Introduction to Corporate Securities - Sources of Business Finance, Business Economics & Finance | Business Economics & Finance - B Com PDF Download

Security, in business economics, written evidence of ownershipconferring the right to receive property not currently in possession of the holder. The most common types of securities are stocks and bonds, of which there are many particular kinds designed to meet specialized needs. This article deals mainly with the buying and selling of securities issued by private corporations. (The securities issued by governments are discussed in the article government economic policy.)

Types Of Corporate Securities

Corporations create two kinds of securities: bonds, representing debt, and stocks, representing ownership or equity interest in their operations. (In Great Britain, the term stock ordinarily refers to a loan, whereas the equity segment is called a share.)

Bonds

The bond, as a debt instrument, represents the promise of a corporation to pay a fixed sum at a specified maturity date, and interest at regular intervals until then. Bonds may be registered in the names of designated parties, as payees, though more often, in order to facilitate handling, they are made payable to the “bearer.” The bondholder usually receives his interest by redeeming attached coupons.

Since it could be difficult for a corporation to pay all of its bonds at one time, it is common practice to pay them gradually through serial maturity dates or through a sinking fund, under which arrangement a specified portion of earnings is regularly set aside and applied to the retirement of the bonds. In addition, bonds frequently may be “called” at the option of the company, so that the corporation can take advantage of declining interest rates by selling new bonds at more favourable terms and using these funds to eliminate older outstanding issues. In order to guarantee the earnings of investors, however, bonds may be noncallable for a specified period, perhaps for five or 10 years, and their redemption price may be made equal to the face amount plus a “premium” amount that declines as the bond approaches its maturity date.

The principal type of bond is a mortgage bond, which represents a claim on specified real property. This protection ordinarily results in the holders’ receiving priority treatment in the event that financial difficulties lead to a reorganization. Another type is a collateral trust bond, in which the security consists of intangible property, usually stocks and bonds owned by the corporation. Railroads and other transportation companies sometimes finance the purchase of rolling stock with equipment obligations, in which the security is the rolling stock itself.

Although in the United States the term debentures ordinarily refers to relatively long-term unsecured obligations, in other countries it is used to describe any type of corporate obligation, and “bond” more often refers to loans issued by public authorities.

Corporations have developed hybrid obligations to meet varying circumstances. One of the most important of these is the convertible bond, which can be exchanged for common shares at specified prices that may gradually rise over time. Such a bond may be used as a financing device to obtain funds at a low interest rate during the initial stages of a project, when income is likely to be low, and encourage conversion of the debt to stock as earnings rise. A convertible bond may also prove appealing during periods of market uncertainty, when investors obtain the price protection afforded by the bond segment without materially sacrificing possible gains provided by the stock feature; if the price of such a bond momentarily falls below its common-stock equivalent, persons who seek to profit by differentials in equivalent securities will buy the undervalued bond and sell the overvalued stock, effecting delivery on the stock by borrowing the required number of shares (selling short) and eventually converting the bonds in order to obtain the shares to return to the lender.

Another of the hybrid types is the income bond, which has a fixed maturity but on which interest is paid only if it is earned. These bonds developed in the United States out of railroad reorganizations, when investors holding defaulted bonds were willing to accept an income obligation in exchange for their own securities because of its bond form; the issuer for his part was less vulnerable to the danger of another bankruptcy because interest on the new income bonds was contingenton earnings.

Still another hybrid form is the linked bond, in which the value of the principal, and sometimes the amount of interest as well, is linked to some standard of value such as commodity prices, a cost of living index, a foreign currency, or a combination of these. Although the principle of linkage is old, bonds of this sort received their major impetus during the inflationary periods after World Wars I and II. In recent years they have had the most use in countries in which the pressures of inflation have been sufficiently strong to deter investors from buying fixed-income obligations.

Stock

Those who provide the risk capital for a corporate venture are given stock, representing their ownership interest in the enterprise. The holder of stock has certain rights that are defined by the charter and bylaws of the corporation as well as by the laws of the country or state in which it is chartered. Typically these include the right to share in dividends and other distributions, to vote for directors and fundamental corporate changes, and to inspect the books of the corporation, and, less frequently, the “pre-emptive right” to subscribe to any new issue of stock. The stockholder’s interest is divided into units of participation, called shares.

A stock certificate ordinarily is given as documentary evidence of share ownership. Originally this was its primary function; but as interest in securities grew and the capital market evolved, the role of the certificate gradually changed until it became, as it is now, an important instrument for the transfer of title. In some European countries the stock certificate is commonly held in bearer form and is negotiable without endorsement. To avoid loss, the certificates are likely to be entrusted to commercial banks or a clearing agency that is able to handle much of the transfer function through offsetting transactions and bookkeeping entries. In the United States, certificates usually are registered in the name of the owner or in a “street name”—the name of the owner’s broker or bank; the bank may for legal reasons use the name of another person, known as a “nominee.” When a certificate is held in the name of a broker or bank nominee, the institution is able to make delivery more readily and the transfer process is facilitated. Investors, for legal or personal reasons, may prefer to keep the certificates in their own names.

A corporation may endow different kinds or classes of stock with different rights. Preferred stock has priority with respect to dividends and, if the corporation is dissolved, to the division of assets. Dividends on preferred stock usually are paid at a fixed rate and are often cumulated in the event the corporation finds it necessary to omit a distribution. In the latter circumstance the full deficiency must be cleared before payments may be made on the common shares. Participating preferred stock, in addition to stipulated dividends, receives a share of whatever earnings are paid to the common stock. Participation is usually resorted to as an inducement to investors when the corporation is financially weak. Although a preferred issue has no maturity date, it may be given redemption terms much like those of a bond, including a conversion privilege and a sinking fund. Preferred stockholders may or may not be allowed to vote equally with common stockholders on some or all propositions or more characteristically may vote only upon the occurrence of some prescribed condition, such as the default of a specified number of dividend payments.

Common stock, in some countries called ordinary shares, represents a residual interest in the earnings and assets of a corporation. Whereas distributions to bonds or preferred stock are ordinarily fixed, dividends paid on common stock are set at the time of payment by the directors and tend to vary with earnings. The market price of common stock is likely to move in a relatively wide range, depending on investors’ expectations of earnings in the future.

Options

An option contract is an agreement enabling the holder to buy a security at a fixed price for a limited period of time. One form of option contract is the stock purchase warrant, which entitles the owner to buy shares of common stock at designated prices and according to a prescribed ratio. Warrants are often used to enhance the salability of a senior security, and sometimes as part of the compensation paid to bankers who market new issues.

Another use of the option contract is the employee stock option. This is used to compensate key executives and other employees; it is normally subject to a variety of restrictions and is generally nontransferrable. Stock rights, like warrants, are transferrable privileges permitting stockholders to buy another security or a portion thereof at a specified price for an indicated period of time. The stock right allows stockholders to subscribe to additional shares of stock in proportion to their present holdings. Stock rights usually have a shorter life-span than warrants, and their subscription price is below, rather than above, the market price of the common stock.