By Daniel Archibald | CFA
In order to raise funds, large businesses and governments can borrow from creditors, and in the case of business, can seek equity capital. The former fundraising process involves the debtor entering into a contract to provide investors with a rate of interest plus repayment of the debt in full. The latter process involves the business offering investors a percentage of any future distributed profits (and a share of any liquidated assets if the business stops operating). The obligations attached to debt are fixed up front and are legally binding. The obligations attached to equity will vary with business success or failure. Both of these financial instruments (debt and equity) are dependent on the business or government to remain solvent over the period of the agreement - which for debt might be a maturity of 1 year, 5 years, 10 years, etc; and for equity is effectively without maturity (i.e. an infinite period).
In order for investors to sell such financial instruments they need to undergo a process known as securitisation. This involves turning the loan or equity capital into a number of equal parcels, that can be recognised by other investors and which can be traded. In this way, loans are turned into bonds and equity is turned into shares. And these financial securities can now be traded on financial markets. Without this process, the likely providers of debt would be banks (i.e. bank loans) and the likely providers of equity would be closely related investors (e.g. family). But with securitisation, investors big and small can allocate capital to bonds and shares, with the comfort of being able to find buyer when the time comes to redeem.
Financial securities such as shares and bonds are familiar in today's world, as well as units in listed property trusts and exchange-traded funds. Another form of securitisation, which received plenty of attention during the market panic a decade ago, is asset-backed securities, in particular, residential-mortgage-backed securities (RMBS). This form of securitisation does not provide investors with debt or equity capital, but instead sells to investors part of a company's assets. Banks are major source of such securities, who use it as a way to manage mortgage exposures by essentially pooling together a portion of their loan book (which are assets for a bank) and package them in a way that meets investor needs. The end securities might be packaged into low risk/return, whilst some may be high risk/return. Other assets that are commonly securitised includes other types of loans (car loans, personal loans, etc) and accounts receivables. The main difference between capital securities (bonds and shares) and asset securities is that the former adds new debt or equity onto the balance sheet when issued, whereas the latter effectively removes assets from the balance sheet. The resulting cash can be used to retire existing debt or equity or to purchase new assets.
In all the above cases, it is simple to see to what investors are exposed. Bonds give investors exposure to the credit risk of the business/government (solvency). Shares give investors exposure to the earnings risk of the business (profits). Asset-backed securities give investors exposure to the earning-generating assets (underlying business/credit risks - primarily of banks). And In all cases, cash is injected into the business in exchange for access to investment returns. Another growing form of securitisation is that conducted by insurers. Insurance-linked securities (ILS) allow insurers to sell bond-like investments that provide exposure to their main drivers of earnings (i.e. mortality risk, catastrophic risk). These are similar to asset-back securities in that the insurer pools together policies, and packages them in a way that meets investor needs. The value of the policies is the present value of expected premium payments less the present value of expected claims, which is essentially the level of reserves an insurer is required to hold in holding the policies. An ILS will generally pay a rate of interest over its term, with repayment of principal contingent on overall claims within the policy pool. This could mean that ILS investors might lose some or all of their capital in the event of higher mortality or property loss due to a natural disaster or pandemic, etc.
The ability of business and governments to create financial securities, and for investors to hold and trade them, is a key reason for the efficient allocation of capital through global markets and industry. Transparent and speedy pricing of bonds, shares and other securities, provides investors with the right information they need in order to make sound investment decisions.