Securities – shares, bonds, funds
Sophie has put six months’ worth of net income in a savings account. She can access the money at any time to pay for unexpected expenses. Sophie is now looking to invest EUR 10,000 in higher-return assets. In addition, she would like to invest EUR 150 every month going forward. That is why she wants to know what options she to make (sustainable) investments in securities.
Capital markets offer a wide range of options for you to invest money and build wealth. Three of the most important categories of financial products are shares, bonds and funds. They all offer different risks and opportunity profiles to investors.
Bonds
Bonds issuance enables companies and governments to borrow large amounts of money from non-banks in capital markets, not just from banks. A bond involves subscribers lending money to an Issuer for a certain period of time. In return, they receive interest payments. At maturity (the end of the specified term), the bond is repaid. In the issuer is a government, the bonds are referred to as “government bonds”. Bonds issued by companies are also known as “corporate bonds” and bonds issued by banks are called “bank bonds”. If the money raised is used to finance sustainable projects, the bonds are called “green bonds”.
Unlike shareholders, bondholders do not acquire an ownership interest in a company. Instead, they grant a loan. During the life of the bond, they receive interest payments. In addition, they have the right to get back the principal at maturity (Redemption). Bondholders can hold their bonds to maturity or sell them at the prevailing market price. Bond prices are determined by the general level of interest rates and by the credit quality of the issuer.
Example
Wolkenlos AG issues bonds with a total nominal value (total issuence) of EUR 20 million. The bond has a term of three years. At maturity, it will be “redeemed” (i.e. repaid to bondholders). Ms. Schwabl buys a EUR 1,000 three-year Wolkenlos AG bond. She holds the bond to maturity. Although she receives regular interest payments of 5% (less investment income tax), she does not acquire any ownership interest in the company and cannot attend its annual general meetings. Wolkenlos AG owes Ms. Schwabl a debt until maturity, at which point the company has to pay back, or “redeem”, the bond. In the first and second year, Ms. Schwabl receives EUR 50 in interest payments. In the third year, she receives EUR 1,050 (EUR 1,000 in principal repayment+ EUR 50 in interest). If Ms. Schwabl wants to get her money back before maturity, she can sell the bond on an exchange. She will then get the market price of the bond, which is not necessarily equal to its nominal value, but is determined by supply and demand for the bond on the exchange.
The amount that investors lend to an issuer and which they receive back at maturity is also known as the Nominal / face value. The annual interest payments are called Coupons. The term coupon dates back to the days when bonds were issued in paper form. At that time, bondholders would actually clip their coupons to receive their interest payment. Coupons can be paid at various frequencies. In the example above, the interest payments are made annually, as is the case for most bonds. However, there are also bonds that come with quarterly or semi-annual coupon payments.
Buying bonds always involves a certain amount of risk. This risk varies depending on who the debtor is, i.e. who has to repay the principal and make the interest payments. Bonds issued by countries with high Creditworthiness such as Austria are very safe. In the case of corporate bonds, the risk depends on the issuer’s credit rating, i.e. its economic and financial situation. In a worst-case scenario, the bond price can go to zero if the company is unable to repay the money that it borrowed.
Bondholders receive an income from the annual interest payments. The interest rate is determined by the level of prevailing market interest rates and by the probability that the money will be repaid. The more likely the repayment (low risk), the lower the interest rate. In addition, investors can also benefit when the price of the bond goes up. Bond prices tend to be less volatile than share prices. Green bonds are a type of bond that are used exclusively to fund sustainable projects. A recent EU-regulation has set uniform requirements for issuers of green bonds. Bonds that meet these criteria can be called European green bond or EuGB. The Austrian government also started issuing green federal bonds in 2022.
Shares
A Share is a security that represents a unit of ownership in a Stock corporation. Investors who buy shares of stock acquire an ownership interest and voting rights. A person that has bought shares is called a Shareholder. Companies issue shares to raise capital (i.e. Equity).
Example
Mr. Markovic has saved EUR 10,000. He decides to use to money to buy shares in Baufix AG. Baufix AG shares are currently trading at EUR 67.50. With EUR 10,000, Mr. Markovic can buy 148 shares at a price of EUR 67.50. He now has 148 shares with a total value of EUR 9,990 in his Custody account (or securities account/brokerage account). If the share price rises to EUR 69.10, Mr. Markovic will still have 148 shares in his custody account. However, their total value will have increased to EUR 10,226.80. At its annual general meeting, Baufix AG declares a dividend of EUR 0.2 per share. Mr. Markovic will get EUR 29.60 in dividends from Baufix AG. Of the amount paid by the (Austrian) company, investment income tax (KESt) will be withheld at a rate of 27.5% and paid to the tax office. This means that a net dividend of only EUR 21.46 will be credited to his custody account. Two years later, the shares trade at EUR 72.20 and Mr. Markovic decides to sell 50 of the 148 shares he owns. As he bought the shares for EUR 67.50 and sold them for EUR 72.20, he makes a capital gain on the sale.
Owning shares is always associated with risk. Stock prices tend to rise when demand for them increases. This can be due to strong company earnings, growth prospects and general market trends. By contrast, stock prices go down when investor confidence wanes, for example due to bad company news, economic uncertainty and negative market trends. In the worst case, the stock goes to zero and shareholders lose the money they invested.
Share prices can be subject to high volatility that is influenced by supply and demand. However, investors can reduce their risk by buying shares in different companies from different sectors and/or regions (see Diversification) and holding them for a long period of time.
Shareholders can generate returns in two ways. They can receive Dividend payments. When a company earns profits, it can decide to distribute a part to its shareholders. Dividends are therefore the part of a company's profit that is paid (distributed) to shareholders. In addition, investors can make money when their stock goes up in value. When a share price increases over time, investors can sell the shares at a higher price than the purchase price. Both dividends and capital gains from share sales are subject to Investment income tax. In addition, investors need to consider various fees, such as custody account fees and order fees, when calculating the actual returns.
Investors are increasingly recognizing the value of sustainable stocks, which not only generate financial returns but also have a positive social and environmental impact. Sustainable stocks are stocks of companies that respect certain environmental, social and corporate governance criteria (ESG criteria) in their business practices. Companies have a legal duty to disclose the resources they use, the source of their inputs, the companies they cooperate with, any harmful residues in their products, and many other pieces of information.
Funds
Funds make it possible to invest in a wide range of assets without having to buy and sell individual stocks, bonds and other securities. They buy a large number of assets, with the shares of a fund representing (equal) portions of its net assets. Fund shares can be bought and sold by investors. As such, funds enable retail investors to invest in larger, diverse portfolios that would otherwise be difficult for individuals to build. In particular, they allow retail investor to spread their risk in a way that would otherwise be reserved for large investors. Buying fund shares generally requires a significantly lower minimum investment than the purchase of many individual assets.
The risk of investing in a fund is determined by the assets in the fund’s portfolio. As a rule, funds with a higher proportion of shares mean higher risk.
The potential for profits also varies by the composition of fund assets. Investors receive income from stock dividends, from bond interest and can make capital gains when fund assets increase in value. Funds that invest only in shares offer higher potential returns than funds that only hold bonds. However, funds with a high proportion of bonds are a safer investment option.
When selecting assets for sustainable funds, fund managers typically use one or more of the following strategies:
Exclusion criteria
Exclusion criteria serve to exclude companies and sectors that violate certain ethical, social or environmental standards. Specifically, companies can be excluded for being involved in activities related to tobacco, weapons, gambling, child labor and practices that damage the environment.
Norms-based screening
Norms-based screening helps assess whether companies comply with certain international standards and norms. Cases in point are the environmental standards of the International Labour Organization (ILO) or the Principles for Responsible Investment of the United Nations.
Best-in-class
Best in class is an approach to identify companies that stand out against their competitors when it comes to environmental, social and corporate governance aspects (ESG factors). The idea is to invest in companies that are better than others in the same sector.
Types of funds
In actively managed funds (investment funds), professional fund managers strive to put together a portfolio of assets that outperforms its benchmark index. To achieve that goal, fund managers regularly make decisions about buying and selling assets based on their analysis of market trends, company performance and other factors. This means that the composition of the fund changes constantly. The aim is to maximize returns and outperform the market average. Actively managed funds typically mean higher expenses for investors because they have higher costs (e.g. management fees).
Funds can be divided into different groups according to the type of assets they invest in.
Stock funds
Stock funds invest only in stocks. The value of the fund is therefore determined by the prices of the stocks the fund has invested in. To eliminate the risk that individual stocks underperform, stock funds diversify their investments across a wide range of different companies, sectors and regions.
Bond funds
Bond funds invest only in bonds. They typically have a lower risk than stock funds.
Hybrid funds
Hybrid funds invest in both stocks and bonds. They strike a balance between stock and bond funds with regard to risk and returns.
Country and sector funds
Country and sector funds focus on specific countries (e.g. Austria funds) or specific sectors (e.g. pharmaceutical sector funds).
Funds also differ in terms of whether income (e.g. from dividends or interest) is reinvested (accumulation fund) or distributed. Reinvestment of income increases the value of fund shares as it adds to the fund’s net asset value. Accumulation produces compound interest, which is important if the objective is to build wealth for the future. For tax purposes, reinvested income is treated the same as distributed income, and is subject to investment income tax. If the income is distributed, it will be credited to your bank account, meaning you can access it. However, it will not help to build wealth for the future.
Passively managed funds, also known as index funds or passive ETFs (exchange-traded funds), aim to track, as closely as possible, the performance of a benchmark index. These funds seek to hold all assets in the same weighting as the index. As index funds track the market, their management requires fewer active decisions, which usually results in lower costs. ETF investors therefore pay significantly lower fees (no active fund management is required, so there are no management fees). However, buying and selling ETFs can be subject to fees, as is the case with actively managed funds.
A brief recap
What are bonds? What is the risk and return profile of bonds?
Bonds are securities that enable buyers to lend money to an issuer for a certain period of time. In return, they receive regular interest payments. At maturity, they get back their principal. The return on bonds comes mainly from interest payments. Some of the biggest risks associated with bonds are default risk and interest rate risk.
What are shares? What is the risk and return profile of shares?
A share is a security that represents a unit of ownership in a stock corporation. Investors who buy shares of stock acquire an ownership interest and voting rights. A person that has bought shares is called a shareholder. Companies issue shares to raise capital (i.e. equity). Returns on stock investments can come from dividends and capital gains. In most cases, higher expected returns are associated with higher risks.
What are funds? What is the risk and return profile of funds?
An investment fund is a pool of various securities (or other assets). It allows people to invest in a broad variety of assets without having to buy these assets individually. A distributing fund, also known as income fund, is a fund that pays out the income it earns to the investors on a regular basis. The earnings of an accumulation fund are retained. They are reinvested to increase the fund’s value and generate compound interest. The risks and returns of funds are determined by their investment strategy and the fund’s assets.
What is the difference between actively and passively managed funds?
Actively managed funds are operated by fund managers who strive to maximize returns by selecting what assets to invest in. Passively managed funds, on the other hand, aim to replicate an index instead of actively selecting what assets to invest in. Actively managed funds tend to have higher fees and can deliver higher returns. However, they also have greater risks.
What are some sustainable investment strategies?
Sustainable investment strategies involve investments in companies that take environmental, social and governance (ESG) criteria into account. This can be done by selecting companies with a positive environmental impact, social responsibility and good corporate governance, as well as by excluding companies operating in controversial industries or violating certain ESG standards.
