Fundamentals of Financial Instruments. Sunil K. Parameswaran

AND MORTGAGE-BACKED SECURITIES

      A mortgage is a loan that is backed by the collateral of specified real estate property. The borrower of funds, the mortgagor, is obliged to make periodic payments to the lender, the mortgagee, to retire the debt. In the event of the mortgagor defaulting, the lender can foreclose the mortgage, which means that the lender can take over the property to recover the balance due.

      A mortgage by itself is an illiquid asset for the party that makes the loan to the home buyer. Such lenders are called originators. To rotate their capital, lenders will typically pool mortgage loans and issue debt securities backed by the underlying pool. Such securities, the cash flows for which arise from the payments made by borrowers of the underlying loans, are referred to as mortgage-backed securities. The process of converting an illiquid asset such as a home loan into liquid marketable securities is referred to as securitization. The process of securitization, although it is common in the case of mortgage lending, is not restricted to such loans. In practice, receivables from automobile loans and credit card receivables are also securitized. The securities generated in the process are referred to as asset-backed securities.

HYBRID SECURITIES

      A hybrid security combines the features of more than one type of basic security. We will discuss two such assets, namely convertible bonds and warrants.

      A convertible bond is a debt security that permits the investor to convert the bond into shares of equity at a predetermined rate. Until and unless the investor converts the bond, it will continue to trade in the form of a standard debt security. The interest rate on such bonds will be lower than the rate on securities without the option to convert because the conversion feature will be perceived as a sweetener by potential investors. The rate of conversion from debt into equity will typically be set in such a way that the conversion price is higher than the market price prevailing at the time of issue of the debt. For instance, a bond with a principal value of $1,000 may be convertible to 25 shares of equity. In this case the conversion price is $40, and the share price prevailing at the time of issue of the convertible will be less than $40.

      A warrant is a right given to investors which allows them to subscribe to the equity shares of the company at a future date at a predetermined price. Such rights are usually offered along with debt securities to make the bonds more attractive to investors. Once issued, the warrants can be detached from the parent security, and can be traded in the secondary market.

PRIMARY MARKETS AND SECONDARY MARKETS

The function of a primary market is to facilitate the acquisition of new financial instruments by investors, both institutional and individual. Thus, when a company goes in for an issue of equity shares to the public it will be termed as a primary market transaction. Similarly, if the government were to raise funds by issuing Treasury bonds, it will once again be termed as a primary market transaction.

      Once a financial asset has been created and sold to an investor in the primary market, subsequent transactions in that instrument between two investors are said to take place in the secondary market. For instance, assume that GE went in for a public issue of five million shares out of which Frank Reitz was allotted 10,000 shares. This would obviously be termed as a primary market transaction. Now assume that, six months hence, Frank sells the shares to Mike Pierce on the New York Stock Exchange. This would obviously constitute a secondary market transaction. Thus, while primary markets are used by governments and business entities to raise medium- to long-term capital for making productive investments, secondary markets merely facilitate the transfer of ownership of an asset from one party to another.

      Primary markets by themselves are insufficient to ensure the functioning of the free market system. That is, secondary markets are a sine qua non for the efficient operation of the market economy. Why is this so? Consider an economy without a secondary market. In such an economy, an investor who subscribes to a debt issue would obviously have to hold on to it until its date of maturity. In the case of equity shares, the problem will be more serious, for such securities never mature. Consequently, acquirers of shares in a primary market transaction and future generations of their family would have no option but to hold the shares for ever. In practice, no investor will make an investment unless they are confident there exists an avenue for a subsequent sale if they were to decide they no longer required it.

      The ability to trade in a security after acquiring it in a primary market transaction is important for two reasons. First, one of the key reasons for investing in financial assets is that they can always be liquidated or converted into cash. In practice, such needs can never be perfectly predicted, and consequently investors would desire access to markets that facilitate the ready conversion of securities to cash and vice versa. Second, most investors do not hold their wealth in the form of a single asset but prefer to hold a basket or portfolio of securities. As the old adage says, “Don't keep all your eggs in one basket.” Thus, a prudent investor would seek to diversify wealth among various asset classes such as stocks, bonds, real estate, and precious metals such as gold. In practice this kind of diversification will usually be taken a step further in the sense that the entire wealth that an investor has earmarked to be held in stocks will not be invested in the shares of a single company like IBM. That is, a rational investor will diversify across industries, and within an industry they will choose to invest in multiple companies. The logic is that all the companies are unlikely to experience difficulties at the same time. For instance, if the workers at GM were to be on strike, it is not necessary that workers at Ford should also be on strike at the same point in time. Consequently, if one segment of the portfolio were to be experiencing difficulties, the odds are that another segment would be doing well and will hence tend to pull up the performance of the portfolio.

Secondary markets are critical from the standpoint of holding a diversified portfolio of assets. In real life, investors' propensity to take risk does not stay constant over their life cycle. We know that debt securities promise contractually guaranteed rates of return and are paid off on a priority basis in the event of liquidation. On the other hand, equity shareholders are residual claimants who are entitled to payments only if there were to be a surplus after taking care of the other creditors. Thus, the risk of a debt investment will be lower as compared to an equivalent equity investment. Young investors who are having steady and appreciating income usually have a greater capacity to take risk, and consequently tend to invest more in equity securities. Even from the standpoint of equity shares, young investors are less concerned about steady dividend payments and tend to focus more on the odds of getting significant capital gains in the medium to long term. Senior citizens, on the other hand, want predictable periodic income from their investments and have little appetite for risk. Such investors therefore tend to hold a greater fraction of their wealth in debt securities. If and when such investors acquire equity shares, they display a marked preference for high-dividend-paying and less risky stocks.

      Thus, as they grow older, investors periodically make perceptible changes in the composition of their portfolios. Young single investors who have recently secured employment may be willing to take more risks and would probably put a greater percentage of their wealth in equities. Later, as the family grows and investors approach middle age with children ready to go to college, they will probably distribute wealth more or less evenly between debt and equities. A similar redistribution of wealth across asset classes is observed when an investor approaches retirement. Elderly investors tend to have their wealth primarily in the form of debt securities. There is a saying in financial markets that an investor should allocate a percentage of his wealth to equity shares that is equal to 100 minus his age. That is, a person who is 30 years old should have 70% of their wealth in equities, whereas a person who is 70 years old should have 30% of their wealth in equities. Another way of stating this is that the percentage of wealth that is invested in debt securities should be equal to the investor's age.

      Hence, from the standpoints of providing liquidity and permitting portfolio rebalancing, it is important to have active secondary markets. The absence of such markets would severely affect individuals' willingness to save, and consequently lower the level of investment in the economy.

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