Capital Market Instruments

Capital market instruments are basically either equity (stock) securities or debt (bond) securities, as far as negotiable
securities are concerned. Negotiable capital market instruments include corporate stocks, mortgages, corporate bonds,
treasury securities, state and local government bonds, US government agency securities, among others. Non-negotiable
capital market instruments include non-negotiable bank and consumer loans and leases.

The non-negotiable (non-marketable) instruments in the capital markets are the following:

1. Loans
Companies who need a large amount of funds to finance special projects like purchase of land or building, plant
expansion, or even bond retirement usually resort to borrowing from institutional lenders like commercial banks.
They do what is known as one-on-one transaction with these lenders. Stockholders usually guarantee these
loans. The amount of loan granted depends on how well the lenders know the borrowers. Long-time, well-
established companies can really borrow a large amount of funds to finance their capital needs.
2. Leases
Leases are arrangements where the owner of the property (lessor) leases/ rents the property out to the user of
the property (lessee) for a fixed monthly lease payment. Usually, properties can be ultimately owned by the
lessee if the lease agreement is a lease-to-buy. Companies who want to buy capital equipment or machinery can
arrange for a lease-to-own contract with a financial institution. They initially lease the equipment or machinery
and toward the end of the lease contract, they have the option to buy the equipment or machinery being leased.
This is a convenient way to own equipment and machinery. Even buildings are sometimes purchased in this
manner.
3. Mortgages
Land, building, and machineries are usually mortgaged upon purchase. The companies borrow money from
banks and other lending institutions to buy the land, building or machinery, and these are used as collateral for
the loan obtained. Assuming a company wants to buy a building worth P500,000, and the company does not
have such amount for the purchase. The company can go to a bank or a mortgage company and obtain funding.
However, the bank usually requires that the company has an equity in the property in the form of some sort of
down payment, say 20% of the value of the building. The bank will finance the remaining 80% and will put a lien
on the building in the form of the mortgage. The company can therefore enjoy using the property and paying it
in installment to the bank. Lending institutions are more secured knowing that something of value guarantees
the loan.
4. Letters of Credit
A letter of credit is a letter from a bank guaranteeing a buyer's payment to a seller on the agreed date and for
the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank will be
required to cover the full or remaining amount of the purchase.
Domestic letter of credit is for domestic use only. It can cover purchase of merchandise or capital equipment.
Domestic letter of credit for capital expenditures like purchase of building or equipment 1s used in the country. If
the purchase is for merchandise or inventories, the letter of credit belongs to the money market. On the other
hand. if the letter of credit is for the purchase of capital asset or equipment. the letter of credit belongs to the
capital market. Similarly business firms use domestic letters of credit for purchase of inventories.
International letter of credit is for international trade. If a company wishes to import certain merchandise or
capital machinery or equipment abroad, it can use the international letter of credit to finance the purchase.
International letter of credit is an international bank's future promise to pay for the merchandise. equipment, or
machinery imported overseas. It can be used to finance the purchase or provide a standby guarantee of payment
behind IOUs issued by a corporate Customer. Through a letter of credit, the bank substitutes its own promise to
pay for the promise of one of its customers. Substituting its promise, the bank reduces the seller's risk,
facilitating the flow of goods and services through international markets. If the seller becomes concerned about
the soundness of the bank issuing the letter of credit, the seller may ask his or her own bank to issue a
confirmation letter in which that bank guarantees against foreign bank default. (Rose 1994)
Laman and Laman (2007) gave the following example for the operation of a letter of credit:
A Japanese exporter who wishes to sell to a Filipino importer on a three-month credit may request the
importer to furnish him a banker’s letter of credit authorizing the drawing of drafts from a bank, instead of from
the importer. Since the bank accepts drafts drawn against it under the terms of the letter of credit agreement,
the exporter obtains a banker’s acceptance rather than an ordinary draft from the importer. In this case, the
exporter is assured payment. The importer gives the assurance that he will provide the funds to meet the draft
when due. He will also pay all the expenses due, including the bank’s commission and that the title to the goods
will remain with the bank until the full amount has been reimbursed.
Following are the specific marketable (negotiable) instruments dealt with in the capital markets:
1. Corporate Stocks
Corporate stocks are the largest capital market instrument. Stocks are evidences or certificates of
ownership in a corporation. The holders are called shareholders or stockholders. Shares of stocks are actually
intangible while the stock certificates are the tangible evidence of ownership. The capital stock of a company is
divided into shares, and each share is denominated in Philippine currency in the Philippines and in the currency
 of the country where the company is located in foreign countries. As such, stocks in the capital market can be
stocks of domestic companies or stocks of foreign companies.
As discussed in Chapter II, shares of stock may be classified into:
A. Value on the stock certificate
1. Par value shares
2. No-par value shares
a. with stated value
b. without stated value
B. Rights to dividends
1. Common shares
2. Preferred shares
a. as to assets
b. as to dividends
(1) cumulative
(2) non-cumulative
(3) participating
(4) non-participating

Unlike debt instruments, stocks do not have maturity dates. They remain outstanding as long as the issuing
corporation is in business and is not retired or called in by the issuing company. Secondary markets provide liquidity and
enhance the marketability of new issues of stock, reducing the real costs of financing to business firms and expanding
the possibilities for raising funds. Stocks are traded by brokers in organized stock exchanges and over-the-counter or OTC
markets. Any corporation with more than 300 stockholders may have its stock traded over the counter. Large
corporations that meet certain standards of size and stability may apply to the Securities and Exchange Commission (SEC)
for listing on organized stock exchanges such as the Philippine Stock Exchange (PSE).

Stocks earn dividends out of earnings which can be in the form of cash dividends, stock dividends, stock options, stock
splits, and property dividends. Unlike dividends out of earnings, liquidating dividends are given by companies in the
extractive industry as natural resources are depleted, and stockholders of these companies receive liquidating dividends
which are in effect return of capital. If a corporation is in liquidation, it gives liquidating dividends, which are returns of
capital.

Cash dividends are dividends distributed in the form of cash, say P10/share cash dividend, which means the company will
pay those who own shares in the company at the rate of P10/share. If one owns 1,000 stocks, he will receive P10,000 in
cash dividend.

Stock dividends are dividends given out to stockholders in the form of stocks, say a 10% stock dividend will give a
stockholder who owns 1,000 shares of stock a corresponding 100 shares of stock as stock dividend. Stock dividends are
like “paper transactions” because they do not involve any asset on the part of the company declaring the dividend. All
that the company needs 1s enough unissued common stock and enough retained earnings and a board declaration.

Stock options are the right or options given to outstanding stockholders to purchase additional shares of stocks. They are
also known as pre-emptive rights. Employees are sometimes given stock options as incentive or benefits. Stock splits
involve changing old shares with new shares. Stock split up increases the number of shares while the total value remains
the same. But the value per share decreases. For example, a stock split up of 1-2 entitles each stockholder, say one who
owns 100 shares of ₱10 par value (₱1,000) to own 200 new shares with the same total value as the old 100 shares
(₱1,000). This means that the value of each share is decreased to ₱5 per share for the 200 new shares (200 x ₱5=
₱1,000). Stock split down is the reverse. In a split down, the number of new shares issued is reduced while the value per
share is increased. A 2:1 stock split down means that stockholder who owns 100 shares will, in return, receive, 50 shares
that have the equivalent value of the old 100 shares. The value of each share increases to ₱20 as the number of shares
decreases to 50 (50 shares x ₱20 = ₱1,000).

Property dividends are in the form of non-cash assets distributed as dividends to stockholders. A company can declare
property dividends and distribute its own holdings of, say, government securities. Instead of selling the securities and
giving cash dividends the company distributes the government securities as property dividends.

2. Corporate Bonds

Corporate bonds are certificates of indebtedness (IOUs) issued by corporations who need large amount of cash.
These certificates are called bond indentures. At times, it is impossible to borrow a large amount from a single institution.
This is the time corporations decide to issue bonds. Bonds have specific interest rates and maturity dates. Most
corporate bonds are long-term bonds, i.e., they mature in more than a year.

There are also secured bonds and unsecured bonds. Secured bonds are collateralized either by mortgages or other
assets. Securitized mortgages are mortgages packaged together by financial institutions and sold as bonds backed by
mortgage cash flows such as interest and principal repayments on these mortgages. Unsecured bonds do not have any
sort of guarantee. They are also called debenture bonds. Each year, new corporate bond issues exceed new stock issues
substantially in spite of the fact that the total value of corporate bonds outstanding is less than one-third the value of
stocks. This is because bonds can be rolled over and are usually recalled prior to maturity (Thomas 1997). Debenture
bonds do not provide any lien against any specific property or security for the obligation. This is the reason why
debenture bonds are generally issued by companies with a steady high credit rating. Large mail-order houses and
commercial banks are some of these companies.

There are also variable rate bonds. The interest rate on these bonds fluctuates and changes with the changes in market
rates.

Bonds are generally preferred over stocks because most companies redeem bonds prior to maturity. Also, the interest
payments are regular, unlike dividends.

The behavior of the bond market is important in companies financing decisions. When bond yields are high, many
investment projects are postponed because the cost of borrowing is high, and the cost of borrowing is very important in
every financial decision. The rate of return of a particular project should always be higher than the cost of borrowing to
finance the project. If the cost of financing is high, the project is generally postponed until the bond market becomes
favorable for borrowers. Clearly, what is desirable for borrowers and bond issuers is unfavorable to investors who need
higher returns on their investments. They will not invest in bonds that will yields.

Corporate bonds generally have original maturities of 10 to 30 years and are traded over the counter in a market which is
"thin" compared to the major stock exchanges and the US government securities market. Many corporate bonds have
call features, i.e., can be called in for redemption prior to maturity by the issuing companies. Some are even convertible
into common stocks, a feature that attracts investors, and these convertible bonds usually carry lower interest rates.
Some bonds come with warrants, which are options to buy common stock at a stated price. These warrants that
accompany the bonds make the bonds like convertible bonds. This is because holders of the bonds are holders of the
warrants that come with the bonds giving them options to buy common stock. Buyers of corporate bonds are primarily
institutions that do not require highly liquid financial assets. These include life insurance companies, private pension
funds, state and local government retirement funds, and non-profit organizations.

Debenture bonds are unsecured bonds backed only by the reputation and financial stability of the issuer. Mortgage
bonds are bonds secured by real property of the issuer which can be foreclosed and sold by the trustee in the event that
the issuer fails to pay the bonds at maturity.

Floating-rate bonds refer to bonds in which the interest rate changes depending on market conditions.

Junk bonds refer to bonds that offer high yield of return but are considered as low quality and high-risk bonds.

Eurobonds are bonds payable or denominated in the issuer's currency but sold outside of the issuer's country. Most
issuers are from countries such as United States of America, European countries, and Japan.

Serial bonds are bonds with serial payment provisions and are paid off in installments over the life of the issue.

Straight bonds are bonds which mature at one time.

Convertible bonds are bonds which can be converted to other forms of security such as ordinary shares. Redeemable
bonds are bonds with provision, allowing the issuer to retire or redeem the bonds before maturity.

Income bonds are bonds that pay interest only when the interest is earned by the issuing company. These bonds cannot
put issuing companies into bankruptcy, but from the point of view of the investor, they are more risky than the ordinary
bonds.

Putable bonds are bonds that can be turned in and exchanged for cash at the holder’s option. Put option generally can
Only be exercised if the issuer takes some specified actions as being acquired by a weaker company or increasing its
outstanding debt by a large amount. Putable bonds have not been used to a large extent.

Popular in Brazil, Israel, Mexico, and a few other countries, plagued by high rates of inflation. Is the indexed or
purchasing power bond, the interest rate paid on which bonds are based on an inflation index such as the consumer
price index. Therefore, the interest paid rises automatically when the inflation rate rises, protecting the bondholders
against inflation. The British government has issued an indexed bond whose interest is set equal to the British inflation
rate plus 3%. These bonds, as such, provide a “real return" of 3%. Mexico has also used indexed bonds whose interest
rate is pegged to the price of oil to finance the development of its huge petroleum reserves, since oil prices and inflation
are correlated, offering some protection to investors against inflation (Weston and Brigham 1993). An increase in the
inflation rates increases the return on these bonds which is favorable to investors.

3. Treasury Notes and Bonds

Similar to Treasury bills, Treasury notes and bonds are issued by the treasury of the country concerned. The
Philippine Treasury issues 10-to-30-year Treasury bonds or T-bonds. T-notes could be over 1-to 10-year notes. The
interest rate on the T-notes and T-bonds are generally higher than the interest rates on T-bills because of the longer
maturity period. Like T-bills, they are almost default free, being backed by the government but are subject to interest rate
fluctuations and changes.
 Unlike T-bills, T-notes and T-bonds are not discounted. They pay coupon interest semi-annually. They come in
denominations of P1,000 and multiples of P1,000. These T-notes and T-bonds are registered issues, which means the
treasury records the name and address of the current holder of each security and credits the bank account of the owner
of record for accrued interest every six months. Like stocks, T-notes’ and T-bonds bid/ask prices are reported in major
business newspapers and journals like the Wall Street Journal in the United States or business sections of the regular
newspapers. T-notes and T-bonds are actively traded in the secondary markets.

Inflation-indexed bonds in the United States bear coupons indexed to reflect inflation (measured by the
Consumer Price Index or CPI) and even the final principal payment is an inflation-adjusted principal.

T-notes and T-bonds are usually issued to fund the national debt and other national expenditures. While default-
risk-free, they are not entirely risk-free. These instruments experience a wider price fluctuation than money market
instruments as interest rates change, and, therefore, are subject to interest rate risk. Also, many of the older issued
bonds and notes (off the run” issues) may be less liquid than newly issued bonds and notes (*”on the run” issues), and,
therefore, subject to liquidity risk.

4. Municipal Bonds

State and local governments and other political subdivisions must finance their own capital investment projects like
roads, schools, bridges, sewage plants, and airports. These projects need financing. These local governments usually
issue municipal bonds for the purpose. New issues of municipal bonds are generally bought by investment bankers and
resold to 'commercial banks, insurance firms, and high-income individuals. They are not, however, as saleable as
corporate bonds.

5. Mortgage-backed Bonds

Individual mortgages are non-negotiable, not liquid, nor suited to trading in the secondary markets. As a result,
mortgage companies and banks grouped mortgages into a standard million block group and issued securities backed up
by these mortgages. Such securities issued came to be called mortgage-backed securities, which are