CAPITAL MARKET SECURITIES

CAPITAL MARKET SECURITIES

Capital market securities are long-term securities issued by corporations and governments. Here “long-term securities” refers to securities with original maturities greater than 1 year and perpetual securities (those with no maturity). There are two types of capital market securities: those that represent shares of ownership interest, also called equity, issued by corporations, and those that represent indebtedness, issued by corporations and by the U.S. and state and local governments.

Equity

The equity of a corporation is referred to as “stock”; ownership of stock is represented by shares. Investors who own stock are referred to as shareholders. Every corporation has common stock, and some corporations have another type of stock, preferred stock, as well. 

Common stock is the most basic ownership interest in a corporation.

Common shareholders are the residual owners of the firm. If the business is liquidated, the common shareholders can claim the business’ assets, but only those assets that remain after all other claimants have been satisfied.

Since common stock represents ownership of the corporation, and since the corporation has a perpetual life, common stock is a perpetual security; it has no maturity. Common shareholders may receive cash payments—dividends—from the corporation. They may also receive a return on their investment in the form of increased value of their stock as the corporation prospers and grows.

Preferred stock also represents ownership interest in a corporation and, like common stock, is a perpetual security. However, preferred stock differs from common stock in several important ways. First, preferred shareholders are usually promised a fixed annual dividend, whereas common shareholders receive what the board of directors decides to distribute. And although the corporation is not legally bound to pay the preferred stock’s dividend, preferred shareholders must be paid their dividends before any common dividends are paid. Second, preferred shareholders are not residual owners; their claim on a liquidated corporation takes precedence over that of common shareholders.

And finally, preferred shareholders generally do not have a say in corporate matters, whereas common stockholders have the right to vote for members of the board of directors and on major issues.

Indebtedness

A capital market debt obligation is a financial instrument whereby the borrower promises to repay the face amount of the obligation by the maturity date and, in most cases, to make periodic interest payments to the holder of the debt obligation, referred to as the lender. These debt obligations can be broken into two categories: bank loans and debt securities.

While at one time, bank loans were not considered capital market instruments, in recent years a market for the buying and selling of these debt obligations has developed. One form of bank loan that is bought and sold in the market is a syndicated bank loan. This is a loan in which a group (or syndicate) of banks provides funds to the borrower. The need for a group of banks arises because the amount sought by a borrower may be too large for any one bank to be exposed to the credit risk of that borrower.

Debt securities include (1) bonds, (2) notes, (3) medium-term notes, and (4) asset-backed securities. The distinction between a bond and a note has to do with the number of years until the obligation matures when the security is originally issued. Historically, a note is a debt security with a maturity at issuance of 10 years or less; a bond is a debt security with a maturity greater than10 years.1 The distinction between a note and a medium-term note has nothing to do with the maturity but rather the way the security is issued. Throughout most of this book we will simply refer to a bond, a note, or a medium-term note as simply a bond. We will refer to the investors in any debt obligation as either the debt holder, bondholder, or note holder.

A debt security may provide a promise to pay the investor periodic interest (referred to as a coupon); a debt security that does not include a promise to pay interest is referred to as a zero-coupon debt. In the case of debt that pays interest, interest is generally paid at regular intervals (say, semi-annually) and may be a fixed or floating (or variable) rate.

The interest rate for a floating rate security is usually tied to the interest rate on a market interest rate, the price of a commodity, or the return on some financial instrument.

Bonds, notes, and medium-term notes are issued by corporations, the U.S. government, U.S. government agencies, and municipal governments.

Corporate debt securities backed by specific assets as collateral are referred to as secured notes or secured bonds. If they are not backed by specific assets, they are referred to as debentures. If a debt obligation is secured and the borrower is unable to make interest or principal payments when promised, in theory the creditors may be able to force the sale of the collateral for the purpose of collecting what is due them. Collateral therefore reduces the security’s riskiness and the level of return, or yield, the issuer (the borrower) must pay. The claims of debt holders take precedence over those of shareholders, but debt holders are unlikely to be paid the full face value for their securities if a corporation must be liquidated.

U.S. government notes and bonds are interest-bearing securities backed by the “full faith and credit” of the United States; there is little uncertainty regarding whether the interest and principal will be paid as promised. The bonds and notes of U.S. government agencies, such as the Tennessee Valley Authority, are also backed by the government. The securities of government sponsored enterprises, such as the United States Postal Service and the Federal Home Loan Bank are not explicitly backed by the government, yet there is little uncertainty whether the interest and principal on these securities will be paid as promised.

Bonds issued by state and local governments are called municipal bonds. They are either general obligation bonds, which are backed by the general taxing power of the issuing government, or revenue bonds, which are bonds issued to finance a specific project and are repaid with the revenues from that project.

Interest on federal government bonds is taxed as income by the federal government, but in most cases not by the states. The interest on municipal bonds is generally taxed as income by the states, but not by the federal government.

The exclusion of interest on municipal bonds from federal income tax makes these bonds attractive to investors. It also allows local governments to pay lower-than-average interest on their bonds.

The major financing instrument for corporations that developed in the 1990s was the asset-backed security. This is a debt security that is backed by loans or receivables. For example, Ford Credit, a subsidiary of Ford Motor Company, has issued securities backed by a pool of automobile loans. The process of issuing securities backed by a pool of loans or receivables is referred to as securitization. We’ll see the advantages of a corporation issuing an asset-backed security relative to a corporate bond.

Derivative Instruments

A derivative instrument is any contract that gets its value directly from another security, a market interest rate, the price of a commodity, or a financial index. Derivative instruments include: (1) options, (2) futures/forwards, (3) swaps, and (4) caps and floors.

What is important to understand is that derivative instruments can be used to control the wide range of risk faced by corporations and investors. This is one reason why derivatives are often referred to as risk control instruments. We must postpone a detailed discussion of the risk reducing role of derivative instruments at this juncture since we have not discussed the various risks faced by corporations and investors. This key role played by derivative instruments in global financial markets was stated in a 1994 report published by the U.S. General Accounting Office: Derivatives serve an important function of the global financial marketplace, providing end-users with opportunities to better manage financial risks associated with their business transactions. The rapid growth and increasing complexity of derivatives reflect both the increased demand from end-users for better ways to manage their financial risks and the innovative capacity of the financial services industry to respond to market demands.

Unfortunately, derivative markets are too often viewed by the general public—and sometimes regulators and legislative bodies—as vehicles for pure speculation (that is, legalized gambling). Without derivative instruments and the markets in which they trade, the financial systems throughout the world would not be as integrated as they are today and it would be difficult for corporations and investors to protect themselves against unwanted risks.