Capital Markets and Financial Assets [Corporate Finance I Studied #3]

OK so. Financial market. It’s just a market where folks who need money (governments, corporations, whoever) go to raise it.

Two flavors:

Capital market — where financial assets for raising long-term capital get issued and traded.
Money market — same idea, but for short-term capital.

Now in this financial management class, even though we’re not going full “perfect capital market” mode, we’re going to lay down some assumptions that get us pretty close:

Transaction costs basically minimized (securities transaction tax, other taxes, trading fees, info-gathering costs, all of it).
Securities have the highest possible liquidity.
Any info that could move prices reaches investors instantly.

Ahh… I’m just going to copy-paste the textbook definition of perfect capital market.

A market in which no impediments exist with respect to transaction costs, taxes, the divisibility and marketability of assets, regulation, and so on. A market that satisfies the assumptions of perfect competition in goods and capital markets, is informationally efficient, and where every participant is a rational actor trying to maximize expected utility.
— Naver Knowledge Encyclopedia (Maeil Business Newspaper, MK.co.kr)

OK, moving on.

Issuing (primary) market

Issuing market — the market where entities that need funds issue securities to raise those funds.

Corporations, public institutions, local governments, the state itself — they all come to the issuing market and float stocks or bonds to raise money.

(Also called the primary market. The name will make sense in about thirty seconds.)

Why it matters:

Alongside keeping interest costs low, it makes it easy to raise money using other people’s capital.
IPOs dilute major shareholders, separate ownership from management, and (in theory) bump up management efficiency.
Gives stock investors a slice of the corporate results and some indirect say in how things are run.

Issuing institution — the intermediary between the issuer and investors that handles the dirty work. In Korea, these are securities companies or investment trust companies.

The main thing they do is underwriting. Two flavors:

Stand-by underwriting — the institution takes the issuer’s securities, tries to sell them, and whatever doesn’t move, they eat (underwrite). They charge underwriting fees + sales commissions.
Firm commitment — the institution underwrites all the securities in its own name, then turns around and sells them to investors on its own responsibility. No commissions here — they make their money off the spread between the underwriting price and the selling price.

Underwriting securities companies and trust companies usually don’t go solo. They pile into an underwriting syndicate together and spread the risk around.

So: issuer, issuing institution, and then investors. Investors split into institutional and individual.

Institutional investors = securities companies, banks, investment trust companies, insurance companies, and so on.

Individual investors = well, us. The little guys. Retail. (joke)

Secondary market

Secondary market — where already-issued securities change hands. Hence “secondary.” (And now “primary market” makes sense, yeah?)

What it does for you:

Gives liquidity to issued securities, which in turn makes fundraising smoother for issuers.
Investors compete freely → fair prices.
Makes info get baked into prices even faster and more efficiently.
Gives investors a shot at building diverse portfolios — same thing as saying it lets you spread risk.
Helps you predict the price of newly issued securities.

Securities market — stocks & bonds

Stocks

Stock — a certificate representing the rights of a shareholder who’s kicked in capital to a corporation. Those rights: the right to claim profit dividends, the right to claim a share of residual assets, voting rights, etc.

Right to claim profit dividends — claim on the profits the company makes through its business. Dividends usually paid once a year.
Right to claim residual assets — if the company dissolves, you get a cut of what’s left, proportional to your stake. (In practice this almost never pays out — by the time a company folds, liabilities have eaten through the asset side.)
Voting rights — you get to show up at shareholder meetings and weigh in on the big stuff. One share = one vote.

Common stock — includes all the general rights: dividends, residual assets, voting.

Preferred stock — gets priority over common stock on dividends and residual asset distribution. But no voting rights.

cf. Preferred stock has subtypes. If dividends can’t be paid, cumulative preferred stock accumulates the unpaid bit to be paid later, while non-cumulative just… lets it evaporate. There’s also participating preferred stock that can grab extra profits beyond the promised dividend, and non-participating that can’t.

Par value stock — stock where the par value is expressed as a pre-determined amount. In Korea, issuing these isn’t allowed anymore; even in the US, where par value stocks still exist, they’re pretty uncommon.

Why? Because par value is basically the historical value from when the company was founded. It has nothing to do with actual value.

Which is to say — it’s pretty much meaningless.

Non-voting stock — yeah, there are common stocks with no voting rights too.

In exchange, the priority order for profit distribution sits lower than preferred stock but higher than regular common stock.

In Korea, non-voting stock isn’t allowed to exceed 1/4 of the company’s total issued shares — otherwise some guy holding a tiny number of voting shares could just waltz in and take over the whole company.

Bonds

Bond — a negotiable security; basically a promissory note for debt, laying out conditions for fixed interest payments and principal repayment.

By issuer:

Corporate bonds — issued by a company. The sketchier the company’s credit, the more expensive it is for them to raise money, right??? Which also means we can pick them up cheap.
Government / public bonds — issued by the state or local governments to cover fiscal deficits or fund public projects. Treated as risk-free assets (under the assumption that, y’know, a country doesn’t just collapse).
Special bonds — issued by special corporations established under special law. Korea Development Bank → industrial finance bonds; Bank of Korea → monetary stabilization bonds; public enterprises → housing corp bonds, investment development bonds, electricity bonds, etc.

By interest payment method:

Coupon bond — pays interest at regular intervals, repays face value at maturity.
Discount bond — issued with the total interest already knocked off the face value up front (hence “discount”), pays back face value at maturity. Ex. monetary stabilization bonds.
Compound bond — no interest payments along the way; at maturity, all the interest that should have been paid each period gets paid in one lump together with the face value.
Perpetual bond — no principal repayment ever; you just collect a fixed interest amount at regular intervals, forever.

By principal repayment method:

Callable bond — the issuer has the right to repay principal before maturity. The price they pay on early redemption (the call price) is usually higher than face value, and the earlier they yank it, the higher the premium gets.
Why would the issuer do this? Simple — if interest rates fall, they eat the call premium, redeem early, and re-issue bonds at the lower rate. Cheaper for them overall.
Bullet bond — the plain-vanilla version. Full principal repaid in one shot at maturity.

A few more bond flavors

1. Guaranteed vs. non-guaranteed corporate bonds

Corporate bonds split into “with a guarantor” and “without.”

A guarantee means some third party stands behind payment of principal and interest — if the issuer can’t pay, the guarantor picks up the tab. Banks and securities companies used to play this role all the time, but since the 1990s, the practice has been fading out.

2. Secured vs. unsecured corporate bonds

Similarly, corporate bonds may or may not come with collateral.

Secured corporate bonds require collateral at issuance. If it’s real estate, that’s a mortgage bond; if it’s negotiable securities, that’s a collateral bond.

3. Convertible securities — convertible bonds, convertible preferred stock, that family.

Convertible bonds are bonds, sure, but the investor has the right to convert them into common stock if they want.

Convertible preferred stock — same deal, but it’s preferred stock the investor can swap into common stock.

Interest rates on convertibles are generally lower than on regular corporate bonds — because, you know, you’re getting the conversion option on top.

The company loves this because: low interest to pay, and if the conversion right gets exercised, they don’t even have to repay the principal and interest anymore. Pure win.

(Heads up though — existing shareholders’ control gets diluted, so it’s not all free lunch.)

4. Bond with warrants (preemptive / subscription right bond)

A bond that gives the owner the right to buy new shares of the issuing company.

Here’s the key difference from convertibles — even if the warrant gets exercised and you buy the new shares, the bond itself doesn’t go away. It keeps doing its bond thing. You’ve just separately got the right to buy new shares at a set price and quantity within a certain time window.

These often get used as a sweetener on bonds issued by high-growth companies — “invest in our bonds AND you get to pile into our stock later if it rips.”

Beneficiary certificates

Beneficiary certificate — a rights certificate issued by an investment trust company.

An investment trust company takes the money investors hand them, invests it in negotiable securities on the investors’ behalf, and distributes whatever profits come out of it back to the investors. The beneficiary certificate is basically the piece of paper that formalizes this whole arrangement — think of it as a negotiable security issued under the contract between the trust company and the investor covering “you invest on my behalf, and I get my cut of the profits.” heh

Types of investment trusts

1. Contractual investment trust

Most Korean investment trusts run this way.

Three parties operate the thing under a trust contract: truster, trustee, beneficiary.

Truster = the investment trust company itself — the settlor, the one that issues beneficiary certificates and manages assets.
Trustee = a (licensed) bank that holds and safeguards the entrusted assets. They charge a fixed fee and that’s how they eat.
Beneficiary = the one with the right to receive profits. That’s the investor.

Contractual trusts come in unit type and fund type, depending on how the trust is run.

Unit type runs at a fixed monetary scale set per unit. Once the unit is established, no additional money can flow in, and — brutally — you can’t redeem during the contract period either. ;_;
Fund type lets money flow in, and investors can redeem whenever they want. That’s the big difference.

2. Corporate investment trust

Aka the mutual fund. This is where the fund itself gets legal personhood and runs as an independent company.

Investors become shareholders of that company, and they collect their cut of the trust’s earnings as dividends.

Splits into closed-end and open-end.

Closed-end — you can’t pull your investment out directly. No redemption requests allowed. If you want out, you sell your fund shares on the securities market. So closed-end funds are listed on the market.
Open-end — you can recover your investment anytime. So there’s no reason to be listed and traded on the stock market → not listed. Joining and leaving are free, and the fund’s total size drifts around constantly.

Originally written in Korean on my Naver blog (2016-10). Translated to English for gdpark.blog.