The capital market is a global financial marketplace for trading long-term securities—bonds with a maturity of at least a year, and shares. It is where governments and businesses can raise funds and investors make money.

The structure

The capital market encompasses the debt capital market, where bonds are sold, and the stock exchange, where shares are sold. Both have a primary and a secondary market.

Capital market

Primary market

The market issues new bonds and shares, with investment banks overseeing the trading. It is also known as the new issue market (NIM).

GOVERNMENTS SELL BONDS

COMPANIES SELL BONDS AND SHARES

BONDS SHARES
Sold on debt capital market (bond market)

SHARES
Sold on debt capital market (bond market)
Sold on stock
exchange (equity capital marke

INVESTORS

Secondary market

Investors buy bonds and shares from other investors, not from issuing companies. The cash proceeds go to an investor, not to the underlying company or entity

BONDS

SHARES

Individual investors buy and sell
shares and bonds previously issued on the primary market

WHAT IS A BOND?

A bond is a debt security that a company issues to investors. By buying bonds, an investor is effectively loaning money to the issuers, who in return agree to pay interest to the investor. A bond has a set term of maturity (a limited number of years of validity) and until that
time the interest is paid to the investor annually. When the bond matures, the issuer repays the original sum of the loan to the investor. Companies or governments issue bonds to raise money that can then be put back into the business or used to fund government.

Bonds or shares: pros and cons

Bonds (debt investments)

• ✓Sellers are contractually obliged to pay interest✓Bonds are less risky: debt capital markets are less volatile than stock exchanges; if the issuing company has trouble, bondholders are paid before other expenses and before compensation to shareholders
  ✗ Buyers of bonds have no stake in the company
• ✗ Buyers cannot access principal sum until bonds mature

Shares (equity)

• ✓Buyers of shares gain a stake in the company
• ✓Sellers of shares have to pay dividends, although these can be reduced or suspended if the company feels it is necessary
• ✗ Shares are more risky: changes in company profits and in the economy as a whole can cause share prices to rise and fall; if the company fails, the shares become worthless

How do bonds work?

Bondholders effectively buy a slice of a larger loan with each bond, for which they receive interest, along with the original sum on maturity. Issuing, buying, and selling bonds takes place in the debt capital market. The marketplace has several functions: it offers bonds and other types of loans to investors; it operates as a fixedincome market, because the issuer is required to pay regular interest; and it enables companies and governments to raise long-term funds. Overall, the debt capital market is much larger than the stock exchange (equity capital market), where shares are bought and sold. It attracts investors because bonds provide more protection from risk than shares. There are various types of bonds, some safer than others—the risk lies in whether the issuer will be able to pay the interest and repay the principal sum on maturity. A secured bond is backed by an asset, such as property; an unsecured bond is not and so carries more risk. Both bonds and shares may be
referred to as securities. The term describes the share or bond itself, and the certificate of ownership or creditorship that gives the holder the right to receive a dividend, in the case of shares, or interest payments, in the case of bonds.

TYPES OF BONDS

Government bonds are the safest type of bond since governments in developed capitalist economies are unlikely to default on interest payments on the loan or on the principal sum.

Corporate bonds

Secured bonds are secured by the assets of a company, making them a less risky investment than shares. Examples include equipment, trust certificates, and mortgage bonds

Unsecured bonds are not backed by pledged collateral and are a riskier investment—if the company fails, investors are paid only after secured bonds have been paid out. Because they are more risky, investors expect a higher return (interest) on their investment.

Investing in the debt capital market

A company wants to raise $100 million to finance growth but does not wish to issue further shares. Instead, it raises the money by issuing bonds on the debt capital market.

Company issues bonds The company issues 1 million bonds at $100 each. Each bond effectively acts as a loan between the investor and the company.

Investors buy bonds Each bond has a set maturity date of 10 years and a 7 percent interest rate, with a face value of $100. During the 10 years, the company can use the money as capital.

Investors receive annual interest Each year, the company pays an investor $7
(7 percent of $100) for each bond bought, in return for using the principal sum as capital to fund its business. After 10 years, the investor has received a total of $70 interest per bond.

Mature bond is repaid Once the bond reaches its date of maturity, in this case 10 years, the original sum of money, $100, is repaid to the investor. So the investor receives a total of $170, including interest, over the full term, in return for the original $100 investment.

NEED TO KNOW

❯ Debt instrument Official term for bond or other long-term debt

❯ Convertible bond Bond that can be converted into shares of the issuing company, or cash

❯ Warrant Security that allows the holder to buy stock in a company at a fixed price for a certain period of time

❯ Callable bond Bond that gives the issuer the right to redeem it before maturity

❯ Non-callable bond Bond that cannot be redeemed or sold back to the issuer before maturity but continues to provide interest

$100 trillion
the estimated value of global debt markets