How are stocks traded?

Securities

What is behind stocks, bonds, certificates and funds

Hendrik Buhrs
Expert for banks and stock exchanges As of November 01, 2016

Hendrik Buhrs

Hendrik Buhrs is an editor in the bank and insurance team. Before joining Finanztip, he reported on economic and consumer issues for the radio programs of Hessischer, later for Westdeutscher Rundfunk. Hendrik studied economics in Münster and Exeter. He gained his first professional experience at Radio Q and on Recklinghausen local radio. He likes to invest the money he has saved in travel.

  • Securities record a participation in a company or an obligation in writing. They vouch for a right.
  • The most important types of security are stocks, bonds (fixed income securities), certificates and warrants, funds and ETFs.
  • For example, the share certifies the shareholder's rights vis-à-vis the stock corporation.
  • A bond (bond) certifies its holder a claim for repayment of the amount invested and usually interest payments.
  • Each security class has numerous characteristics: In the case of shares, there are ordinary or preference shares; in the case of bonds, for example government bonds or corporate bonds.
  • Securities can change hands and are often traded on the stock exchange.

The term security comes from a world in which business was still carried out analogously. At that time, the security was a document certifying that the holder had a right to a third party. For example, if you owned a share, you had proof of your rights vis-à-vis the stock corporation in your hand. Anyone who owned a bond was able to document their entitlement to repayment of the nominal value and interest payments from the debtor in black and white.

Today, the rights of shareholders or bondholders are mostly evidenced in global certificates that are deposited with a digital office (clearing). The shareholder or bond holder no longer has a security (certificate) in their hands, but electronic evidence.

There are these types of securities

Securities are structured differently. Depending on the legal right, their owners can then use them for different purposes. Checks and bills of exchange, for example, played an important role in payment transactions and credit business.

For private investors, those securities are particularly interesting that they can use for investments. This works best with securities that are traded on the stock exchange. The Frankfurt Stock Exchange distinguishes among other things the following classes of securities:

Each of these security classes has numerous sub-categories.

In the case of shares, it comes down to voting rights

Shares certify a shareholder's right to membership in a stock corporation. The shareholder does not become a creditor, but a co-owner of the company. For the company, share capital is equity.

As equity providers, shareholders have rights and obligations. If things are going well economically, they not only benefit from a better share price, but often also from a so-called dividend. The company is thus distributing parts of its net profit to the shareholders.

In addition to the right to the dividend, participation in the annual general meeting is one of the most important rights of shareholders. Holders of voting shares (common shares) can participate in the resolution at the general meeting. Important points are, for example, the use of retained earnings, capital increases and discharge of the board of directors and the supervisory board. With the discharge, the shareholders declare that they were satisfied with the work of these bodies in the past financial year.

A distinction must be made between the ordinary shares to which voting rights are attached and the so-called preference shares. Holders of preference shares typically receive a higher dividend than holders of common shares. In doing so, you waive your right to vote.

Further rights: subscription rights and participation in the sales proceeds

Another right of shareholders is the so-called subscription right. It is always important as soon as a company decides to increase its capital - i.e. to issue new shares. If the number of shares increases, existing voting rights lose value. It can also be the case that the share price falls in the event of a capital increase. To compensate for this, shareholders receive new shares via subscription rights. Alternatively, they can sell their subscription rights on the stock exchange. The general meeting can also exclude subscription rights with a three-quarters majority.

If the stock corporation is dissolved, shareholders also have the right to a portion of the sales proceeds. In the event of bankruptcy, however, shareholders are the last of the financiers to be paid out. Banks and bondholders come first.

Our tip: Always stay up to date - with our free newsletter!

Our tip: stay on the topic [category] always up to date - with our free newsletter!

Great variety in bonds

Bonds are also called (fixed) interest securities, debentures, bonds or bonds. The bond holder has given the issuer (issuer) a certain amount of money for a certain period of time and is usually also entitled to a regular (fixed or variable) interest payment.

An example: A bond has a ten-year term and an interest coupon of 3 percent. This means that the holder of the bond receives 3 percent interest on the nominal value of the bond every year, for example EUR 30 interest on EUR 1,000 nominal value. That's 300 euros over ten years. After ten years, the investor receives back the 1,000 euros including the last interest payment, i.e. 1,030 euros.

Government bonds versus corporate bonds

Both governments and companies can issue (issue) bonds. One speaks of government bonds or corporate bonds. In the case of government bonds, a country, for example Germany or the USA, borrows money from buyers in the market on certain terms. It uses the income to finance its budget.

How much interest a country has to pay for the bond depends in particular on the development of interest rates, the term of the bond and the creditworthiness (creditworthiness). Germany continues to receive the top AAA rating from the rating agencies. In their opinion, there is practically no risk that the Federal Republic of Germany will not be able to repay the bonds. Germany therefore currently only needs to offer low interest rates. For a ten-year federal bond, the federal government currently has to offer only a slightly positive interest rate. Other countries like Spain or Italy have to pay more interest if they want to raise money through bonds.

Companies also issue bonds. The interest also depends on the creditworthiness. Companies are therefore also dependent on rating agencies to rate their creditworthiness. The car manufacturer Daimler, for example, has been rated as a safe investment by all three rating agencies Standard & Poor’s, Moody’s and Fitch (rating A- or A3) since 2012, as long as no unforeseen events affect the overall economy.

This good rating means that a company like Daimler does not have to offer much for bonds in the relevant market environment. A bond in euros that matures in 2022 (WKN A1PGWA) promises its holder interest of 2.375 percent per year. However, the investor must buy the bond at an inflated price while interest rates are low, around 112 percent of the actual face value on which the interest is due.

An example: The investor buys the bond for 1,120 euros, but receives the 2.375 percent interest per year only on 1,000 euros. He also only receives 1,000 euros plus the last interest rate as repayment. The high purchase price thus dampens the bond yield - it is lower than the interest rate.

Safe havens versus junk bonds

Bonds can also be classified according to their default risk. Government bonds from countries with top credit ratings are seen as “safe havens” and generate very little returns. If you want to earn a little more, you have to increase your risk and buy bonds from states or companies whose bankruptcy potential is estimated to be higher.

In this context, the term high-yield bonds (English: high yield bonds) or, colloquially, junk bonds (English: junk bonds) has been coined in recent years. This refers to corporate bonds with high promised interest rates and a high risk of default. The so-called SME bonds, so-called minibonds, which are brought onto the market by medium-sized companies, often fall into the category of high-yield bonds.

They often promise interest payments of 5 percent or more per year. That should make investors prick up their ears. In recent years, some medium-sized companies that had previously issued bonds went bankrupt, for example the Saxon bicycle manufacturer Mifa, the dream ship MS Deutschland, the fuel manufacturer German Pellets or, in autumn 2016, the agricultural group KTG Agrar.

The exotic: convertible, subordinated and inflation-indexed bonds

In addition to the bond types mentioned, there are a number of more exotic versions for fixed-income securities. For example, some companies issue so-called convertible bonds. In this case, investors can consider whether they want to exchange the bonds for shares during their term. Every bond certifies the right to exchange it for shares for a fixed price (conversion price). An exchange can be worthwhile if the price of the share is higher than the conversion price. You can read what is important in detail in the detailed article on convertible bonds.

So-called subordinated bonds also appear again and again. The bondholder's claim in the event of a corporate bankruptcy is of secondary importance. Should the issuer have to file for bankruptcy, the insolvency administrator would prefer other creditors (banks, holders of regular bonds) when dividing the remaining assets. In the worst case, holders of subordinated bonds receive nothing in the event of bankruptcy.

Another niche are so-called inflation-linked federal bonds. Interest payment and repayment value are linked to the development of inflation.

For stock market professionals: certificates and warrants

Certificates are a special form of bonds. The holder of a certificate enters into a business with the issuing bank. He is the issuer's creditor.

Depending on how the certificate is structured, the investor receives a payment if an underlying index, commodity, an underlying share or a currency achieves a certain performance. With a certificate, for example, investors can earn money even when the stock market falls. You can only participate to a limited extent in a price increase, but limit losses. Because most certificates are derived from a security, they belong to the group of derivatives (derivare = to derive).

The market for certificates is vast. You can read about the types of certificates in our detailed article. Certificates are often expensive, and they are treated like subordinated bonds. So if the issuing bank goes bankrupt, it is not said whether you as an investor will get something out of it proportionately. This is another reason why certificates are only for absolute finance professionals.

Warrants are a subtype of certificates. They are also issued by banks and are usually tradable on the stock exchange. A warrant secures the right to buy or sell a certain good on a certain date.

An example: The holder of a warrant acquires the right to buy 100 Daimler shares in six months at a price of 60 euros each. If the rate is higher than 60 euros six months later, the buyer has made the right bet. The bank must redeem its debt and pay the investor the difference between the agreed purchase price and the current price (English: cash settlement).

Many individual stocks bundled: funds

Another class of securities listed on the stock exchange are funds. A fund bundles individual stocks in one package. Investors can then purchase shares in the fund and do not have to buy all stocks or bonds individually. The best known are equity funds and bond funds, also known as bond funds. Funds often specialize in a particular investment segment, such as stocks with good dividends, undervalued stocks, stocks in smaller companies, stocks in emerging markets, and so on.

Money that is in funds is a special fund. This means that the fund's assets belong to investors, regardless of whether the investment company goes bankrupt. The fund assets may not be included in the insolvency estate of the fund operator.

Real estate funds

Real estate funds are also known. The investor also participates in real estate projects. A distinction must be made between open and closed funds. Investors can sell units in open-ended funds at any time after they have owned them for a set period of time.

In the case of closed-end funds, on the other hand, their share is fixed as an entrepreneurial participation. Your return stands and falls with the success of the underlying real estate projects. If the fund is run as a company under civil law (GbR) and has financial difficulties, so-called additional payment obligations may arise. This means that the shareholders will have to make more money available to the fund to meet current expenses.

Exchange traded index funds: ETFs

Exchange Traded Funds, or ETFs for short, replicate an existing stock index (or bond index). Because an ETF copies the index and the investor does not have to make any active decisions, it costs significantly less than a regular, actively managed mutual fund. Those who want to diversify as widely as possible can do so with an ETF on the MSCI World share index.

More on this in the index funds / ETFs guide

  • With inexpensive ETFs, you can easily build wealth.
  • Our ETF recommendations forMSCI World-ETFs: iShares (ISIN: IE00B4L5Y983), Xtrackers (ISIN: IE00BJ0KDQ92) and Source (ISIN: IE00B60SX394); ForMSCI-All-Countries-World-ETFs: SPDR (ISIN: IE00B44Z5B48) and iShares (ISIN: IE00B6R52259)

To the advisor

There are also so-called ETCs, short for Exchange Traded Commodities. They replicate certain commodity indices, such as Xetra Gold. From a legal point of view, however, they are not funds, but bonds, similar to certificates. The credit in ETCs is not a special fund.

Buy securities and funds easily online

The yields on bonds are currently unattractive. Anyone who would like to have the chance of a slightly higher return on their portfolio can therefore not avoid stocks in the current low interest rate environment. Of course, equity investors are exposed to the risk of the market - equity markets can sometimes fluctuate wildly. However, financial tip calculations have shown that fluctuations and thus losses offset each other if investors stick with them for the long term. In the past, even an 80 percent equity portfolio has never lost in any 15 year period.

Fluctuations can be cushioned by spreading shares widely across countries and industries as an investor. The return can be increased if you pay attention to the costs of funds. Inexpensive ETFs on broadly diversified indices such as the MSCI World or Stoxx Europe 600 are available cheaply or sometimes free of charge from some online banks and securities dealers (brokers). All you have to do is open a free depot. We have described exactly how you buy stocks and ETFs in the detailed article Buy stocks.

More on this in the securities account guide

  • With the right securities account, you pay little for buying and selling equity funds (ETFs).
  • Finanztip recommendations: Among the cheap and versatile custody accounts did the best: ING, Comdirect and Consorsbank and DKB. The cheapest providers are: Smartbroker, Scalable Capital (Free Broker) and Trade Republic.

To the advisor

Taxes on Securities

From a tax point of view, holders of securities generally generate income from investments. Since 2009, investors have had to tax profits from capital investments at a uniform rate of 25 percent plus solidarity surcharge and, if applicable, church tax. You pay the flat tax. Profits are, for example, annual interest payments from bonds or pension funds, dividends from stocks or equity funds and capital gains on sale. Every saver has an exemption of 801 euros per year.

With the reform of the taxation of investment funds (Investment Tax Reform Act), which comes into force in 2018, there are some changes. Fund investors who bought before 2009 must expect that they will have to pay tax on sales profits of EUR 100,000 or more in the future. So far, profits on funds that investors bought up to the end of 2008 were exempt from tax. In addition, the annual assessment basis for funds changes. We have explained what this means specifically for ETFs in the ETF guide and in a blog post.

Sara Zinnecker

Sara Zinnecker

Sara Zinnecker was editor for investment topics until June 2020. Sara had previously written about investments and retirement provision for the Handelsblatt.She completed her traineeship at the Georg von Holtzbrinck School for Business Journalists.

* What the star means:

With our recommendations, we want to help as many people as possible to do their own finances. This is why our content is available online free of charge. We finance our extensive work with so-called affiliate links. We mark these links with an asterisk (*).

At Finanztip, however, we handle affiliate links differently than other websites. We only link to products that were previously recommended by our independent expert editorial team. Only then can the relevant provider set a link to this offer. We get money if you click on such a link or conclude a contract with the provider.

Whether and in what amount a provider pays us has no influence on our recommendations. What our experts recommend to you depends solely on whether an offer is good for consumers.

You can find more information about how we work on our About Us page.

^

+++ Pssst! Your newsletter full of savings tips +++

  • Lower your expenses for electricity, rent, cell phones, cars, travel and much more.

  • Don't miss any deadlines for filing your tax return or changing your insurance policy.

  • Free in our Newsletter. Register now!