Most readers might have heard economic commentators on CNBC citing the term “capital markets”. The term is also used when companies come to issue new securities and are looking to raise capital for expansion. In this article, Piggy explains how this market operates and investigates some of the common financial instruments traded.
Generally, a market is the means through which buyers and sellers are brought together to aid in the transfer of goods or services. It is worth noting that a market does not have to be a physical location like a vegetables market. It is only necessary that the buyers and sellers can communicate regarding the relevant aspects of the transaction. A capital market is where governments, municipalities and corporations can issue shares and bonds or other securities to raise capital. The two main types of instruments are (i) equity (ordinary and preference shares) and (ii) debt (bonds and debentures). These securities are also traded on the secondary markets.
EQUITY (Common and Preferred Stock)
Common stocks also known as equity securities or equities, represent ownership shares in a corporation. Each share of common stock entitles its owner to one vote on any matters of corporate governance that are put to a vote at the corporation’s annual meeting and to a share in the financial benefits of ownership. The corporation is controlled by a board of directors elected by the shareholders. Managers have the authority to make most business decisions without the board’s specific approval. The board’s mandate is to oversee the management to ensure that it acts in the best interests of shareholders. The two most important characteristics of common stock as an investment are its residual claim and limited liability features.
Residual claim means that stockholders are the last in line of all those who have a claim on the assets and income of the corporation. In a liquidation of the firm’s assets the shareholders have a claim to what is left after all other claimants such as the tax authorities, employees, suppliers, bondholders, and other creditors have been paid. Limited liability means that the most shareholders can lose in the event of failure of the corporation is their original investment. Unlike owners of unincorporated businesses, whose creditors can lay claim to the personal assets of the owner (house, car, furniture), corporate shareholders may at worst have worthless stock. They are not personally liable for the firm’s obligations.
Preferred stock has features like both equity and debt. Like a bond, it promises to pay to its holder a fixed amount of income each year. In this sense, preferred stock is similar to an infinite-maturity bond, that is, a perpetuity. It also resembles a bond in that it does not convey voting power regarding the management of the firm. Preferred stock is an equity investment, however. The firm retains discretion to make the dividend payments to the preferred stockholders; it has no contractual obligation to pay those dividends. Instead, preferred dividends are usually cumulative; that is, unpaid dividends cumulate and must be paid in full before any dividends may be paid to holders of common stock.
DEBT (Bonds and Debentures)
The bond market is composed of longer-term borrowing instruments such as Treasury Notes and Bonds that are issued by the government in-order to finance long term projects. Other instruments include Municipal and Corporate Bonds.
Municipal bonds are issued by state and local governments. They are similar to Treasury Bonds except that their interest income is exempt from tax. There are basically two types of Municipal Bonds. These are general obligation bonds, which are backed by the “full faith and credit’’ (i.e. the taxing power) of the issuer, and revenue bonds, which are issued to finance particular projects and are backed either by the revenues from that project or by the particular municipal agency operating the project. Typical issuers of revenue bonds are airports, hospitals, and port authorities.
Corporate bonds are the means by which private firms borrow money directly from the public. These bonds are similar in structure to Treasury issues—they typically pay semi-annual coupons over their lives and return the face value to the bondholder at maturity. They differ most importantly from Treasury bonds in degree of risk. Default risk is a real consideration in the purchase of corporate bonds.
The info-graph below outlines the differences between Stocks and Bonds;
Overall, how you choose to invest your capital in stocks or bonds depends on the following considerations;
- Your required rate of return;
- How much risk you can tolerate;
- How long you can invest your capital;
- Your personal tax liability; and
- Your need for quick access to your cash
Lean more about Capital Markets by downloading a copy of the Investor 101 Handbook below
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