Shares are issued by corporate entities (local and foreign) (see Figure 2). Shares are listed on an exchange or unlisted. Foreign shares are generally called inward listed shares.
Figure 2: issuers of shares
There are two broad types of shares:
• Ordinary (also called common) shares (also called stocks). These shares impart to the holder the right to vote on issues that affect the company. However, the shareholder does not have a right to the profits until the board of directors declares a dividend. (See Box 2 for an example.)
• Preference (also called preferred) shares. These shares impart to the holder the prior right over ordinary shareholders to the distribution of dividends and capital in the event of the company winding up. These may be perpetual (i.e. do not have a redemption / maturity date) or may have a finite life (like non-perpetual bonds). (See Box 3 for an example.)
There are a number of types of preference shares:
• The "normal" or "common" preference share (= redeemable and pays a fixed dividend).
• Non-cumulative preference share.
• Participating preference share.
• Convertible preference share.
• Hybrids of the above.
Shares stand behind debt in the line-up for payment in the event of the liquidation of the company, and ordinary shares stand behind preference shares. This means that ordinary shares have a residual value, or residual claim, status. The pecking order (or waterfall) of risk may be portrayed as in Figure 3.
It should be apparent that holders of debt instruments are creditors of the issuing companies. They are not owners of the issuing companies, but they have a superior claim on the issuing companies' profits and assets in relation to the shareholders.
BOX 2: EXAMPLE OF ORDINARY SHARE CERTIFICATE
Figure 3: waterfall of claims on company in event of liquidation
BOX 3: EXAMPLE OF PREFERENCE SHARE CERTIFICATE
As a result of the processes of borrowing, lending and financial intermediation, there is a wide range of debt instruments (evidences of debt / debt claims) in the financial systems of the world. A debt instrument can be defined as a claim against a person or company or institution (such as a government entity) for the payment of a future sum of money (the nominal / face / redemption value) and/or a periodic payment of money. In many instances there is no periodic payment of money (as in the case of treasury bills), while in others there is (as in the case of most long-dated bonds, interest on which is payable six-monthly in arrears). Similarly, there may be no promise of a sum of money in the future but a periodic payment only, as in the case of an undated bond (perpetual bond).
The debt market is made up of:
• The short-term debt market (STDM - claims up to a year; but this is an arbitrary term), which (when the deposit market is added) is referred to as the money market. This is our definition of the money market; some scholars prefer to only include marketable STDM instruments in this definition. There are good reasons for the wide definition, the main one being that price discovery largely takes place in the non-marketable part of this STDM.
• Long-term debt market (LTDM - claims from one year onwards). The bond market is the marketable arm of the LTDM, and claims in this market range from a year to deep into the future, in some cases up to 30 years. This does not apply in the non-marketable LTDM.
The most common money market instrument requires the issuer to pay a single amount at maturity, while the most common bond instrument requires the issuer to pay periodic interest and to redeem the claim on the maturity (due) date.
One of the most important characteristics of financial claims is that of reversibility or marketability. This refers to the ease with which the holders of securities can recover their investments, and can be achieved in one of two ways, i.e. by recourse to the issuer or by recourse to a secondary market (in which the holder can sell the claim).
Figure 4: debt instruments (securities) (excluding deposits)
Figure 4 illustrates the financial system and the debt (and share) and securities issued by the ultimate lenders and QFIs. For the moment we exclude the banking / deposit part of the money market.
The household sector (as a borrower) is not able to issue marketable securities, for obvious reasons. They may issue IOUs to friends or family, but generally the debt they incur is loans from banks in various forms such as:
• Fixed term loans.
• Leasing contracts.
• Installment credit contracts.
The financial debt instrument (claim / asset) held by the bank is a contract, a mortgage bond, a negative balance on a bank statement, or some other evidence of debt. NMD in these forms make up a large proportion of banks' balance sheets. As we have seen, NMD may be split into short-term debt (= money market debt; e.g. overdrafts belong here), or long-term debt (= long-term debt market; e.g. mortgage advances and leasing contracts fit here).
The corporate sector issues NMD in the main because most companies are not large enough to be able to issue marketable debt (MD) (no investor will buy this debt). It is only the large listed companies that are able to issue MD (if the debt is highly rated by a rating agency). The NMD issued by companies is essentially the same as for the household sector, and the NMD of these two sectors makes up the vast majority of banks' balance sheets. The MD issued by the corporate sector is relatively small.
The MD issued by the corporate sector is:
• Corporate bonds. These are longer-term (i.e. longer than a year and usually 3-15 years) fixed-interest and variable-rate securities.
• Commercial paper (CP). These are undertakings to pay a certain sum of money on a particular date in the future. They are not endorsed by banks, and are short-term in currency (i.e. in term to maturity).
• Bankers' acceptances (BAs). BAs are bills of exchange drawn on and accepted (guaranteed) by a bank. They usually are drawn for periods of 91 days and 182 days. Countries have different conventions in this respect.
• Securitization bonds (as the SPVs are usually companies, the paper can be termed corporate bonds). An example is mortgage-backed securities (MBS).
• Collateralized debt obligations (CDOs, also called collateralized loan obligations - CLOs).
It will be evident that corporate bonds, securitization (SPV) bonds (CDOs, etc) are part of the bond market, whereas CP and BAs are part of the money market.
The government sector differs from country to country, but there are at least two levels: central government and local governments. Some countries have provincial governments. Central governments usually fund part of their budget deficits by the issue of MD (because this form of funding is cheaper):
• Government bonds, which range from a few years to up to 30 years, and make up the major part of bond market. See Box 4 for an example.
• Treasury bills (TBs), which range from 91 days to 273 days (in most countries).
As government bonds and TBs are the debt obligations of the central government, they are repayable out of the revenues and assets of the government of the country. As such they are regarded as risk-free securities and the rates on these are regarded as the risk-free rates13. TBs are one of the main instruments of the money market. See Box 5 for an example.
BOX 4: EXAMPLE OF CENTRAL GOVERNMENT BOND
Local authorities usually borrow in the form of NMD and mainly from banks. In some countries the larger local authorities are able to issue MD, which is called by many names such as local authority bonds (bond market) and bridging bonds (money market).
The foreign sector (where exchange controls allow this) issues into the local market:
• Foreign bonds (usually corporate entities) (bond market).
• Foreign CP (money market).
BOX 5: EXAMPLE OF TREASURY BILL