The Capital Markets

Capital Markets Prices
Capital Markets Prices

The Capital Markets

The means by which funds flow to those who need capital from those who have excess funds to invest are some of the most important elements of the world’s economic system. One of those pathways is the one provided by banks and other intermediaries who accept deposits on the one hand and loan those funds out on the other. A far more important flow, however, is that provided by the world’s “capital markets” - those markets that allow organizations to raise long term funds, or capital, by selling securities to the investment community.

Borrowers and Investors

Funds users include corporations and governments seeking long term funds for such things as building construction and capital equipment purchase.

Funds investors include both professional investors like mutual funds and insurance companies, and individual investors. Some investors are merely trying to increase the value of their assets. Others, like insurance companies and pension funds, have the added objective of meeting certain expected cash outflows, like the pension or insurance benefits they have agreed to provide.

Types of Securities

There are two basic types of securities: equity instruments or “stock”, which represent ownership in a company, and debt instruments or “bonds” which represent an issuer’s promise to pay.

Equity instruments, or “stocks”, represent a share in the ownership of the issuing company. Although dividends can sometimes provide a significant source of income, they are not guaranteed payments and can easily be reduced if a company falls on hard times. Stocks can, however, increase in value significantly if the company prospers.

Bonds are essentially promises by the issuing company to repay the principal amount of the bond at maturity and to pay interest on that principal at certain specified times. Bonds are essentially long term debt instruments with a maturity greater than one year. Debt instruments with a maturity of less than one year are referred to as “money market” instruments as they are typically used for short term cash management. Bonds may be either registered or bearer instruments. If registered, the bondholder’s name is recorded on the issuer’s books; if bearer, the bond is payable to whoever holds the bond certificate.

Let's have a look at which form of security, a stock or a bond, would best meet each of these investment objectives.

An investor who wants a steady income: Common stock offers no guarantee of income. Even mature companies that pay regular dividends may reduce or eliminate them if the need arises. Young growing companies often plow most of their profits back into the business. So a bond is the better option for an investor who seeks a steady income.

An investor who wants to maximum potential long term gain: Though a bond can increase in value if interest rates fall, stocks offer far more potential for an increase in value. So stocks are right for this investors objectives.

An investor who seeks minimum risk to principal: Because the value of stocks, particularly the stocks of smaller, less established companies, can swing widely and unpredictably, they are generally not a good choice if protection of principal is a primary objective. A bond is a better choice.

An investor who seeks protection against inflation: Over the long term, good stocks can offer some protection against inflation since stock prices will tend to rise with inflation. So stocks meet this investors objectives.

Now let's look at which form of security would best meet each of these funding objectives.

Lowest cost of funds: Bonds require the issuer to make interest payments. Common stocks require no promised payments to the investors. So stocks offer the lowest cost of funds.

The minimum dilution of control over corporation: Because common stockholders have the right to vote on corporate matters, issuing stock surrenders some control of the company to others. Bonds confer no voting rights to their holders. So bonds offer minimum dilution.

Funding for governmental needs: Governments can’t offer shares in the ownership of their countries. So for governments, bonds are the only option.

Primary Market Mechanism

The market for new issues of securities is called the Primary Market. Though each security’s primary market has its own special characteristics, there are three mechanisms common to many of them: auctions, underwriting syndicates, and private placement. Let's take a moment to investigate each of these three important activities.

Auctions

Government bonds such as U.S. Treasuries are often brought to market by auction. In this process, participants submit competitive bids for portions of the issue. Those offering the lowest prices have their bids filled.

Auctions also often allow for small non-competitive bids. These bidders bid for a certain portion of the issue, but agree to pay whatever price the competitive bidding determines. Generally, a small portion of an issue is set aside for non-competitive bidders.

Auction: $110 million in bonds

Bids:

Tender & Co. $20MM 8.27%

Bond & Co. $18MM 8.36%

Broker & Co. $25MM 8.24%

Block & Co. $20MM 8.35%

Prime & Co. $15MM 8.24%

Dealer & Co. $10MM 8.23%

Trader & Co. $15MM 8.32%

Let’s take a closer look at a bond auction. In the above case, dealers submit competitive bids giving the amount they wish to purchase and the yield they will accept. From the bids in this example which would you say is the most favorable from the issuer’s point of view? Take a guess.You have probably guessed it's the Dealer Company’s 8.23%. Remember, the yield represents the interest the issuer will have to pay for these funds. The issuer is looking for the lowest yield possible.

In the example below the bids are ranked from lowest yield to highest. After setting aside a portion of the issue for non-competitive bidders, the dealer’s bids are then filled one at a time, starting with the dealer bidding the lowest yield, until the total amount of the issue is spoken for.

The yield these lucky bidders will receive, and therefore the price they will have to pay, depends on the type of auction being conducted.

Auction: $110 million in bonds
 
 
 
Auction Type: Regular or dutch
 
 
 
Bids
Amount
Yield
Amount Received
Non-competative bids:
 
 
$20MM
Dealer & Co
$10MM
8.23%
$10MM
Broker & Co
$25MM
8.24%
$25MM
Prime & Co
$15MM
8.24%
$15MM
Tender & Co
$20MM
8.27%
$20MM
Trader & Co
$15MM
8.32%
$15MM
Block & Co
$20MM
8.35%
$5MM
Bond & Co
$18MM
8.36%
$0
Total
 
 
$110MM

Regular or Dutch Auctions

In a regular auction, each competitive bidder included in the distribution receives the yield they bid. Non-competitive bidders receive the weighted average of the successful yields. In the above case the weighted average is 8.265% average yield.

The range between the average of the successful yields and the highest yield is known as the “tail”. Dealers always strive to place a bid in the “tail”, that is, to make a successful bid producing one of the higher yields.

In a Dutch Auction, all bidders included in the distribution, both competitive and non-competitive receive the same yield. The yield granted is the highest yield bid in the distribution group. In other words, it is the single yield at which enough bidders would buy to purchase the entire issue. In the example above the highest yield bid is Block & Co at 8.35% is the highest bidder in the distibution group. Bond & Co is higher at 8.36% but they are not in the group receiving a portion of the issue.

Underwriting Bonds

Corporations and many other issuers hire investment bankers to underwrite their security issues and bring them to market. The underwriter purchases the entire issue from the issuer, but purchases it at a price slightly lower than the price at which the security will be offered in the public market. 

Underwriting assures the issuer of a certain level of proceeds from the issue, regardless of what may actually happen in the market.

If for example the price paid to an issuer was 98 with the expected public offering price being 99. When the underwriter actually begins to sell this new issue, which of the situations below would he hope for?

A) issue is sold at 97

B) issue is sold at 99

C) issue is sold at 107

If the issue is sold at 97 it would be a disaster. The underwriter would lose heavily if the issue had to be sold at a price less than he paid the issuer.

If the issue was sold at 99 it would be ideal. It gives the underwriter a good return and makes the issuer happy.

If the issue was sold at 107 it would at first glance, seem great for the underwriter. But the issuer would almost certainly question why the price he received was so low and be hesitant to use this underwriter in the future. If this issue sells at 107, it has probably been very much mis-priced.

An underwriter will often form a syndicate of investment banks to help sell the new bonds and to share the risk. Individual investment banks often have strong relationships with particular segments of the investor community. Syndicates are formed to take advantage of this and make the base of potential customers as wide as possible.

A syndicate may also include a “selling group”. The broker/dealers in the selling group are included purely to expand the sales capability of the syndicate and are not obligated, as the syndicate members are, to sell a certain portion of the issue.

Manager's fee 15% Underwriting fee 25% Selling concession 60%
Manager's fee 15% Underwriting fee 25% Selling concession 60%
Underwriters
Underwriters

The underwriting spread earned on an issue is actually divided into three portions: the manager’s fee, which compensates the syndicate manager for his management responsibilities, the underwriting fee, which compensates the underwriter for market risk they take, and the selling concession, which compensates anyone who makes a sale.

In some cases, a security issue may be sold directly to a single investor or small group of investors such as insurance companies or pension funds. In this case, the investment banker acts as an agent in bringing together the buyers and seller and does not assume any underwriting risk. A private placement avoids the expense of a public offering.

The Secondary Market

The market in which existing securities are bought and sold is called the Secondary Market.  There are two common forms: the over-the-counter or OTC market and the exchange.

In an exchange market, brokers representing many buyers and sellers gather on the exchange’s trading floor to find potential counterparties and settle on prices by competitive bidding. Brokers act as agents for their customers and do not trade for their own account. They get compensated by charging their customers a commission.

Unlike an exchange market, an over-the-counter, or OTC, market is not located in one place. It is made up of many separate dealers. These dealers buy and sell from their own account. A customer can negotiate with a dealer for a better price, but may have to call several dealers to find the best price.

In order to manage their inventories, dealers in an OTC market trade actively with each other as well as with customers. This dealer-to-dealer market, called the “inside market”, often takes place through special dealer’s brokers. This allows each dealer to keep his activities hidden from his competitors.

A dealer’s staff typically consists of both Traders and a Sales Desk. The traders make prices and manage the firm’s position by trading with other dealers. The Sales Desk manages the relationship with the dealer’s customers. When a customer calls for a quote, the Sales Desk will get the current price from the trader. A good Sales Desk is a valuable source of market information to the dealer’s customers and a valuable source of information on the demand for securities to the trader.

Dealers make their profit from the “spread”, the difference between the price they buy a security at and the price at which they sell it. Therefore, if a dealer buys a security, he generally wants to be sure he buys it at a price less than he could sell it for on the “inside market”. And if he sells, he wants a price that is higher than it would cost him to buy it.

Clearing House
Clearing House

Trade Settlement

A final important aspect of the capital markets to understand is the settlement systems. Once a trade has been agreed, it must be settled. That is, the agreed cash and securities must be exchanged on the agreed settlement date. For the Seller, this means delivering the securities and insuring that the proper cash is received. For the Buyer, this means insuring that the correct securities are received and that ownership of those securities, if they are registered, has been properly transferred and if for some reason this exchange can not take place as agreed, the trade is said to have “failed”.

Here are some potential settlement problems. Could any of these result in a significant loss to either the buyer or the seller? Yes they could.

  • A lost bearer security would be a major loss. Its owner would stand to lose the entire value of the security.
  • settlement fails to occur on the scheduled date and takes place two days later. There is no direct loss, the purchaser of this security might have resold it for settlement on the same date as this trade. With no security to deliver, his second trade would fail, subjecting him to penalties.

  •  A seller goes bankrupt before settlement, no security is received, but no cash is paid either. Here too there is no direct loss, but the Buyer may be forced to purchase a replacement security at the current market price. If prices have risen significantly since the original trade, he stands to lose a significant amount.

Because significant losses due to settlement problems are possible, financial institutions follow a three step process to settle their trades. 

First, the counterparties compare trade details like security and amount and price to be sure they agree.

Next they determine the amount of cash and securities to be exchanged, a step called “Clearance”. 

Lastly, the actual cash and securities are exchanged.

The world’s financial institutions have worked hard to insure that the systems that carry out these steps are as robust as possible.

Physical security certificates expose investors to the risk of loss and to the administrative burden of re-issuing a new security certificate each time an owner’s name changes. To eliminate this, the physical certificates in most markets  have been placed in depositories and transfer of ownership is accomplished purely by “book entry”. 

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Comments 3 comments

Stock Tips 5 years ago

I really appreciate your post and you explain each and every point very well. Thanks.

Regards

Stock Tips


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one2get2no 5 years ago from Olney Author

Thank you for your comment I appreciate it.


lara 2 years ago

excellent portray. I'm thankful.

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