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Book title: Understanding Financial Markets & Instruments
Author: Braam van den Berg

Chapter 4: The capital market and instruments

4.1   Introduction 
4.2   Capital market securities 
4.2.1   Interest rate securities 
4.2.2   Zero-rated coupons 
4.2.3   Asset-backed bonds 
4.3   Regulation of the market 
4.4   Issues of new securities 
4.5   Trading principles and systems 
4.6   Value determination of bonds 
4.6.1   Zero-rated coupon bonds 
4.6.2   Interest rate bonds 

4.1   Introduction

The capital market is the market for the issue and trading of long-term securities.  The term in this instance is measured as the term to maturity of the security and in order to be classified as a capital market instrument, the term to maturity should be longer than 3 years.  During the trading of these instruments, the securities traded are informally classified into short-term, medium-term and long-term securities depending on their term to maturity.  Where the term to maturity of the instrument is up to five years, the security is classified as a short-term capital market instrument.  Where the term to maturity is five to ten years, the security is classified as medium term, and where the term to maturity is more than 10 years, the security is known as long-term.

The primary market is the market for the first issue of securities.   This issue is normally done by means of a public issue or by private placement.   The secondary market is the market for trading securities once they have been issued.  The secondary market has a big influence on the issues in the primary market, as the market rate is determined in the secondary market.  Issues in the primary market at below market rate, determined in the secondary market, would be issued at a discount on the nominal value of the instrument.  If the volumes traded in the secondary market are high it could be an indicator that an excess of long-term money is available in the market, and it may thus be an opportune time to issue new securities into the market by means of the primary market.  Therefore, if the liquidity in the secondary market is high, chances are that new issues would be more successful than in an illiquid market.

4.2   Capital market securities

Instruments issued and traded in the capital market differ in certain characteristics, such as:

  • term to maturity (as discussed above)
  • interest rate paid on the nominal value
  • interest payment dates
  • nominal amount in issue.

4.2.1   Interest rate securities

The interest paid on the nominal amount of capital market securities (called the coupon rate) appears on the certificate received by the holder (the investor) of such a security (see example of a certificate:  appendix 1).  This coupon rate is one of the parameters used to determine the consideration paid for the security when traded in the secondary market.  Most securities are issued at a fixed coupon rate such as the Eskom 168 (E168) security that is issued at a coupon rate of 11%.   This means that the registered holder of an Eskom E168 certificate will receive 11% interest per year (NACSA) on the nominal amount of the instrument.  The nominal amounts are in multiples of R1 million, and the interest on the E168 is paid biannually on 1 June and 1 December.  The holder of an E168 with a nominal value of R1 million will thus receive R55 000 on 1 June and R55 000 on 1 December.  Certain securities are, however, issued at a variable coupon rate, where the coupon rate is then linked to a well-known interest rate such as the prime overdraft rate or the 90-day BA rate.

Capital market securities are physical certificates and the issuer of the security keeps a register of owners.  This register is used by the borrower (issuer) to pay interest to the lender (owner of the security) on the interest payment dates indicated on the certificate.  When an instrument is sold to a new owner in the secondary market, the buyer is registered as the new owner on the settlement date of the transaction.  For administrative purposes the register of the issuer closes for registration of new owners, normally one month prior to the interest  payment date.   The date when the register closes is known as the last day to register (LDR).   This means that the person or company who is registered as the owner one month before the interest payment date (on LDR), will receive the interest on the payment date.

If a bond is sold and settled between the LDR and the interest payment date, the seller will receive the interest payment.  The buyer is then known to buy the instrument "ex interest" (without interest).  However, if a transaction takes place before the LDR, the buyer buys the instrument "cum interest" (including interest), because he will be registered as the owner before the register closes, and will receive the next interest payment.

4.2.2   Zero-rated coupons

Long-dated (securities with long terms to maturity) zero-rated coupons are capital market instruments issued by borrowers of money.  These instruments do not earn interest on the capital amount invested by the lender, and are therefore issued and traded at a discount on the nominal value, similar to discount instruments in the money market such as BAs and treasury bills.

The market value (nominal value less discount) of zero (or nil)-rated coupon bonds depends on the yield that the investor (lender) expects on his investment.  The redemption amount, which is the only cash inflow for the investor, is equal to the nominal value of the bond, and is thus known to the investor.  Since the redemption date is also known, the investor can calculate the amount that he is willing to pay for the bond according to the yield (expressed in terms of interest rate) that he wants to earn on the investment.  This yield on zero-rated coupon bonds is normally linked to the market rate on long-term (capital market) investments.

4.2.3   Asset-backed bonds

Where an asset exists which represents cash inflow stream such as a normal loan or investment, a bond can be issued to fund this asset.  The bond income is then derived or backed by the income stream of the asset.  The performance on the bond is then dependent on the asset performance.

4.3   Regulation of the market

The market was unregulated in terms of trading up to the 1980s.  Trading took place on an OTC basis and the settlement system, which is still used in some cases, where physical settlements take place on the second Thursday after the transaction.  With the new bond exchange, settlement will come in line with international standards, with settlement taking place three days after the transaction by electronic means.

In 1989 the Financial Markets Control Act was promulgated which regulated the initiation and existence of financial markets.  The Bond Market Association was formed to establish an exchange and from this the Bond Exchange of South Africa (BESA) was established as a formal financial exchange licensed under the act on 15 May 1996.  BESA is responsible for the listing/delisting of instruments, its members and the surveillance of trading activities.

Members of BESA include resident banking groups, large issuers, stockbrokers and a number of major resident financial institutions and intermediaries meeting specific requirements.  BESA members are allowed to act as agent and principal (dual trading capacity), or as principal only.  A Guaranty Fund has been established in order to protect the investing public against the consequences of the insolvency of members.

4.4   Issues of new securities

The major issuers of bonds in South Africa at present are the Republic of South Africa ("RSA") through the Treasury and semi-governmental bodies such as Eskom, Development Bank of Southern Africa, Telkom, Transnet and Land Bank.   Government bonds are commonly referred to as "gilts".   Intermediaries such as brokers and banks (especially merchant banks) are often used by borrowers to administer the issuing of new bonds.

Bonds can be issued in the primary market using several different methods.  As with equities, bonds can be issued by way of public subscription where a prospectus is issued which contains details of the company issuing the bond, and of the bond itself.  The public can then subscribe to the bond, and the borrower or an intermediary on behalf of the borrower will allocate bonds to subscribers on issue date by means of a certain process.

Bonds can also be issued through private placing.  This method is used when the borrower (or an intermediary on behalf of the borrower) places bonds with certain investors selected by the borrower.  The selected investor would then receive a certain amount of bonds at issue date and pay the borrower the issue price for the bonds received.

A third method used to issue bonds is known as the "tender" method.  The borrower or intermediary will issue a media statement that bonds will be issued in the market on a certain date.  The details of the bonds and the capitalisation of the issue (total nominal amount to be issued) will also be communicated.  Interested parties are then invited to tender before a certain date for these bonds.  Tenders from interested parties would normally consist of the nominal amount plus the percentage of the nominal amount that the interested party is willing to pay for the bonds at issue, for example, a tender for R5 million worth of bonds at 97% of the nominal amount.  If this tender succeeds, the tendering party will take up R5 million worth of bonds at issue date and pay the borrower (R5 000 000 x 97%) = R4 850 000.  The borrower usually allots the bonds in order of highest tenders first, but it is in his power to decide who will receive bonds at issue date.

Another method that is used to issue new instruments is known as the "tap" method, whereby not all the bonds are allocated at the first issue (which can be done by any of the above three methods).  If, for instance, a borrower wants to issue R100 million worth of bonds he can choose to issue only R60 million at the first issue.  The borrower or intermediary then starts creating a secondary market for these instruments by buying and selling the issued instruments in the secondary market.   This process, where one party buys and sells the same instrument in the market, is known as market making.  The market maker thus has a bid (to buy) and an offer (to sell) in the market for the same instrument, trying to create an active and liquid market in this instrument.  The "tap" method is then used by the borrower or intermediary, whereby more instruments are sold in the market than that bought back.   By using this method, the amount of the loan is increased, often without the market realising it.  This method can also be used in inverse form to decrease the total outstanding loan.  The ultimate borrower in the capital market can use the tap method, because he is allowed to trade in his own securities.  This is however not possible in the equities market because a company is not allowed to buy its own shares according to the Companies Act.

4.5   Trading principles and systems

Capital market instruments or bonds are instruments that represent future cash flow streams.  In the case of an interest-paying bond, the cash flow will be made up of periodic interest payments and the nominal amount at redemption date.   In the case of nil or zero-rated coupon bonds, the cash flow is a single payment of the nominal or redemption amount at the redemption date.

As can be seen from the value determination in 4.6, the values of these instruments are determined by discounting the cash flows back to the current date at an applicable rate (the yield or market rate).  If the rate used to discount the cash flows back to a present value is high, the present value is low.  If the rate used to discount the cash flows is low, the current value is high.  This rate used for discounting the cash flows will be the yield that the investor would receive (known as the yield-to-maturity or YTM) on his original investment (the physical investment being the present value) if he keeps the bond up to maturity.

Bonds are thus traded in terms of yields-to-maturity expressed as interest rates.  The rate at which the bond traded for a specific day or period would be known as the market rate for that specific day or period.

South African bonds can be screen traded, or by open outcry, through a BESA member.  Screen trading takes place through intermediaries such as FCB or IMB.   Bids and offers received telephonically from players in the market are quoted on a screen.  This screen is available to traders in the market.  If a trader wants to trade on one of the bids or offers quoted, he phones the intermediary (FCB or IMB) who then lets the other party to the transaction know that the deal is closed and the detail thereof.  Both parties have to book the deal with BESA who matches the deal and sends a report of deals done to every member at the end of the day.  Trading hours on BESA are from Monday through to Friday from 07h00 to 17h00.  Bonds are exempt from marketable securities tax and stamp duty.

A dealer's note or a capital market transaction note is normally completed by the dealer, mostly on screen, who then hands it to the administrative section for confirmation, settlement and accounting purposes.  The dealer or capital market transaction note normally has at least the following information indicated (see appendix 6 for an example):

  • the name of the bond traded, e.g. E168
  • the nominal amount traded
  • the rate or yield at which traded (from which the settlement amount or value will be calculated)
  • the counter party
  • whether the transaction is a buy or a sell
  • the date and time of the transaction
  • the settlement date (which differs from the transaction date)
  • the dealer's name and signature.

Dealers do different kinds of transactions.  If a dealer acts only as an agent, transactions are done in such a manner that the dealer's company has no open position.  A back-to-back deal, for instance, is a transaction where the instrument involved is bought and sold, resulting in no open position for the trader.

Small participators in the market often do not have the funds to settle the transaction on the settlement date.  If such a trader in the market is of the opinion that rate will decrease, resulting in an increase in value of the security, he could do the following deal:

  • He could buy the instrument for settlement in three days time (for this example, assume that the first settlement date is 1 March).  If the rates have not moved down on 1 March, he will want to keep the instrument, but does not have the cash to settle the transaction.  He can then do a transaction with a large institution where he sells the instrument to them for settlement on 1 March, and buys the instrument back from them for settlement on 4 March.  This transaction, where an instrument is simultaneously bought and sold to the same party for different settlement dates, is called a carry transaction.  The trader's position for 1 March is a net nil position because he has bought and sold the instrument.  He must, however, settle on 4 March, or do a similar carry transaction for that date.  Since the implementation of the T+3 settlement period on the bond exchange (settlement within three working days of the transaction), these transactions have mainly been replaced by scrip lending (see below) or future swaps transactions.

An instrument can be sold short in the capital market (a bear sale).   If an instrument is sold on 1 April for settlement on 4 April, without the seller physically owning the instrument, it can be bought back before 4 April for settlement on 4 April.  Alternatively, the certificates needed to settle the transaction could be borrowed from a large institution owning some of these instruments and not trading in them.  Security will have to be given, and credit risk checks will be done on the borrower.  This is known as scrip lending.  Scrip lending typically costs the borrower between 2% and 3% per year of the value of the scrip for the period that the scrip is being borrowed.

Some institutions that have scrip on hand also offer physical/future swap transactions.  This means that the person or institution that is short of scrip because of a bear sale, can swap the physical scrip and a future to sell the same stock, with the institution that has the scrip on hand physically.  The difference between the buying price of the physical stock and the selling price of the future contract will be the profit that the facilitator would make.

4.6   Value determination of bonds

4.6.1   Zero-rated coupon bonds

A simple way of determining the trading value of these assets is by expressing the nominal value of the coupon as a percentage of the nominal value plus the yield that the investor wants to earn on his investment over the period, for example:

TV = NV/(1+i)^n                 (for clarity  x^n = x to the power of n)

TV     - trading value
NV     - nominal value
i         -  yield in terms of rate (for the transaction)
n        -  periods left to redemption date (To be expressed in the same time zones as yield rate periods)

Example:
If the investor wants to earn 12% interest on his investment and the remaining period to redemption is 2 years, then the amount that he would be willing to pay for a zero-rated coupon with a nominal value of R2 million would be:

TV = R2 000 000/(1+0.12)^2
TV = R1 590 000

4.6.2   Interest rate bonds

To calculate the consideration that the buyer of a bond would pay to the seller, all the cash flows belonging to the buyer should be discounted back to the settlement date, at the rate at which the transaction is done (YTM).  The "all-in-price" of a bond is this present value that expresses the consideration that the buyer of a bond would pay to a seller, and takes into account the next interest payment that the buyer would receive if the transaction was cum interest, or the next interest payment that the seller would receive if the transaction was ex interest.

The all-in price is calculated as:

AIP = V^(d1/d2) x [0,5c x (AV + e) + 100 x V^n]

Where

AIP     = the all-in price
d1       = number of days from settlement date to next interest date (to calculate the interest portion belonging to the buyer)
d2       = number of days from last interest date to next interest date
i           = the yield (interest rate expressed as a number) at which the transaction is done
V         = 1/(1 + i/200) is the present value of one payable in six months' time at the YTM
c          =  the coupon rate expressed as a number
n          =  the number of complete six month periods (if interest is paid every six months) from next interest date to redemption date
AV       = (1 - V^n) / (i/200)
e          = 1  if the transaction is cum interest and 0  if the transaction is ex interest.

The accrued interest is the interest portion of the next interest payment that is liable to the seller if the transaction is cum interest, and in the case of an ex interest transaction, the accrued interest is the portion liable to the buyer.

Accrued interest is calculated as follows:

If cum interest:
                     d2 - d1 x c
   Al    =        365

If ex interest:
                      d1 x c
    Al   =          365

Where
     Al   =  Accrued interest

The clean price of a bond is the discounted cash flows of a bond ignoring the consequences of ex and cum interest payments, and is mainly used for accounting purposes.  The clean price (CP) is calculated as follows:
CP  =  AIP - Al
Extensive example:  determination of trading value

The following stock relates to the transactions described below:

Stock: Eskom E168
Date of maturity: 1 June 2008
Nominal amount R1 million
Coupon - annual: 11,00%
Interest dates: June 1 and December 1

a)  The stock is sold on 28 June 1996 at a yield of 16%, settlement date 6 July 1996.

  • Calculate the value that the buyer will pay (all-in price).
    The determinants of this equation will be as follows:
    d1   =   148
    d2   =   183
    i      =    16
    V    =    0,925926
    c     =    11
    n     =     23
    AV   =   10,3711
    e      =    1
    AIP   =   R747 709
  • Calculate the clean price.
    Al   =   10 548
    CP  =   R737 161

b)  The stock is sold on 1 November 1996 at a yield of 15,5%,   settlement date 9 November 1996.

  • Calculate the consideration (all-in price).
    In this case the following determinants are relevant:
    d1   =   22
    d2   =   183
    i      =    15,5
    V    =     0,928074
    c     =     11
    n     =     23
    AV  =    10,58531
    e     =     0
    AIP  =    R755 025
  • Calculate the clean price.
    Al   =   -6 630
    CP =   R761 655

 

 

Courses and training in Financial Markets, Instruments, Investments and Derivatives are supplied by the Academy of Financial Markets.  They can be contacted on info@academyfm.co.za or via their web site.  New developments in the Financial Markets are incorporated in updates (see index) of this book and can be obtained from The Academy of Financial Markets.