Equity vs Fixed Income
If a person wants to generate income or appreciation in the future he acquires an asset known as investment. An investment is always purchased to generate more in the future than you invest today. But there is always a risk associated with the investment. Investments instead of profits can also generate losses as they can lose value in the future. For example, you invest in a company and that company goes bankrupt. One can invest in these different types of investments such as bonds, stocks, mutual funds, exchange-traded funds, index funds, and options. This article aims to provide an overview of Equity vs Fixed Income.
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Equity vs Fixed Income
Equity: Equity income investments are those incomes that are known to pay dividends and hence are generally referred to as income from stock dividends. The most common type of equity income investments is stocks.
Fixed income: Fixed incomes are those types of securities where the investors receive a fixed amount until maturity dates and then at maturity the principal amount is repaid to the investor. Government bonds are the most common types of fixed-income investments. The payment of fixed income security is known in advance.
Equity: The types of equity incomes are as follows:
- Shares – The units of partial ownership in a company are known as shares. They are traded through BSE (Bombay Stock Exchange) or NSE (National Stock Exchange). The risk in shares is equally high.
- Equity futures – In Futures, the investors have an obligation of purchasing or selling an underlying asset at a predetermined rate and a predetermined time. The minimum time for investing in futures is three months. Its settlement date is generally the last Thursday of the third month.
- Equity options – Options are similar to futures. The parties involved are not legally obliged to follow up on their agreement.
Fixed Income: The types of fixed income are as follows:
- Bonds – a Bond is basically an obligation between the investor and the issuer. The issuer pays the interest payments (as per the agreement) and the principal amount (on the maturity day). The bond issuers are generally governments or corporations.
- Treasury bills – Treasury Bills also known as T-Bills are government securities that are issued at zero-coupon rates or zero interest rates. T-Bills are short-term securities that have a maximum tenure of one year.
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Equity: These markets are accessible for general investors. Investors trade-in in equity via BSE (Bombay Stock Exchange) and NSE (National Stock Exchange). Eg: companies issue IPO in equity markets.
Fixed Income: Fixed incomes are debt instruments. It includes bonds, debentures, and other debt instruments which are issued by both government and municipal corporations and corporate.
Risk and Returns:
Risk – There are different types of risk involved in equity income. They are credit risk (where a company is unable to pay its debt or becomes bankrupt), liquidity risk (where a company fails to meet its short-term obligation), and Inflation risk (where the value of the company goes down).
Return – return on equity known as ROE is calculated by dividing the net income by shareholder’s equity.
ROE = Net Income / Shareholders Equity
Shareholders’ equity is actually the company’s asset minus the debts of the company and hence ROE is considered as the return on net asset.
Risk – There are different types of risk involved in fixed-income investments. They are interest rate risk (whereas the interest rate increases the price of the bond decreases. There is an inverse relationship between the interest rate and the value of the bond), reinvestment risk (to reduce reinvestment risk the investor will want the interest rate to increase as the investor will obtain higher returns) and credit risk (where the issuer will not pay the principal or coupon of the bond. Also known as default risk).
Return – the returns on a fixed income are generated periodically while the interest payable remains constant, irrespective of market fluctuations. The final value of fixed income security is calculated before it is issued.
Which types of investors prefer?
Equity: Investing in equity income is mostly preferred by conservative investors who look for value stocks that the investor can buy and hold. This also provides long-term payments. Investors interested in equity income should invest in quality stocks as they provide high dividend yield.
Fixed Income: Fixed income securities such as corporate bonds, government bonds, preferred company stocks, and CDs are more stable than pure equity holdings. Investors tend to rely on this asset class more during times of economic downturn or when steady income is the objective of the investment account.
Benefits of investing:
Equity: There are various benefits to investing in equity income.
- Risk mitigation – A fund manager generally follows a set of rules which are defined by the regulator or by the asset management company (AMC). This helps in mitigating various forms of risk. They are well documented.
- Diversification – Risk mitigation also ensures that many mutual funds are very well diversified across stocks. They are not over-exposed to particular stocks and sectors.
- Income generation – Fixed-income investment helps generate a source of income. Investors receive a fixed amount of income in the form of coupon payments. The income is exempted from taxes in many municipal bonds.
- Total return – Investors can seek higher returns by assuming more credit risk or interest rate risk. The total return received in fixed income securities is more as compared to equity income.
After doing good research one can easily pool their money in equity funds. It’s important to know the working of equity funds. The investors should know the objectives of the fund and then should map it to their profile. On the other hand, fixed income is an investment approach focused on the income and preservation of capital. It includes government bonds and corporate bonds. It offers income with less risk as compared to equity.
Author: Saachi Lodha
About the Author – A passionate professional with knowledge of Accounting and Finance and currently exploring Financial Risk Management (FRM) to gain knowledge and exposure. As a part of the FRM course also writing blogs to explore the field more and deep dive into the content.