Investment companies also purchase those securities, but in much larger quantities than individual investors do.

The three basic types of investment securities are stocks, bonds, and money market securities. Corporations issue stocks and bonds. State and federal governments and municipalities issue money market securities.

CORPORATE BONDS

When an investor lends money to a corporation, the company must pay back that investor with the bond's initial principal (plus interest) on a specified date. This loan (contract) is called a corporate bond. The terms of the legal agreement between the investor and the corporation are spelled out in the bond's indenture (deed of trust) on the bond certificate. These terms specify how and when the principal will be repaid, the coupon interest rate, a description of any property that is secured as collateral in case of default, and the steps taken in the event of default.

Corporate debt is either secured or unsecured. Secured bonds are backed by assets owned by the issuing corporation. If the issuer of the secured debt goes bankrupt, the trustee will take possession of the assets and liquidate them on behalf of the company's bondholders. If a company defaults, bondholders are repaid using the proceeds from the sale of the company's assets that secured the payments.

Mortgage bonds are secured by one or several mortgaged properties. Since these bonds are backed by real estate holdings (or "real" property such as equipment), the mortgaged properties are sold back to bondholders in the event of default.

Equipment trust certificates are secured by a specific piece of large equipment (airplane, ship, etc). The bonds are repaid at a rate which is faster than the depreciation rate of the specific equipment that is backing the bonds.

Collateral trust certificates are secured by the securities of another company who is usually affiliated with the issuer in some way. Since securities are backing the bond, the money is borrowed at a lower interest rate. If the borrower has poor credit, a collateral trust certificate is usually the only way money can be borrowed at a reasonable rate.

A call feature allows the bond's issuer to partially or fully redeem the bond before its maturity date. If a corporation wants to redeem a bond early, it will notify the bondholder(s). It lets them know how much it will be redeeming the bond for, as well as what day it will be redeemed. Then, it will pay the bondholder(s). A company usually redeems a bond early when it notices that market interest rates are declining. During this time, the company is able to replace the current bond with a different one that has a lower coupon rate. This saves the company money! In other words, the company takes advantage of the bond's declining interest rate by taking away the bond from all its bondholders and replacing it with a "cheaper" bond. "Taking away" a bond just means "calling" a bond or "paying its bondholders."

Unsecured bonds ("debentures") are backed only by the corporation's good faith and credit, not by specific assets. If the company defaults, the bondholders will have the same claim on the company's assets as any other general creditor. The payout order that occurs in the event of bankruptcy is called liquidation priority. Secured bondholders are paid before debenture holders, and stockholders are paid after unsecured bondholders.

High-yield bonds are unsecured corporate bonds and are considered "non-investment grade" by credit rating companies. The financial profile of a company issuing high-yield bonds raises questions among bond analysts whether a company will return principal and make timely interest payments to bondholders. An investor must assume higher degree of risk when lending money to such company and, therefore, junk bonds must pay higher yields to investors than bonds with investment-grade credit ratings.

A corporation may issue convertible bonds, which allow investors to convert a bond into shares of the company's common stock at a predetermined ratio. A corporation issues these bonds to borrow money at a lower rate of interest than the company would pay on a non-convertible bond. The convertible bond indenture will either give the conversion price, or state the number of shares that are actually "convertible." The price of the stock determines whether or not the bond is worth converting. The price per share that the corporation sells stock in exchange for a bond is called the conversion price. The conversion ratio is the par value of the bond divided by the conversion price. This ratio states the number of shares received. Parity refers to when the stock's market price is equal to the stock's conversion price.

OTHER TYPES OF BONDS

Zero-coupon bonds do not make any periodic interest payments and are sold at a deep discount. Upon maturity, they are redeemed only at face value. Corporations, municipalities, and the U.S. government all offer zero-coupon bonds. Since they are more sensitive to interest rate changes, they are more volatile than any other bonds of similar quality. If an investor sells the bond before maturity, he risks losing some principal if the sale is during a time of rising interest rates. They are great investments for investors who need a particular redemption value on a certain date (but no sooner). This is why zero-coupon bonds are a popular college savings tool.

A collateralized mortgage obligation (CMO) is a fixed-income security that uses mortgage-backed securities as collateral. CMOs are divided into maturity classes called tranches. Each tranche has its own estimated life, interest rate, and payment priority. All tranches are backed by the same pool of mortgages and receive interest payments, but the "youngest" tranche receives principal payments. The life of the youngest tranche expires when the principal payments are exhausted. Then, this same payment process begins again with the next youngest tranche. This continues until every tranche exhausts all principal payments.

MONEY MARKET INSTRUMENTS

Money market securities are debt instruments with maturities of one year or less. Since they are fixed-income securities with short-term maturities, they are extremely liquid and provide short-term funding to whoever issues them. Municipalities, corporations, and the U.S. government each offer different types of these securities for the public to purchase. They are very safe investments due to their high credit ratings, and they are issued at a discounted face value.

A corporation raises funds by issuing bonds, repurchase agreements or reverse repurchase agreements, or with loans from other lenders. However, the following are the most common ways a corporation raises capital:

Negotiable certificates of deposit (NCDs) are time deposits with a minimum face value of $100,000. However, most are issued for $1 million or more. They are unsecured promissory notes guaranteed by the issuing bank. Most negotiable CDs mature in one year or less. Since, they are negotiable, these CDs can be traded in the secondary market. The FDIC insures the first $250,000 of the CD.

A banker's acceptance is a short-term time draft drawn on a bank with a specified payment date (usually between one and 270 days). U.S. corporations use bankers' acceptances to buy goods and services in foreign countries.

Corporations use short-term, unsecured commercial paper to raise cash in order to finance accounts receivable and seasonal inventory declines. While the maturity of commercial paper can range from 30 to 270 days, most paper matures within 90 days. It is also issued at a discounted face value.

In order to fund upcoming projects, municipalities offer certain types of money market securities that are tax-exempt. The securities that municipalities offer are as follows:

A construction loan note (CLN) is a short-term obligation in the form of a note and is used to fund construction projects (i.e. housing developments). In most cases, the note issuers repay the note obligation by issuing a longer-term bond, using this bond's proceeds to pay back the note.

A revenue anticipation note (RAN) is a short-term debt security used to procure immediate funding in order to finance a large project (i.e. turnpike tolls, stadium ticket sales, etc). RANs are repaid with the expected revenues from this project.

Bond anticipation notes (BANs) are short-term, interest-bearing securities that are issued in anticipation of larger bond issues. BANs are smaller, short-term bonds issued by governments and corporations. They are used as short-term financing tools since the proceeds of the larger, future issue will cover the tax anticipation notes.

Tax anticipation notes (TANs) are short-term debt securities that are issued in anticipation of future tax collections. TANs are generally issued to provide immediate funding for a capital expenditure (i.e. highway construction).

The money market securities that are issued by the U.S. government and its federal agencies are as follows:

• Treasury bills/notes/bonds
• Treasury and agency securities with remaining maturities of less than one year
• Federal National Mortgage Association (Fannie Mae) short-term discount notes
• Federal Home Loan Bank short-term discount notes and interest-bearing notes
• Federal Farm Credit Bank notes and bonds that mature in one year
• Short-term discount notes issued by smaller agencies

U.S. GOVERNMENT SECURITIES

The United States government is the largest issuer of debt securities. Its bonds are the safest fixed-income investments that are available. U.S. government securities are issued either with direct government backing or "moral" guarantee.

Treasuries are highly liquid investments. The government initially sells treasury securities directly to investors through the primary market. Treasuries also have a large secondary market. They have no credit risk, but prices might fluctuate with changes in interest rates. They are sold in book-entry form, meaning the investor never receives the actual "paper" security. Instead, the Federal Reserve Bank enters the security owner's name in its records.

Treasury bills (T-bills) are direct, short-term debt obligations. Using a competitive bidding process, they are issued weekly with maturities of 1, 3, and 6 months. T-bills have minimal interest-rate risk, since they have very short-term maturities. Treasury bills are issued at a "discount upon redemption" price, but yield no interest. They are sold in multiples of $100 (the minimum denomination being $100). Secondary market quotes are based on a par value of $1,000.

Treasury notes (T-notes) are direct debt obligations that make interest payments semi-annually at a percentage of par value. They are issued with maturities of 2, 3, 5, 7, and 10 years. Like T-bills, T-notes are sold in multiples of $100 (the minimum denomination being $100). T-notes are quoted in terms of 32nds.

Similar to T-notes, treasury bonds (T-bonds) make fixed interest payments semi-annually at a percentage of par value. They have maturities that are more than 10 years (usually between 10 and 30). When a T-bond matures, the owner is paid the face value. Bonds with maturities of 30 years are callable at par value beginning 25 years after issuance. Just like T-bills and T-notes, T-bonds are sold in multiples of $100 (minimum denomination of $100). Secondary market quotes are based off a $1,000 par value, and are quoted in terms of 32nds.

While interest earned on all treasury securities is subject to federal taxation, they are exempt from state and local taxes. T-bill owners pays federal taxes on interest in the maturity year, while T-note and T- bond owners pay in the year when interest is paid.

AGENCY ISSUES

Agency securities are debt instruments issued by federal agencies and government-sponsored enterprises (GSEs) and are subject to federal taxation.

Since federal agencies are direct arms of the U.S. government, federal agency securities have a "good faith" and credit backing from the United States. Examples of federal agencies are as follows:

•U.S. Postal Service (USPS)
•Small Business Administration (SBA)
•Government National Mortgage Association (GNMA or "Ginnie Mae").

Aside from Ginnie Mae, federal agencies no longer issue securities directly to the public.

Government-sponsored enterprises (GSEs) are publicly-chartered (but privately-owned) corporations. They were created by Congress to provide low-cost loans to a certain population (i.e. farmers, students, homeowners, etc). GSEs issue a wide variety of securities, such as discount notes with maturities up to 360 days, or bonds with maturities up to 30 years. GSE securities are not direct obligations of the U.S. government, but their credit risk is very low because federal government entities do not default on their obligations. Some examples of GSEs are as follows:

•Federal Farm Credit System
•Federal Home Loan Banks
•Federal Home Loan Mortgage Corporation (FHLMC or "Freddie Mac")
•Federal National Mortgage Association (FNMA or "Fannie Mae")
•Student Loan Marketing Association(SLMA or "Sallie Mae")

U.S. SAVINGS BONDS

Series EE bonds are 30-year investments issued in denominations between $50 to $10,000. They are purchased at financial institutions by savings bond agents at 50% of their face value. Series EE bonds that were purchased after May 1,1997 and held for five years, yield 90% interest rate. This is equal to a 5-year T-bond’s average yield based on the previous 6 months. Variable rate is reset on May 1 and November 1 of each year. EE bonds are only subject to federal taxation (free from state and local taxation). Taxes on the interest of these bonds can be deferred until the bond matures or is cashed in.

Series HH bonds are 20-year investments with face values ranging from $500 to $10,000. The only way to acquire HH bonds is to exchange at least $500 of EE bonds for them. EE bonds are only subject to federal taxation. They pay semi-annual interest.

Series I bonds correlate with inflation. They are sold at face value and are issued in denominations between $50 and $10,000. Their interest rate is adjusted according to inflation and is reset semi-annually. The interest is paid over 30 years and reinvested back into the principal if the bond is held. They are free from state and local taxation, and federal taxes are deferred until bond redemption or maturity. I bonds are partially or completely tax-exempt if used for higher education purposes.

MUNICIPAL BONDS

When state and local governments or U.S. territories need to raise money, they may issue municipal bonds (also called muni bonds or munis). Muni bonds are second to U.S. government and agency securities in principal safety.

General obligation (GO) bonds can only be issued by entities that can levy and collect taxes. They are usually issued to fund properties or facilities used by the public (i.e. government buildings, schools, prisons, police or fire stations, etc). Local governments depend on property ("ad valorem") taxes to pay the obligations of their debt securities. State-issued GO bonds are paid from income, sales, and other taxes. Limited-tax GO bonds are issued by school districts, but are issued with a legal limit on the amount of taxes they can impose. Other government units (those that have do not have a legal limit on their "power to tax") issue unlimited tax bonds.

A municipality's financial safety and stability is based on the following four factors:

1. tax burden on the issuer and the source of tax payments
2. budgetary structure and financial condition of the issuer
3. existing issuer debt, which is measured by overlapping debt and net debt per capita
4. overall economic health of the community (i.e. changes in property values, average household income, etc)

Revenue bonds are backed by user fees and other charges generated by a particular "public works" project. Examples of what they are used to finance are airports, colleges and universities, toll roads and bridges, public power systems, sewer and water systems, hospitals, housing developments, sports facilities and convention centers, rapid transit, and industrial development.

The revenue generated from facility-use (i.e. ticket sales, parking fees, concessions) goes toward paying the interest and principal on the bond. The quality of a revenue bond depends on whether or not the funded project will generate enough cash to pay the interest and principal on the bond. Analysts review the flow of funds and distribute the revenue generated by the project.

A net revenue pledge states that revenues are allocated to operating and maintenance expenses first, and then to bondholders. A gross revenue pledge pays bondholders first. The tax equivalent yield (TEY) is the pre-tax yield that a taxable bond possesses in order to be equal to a tax-free muni bond.

                               TEY = THE TAX-FREE MUNI BOND'S YIELD / (1 - BOND OWNER'S TAX RATE)

RIGHTS OF OWNERSHIP OF COMMON STOCKHOLDERS

A corporation is owned by its shareholders. It issues common and preferred stock. Common stock is the most popular type of equity security that is purchased by investors. Bonds represent debt, stock represents equity (ownership). Common stock shareholders have rights of ownership (certain rights of shareholders that are specified in the corporation's bylaws).

Evidence of ownership refers to when a corporation records ownership either by issuing a physical certificate or by making a book entry (an electronic journal form of ownership registration). Records of ownership are maintained by a transfer agent. These agents have power of assignment (retitle ownership), power of authentication (verifies ownership for lost or mutilated certificates), and power of substitution (uses a signed stock power in lieu of a signature on the back of the certificate. A transfer agent’s books are reviewed by a registrar to ensure every share has been legally issued.

The right to transfer ownership refers to the shareholder’s ability to sell or gift the share to another person.

The right to inspect the books refers to public companies being required to provide their shareholders with specific reports (private companies are subject to the reporting requirements of their state of incorporation) :

•The Annual Report
•“Form 10-K” (if not already included in annual report)
•quarterly “Form 10Q”
•current periodic “Form 8-K”
•Changes in Ownership

The right to vote is a shareholder's ability to weigh-in on company matters. Having the "right to vote" is actually having the right to “vote the shares” of the company. “Vote the shares” just means that "the shareholder does not vote," the shares do. Each year, a shareholder receives a proxy statement, which is a document (ballot) covering multiple topics that will be discussed and voted on at the company’s annual meeting. The shareholder fills out this ballot and returns it to the company. This process is called proxy voting. The voting rights of a shareholder are as follows:

•An increase in the authorized shares
•A major change in the corporate structure
•The election of the board of directors
•The approval of changes in the fee structure
•The ratification of the independent auditors

A company must choose only one of the two voting styles --statutory or cumulative. Statutory voting (“straight voting”) is the most common style. It entitles a shareholder to one vote per share, and the votes must be divided evenly among the candidates or issues. With cumulative voting, to determine the maximum number of votes that could be placed on a vacancy, take the number of owned shares and multiply it by the number of vacancies. For example, when voting on a chair member... (500 shares X 3 vacancies = 1,500 votes). Do not use the number of candidates!

Another right of ownership that a shareholder has is the right to receive dividends. Dividends are declared by the board of directors. Once they are declared, shareholders have the right to receive them. Dividends are not voted on by shareholders. When a cash dividend is declared, it is recorded as a current liability (which decreases working capital). When the dividend is paid, working capital is unchanged (current liabilities and current assets are offset).

                                                     Working Capital = Current Assets – Current Liabilities

The privilege to maintain the same proportionate ownership in a company is known as a preemptive right (also called “anti-dilution provision” or “subscription right”). However, not all companies grant preemptive rights. Therefore, when a company issues additional shares, it will have a dilutive effect (reducing a shareholder’s percentage of ownership), unless these preemptive rights have been written into the company’s contract, allowing a shareholder to purchase an equal increase in shares. Open-end investment companies (mutual funds) do not have preemptive rights, and closed-end investment companies might have preemptive rights, which are characterized by the following:

• Issued only to shareholders
• Exercisable below the CMV (current market value)
• Short life of 30 to 90 days
• A standby underwriting agreement guarantees the issuer that 100% of the rights will be exercised (shareholders    can sell their rights or abandon them)

COMMON STOCK

If a company wishes to decrease the price of its stock to make it more marketable, it will split up its stock. It might perform a forward stock split, which is when the par value and the market price of the stock are adjusted per a particular ratio. This means that even though a stockholder's number of shares will increase, the absolute value of an investor's shareholding will not change. A company might also perform a reverse stock split, where the shareholder will receive fewer shares at a higher "per-share" value.

If a company wants to increase the price of its shares, it will buy back its shares on the open market. This is called a stock buyback or a stock repurchase. These stocks will be put aside as "non-voting shares" and will not pay a dividend. Once they have been put aside, they are now known and listed as treasury stock. Now that the outstanding stock (the stock still remaining/not repurchased by the company) has been reduced in number, the price of the stock will go up.

Instead of paying dividends to its shareholders in cash, a company might choose to pay them dividends with additional shares of stock ("stock dividends"). Unlike cash dividends which are taxable in the year received, stock dividends are only taxable when they are sold.

PREFERRED STOCK

Preferred stock is not issued by all companies. It is called "preferred" stock because if the company declares bankruptcy, its holders receive payments from dividends and liquidation of assets before common stockholders do.

Cumulative preferred stock is a type of stock that states that any missed dividend payments must be payed to the preferred stockholders before any common stockholders receive their dividends. Dividends in arrears refers to dividends on preferred stock that are past due.

Convertible preferred stock is preferred stock that can be converted into (exchanged for) for common stock at a specific price and at the discretion of the shareholder. The conversion price is the price at which this exchange occurs. With this convertible stock, holders are able to take advantage of capital appreciation (a rise in the stock's value based on the market price). It is advantageous for a shareholder to convert to common stock above the conversion price. Due to its convertible feature, convertible preferred stock pays a lower dividend than other preferred stock. However, it does pay higher dividends than common stock.

                                                           Conversion Ratio = Par Value / Conversion Price

Callable preferred stock can be repurchased or called at a specific price in the future. In order to persuade investors to buy the stock, the call price will usually be higher than the stock's par value.

Participating preferred stock pays the holder a higher dividend than that of common stock when a company experiences exceptional earnings in a year's time.

LIQUIDATION PRIORITY

When a company declares bankruptcy and liquidates its assets, payments are made in the following order:

1. Wages owed to employees followed by IRS or tax debt
2. Secured debt followed by unsecured debt, general creditors, and subordinated debt
3. Preferred stockholders followed by common stockholders

OTHER TYPES OF EQUITY SECURITIES

Foreign corporations may choose to list their shares on U.S. stock exchanges by issuing American Depository Receipts (ADRs). This process allows American investors to purchase the shares of the foreign company, since the shares are not registered with the SEC. Typically, a large U.S. bank with offices in that foreign country purchases a large quantity of the stock, hold it "in trust," and then issue the ADRs (which are backed by the shares that are held "in trust"). ADR purchases receive no voting rights. Declared dividends will be in the foreign currency, but converted and paid in U.S. dollars (currency exchange risk).

Subscription rights (also known as rights privileges or rights) are privileges that are granted to existing shareholders (i.e. the right to subscribe to shares of a new offering of common stock before they are offered to the public ). Shareholders also have the right to subscribe to these shares at a lower subscription price than the market lists. Rights usually have a "short life" (a short period during which they may be exercised), and they are freely transferable in the secondary market (just like stocks on an exchange). This allows a corporation to raise additional funds quickly. Companies might offer rights at a different subscription ratio. This is called a rights offering. The subscription price is usually lower than the stock's market price. Rights that are not exercised or sold during this period will expire at the end of it.

Similar to rights, stock warrants offer the option to buy common stock in the future at a specified subscription price. Unlike rights, warrants do not expire for three to five years (if they expire at all), and warrant subscription prices are higher than the current market price for the newly issued stock. Warrants are also traded on the open market.

Options are contracts to buy or sell a certain number of shares of an underlying stock at a specified price over a given period of time. The buyer or holder of the option is the person (or entity) who pays for the right to exercise the terms of the contract. The seller or writer of the option is the person (or entity) who grants/owes the owner the right to exercise the contract.

The buyer/holder of the call option buys the right from the writer to purchase an underlying security at a fixed price (or, "calls" the security away from the writer/seller). The writer of the option now has an obligation to sell the security at that fixed price if the holder exercises his right to call the stock away from the seller/writer.

When an investor owns a "put," he has the right to sell ("put") the underlying security to the writer at a fixed price. In turn, the writer will have an obligation to buy the security from the put owner.

An exchange-traded fund (ETF) is a type of security that combines features of stocks and mutual funds. Each ETF is designed to track an index and owns a few stocks. The portfolio is not actively managed and the ETF is traded like a stock. This allows the price of the ETF to fluctuate throughout the day based on market demand.

Hedge funds are aggressive portfolios designed to maximize returns while minimizing risks. Since they are only available only to sophisticated investors, they are unregulated.