6 mins read . 21 Nov 2022
In India, the equity market is characterized by the NSE and the BSE. Most of the private debt paper are also traded on the NSE and BSE, but bulk of the government debt transactions by banks and institutions happen directly in the SGL account with RBI. Just as you have equity in stock market, the stock exchanges also have the fixed income market as part of the exchange mechanism. However, it is much smaller in size and is restricted only to non-institutional players. Today fixed income trading is not as simple and popular among retail as equity trading is . Here let us look at some of the key difference between equities and fixed income markets.
Equity investments allow investors to hold partial ownership of issuing companies and such equity shares can be freely traded in the stock markets in the case of listed stocks. As one of the principal asset classes, equity plays a very important role in every portfolio; both as a risk diversifier and also as a long term wealth generator.
Let us turn to the categorization of equity investments in the stock market. There are various options available to you. You can invest in stocks and also in stock mutual funds; which can either be open ended or close ended. Within the ambit of stocks, you have common stocks and preferred stocks. Common stocks, as the name suggests, are the securities that are traded most often and give the owners the right to earn dividends declared by the company, participate in the growth of the company through capital gains and to vote in the annual general meeting (AGM) to express their individual voice. In contrast, preferred stocks offer a relatively lower risk, a degree of assured returns as dividends which may be accumulative or non-accumulative. However, preference shareholders are not entitled to vote at the AGM as they are not part owners.
How are shareholders compensated? They have a stake in the company but compensation comes in various ways. There is the regular flow of dividends paid out of the profits of the company in question. However, dividends are discretionary and not obligatory. Above all, the most important benefit comes from the capital appreciation from the performance of the company. In addition, equity shareholders also get the benefits of corporate actions like rights shares at discount, enhanced shares through bonus and splits as well as an indicative method to monetize their holdings through buyback of shares in case of cash rich companies.
However, equities come with some risks too. The higher returns come with higher price volatility and risk. In the event of bankruptcy, the shareholders often get nothing as they only have a residual claim on the net assets of the company. Equity share markets are a reflection of the risks to the economy to sectors and to specific stocks.
A fixed-income security, as the very name suggests, promises fixed amounts of cash flows at fixed dates. Such fixed income securities are relatively more secure and less volatile in terms of returns and cash flows. Thus they provide stability to any portfolio of assets. Let us dwell on two types of bonds available to investors in the market.
Broadly, there are coupon bonds and zero-coupon bonds (deep discount bonds). Let us look at zero coupon bonds first. They just promise one single cash flow, equal to the face value when the bond matures. Such zero coupon bonds are issued at a discount and redeemed at par and the difference is the CAGR yield on the bond. On the other hand, a coupon bond pays out its listed face value upon maturity. In addition, it also pays regular interest either annually, half-yearly or quarterly; depending on the bondholder agreement. In terms of tax treatment, there is no difference between coupon bonds and deep discount bonds since interest is taxed on an accrued basis and not on receipt basis.
Are there risks to fixed income securities? Well, there are quite a few risks. Firstly, they are not suited to long term wealth creation as they provide lower returns in the long run. Private bonds are open to default risk, if they don’t have solvency. The most important risk in the fixed income market is price risk / interest rate risk, which is the risk of bond prices falling when rates go up. This is most acute for longer tenure fixed income products.