Types of Investment

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There are many types of investment instrument that the self-directed investor can use to invest their money. For the purposes of such investment, we exclude consideration of insurance-style or annuity products, which fall outside the scope of ShareSoc’s remit. Our purpose is to support self-directed investors, who wish to avoid the fees and opaque structures that most such products entail. The following types of instrument are the most common ones a self-directed investor might consider, and each is discussed in a section below:

• Bank Accounts. The various types of bank account will be the most familiar instrument to all investors. They offer a high degree of security but, at the present time, very low returns, so are not particularly attractive, except as a temporary home for uninvested cash and for “reserves” that will meet an investor’s short-term needs (including funds needed for unexpected emergencies). Given the inherent short-term unpredictability of public markers, it is wise to always have some cash available to take advantage of bargains, should they arise. We will not discuss bank accounts further here.
• Another very secure form of investment is government securities.
• Moving up the risk ladder, the next most secure type of investment is the corporate bond.
• Next, we come to shares, also known as “equities”. ShareSoc is primarily focussed on direct share investment, and this is the type of investment the Investor Academy chiefly addresses.
• Collective investments are an indirect way of investing in underlying securities or other assets.
• Derivatives offer experienced and sophisticated investors methods for enhancing returns and/or hedging risk.
• Structured products are a complex form of derivative investment
• Property (also known as “real estate”) is another well known way of investing
• P2P Lending. A recent innovation, allowing investors to generate a return by lending to borrowers.
• Precious metals. It is questionable whether these can be called an investment, as they do not generate a return.
• Alternative investments. A broad term for a number of investments that do not fall into the above categories.

Government Securities

UK government securities are know as “gilts” (short for “gilt edged” securities). They are the chief mechanism through which the government borrows. Given that the government has never defaulted in the entire over 200 year history of gilt issuance, the probability of an investor not receiving the promised interest returns and the principal on the stated maturity date is very low. Each UK gilt has a “nominal value” of £100 (“the principal”), a stated redemption or maturity date, at which time the original £100 is repaid (or £100 plus an adjustment for inflation, in the case of index linked gilts). They also pay a “coupon”, at 6 monthly intervals, representing an amount of interest that the gilt pays. In the case of index linked gilts, the coupon also rises with inflation.

Bear in mind, however, that the return of principal is only guaranteed if the gilt is held to maturity. Prices in the market will vary over time, so if you want to sell a gilt in the market before it matures, there is no guarantee that you will receive your original investment back. Note in particular that some older gilts, issued when interest rates were much higher, will trade “above par” if you purchase them now. In those cases you must bear in mind that if held to maturity you will only get the original par value back, which may be less than you have to pay to purchase them. See this page on compound interest for links to tools that can work out the equivalent “yield to maturity” (YTM) of a gilt or bond bought at a different price to par. YTM is the effective interest rate you earn, taking into account the difference between the final repayment you receive, the amount you pay and all interest payments due in between.

Gilts are most easily bought and sold through a stockbroker, in a similar manner to shares. For further information on gilts see this official government website.

Corporate bonds

Corporate Bonds work similarly to Government Bonds in that they are both securities, paying interest regularly (the ‘coupon’) and with the expectation of repaying the bond principal on a set date. The main difference from Government Bonds is that the Government can guarantee their bonds unlike companies that issue their own bonds. For US Government Bonds (“Treasuries”) or UK securities (“Gilts”), those governments have never defaulted (i.e. failed to pay interest or repay principal when due). NB: this is not always true for bonds issued by other governments. Corporate Bonds are only guaranteed by the firm that issues them, so if that firm runs into financial difficulties, it is possible that it may not pay the interest due or even principal when that becomes due (i.e. the firm “defaults”). Therefore, corporate bonds are generally perceived as riskier than government securities. So, they generally pay a higher rate of interest (coupon) than government bonds to compensate for that risk. The higher the perceived risk of a business defaulting, the higher the interest rate the market will demand for its bonds. The riskiest of Corporate Bonds, paying the highest levels of interest are known as ’Junk Bonds’.

What happens when a firm runs into severe financial difficulties?

Legally, there is a hierarchy of creditors that decides the order in which each gets repaid. At the top of the hierarchy are “preferred creditors”. These include employees and government (e.g. HMRC). In the event of an insolvency, the firm of administrators or liquidators are also preferred creditors. These debts must be paid before any other creditors receive anything. Next come “secured creditors”. These are typically banks, who are given a guarantee, ahead of other creditors, when they lend to a firm. Finally come all the other creditors, these include bondholders and trade creditors (i.e. suppliers owed a debt by the business). Sometimes there are different classes of bond issued by a company: senior or junior bonds. In an insolvency, the senior bonds must be repaid in priority over the junior bonds. Again, purchasers of the junior bonds expect to be paid a higher rate of interest than the senior bondholders, due to the extra risk that they are taking.

Ordinary shareholders are the lowest in the hierarchy of creditors and only receive a payment if and when all other creditors have been paid first. In most insolvencies shareholders are likely to receive nothing.

When analysing a particular bond, it is important to determine what other creditors the issuing firm has, or may assume in the future, that may take priority over bondholders. This information should be contained in the prospectus the firm issues when it markets the bond.

Sometimes firms may issue irredeemable bonds (often known as preference shares). It is not intended that these will ever be repaid but they will continue paying interest indefinitely. If a purchaser of such securities wishes to retrieve their invested money, the only way to do so is to sell the bond/preference share on the market.

Shares

Click here for an explanation of what shares/equites/stocks are.

More content is coming soon!  In the meantime, you can find out more about different types of investment via our Investing Basics series.

Coming Soon:

Collective investments

Open ended vs closed ended – open ended bad idea for illiquid underlyings.

Investment trusts are a specific category of closed ended investment companies. The UK tax regime has specific rules for companies that qualify as investment trusts, designed to shield investors in such trusts from double taxation of both the profits from trusts’ activities and resulting from the ownership of investment trust shares. Further information about investment trusts can be found here.

Derivatives

Structured products

Property

P2P Lending

Precious metals

“Alternative investments”

M.A.B.