Investment Type: Background
More and more Canadians are finding themselves interested in the investment world. They've worked hard, paid all their bills, and added to their savings to the point where they should start thinking about their investment options. But like most Canadians, you may have a lot of questions. Where do you begin? What types of investments should you look at? What are the different investment types available to you?
Before you begin asking your banker, broker, or planner for recommendations, it's a good idea to first try to understand a little bit about the basic investment types. What are they? What are their origins? What are their differences? Virtually all of your investment options can be categorized within one of the following:
Note: In addition to the three basic investment types above, Cash and Cash Equivalents can also be considered an investment type. We have not included it in our discussion because it is more often considered to be a parking place for savings while a final investment decision is contemplated or as a reserve for future emergencies and immediate needs.
Fixed Income investments
Investments that fall within the Fixed Income category are a type of loan, where you are loaning your hard-earned savings to a corporation or government. Unlike a Growth investment or a Hybrid investment, however, Fixed Income investments do not give you an ownership interest in the company or government that you lend your savings to. Investment types that fall into this category would include Guaranteed Investment Certificates (GICs), bonds, debentures, and loans.
When you invest in Fixed Income investment types you will typically have a number of guarantees provided by the issuer, such as
- a guarantee that your savings will be returned to you on a certain date, and
- a guarantee that you will be paid a regular income (interest payments)
Remember: When you invest in Fixed Income investments, you do not have an ownership interest in the issuer. You are simply lending your savings for a specified time period and receiving a specific income (interest payments) in return.
Investments that fall into this investment type would include common shares, mutual funds, Exchange Traded Funds (ETFs) and segregated funds. Growth investments, or ownership investments, typically are considered riskier because they do not have any guarantees: the value of the investment is not guaranteed; the income paid by the investment is not guaranteed, and there is no guarantee that the invested savings will be returned.
Holders of ownership investments actually own a portion of the issuing entity. For example, if you own the common shares of a corporation, then you actually own a portion of the company and its business operation. If the business does well, then the value of your ownership (the common shares) should increase, and as a result the company in some cases will at the discretion of the issuer pay you some money while you own the shares (in the form of dividends payments).
Hybrid investments are a type of investment that cannot be strictly classified as neither a Fixed Income nor a Growth investment because they possess characteristics that may be those normally associated only with a Fixed Income investment or a Growth investment.
Investments that fall into this investment type would include Index-linked Guaranteed Investment Certificates (GICs), Principal Protected Notes (PPNs), Convertible Bonds, Capital Trust Securities, etc. When you purchase these Hybrid investments they will offer you a few of the Fixed Income and Growth characteristics. For example, a Hybrid investment may have all or a few of the following characteristics:
- a guarantee that your savings will be returned to you on a certain date, but no guarantee that you will be paid a regular income (interest or dividend payments)(such as Index-linked GICs and PPNs)
- potential for a lump-sum payment, upon the investment's maturity date, that results from an increase in the value of the underlying investment. This is not guaranteed, but rather it's dependent upon the success of the underlying investment (such as Index-linked GICs and PPNs).
- a guarantee that you will be paid a regular income (interest payments), but the issuer can avoid returning your savings by converting the Hybrid investment into common shares (such as Capital Trust Securities)
- a guarantee that your savings will be returned to you on a certain date and a guarantee that you will be paid a regular income (interest payments), but with the option to convert your invested savings into common shares of the issuer (such as Convertible Bonds)
Note: A Hybrid investment is a trickier type of investment to understand because its characteristics can be confusing. When you invest in a Hybrid investment you may or may not
- have an ownership interest in the issuer
- earn a income on your savings
- have your savings returned to you at a future date
The following table outlines the different investments categories and the various investments associated with them.
Note: We have included the category Cash and Cash Equivalents in the table as it is also considered an investment type. However, it is more often considered a parking place for your savings while a final investment decision is contemplated or as a reserve for future emergencies and immediate needs.
Investments in each category
Cash and Cash Equivalents
Capital Structure: another name for different investment types from the corporation's point of view
When learning about the different investment types available, it helps to also look at the investment from the perspective of the corporation or government selling those investments. Why? Well, simply every investment that you buy is an investment that someone else has sold. Wouldn't you like to know why they are selling?
When you invest your savings, you are either lending to a corporation or government or buying an ownership interest in the corporation. You are buying an investment that they are selling. So why are they selling? Simply, corporations and governments sell these investments so they can obtain the money they need to build and finance their activities. In the case of governments, they borrow by selling you bonds to finance their activities (such as the education system, health care, social services, etc.). In the case of corporations, they sell you Fixed Income investments (bonds), Growth investments (common shares), and Hybrid investments (convertible bonds, capital trust securities, etc.) to raise the money they need to build and operate their businesses.
For corporations, these investment types and how much they sell of each is called their capital structure. They use different names for each investment type because they view the selling of these investments differently. So, in essence, here's what the different types of investments available look like to us and to a corporation:
- Fixed Income investments for us is the same as Debt capital for the selling corporation and is represented by bonds
- Growth investments for us is the same as Equity capital for the selling corporation and is represented by common shares
- Hybrid investments for us is the same as Hybrid capital for the selling corporation and is represented by convertible bonds or capital trust securities, etc.
Note: It may seem confusing that investors and corporations have different names for the same investment types, but these differences are due to how each (the investor and the corporation) views the investment type. For example, for a corporation that sells a bond, the bond represents a debt that must be repaid and costs the corporation interest expenses. The investor, on the other hand, sees the bond as a source of interest income and a return of their capital. Also, when a corporation sells common shares, the corporation is selling or giving up ownership of its business. The corporation does not benefit from those shares in the future, but rather must now share future profits and success with additional shareholders. The investor that buys the corporation's common shares sees his/her investment as an opportunity to profit from the corporation's future profitability by having the value of the common shares grow.
Example: Another way to understand the concept of a corporation’s capital structure in its most basic form is to compare it to how a homeowner might finance the purchase of his/her home. A home owner's capital structure will typically include
- ownership (referred to as equity and represented by their down payment)
- borrowing (referred to as debt and represented by their mortgage)
The homeowner’s down payment represents his/her ownership or equity capital, and his/her mortgage is the debt capital. Together both the equity and debt portions make up the homeowner’s capital structure. By comparison, a corporation’s equity capital (or ownership) is represented by the common shares sold to investors, and their debt capital is represented by the bonds sold to investors.
The following figure illustrates how investors and corporations interact with the different investment types:
Deciding how to invest: Fixed Income, Growth or Hybrid?
Understanding the basic types of investments that companies issue and how they fit in the corporation's capital structure can be very helpful because the majority of retail investments originate from this structure. Before asking your bank, broker, or planner for recommendations or deciding which type of investment you should invest in, understanding the basics of the different investment types would be useful.
The benefits and characteristics of each form of capital (Fixed Income, Growth, Hybrid) are different. For example, you need to be aware of the following:
- Fixed Income - Investors that buy a company's bonds are lending their savings and they want to be paid a regular income and have their savings returned on the bond's maturity date. They want the company to focus on safe, conservative business practices and they are not as concerned with the company's growth as common share investors.
- Growth - Common share investors own a portion of the business and want to see all of their company’s resources and efforts focused on the company’s growth, thereby maximizing the benefits to the common share owners.
Remember: different investment types have different priorities!
Investors should also understand that Fixed Income investors and Growth investors have divergent investment interests, or different investment priorities.
Growth investors want the business to grow as fast as possible thereby enhancing the value of the common shares. In contrast again, Fixed Income investors want the company to pay an annual rate of return and repay their invested savings at the agreed upon maturity dates. They want the company to build their business in a safe financially conservative manner.
For example, just as with a home purchase, most homeowners do not wait until they have saved enough money to purchase their house with cash. Most are happy to have a small down payment at the time of purchase and to use as much of the bank's money as they are permitted. They want to borrow as much as permitted so that they have a greater potential investment return on their savings (equity). In contrast, the bank wants the homeowner to have as large a down payment as possible. The larger the down payment the greater the safety the bank has against suffering a loss in the event the borrower fails to make the mortgage payments and in the event the value of the home declines. The homeowner and the bank have different investment priorities.
You should also keep in mind that capital markets are constantly evolving and new variations of the two basic capital structures (equity and debt) are constantly created. When looking at a specific investment, you should try to first identify and classify the investment’s capital characteristics. Is the investment part of the corporation’s debt capital (a Fixed Income investment), its equity capital (a Growth investment) ) or somewhere in between (Hybrid investments)? Once you have identified the investment’s type, then you can properly determine if the investment has a place within your investment strategy.
Not all company capital structures are well suited for individual investors. A large number of today’s capital structures are designed by the corporation’s financial advisors for specific corporate purposes and not for the investor's personal purposes. Some may be specifically designed for the non-taxable investor or for the non-domestic investor.
In addition to the various investment types, the investment industry has been very creative in altering the original Fixed Income (bonds) and Growth (common shares) investment types into two or more secondary investment structures (Split-shares, PPNs, mutual funds, ETFs, etc.) . These secondary capital structures were never issued by the corporation, but rather they were created by the financial markets.
The amount and type of capital issued by a corporation can be influenced by many internal and external factors, including the following:
- the nature of the company’s business
- the industry the company operates within
- the regulatory environment for the company
- the current financial market environment that may favour one capital type over another
- the company’s profitability
- the company’s current credit rating
- the current economic environment
- the age of the issuer (young or mature)
- the competition for capital by its competitors, etc.
Remember: When it comes to investing you should try to understand the difference between the three basic types of investments and their origins. By understanding the investment types, you will be better equipped when analysing the available investment options in deciding which investments fit best within your investment portfolio.