Finance experts have a lot of special talents. Key among these are re-inventing words, and using them in a way that approximately zero English speakers will understand. You might be surprised, for example, to know that disintermediation is a financial strategy, and not a filthy attempt to cheat at Scrabble. In this article, we’ll demystify the definition of some basic financial products:
How Do Investments Differ?
Investments differ in a number of ways. Key considerations are:
- Risk – Some investments can plummet in value overnight, while others can be quite resistant to market conditions.
- Complexity – Some investments, like shares, are straightforward. Others require explanations longer than War & Peace.
- Limitations – There is a limit to the returns which various investments provide. Risky high yield bonds, for example, have the potential for higher returns than most unit trusts.
If we explained all the differences in risk, complexity, and limitations here, you’ll finish reading this post in 2023. For now, let’s just say these are the main ways that investment products differ.
For deeper analyses of specific stocks, bonds, etc., it’s important to consult an independent financial advisor. Before you do that though, brush up on these investment types, and their traits:
When you buy a bond, you are effectively loaning money to the issuer of the bond.
Like loans, most bonds have a tenure (an amount of time until the loan is repaid), interest (which is paid to the bond holders at regular intervals), and a principal loan amount (called the face or par value).
The “tenure” of a bond is defined by its maturity date. Upon maturity, the bond issuer will pay out 100% of its par value to the bond holders.
Until then, bond holders receive regular payments, from the interest on the bond. These payments are called coupons, and the amount of the payment is the coupon rate.
Coupon Rates for Bonds
The coupon rate is expressed as a percentage of the bond’s par value. For example:
Say I buy a bond in an emerging market, gold mining company, because I’ve taken leave of my senses. The par value of the bond is $1,000.
If the coupon rate is 10%, that means the bond gives me regular payments of (10% of $1000) = $100.
There are fixed rate and floating rate bonds. In a fixed rate bond, the coupon rate doesn’t change. In a floating rate bond, the coupon rate is pegged to an index (e.g. SIBOR).
Most bonds give out coupons every six months. However, some bonds give them out monthly, annually, or quarterly.
How Much Does a Bond Cost?
The price of a bond is expressed as a percentage of its par value (e.g. 90% of par value, or 105% of par value).
When the bond is bought at under its par value, it is called a discount bond. When it is bought above its par value, it is called a premium bond.
As to why various bonds are premium or discount, you will have to consult a financial advisor. A premium bond does not necessarily mean higher returns, or lower risk.
Things to Note:
- There are perpetual income bonds, which have no maturity date. These bonds keep paying out interest to bond holders, and are never redeemed by the issuer.
- There are zero coupon bonds. These are bonds that do not pay out anything, until the maturity date.
- The bond issuer has a credit rating, which ranges from AAA (investment grade) to C (junk bonds). This rating determines the risk of the bond issuer defaulting, amongst other things. New investors should stick to investment grade bonds.
- In general, the shorter the maturity date, the lower the risk of the bond.
Shares are issued by companies to raise capital. As the name implies, you buy a share in the company when you buy these.
Shares give you a right to some of the company’s profits, in the form of dividend payments. However, note that a company may or may not pay out dividends, depending on the company’s performance.
Also, not all buyers are focused on dividends. Some buyers aim to purchase shares at a low price, and sell them a higher price when the company performs well.
There are two main types of shares: Ordinary shares, and preferred shares. Dividends are paid to people holding preferred shares first. Should a company go bust, money from its liquidation will also go to holders of preferred shares first.
Holders of preferred shares also have privileged voting rights, when it comes to determining the company’s strategies or policies.
Dividends payouts can be expressed as simple dividends per share (DPS), or as a dividend rate.
DPS simply states how much you will get per share (e.g. $0.40 per share), while the dividend rate is a percentage of the share’s nominal value.
So a dividend rate of 5%, on 1,000 shares, priced at $0.80 each, would work out to:
5% x $0.80 x 1,000 shares = $40
How Much Does a Share Cost?
Shares are usually sold in lots of 1,000 (exceptions exist). The listed price of a share is the price of a single share.
So if the share price is $1, and the share is sold in lots of 1,000, the minimum you have to spend is $1,000 ($1 x 1,000 share).
Things to Note:
- Share prices are tied to wider economic conditions, as well as the performance of individual companies. Avoid investing in a company or industry you don’t understand.
- Blue chip stocks are shares in established companies, like Singtel or Starhub. Penny stocks are shares in small companies, which might be start-ups.
- People who buy shares can be divided into investors and traders. Investors hold shares for a long time, and seek high dividends. Traders actively buy and sell shares to make a profit.
We’re Not Done Yet…
A MoneySmart Investment Series in collaboration with SGX
This is the third article of a 6-part series, focusing on investment for beginners. For more on starting your investment plans, like SGX on Facebook and subscribe to SGX My Gateway here. Over the next few weeks, we’ll be introducing you to the most basic elements of the stock market, and how a non-expert can still profit from it. If you are new to this series, do read the first two parts here: