Financial Markets Operations Management (7 page)

Depending on the payment frequency, the first coupon is paid either six or twelve months after the bond was issued. For example, if a semi-annual bond was issued on 15 January 2014, the first coupon payment would fall due six months later on 15 July 2014 (thereafter on 15 January 2015, 15 July 2015, etc.).

The situation can be complicated when an issuer, typically a government, authorises a bond but only makes part of it (the first tranche) immediately available to investors. The balance of the issue (second tranche) can be made available at some future time. This type of bond is referred to as a
tap bond
or
tap issue
.

In
Table 2.20
we show the details of a fictitious bond issued in two tranches.

We can see here that whilst the first tranche has the full semi-annual number of days (i.e. 181 days from 15 January 2014 to 15 July 2014), the second tranche only has 92 days. With effect from 15 January 2015, both tranches will be consolidated into the single bond and the coupon payments will be made on the normal six-monthly cycle.

Taking the ABC example again (see
Table 2.21
), if the second tranche had been issued on 15 December 2014, the issuer might not wish to go to the trouble and expense of paying a first short coupon only one month later (on 15 January 2015). Instead, the issuer might delay the first coupon payment until 15 July 2015. This would result in the first coupon being paid more than six months after issue and we refer to this as a
first long coupon
.

Equity, also known as shares, is the third asset class that stands alongside cash (plus near-cash instruments) and debt instruments. Debt, as you will recall, represents the borrowing of cash; by contrast, corporate entities that issue equity are, in fact, selling a stake in the entity to investors in exchange for cash.

When a company is first established, it can raise finance by selling shares to external investors. There will be a limit to the total share capital that the company is authorised to issue, and therefore the number of shares that it can sell. The amount of share capital will be published in the company's Memorandum and Articles of Association, as the example below illustrates.

At the end of this share-issuing exercise, ABC Ltd would show the following position in its financial reporting:

• Authorised share capital GBP 10 million (40 million shares);
  
• Issued share capital GBP 5 million (20 million shares);
  
• Unissued share capital GBP 5 million (20 million shares).
  

We have used the term
par value
in this example. Par value represents the capital value of each share (as opposed to the market value). In the example above, ABC Ltd had decided that each
pound sterling of share capital would be represented by four shares, each with a par value of 25p. At some later stage, ABC could decide to make the shares more liquid by subdividing the shares into a lower par value, for example, 10p. Each one pound would be represented by 10 shares and the total number of shares authorised would be 100 million shares (GBP 10 million multiplied by 10 shares).

Whereas bond issuers have an obligation to pay interest and the principal amount of the loan as and when due, equity issuers have no such obligation. Bondholders know how much cash they will receive and when they will receive it. Shareholders, on the other hand, can only expect to benefit if the company distributes profits by way of a cash dividend. Shares do not have a maturity date, so, apart from the expectation of cash dividends, the only other predictable benefit is that shareholders have the right to vote at Annual General Meetings (AGMs) and Extraordinary General Meetings (EGMs).

Share prices do fluctuate for a variety of reasons and can be highly volatile at times. Shareholders can benefit, as the value of the shares they hold will increase if the market price is above the original purchase price. The shareholder could then sell the shares and make a profit. However, if the share price is below the original price and the shareholder decides to sell, then there will be a loss.

What is the maximum loss that a shareholder can suffer? As the share price cannot go below zero, the maximum loss will be the total investment that the shareholder made. What about the maximum profit? Depending on the individual circumstances for the company, the share price can increase without any upper limit.

See
Table 2.22
for a comparison of equity with debt from an investor's point of view.

You might wonder why any investor would wish to risk his money buying shares. A cursory glance at a typical institutional investor's portfolio could very well show that over 60% of the portfolio is invested in shares, with 30% in bonds and the remaining 10% in cash/near-cash instruments/alternative investments and, perhaps, derivative instruments.

From an operational point of view, we do not need to be concerned about why investments are made, only that they have been made and need to be processed. As a matter of interest, investors will invest in equities in the hope (but without any certainty) that the market value of their holdings increases and that companies pay cash dividends on a regular basis. We saw that there is no theoretical limit to how high the share price can go over time, and it is the anticipation of such a price increase over time that can motivate an investor.

As a comparison, investors in bonds are looking for a degree of certainty: certainty of income (coupon payments), certainty of timing and certainty of repayment. You could argue that the “cost” of this certainty is a relatively stable bond price and a known coupon rate. Remember that the price of a bond is linked primarily to the yields in the market. As yields go up, the price of the bond goes down and as yields go down, then the price of the bond will go up. You can appreciate that there are limits to how high or low yields can go.

There are two main classes of equity:

• Ordinary shares
  
• Preference shares.
  

When a company issues shares for the first time, we refer to this as an
Initial Public Offering
(IPO). The same company can subsequently issue more shares and we would refer to this as a secondary issue of shares (e.g. a
rights issue
). We will cover rights issues in Chapter 11: Corporate Actions.

A company becomes a public company through an IPO and shares are sold to investors in exchange for cash. Details of any proposed IPO must be disclosed in a prospectus document. The prospectus explains the company's performance to potential buyers, including an overview of its financial history and is generally approved by the local regulatory authority. The prospectus provides sufficient information to enable a prospective investor to make a judgement as to whether an investment should be made.

The company will not arrange an IPO on its own. It will employ the services of an investment bank, which will act as an underwriter and provide advice on the best method of issuing the IPO, assess the share price at which the shares will be offered and arrange for the shares to be sold. The company will also employ a law firm to obtain securities-related legal advice.

One method of issuing shares is through an
open offer
whereby, after a period of advertising the issue through the media and by meetings with potential institutional investors, investors are invited to apply for shares at a price that is not advertised until a few days before the issue is due to close. An interested investor will then apply for a quantity of shares and arrange for the appropriate amount of cash to be paid to the issuer's agent. If the preliminary public relations exercise has gone well and there is a high level of investor interest, then the price might be set at the higher end of the anticipated price range. Even so, the number of shares applied for might very well exceed the number of shares being offered, in which case the company needs to decide how it is going to allocate the shares.

On the other hand, if the market conditions are not right and/or there is little investor appetite to buy the shares, then fewer shares will be sold and the underwriters will be expected to buy the unallocated shares. This way, the issuing company is able to issue sufficient shares to get the amount of cash it was hoping for.

A recent example of an IPO was the British Government's GBP 1.7bn privatisation of the Royal Mail Group in October 2013. There was a great deal of interest in the issue and the shares were priced at 330p per share (at the higher end of expectations). The institutional tranche was twenty times over-subscribed, with allocations scaled back or no allocation made at all. The retail offer was seven times over-subscribed, with only those who had applied for
less than GBP 10,000 worth of shares being successful. On the first day of trading, the share price rose to 459p before closing at 431p per share.

The largest IPOs have occurred in China and the USA, with the largest half dozen shown in
Table 2.24
.