Written by: Callum Magee
What Are Capital Markets?
Capital Markets are financial markets where long-term debt or equity backed securities are traded between investors who have capital and entities who need it.
Capital Markets consist of two markets: The Primary and Secondary Market. The Primary Market is where stock and debt are directly allocated to investors. This can include when a company goes public for the first time (called an IPO) or when entities issue new debt.
The Secondary Market facilitates the trade of existing/previously issued securities. For example, trading existing bonds, equities, options and futures. Examples of Secondary Markets include the NYSE and LSE.
Capital Markets Vs Money Markets
Although Capital Markets may look similar to Money Markets, they are not the same thing. Money Markets are financial markets where securities are traded between governments, institutions and corporations for a lending term of one year or less. Capital Markets, however, are financial markets where securities are traded between these entities for a lending term of more than one year.
Debt Capital Markets
Debt Capital Markets (DCMs) are markets in which companies and governments issue debt in the form of bonds in order to raise capital. A bond is a fixed income instrument (simply an IOU on a piece of paper) which states the details of the loan and its payments. The bond will usually include the terms of the payment made by the borrower called the ‘coupon’ (similar to an interest payment) and the date in which the borrower will pay the nominal principal back to the lender (the original value of capital the lender gave to the borrower).
The original lender does not have to keep the bond, however. The lender may wish to sell the bond on the Secondary Market. If this is the case, the remaining coupon payments and the original principal will be paid to the bondholder once the principal has expired.
Why do Companies Issue Debt?
Companies may choose to issue debt in order to raise capital because it does not require the company to give up any of its ownership. However, if the company were to go bust, bond holders are first in the pecking order to claim the remaining assets of the company to make up the value they lost from the loan.
Who Uses DCM’s?
The main entities who issue debt in order to raise capital are Governments, Municipalities and Corporations. This way, these entities can raise a large amount of cash very quickly in order to finance spending, projects or pay off existing debt. Those who buy the debt from these institutions include individuals, banks, and other financial institutions.
Recently, central banks have also played a crucial role in Debt Capital Markets. Central banks use of Monetary Policy is used to either stimulate economic growth or slow it down. In doing so, the central bank will either buy or sell debt in the Secondary Market, affecting the markets liquidity in order to achieve economic targets. A recent example of Quantitative Easing includes the US Federal Reserve stating it will buy ‘infinite’ amounts of government or corporate debt in order to stimulate the US economy during the current pandemic.
Equity Capital Markets
Equity Capital Markets (ECM’s) are where financial institutions and companies interact to trade financial instruments and raise capital for companies. The Primary Market in ECM’s consists of IPO’s, Private Placements and Warrants, whereas the Secondary Market consists of sales between existing shares, futures, options and swaps.
When an investor buys equity in a company they may receive dividends (the partial distribution of the firms profits to its investors, usually on a quarterly basis). However, companies do not have to pay dividends, but when they do, its usually paid as an incentive for investors to keep investing capital into the organisation. Because the investor essentially owns a part of the company, they are given the right to vote in any election for the board of directors.
In the circumstances when the company goes bust, shareholders are protected by limited liability, whereby the shareholder is liable for the firm’s debts, only to the extent they invested into the company. Shareholders are also second in the pecking order, behind debt holders, when reclaiming the remaining assets of a failed company.
Why do Companies Offer Equity?
When a company wants to raise a large amount of capital and have exhausted other forms of investment such as bank loans, the company may look to going public in what’s called an IPO.
Companies may also offer equity to bring in expertise from investors, as well as avoiding the extra cost of coupon payments when debt is issued (unless the company pays dividends).
Companies do not however, have to go public in order to offer equity to investors. Some private companies may wish to sell equity to a few private investors or another company in order to raise capital.
Who Uses ECM’s?
Companies issue equity to raise a large amount of cash from investors including financial institutions, individuals and other companies. Some governments may also invest in private companies, leading to that organisation becoming partially nationalised. For example, the French Government has a 15% stake in French car maker, Renault.
Investors with a higher risk tolerance usually invest in equity rather than debt. This is because they may make a profit from capital gain and dividends (which could be cut at any time). Debt on the other hand requires the entities to pay a coupon to their investors and are usually first in the pecking order for the company assets if anything were to go wrong, resulting in debt being a safer investment.
Conclusion
Debt Capital Markets and Equity Capital Markets often have misconceptions. Distinguishing the differences between the two is essential for understanding how the financial markets work. This is especially true when assessing how companies raise capital, understanding who the key players in the financial markets are, and understanding an investors risk tolerance.
