Marketable Securities is nothing but a financial instrument that can be bought or sold very easily. Marketable securities are very important investment class and are favorites of major corporates. As noted in the below picture, Microsoft has more than 50% of its Total Assets as Short Term Investments or Marketable Securities. Why?
This article look at the nuts and bolts of Marketable Securities and also answers the question on why it is one of the preferred investment instrument.
- What are Marketable Securities?
- Features of Marketable Securities
- Classification of Marketable Securities
- Types of Marketable Securities
- Why Corporates and Individual purchase low yielding marketable securities?
- Why invest in Marketable Securities?
What are Marketable Securities?
To put simply – Marketable Securities Definition
Marketable securities are the financial instrument than can be easily bought and sold on a stock exchange within a short period of time
In order to understand the above definition, we first need to understand one important term in the above definition – “financial instruments”.
- Financials instrument represents the legal obligation to pay or receive any monetary value. Financial instruments are the assets than can be exchanged or traded.
- Some of the common types of financial instruments are equity shares, preference shares, debts and derivatives. Marketable securities are part of financial instruments.
- All marketable securities are financial instruments but all financial instruments are not marketable securities.
Features of Marketable Securities
Well, there are many features of marketable securities, but the two most important ones that set them apart from the rest are highlighted below.
#1 – Marketable Securities are Highly liquid
- This is perhaps the single most important feature that every financial instruments must have in order to classify them as marketable security.
- Marketable securities are highly liquid and can be easily converted into cash within short time and at a reasonable price.
- What amounts to short time has not be defined anywhere but as per the conventions and generally accepted principles, this duration should be less than one year.
- Some of examples of instruments who exhibit the following features and hence classified as marketable securities are commercial paper, treasury bills, bills receivables and other short term instruments.
#2 – Marketable Securities are easily transferable
- In order to be highly liquid, marketable securities should be easily transferable.
- Highly liquid and easily transferable features of marketable securities are complementary to one other.
- Marketable securities are instruments than can be easily transferable on a stock exchange or otherwise.
The above two feature can be used to classify any security as marketable securities.
Let’s understand how this is to be used as classification tool with help of practical illustration.
Example of Marketable Securities
Company X Inc. invests in US Treasury bonds having a maturity duration of 30 years in financial year 2016. Company’s financial controller, Mr Adam Smith, is in dilemma as to whether those investments are to be classified as marketable securities or not.
Solution – As discussed above, classification of securities as marketable securities has to be judged based on two important feature – Highly liquid and easily transferable. Classification of securities as marketable securities are not based on the time duration for which it is held by the investors. Marketable securities can be long term or short term. Government securities generally have long maturity duration. For e.g. U.S Treasury maturity can be as high as 30 years or as low as 28 days. Government security is one of the preferred mode of investment used by many fortune 500 Companies. Even though these securities don’t promise to return the principal back to the investor for 30 years, they can be sold relatively quickly in the bond market. Hence they are highly liquid and easily transferable. Thus, they are classified as marketable securities.
Also, see below how Microsoft classified its Marketable Securities. We note that investments with maturity of less than 3 months are classified as cash equivalents and those with maturity greater than three months and less than one year are classified as short term investments.
#3 – Lower return on Marketable Securities
- Return on any security is directly proportional to risk associated with it.
- Higher the risk, higher the return.
- Since marketable securities are highly liquid and easily transferable, inflation* and default risk* associated with them are very low in comparison to other types of securities.
- Investor has to make a trade-off between risk and return when choosing marketable securities.
Different types of risk associated with any security
- Default risk: Default risk is the probability that the issuer or borrower will not be able to make payments on their debt obligations on the due date.
- Interest rate risk: Interest rate risk is the risk associated with the fixed return instrument like bonds, debentures whose value decrease on account of rise in interest rate.
- Inflation risk: Unlike interest rate risk, which affects only fixed income instruments. Inflation risk affects all types of securities. Though it affects every economy, it’s effect is seen more in high inflationary economy where price level of commodities rises drastically every year. Rise in price level reduces the value of money and the decreased value of money results in decreased return on assets.
#4 – Marketability of Marketable Securities
- Marketable securities have an active marketplace where can be bought and sold e.g. London stock exchange, New York Stock exchange and etc.
- Marketability is similar to liquidity, except that liquidity means the time frame within which security can be converted into cash, whereas the marketability implies the ease with which securities can be bought and sold.
Classification of Marketable Securities
Marketable securities can be classified under two categories:
- Marketable equity securities: Marketable equity securities are equity instruments that are trade on stock exchanges. Common type of equity securities are equity and preference shares. These instrument must be held for trading purpose or should be available for sale. If these equity securities are acquired for acquiring control, then these securities aren’t considered as marketable equity securities but, instead, are classified as long term investment in the balance sheet.
- Marketable debt securities: Marketable debt securities are those debt securities that are traded in bond market. Common types of debt securities are U.S Government bonds, Commercial papers and etc. These instruments must be held for trading purpose or should be available for sale.
Types of Marketable Securities
There are different types of Marketable Securities. Some of the common marketable securities available in the market are discussed here.
#1 – Commercial Paper
- Commercial papers are short term debt instruments with a maturity of not more than 270 days.
- They are unsecured debt i.e. they are not backed by collateral or, in other words, borrower does not guarantee payment.
- They are used for short term financing i.e. used for purchase of inventory, current assets and meeting short term liabilities.
- Since they are not secured, they are issued by large institutions and are purchased by big and wealthy corporates.
- They are not regulated by regulatory authorities and this makes them a very cost effective means of financing. They are always issued at a discount from the face value.
#2 – Bills of exchange or bankers’ acceptance
- A banker acceptance is the amount borrowed by the borrower, promised to be paid in future, which is backed and guaranteed by the bank.
- Difference between commercial paper and bills of exchange is that bills of exchange unlike commercial paper is secured debt.
- Like commercial paper, it is also a short term finance instrument which is generally used for purchased of inventory, current assets and meeting other short term liabilities.
- Bankers acceptances specifies the amount of money, the due date and the name of the person to whom payment is to be done.
#3 – Treasury bills (T Bills)
- These T-bills are short term securities with maturity of less than one year.
- In market, one can find different categories of T-bills with three-month, six-month and one-year maturity.
- One of the feature of T-Bills which makes them popular with common investors is that they are not issued at large denominations.
- They are issued in denominations of $1000, $5000, $10,000 and etc.
- Like commercial paper, they are issued at a discount and investors gets a face value on maturity.
In order to understand how discount and return are calculated let us look at the illustration below.
T- Bill Example
U.S Government issues a T-Bill Face Value $10,000; maturity six month at $9,800.
- In this case, Investor will have to shelve $9,800 for purchasing the T-Bill. At the end of six months, Investor can sell back the T-bill to Government at $10,000. Thus earning himself
- $200, which is a discount rate or the interest rate earned by holding the T-bill. Hence it is said that the T-bills are always issued at a discount.
#4 – Certificates of deposits
- These are similar to savings accounts.
- It is issued in lieu of the money deposited at a bank for a specified period.
- These are negotiable instruments and hence can be easily transferable.
- Maturity period of certificate of deposits varies from seven days to one year in case of commercial banks, and from one year to three years, in case of financial institutions.
Why Corporates purchase low yielding marketable securities?
Before we answer that question, let us look at how much amount of marketable security Company Apple holds. Apple, the most valued company of wall street, maintains huge pile of marketable securities.
On Page 49 of the annual report of Apple Inc. for year 2015, following details are available about its Marketable securities.
Annual Report of Apple Inc. for the year ended 2015
|Particulars||Short term Marketable securities (Amount in 000’ million)||Long-term Marketable securities (Amount in 000’ million)|
|U.S. Treasury securities||3,498||31,584|
|U.S agency securities||767||4,270|
|Non- government securities||135||6,056|
|Certificates of deposit||1,405||877|
|Mortgage and asset backed securities||17||16,160|
Source: Apple Annual report
The total amount of marketable securities (Short term and long term) that Apple holds is in excess of $184 billion dollars, whereas the Cash and Cash equivalents are at meagre $21 billion dollars. Some of the important observation which one can derive by looking at above data are as follows -:
- Apple holds far more amount of its wealth in marketable securities ($184 billion dollars) than it holds it in form of Cash ($21 billion dollars). The reason is obvious since cash does not give any return, it is better to hold funds in form of marketable securities which offer return with minimum risk.
- It does not hold all of its marketable securities in only one instrument, but has distributed it in various types of marketable securities like mutual funds, U.S Treasury securities, Commercial papers, Corporate securities and etc. The reason for such distribution is to diversify the risk associated with holding marketable securities.
- Amongst the different types of marketable security, Apple has invested more than half of its funds in corporate securities (104 + 11 = 125 billion dollar). Marketable securities vary greatly in their risk and return profile. Certificate deposits, U.S Government securities and Commercial paper carry low risk with low return. On the other hand, mutual funds and corporate securities offer higher return with higher risk. The possible reason for Apple to hold more than half of its marketable security funds in Corporate deposits could be because of its higher risk appetite.
Why invest in Marketable Securities?
Now let us come back to the question asked above. Almost every Company will invest the certain amount of funds in marketable securities. Broad reasons for investing in marketable security as follows -:
- Substitute for hard cash – Marketable securities are great substitute for cash and bank balances. Idle cash does not grow since no return is received by holding it. On the other hand, bank balance offers only a meagre return. Whereas, marketable securities not only offer adequate return but also retains the benefits associated with holding money, since they are highly liquid and easily transferable.
- Repayment of short term liabilities – Every company has liabilities which are further bifurcated into short term and long term liabilities. Long term liabilities are repaid over longer time period, which generally is more than one year. Whereas short term liabilities are to be paid within one year. Bonus expense, tax expense and etc. are some of the examples of the short term liability. Marketable securities are the best mode of payment of short term liabilities since they are highly liquid and in the meantime also provide the company additional income in form of interests and dividends.
- Regulatory requirement – In order to raise funds and loans from financial institutions, corporates have to follow certain guidelines and rules known as covenants which safeguards the interest of lenders. These covenants are agreed upon by the borrower and lender and are specified in every loan agreement. Covenants are often in form of ratios which the borrower has to maintain throughout the loan period. These ratios mostly deal with liquidity and long term solvency health of companies. Maintenance of marketable securities helps in meeting out solvency ratios since most of the marketable securities are considered as current assets. Hence higher the amount of marketable securities, higher will be the current ratio and liquid ratio. (also, checkout Ratio Analysis)
All the above features and advantages of marketable securities have made them quite popular means of financial instrument. Almost every company holds some amount of marketable securities. The specific reason for holding these depend greatly on the solvency and financial condition of the company. Despite many advantages, there are some limitations like low return, default risk and inflation risk associated with marketable securities. Marketable securities are held by the company for trading purpose or liquidity purpose. Generally, these are held up to their maturity period, but company may sell them prior to their stated maturities for strategic reasons including, but not limited to, anticipation of credit deterioration and duration management.