holders of common shares. Preferred shares
entitle their owners to receive a fixed dividend and to be
the first to receive a share of the company’s profits.
And, if the company is liquidated, preferred shareholders
will be paid before the holders of common shares. However,
they do not have voting rights.
Unlike shares, which represent equity ownership in a company,
treasury bills commonly referred to as T-bills and bonds are
debt instruments. These represent loans to the issuer. We
can think of bonds as long- term loans and T-bills as short-term
loans. While both companies and governments issue bonds, only
governments issue T- bills.
Treasury Bills are issued with a term of one year or less;
so a government may issue a 91 or a 181-day treasury bill,
any period that is less than or equal to one year. The buyer
of a T-bill, that is the investor, lends money to the government
for a specified time. At maturity, that is when repayment
of the loan is due, the government will repay the investor
the full value of the bill, called the face value.
Treasury bills are usually sold at a discount that is at
less than the face value. But because the investor is repaid
at the face value, the investor will receive more money than
was actually paid for the T-bill. The difference between the
purchase price of the Treasury bill and the amount repaid
at maturity represents the interest or the return on the investment.
Let us look at an example.
An investor purchases a 91-day T-bill with a face value of
$10,000 for $9,500. The investor therefore purchased the T-bill
at a discount, having paid $500 less than the face value of
the Treasury Bill. When the T-bill matures, the investor will
be repaid not at the discounted price of $9,500 but at the
face value of the bill which is $10,000, a gain of EC$500.00.
This $500.00 represents the interest earned by the investor.
Bonds, on the other hand, are long-term loans to companies
and governments. When a company needs money to develop a new
product or build a new plant, or a government needs money
to pay, for example, infrastructure development, they may
decide to issue bonds. The issuer, that is the company or
the government, sets the terms of the bond including the interest
rate and the time when the bond will be repaid. Therefore,
the investor who buys the bond lends money to the company
or government for a set term, at a specific interest rate.
The interest is the investor's return on his investment.
The duration is an important determinant of the interest
on the bond. Because the price of a debt security moves opposite
to interest rate movements, the longer the duration, the greater
the possibility that the price of the bond will be affected
by market fluctuations, for example, inflation. So, a 30-year
bond price is likely to fluctuate more than a 5-year bond
because the interest rate is locked in for a longer period.
This we call interest rate risk, one of the risks associated
with bonds. Because Treasury Bills are short-term instruments
they tend to be less vulnerable to interest rate risk fluctuations
than bonds.
Another risk – credit risk, that is the possibility
that the borrower will not be able to repay the loan, is associated
with both bills and bonds. An issuer's debt service record
may provide a good indication as to the level of credit risk
associated with its existing or future securities.
There is a concept of risk and return that states that the
higher the risk the greater is the expected return on an investment.
The logic is that the seller of a high-risk security should
compensate the buyer for assuming a higher risk probability
relative to other similar investments.
A broker dealer can assist investors in understanding and
evaluating these and other investment related risks. Understanding
the risks attached to each security will help each investor
to purchase the securities best suited to his/her needs.
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The Regional Government Securities Market