Financial instruments

Ordinary shares

Ordinary shares (also called common shares) represent ownership in a company. Companies issue (sell) these shares to investors through the market.

When a company issues shares, the amount investors pay is often described in two parts:

• Nominal (par) value: the minimum legal value assigned to each share.
• Share premium: the amount paid above the nominal value.

Together, nominal value plus share premium equals the issue price (the price at which the company sells the shares when they are issued).

For example, if KTA’s share price is $100 and the nominal value is $10, then the share premium is $90.

You won’t be tested on share capital and share premium here because that content is covered in BA3. It’s included to support your understanding.

Characteristics

Yield - Ordinary shares can offer high returns, but returns are uncertain. Investors may benefit from:

• Share price growth (capital gains)
• Dividends

Dividends on ordinary shares are not fixed. Directors decide whether to pay dividends based on company performance.

Risk - Ordinary shares are typically volatile, meaning their prices can rise or fall quickly due to market factors. If the company becomes insolvent, ordinary shareholders may lose all the money they invested.

Maturity - Ordinary shares usually have no fixed maturity date, so they’re generally long-term investments. A company may sometimes buy back its shares, for example if it has excess cash and limited investment opportunities.

Liquidity - If shares are listed on a stock exchange, they can usually be sold quickly (converted to cash). If shares are unlisted, selling them can be difficult because fewer buyers are available.

Value invested - The value invested is based on the share price paid, which can be viewed as nominal value plus share premium.

Transaction costs - Buying and selling shares can involve costs such as:

• Broker fees
• Foreign exchange charges (if buying overseas)

Preference shares

Preference shares are similar to ordinary shares, but they usually pay fixed dividends. Some preference shares can be redeemed (bought back by the company) while others cannot.

Characteristics

Yield - Because dividends are fixed, the return is usually lower than for ordinary shares. Preference shares also typically show less price growth than ordinary shares.

Risk - Preference shares are generally lower risk than ordinary shares. If a company becomes insolvent, preference shareholders are paid before ordinary shareholders.

This doesn’t guarantee repayment. Preference shareholders are paid first, but if the company has insufficient assets, they can still lose money.

Maturity -

• Redeemable preference shares have a redemption date.
• Non-redeemable preference shares do not have a redemption date.

Liquidity - Listed preference shares are usually more liquid (easier to sell quickly). Unlisted preference shares are usually less liquid and may be difficult to sell.

Divisibility/Value - These characteristics are the same as for ordinary shares.

Transaction costs - These are the same as for ordinary shares.

Bonds

Bonds are debt instruments. Like preference shares, some bonds are redeemable and some are not. The key difference is that bondholders receive interest, not dividends.

Interest is treated as an expense in the company’s profit or loss, unlike dividends on shares.

Characteristics

Yield - Bond yields are usually lower than equity returns because bonds are debt instruments with a fixed interest return.

Risk - Bonds are generally lower risk than preference shares. If a company fails to pay interest, it remains obligated to pay it later, and investors may take legal action if the company continues to default.

If the company fails to repay the principal amount borrowed, investors may have the right to claim repayment or seize assets equal to the amount owed (depending on the bond terms and applicable law).

Maturity - Bonds can be:

• Redeemable (repaid at a set date)
• Non-redeemable (irredeemable) (no set repayment date)

Government bonds often have long maturities, sometimes up to 50 years.

Some bonds are convertible (sometimes described as mezzanine finance), meaning bondholders may choose to convert their debt into equity shares in the future if the company’s prospects align with their goals.

Liquidity - Listed bonds are generally more liquid than unlisted bonds.

Divisibility/Value - This is the same as for the previously explored instruments.

Transactional costs - This is the same as for the previously explored instruments.

Mortgages

A mortgage is a long-term loan used to finance property (such as a house). In a typical mortgage arrangement, a bank lends money so the borrower can buy the property, and the borrower repays the loan over time with interest.

Characteristics

Yield - Mortgage yields are usually low because the loan is secured, and banks typically charge relatively lower interest rates on long-term secured lending.

Risk - Mortgages are generally considered lower risk because they are secured and typically involve a bank.

Maturity - Mortgages are usually long-term. In South Africa, repayment periods can extend up to 20 years.

Liquidity - Mortgages are usually less liquid. In some countries, it’s possible to resell the debt (from the lender’s perspective), but mortgages are still generally considered less liquid than traded securities.

Divisibility/Value - Mortgages are not standardized in the same way as shares or bonds, because borrowers’ needs and loan terms differ.

Transactional costs - These depend on the deal, but may include:

• Agent fees
• Legal fees
• Other costs required to complete the transaction