Capital market instruments

Capital market instruments are longer term financial instruments in the form of debt or equity
that are traded either on a securities exchange or directly between investors and borrowers. We
provide an overview of the different types of instrument available.

The capital market is a market in which debt and equity securities are traded. Capital market
instruments have a maturity of 12 months or longer and are usually distinguished from short-term
money market instruments such as treasury bills, Certificates of Deposit (CDs), commercial paper and
bills of exchange, which have a maturity of up to 12 months.

In order to raise finance in the capital markets, issuers typically require a high credit rating, although
some weaker credits may also access the markets using very high yield instruments. The stronger
credits should find it possible to raise funds more cheaply on the capital markets than through
traditional bank lending.

The range of instruments available to both issuers and investors is wider on the capital market than
on the money market, as the capital market itself can be divided into equity and debt markets:

 Equity markets.
Equity securities represent an ownership claim to the assets of a company. Equity securities have
no maturity and they do not oblige the issuer to pay fixed interest at regular intervals. Equity
securities are also subordinated to debt securities. As result it is expensive to raise funds by
issuing equity, but it provides the issuer with a considerable degree of flexibility.
 Longer term fixed-income debt markets.
Debt securities, in contrast to equity securities, accrue interest and are redeemed (paid out) on a
set maturity date. The investor into a debt security becomes a lender and creditor to the issuer.
All types of debt rank senior to equity.

Equity markets
Securities traded on the equity markets come in the form of shares. Shares are equity claims on the
net income and the assets of a company. The value of the shares traded in the capital markets
exceeds that of any other capital market instrument. There are two types of shares: common and
preferred shares.

Common shares
Common shares are characterised by their residual claim and limited liability. Residual claim means
that shareholders are subordinated in the priority of payment to all other claims on a company’s
assets and dividends. If a firm is liquidated, holders of common shares will only receive payment for
their shares after all other stakeholders – for example, bondholders, other creditors, tax authorities,
employees and suppliers – have been paid. Limited liability means that in the event of bankruptcy an
investor is not personally liable for the company’s obligation and can lose at most the initial
investment into the share.

Shareholders have a claim to the company’s operating income after interest and taxes. The payment
of this dividend is at the company’s discretion. Alternatively, the management of the company has the
option to retain these earnings and reinvest them into the business in order to increase the value of
each share.

As common shares represent an ownership claim to the assets of a company, holders of common
shares have the right to vote on corporate governance issues at annual meetings.
Preferred shares
A preferred share is a special type of security which has a fixed periodic claim on a share of the
company’s profits. The payments based on the claim are called dividends. The security is called a
preferred share because the holder has a preferential claim to the profits ahead of common
shareholders. This means that dividends on preferred stock must be paid before any dividends on
common stock are paid.

Preferred shares have both equity and debt components. The preferred share is similar to a perpetual
bond in that it promises to pay a fixed amount of income per year. The fixed dividend payments –
mostly paid every three months – are like a bond’s interest payments. Like bonds they are also
sensitive to interest rate changes. In the event of falling interest rates, preferred share prices go up,
and vice versa.

However, unlike debt, the company is under no obligation to pay the dividend. Preferred dividends are
usually cumulative, which means that if a company returns to making profits after a few weaker years,
all preferred dividends for the previous years have to be paid before dividends can be paid to common
shareholders. Those preferred shares that don’t have this provision are called non-cumulative
preferred shares.

Unlike common shares, preferred shares do not give the holder voting rights. Preferred shares are
subordinated to bonds in claims to the assets of the firm during bankruptcy. Preferred shares may also
be redeemable or convertible into common stock at a specified ratio.

Primary and secondary market

The equity market is divided into the primary and secondary market. The primary equity market is the
market for a company’s first issue of shares through an initial public offering (IPO). New shares other
than IPOs, the so-called seasoned offerings, are also sold via the primary market, which is largely
dominated by investment banks.

The secondary market is where securities are traded between investors either on a security exchange
or over-the-counter.

Longer term fixed-income capital markets

Bonds are the most important medium- and long-term debt instruments. Bonds are similar to loans in
the sense that they borrow a specific amount, the face value of the bond, which is repaid at a set
maturity date. The issuer pays a set interest rate (the coupon) to the buyer of the bond at regular
intervals until the bond matures.

Bonds are called fixed-income securities, because the amount of cash flows is known in advance if the
bond is held until maturity. Bonds are traded at security exchanges or over-the-counter (OTC)
markets comprising of bond dealers, brokers and investors who trade over the phone or electronically.
Most bonds are traded OTC.

Typically only organisations with a strong credit rating such as governments, government agencies or
large corporations will have access to the bond markets.

Unlike shares, bonds do not give an ownership interest in the issuing company or organisation.
Investors in a corporate bond become creditors of the issuing organisation. Debt securities such as
bonds are senior to equity, which means that bondholders must receive any interest or principal
outstanding before shareholders can be paid any dividends.

Bonds
Any security that promises to pay a fixed coupon at regular intervals until medium- or long-term
maturity is considered a bond. There are however many different forms of bonds which are
modifications of the basic principles.

Domestic, foreign and Eurobonds

There is a general distinction between domestic bonds, (issued in the issuer’s own country), foreign
bonds (issued in a foreign country), and Eurobonds (issued in the currency of one country but sold
internationally).

It is important to highlight the difference between ‘Eurobonds’, that are issued internationally and
‘euro bonds’ – bonds that are denominated in euro irrespective of the location.

Government bond market

Domestic debt markets are traditionally dominated by government debt as it offers good liquidity and
is considered virtually riskless. The risk of a government defaulting on debt repayments is much lower
than the same default risk for companies.

As a result, government debt issues are often used as a benchmark yield for corporate debt.

Government debt can be issued by the national, regional, local and municipal government as well as
by government agencies. The maturity of government debt securities can range from one to 35 years.

Corporate bonds
Companies, just like governments, often prefer to borrow in the medium- or long-term at a fixed rate
of interest. The credit rating of a company will have an effect on both the coupon and the maturity
that are available to the company when it issues a bond. The typical corporate bond pays a coupon
twice a year and pays off the face value when the bond matures.

Corporate bonds offer higher yields than government bonds of comparable maturity as they tend to be
the riskier investment.

In most cases corporate bonds do have a credit rating based on the company’s credit history and
ability to repay the obligations, which facilitates the evaluation of this financial market instrument.

Maturity is one of the main features of a bond and indicates when the principal amount is going to be
paid back and for how long interest payments are going to be paid. Depending on their maturity,
corporate bonds fall into one of three categories:

 Short-term notes with a maturity of less than five years.

 Medium-term notes or bonds which have maturities of five to 12 years.
 Long term bonds featuring maturities of more than 12 years.
Different types of bonds/bond structures
Not all corporate bonds are traditional bonds which pay a fixed income at regular intervals before they
are redeemed at a fixed maturity date. The structure of bonds can vary with regard to the coupon
intervals, type of coupon, redeemability, convertibility and many other features. These are the most
important variations:

Floating rate note (FRN)

A floating rate note (FRN) is a bond with a variable coupon. Interest payments are based on floating
interest rates, for example EURIBOR, which are used as a reference rate at periodically set ‘refix’
dates. Typically the interest payment is a fixed spread over a three-month or six-month reference
rate. At the beginning of the coupon period, the spread is added to the reference rate of that
particular day to determine the coupon. While the spread or margin remains constant the reference
rate is variable. Some special FRNs have maximum or minimum coupons, called capped and floored
FRNs.

Index-linked bonds
Similar to a floating rate note, index-linked bonds have a variable coupon depending on an underlying
index, such as the consumer price index or a commodity price or stock index. The coupon paid is a set
margin above the reference index.

Zero-coupon bonds
As the name indicates, zero-coupon bonds do not have a coupon. The return for the investor is
achieved by selling the bond at a significant discount to the nominal value of the bond which is due at
a fixed maturity.

The only cash flows in the life of the zero-coupon bond are the purchasing price and the repayment of
the nominal value or principal at maturity.

As there are no interest payments, the investor is not exposed to any reinvestment risk, the risk that
interest rates and hence reinvestment rates for coupon payments have fallen. As a result, investors
may accept a slightly lower yield for a zero-coupon bond.

Strips
When a bond is stripped, the cash flows of a bond, ie each coupon payment and the payment of
principal, are separated and can then be traded as individual zerocoupon bonds. STRIPS is an acronym
for ‘Separate Trading of Registered Interest and Principal Securities’ but also relates to the actual
tearing off of interest coupons from paper securities.

Perpetual bonds
A perpetual bond does not have a redemption date and is redeemed only if the issuer goes into
liquidation. This means perpetual bonds pay coupons indefinitely. Interest is fixed for the initial period
or for the life of the bond. Perpetual bonds tend to have a call option, but in most cases this option
can only be exercised after 10 years or more. Most perpetual bonds are issued by financial
institutions.

Convertible bonds
Some corporate bonds have the option to convert the bond into a specified number of shares at any
point before the maturity date. The types of convertible bonds may be more attractive to investors, as
an increase of the share price will increase the value of the bond. This will allow the issuer to lower the
interest rate and reduce the financing costs in comparison to a non-convertible bond.

Collateralisation
Most corporate bonds are unsecured bonds – so-called debentures. In contrast to secured bonds that
are backed by collateral, debentures are only backed by the issuer’s general credit and its capacity to
generate sufficient cash flow to repay interest and principal. Subordinate debentures have an even
lower priority than debentures or secured bonds when it comes to claims on the issuer’s assets in the
event of a bankruptcy. In order to determine an issuer’s default risk with regard to unsecured bonds,
credit ratings are the key tool.

Asset-backed securities (ABS)

Unlike a straightforward bond, where the investor relies on the issuer’s overall creditworthiness to
repay interest and principal, ABS are backed by a pool of assets. This pool of assets will generate the
necessary cash flow to service the related payments to investors and serve as collateral. The assets
are pooled to make the securitisation economical and diversify the quality of the underlying assets.
ABS allow companies to raise funds and develop new sources of capital by borrowing against assets.
The types of assets that can be securitised cover a wide range of receivables from residential
mortgages to leasing and loan agreements or credit card receivables.

Calls and puts

Many corporate bonds are issued with a call option. Callable bonds give the issuer the option to
repurchase the bond from the bondholder at a specified price prior to its maturity. This option protects
the issuer if market interest rates fall after the issuance. The issuer can redeem the bond earlier and
issue cheap debt in the form of another bond with a lower coupon. This advantage of early redemption
to the issuer is a risk to the investor and callable bonds tend to carry higher yields than non-callable
bonds. Some callable bonds also pay a premium on the principal if they are redeemed early.

Bonds can also be issued with an option for the investor to require redemption on the bond (put)
before maturity.

Medium-term note (MTN)

An MTN introduces the features of commercial paper to a bond, in the sense that MTNs are issued
continually rather than as a one-off. The maturity of an MTN is longer than one year and it pays either
a fixed-rate or a floating-rate coupon.

Other securities
Some types of securities do not fall exclusively into either of the debt or equity categories:

Warrants
Warrants are options which give the holder the right to buy (call warrant) or sell (put warrant) an
underlying security at a set price. Warrants are issued by firms and represent a claim on the
company’s assets. Should the holder of a call warrant exercise the option, the company will issue a
new share and sell it to the warrant holder.

Bond warrants are sometimes attached to bonds and give the holder the right to buy another security,
for example, more of the same bond or some of the company’s share, at a set price.

Hybrid securities
Hybrid securities are a combination of debt and equity features. Hybrids are a source of capital that
aims to provide the flexibility of equity, but avoid the dilution of shareholder value that may result
from raising additional equity.

In the next month’s Corporate Finance article we will focus on the concept of shareholder value before comparing the different attributes
of debt and equity and their relevance for raising capital.
Hybrid securities generally take the form of subordinated bonds that also have equity characteristics,
such as a convertible bond. However, preference shares are also considered to be hybrid securities as
they are an equity instrument with strong debt characteristics such as cumulative interest,
redeemability and convertibility. Preference shares also do not represent a claim to the assets of a
company.

All hybrid securities are situated somewhere between pure debt and pure equity with regards to
certain characteristics such as maturity (ie indefinite or very long maturities), the ability to defer
interest payments, and seniority.