Capital Market – a financial market in which long-term debt and equity instruments are traded.

Capital market securities include bonds, stocks and mortgages. They are often held by
financial intermediaries such as insurance companies and pension funds, which have little
uncertainty about the amount of funds they will have available in the future.
Capital Market Participants
1. National Government – issues long-term notes and bonds to fund the national debt
Local governments – issue notes and bonds to finance capital projects.
2. Corporations – issue both bonds and stock to finance capital investment expenditures
and fund other investment opportunities.
Capital Market Trading
Primary market – where new issues of stocks and bonds are introduced. Investment
funds, corporations, and individual investors can all purchase securities offered in the
primary market.
Secondary market – where the sale of previously issued securities takes place, and it is
important because most investors plan to sell long-term bonds before they reach
maturity and eventually to sell their holding of stocks as well.
Two types of exchanges for capital securities:
1. Organized Exchanges
2. Over-the-counter Exchanges
Bonds – any long-term promissory note issued by the firm and are the most prevalent example
of the interest only loan with investors receiving exactly the same two sets of cash flows:
1. Periodic interest payments
2. Principal returned at maturity
Trading Process for Corporate Bonds
The initial or primary sale of corporate bond issues occurs either through a public
offering, using an investment bank serving as a security underwriter or through a private
placement to a small group of investors. Generally, when a firm issues bonds to the public,
many investment banks are interested in underwriting the bonds. The bonds can generally be
sold in a national market
Most often, corporate bonds are offered publicly through investment banking firms as
underwriters. Normally, investment bank facilitates this transaction using a firm commitment
underwriting.
Other arrangement can be as follows:
1. Competitive Sale – the investment bank can purchase the bonds through competitive
bidding against other investment banks or by directly negotiating with the issuer.
 2. Negotiated Sale – a single investment bank obtains the exclusive right to originate,
underwrite and distribute the new bonds through a one-on-one negotiation process.
3. Best Underwriting Basis – the underwriter does not guarantee a firm price to the issuer.
Advantages and Disadvantages of Using Bonds
Advantages
1. Long-term debt is generally less expensive than other forms of financing
2. Bondholders do not participate in extraordinary profits
3. Bondholders do not have voting rights
4. Flotation costs of bonds are generally lower than those of ordinary equity shares.
Disadvantages
1. Debt results in interest payments that can be force the firm into bankruptcy.
2. Debt produces fixed charges, increasing the firm’s financial leverage. Although this
may not be a disadvantage to all firms, it certainly is for some firms with unstable
earnings streams.
3. Debt must be repaid at maturity and thus at some point involves a major cash
outflow
4. The typically restrictive nature of indenture covenants may limit the firm’s future
financial flexibility.
Bond Features and Prices
Par Value – the face value of the bond that is returned to the bondholder at maturity
Coupon Interest Rate – the percentage of the par value of the bond that will be paid out
annually in the form of interest. (Stated interest payment / Par value)
Maturity – the length of time until the bond issuer returns the par value to the
bondholder and terminates the bond.
Indenture – the agreement between the firm issuing the bonds and the bond trustee
who represents the bondholders.
Current Yield – refers to the ratio of the annual interest payment to the bond’s market
price.
Yield to Maturity – It is the discount rate that equates the present value of the interest
and principal payments with the current market price of the bond.
[illustration/formula]
Credit Quality Risk – the chance that the bond issuer will not be able to make timely payments.
Bond ratings involve a judgement about the future risk potential of the bond provided by the
rating agencies.
These are favourably affected by:
 1. A low utilization of financial leverage
2. Profitable operations
3. A low variability of past earnings
4. Large firm size
5. Little use of subordinated debt
The poorer the bond rating, the higher the rate of return demanded in the capital markets.
[CREDIT RATINGS PG. 124 – 125]
High quality corporate bonds are considered investment grade.
High credit risk bonds are speculative, also called junk bonds and high yield bonds.
Types of Bonds
1. Unsecured Long-Term Bonds
Debentures – these are unsecured long-term debt and backed only by the
reputation and financial stability of corporation.
Subordinated Dentures – claims if bondholders of subordinated debentures are
honoured only after the claims of secured debt and unsubordinated debentures have
been satisfied
Income Bonds – requires interest payments only if earned and non-payment of
interest does not lead to bankruptcy.

2. Secured Long-Term Bonds

Mortgage Bonds – a bond secured by a lien on real property. Typically, the
market value of the real property is greater than that of the mortgage bond
issued.
Mortgage Bonds subclassified
(a) First Mortgage Bonds – have senior claim on the secured assets if the
same property has been pledged on more than one mortgage bond.
(b) Second Mortgage Bonds – have second claim on assets are paid only
after the claims of the first mortgage bonds have been satisfied.
(c) Blanket or General Mortgage Bonds – all the assets of the firm are
used as security for this type of bonds.
(d) Closed-end Mortgage Bonds – forbid the further use of the pledged
assets security for other bonds.
(e) Open-end Mortgage Bonds – these bonds allow the issuance of
additional mortgage bonds using the same secured assets as security.
(f) Limited Open-end Mortgage Bonds – these bonds allow the issuance
of additional bonds up to a limited amount at the same priority level
using the already mortgaged assets as security.