UNIVERSITY OF BENIN

DEPARTMENT OF FINANCE
B.Sc. 200 LEVEL FINANCE CLASS
BFN 221: INTRODUCTION TO FINANCIAL MANAGEMENT 11

SECURITIES UTILISED IN RAISING FUNDS FROM THE CAPITAL MARKET

In any capital market there are several securities that are traded between long-term fund raisers
and investors acting through their stockbrokers and issuing houses. These securities act as sources
of funds for the firms that issue them when they are sold for the first time in the primary market.
These securities can be categorized into two major classes: Fixed Income Securities, and, Variable
Income Securities.

A. FIXED INCOME SECURITES: -

Fixed income securities are those investment instruments than earn the investor a fixed and almost
certain return throughout the period the securities are held by the investor. They possess the
following characteristics:
1. Characteristics of Fixed Income Securities:
(a) they offer a fixed and almost sure income to the investor irrespective of the
fortunes of the company that issued them;
(b) interest and fixed dividends must be paid as and when they are due otherwise
default might ensure which can lead to a foreclosure on the assets of the
company. In addition, fixed dividends, if not paid, might become cumulative
and accrue until fully paid;
(c) the longer the tenor of the fixed income security, the higher would be the
interest rate or fixed income due to the associated higher risk as Table 9.1
indicates;
(d) the fixed income or dividend on a preference stock, which is a percentage of the
nominal value of the stock, may or may not be cumulative;
(e) fixed income securities, which include Federal Government Eligible Development
 Stocks, Industrial Loans and Debentures, Bonds and Preference Shares, are usually
redeemable at maturity. But some preference stocks, bonds and debentures are non-
redeemable in which case they would attract higher interest rates and dividends rates than
redeemable fixed income securities;
(f) the higher the risk associated with a fixed income securities, the higher would
be the fixed income it attracts;
(g) the higher the level of inflation in the economy, the higher would be the income that a
fixed income security attracts as it is not inflation-proof.

Fixed income securities include Federal Government, State and Local Government Bonds,
Industrial Loans and Debentures of all types as well as Preference Shares.

fixed income securities can also be classified in terms of their tenors. Hence, there are Long-

Dated, Medium-Dated and Short-Dated fixed income securities. The long-dated securities

typically have over fifteen years to maturity. They are more risky as a result and therefore attract

higher interest income and yield.

The medium-dated fixed income security typically has a tenor of nine to fourteen years. Its

price is more influence by the short-term changes in interest rates than the long-dated securities.

However it is less risky than the long-dated securities and therefore attracts a lower yield.

Short-dated fixed income securities typically have a life of four to eight years. The influence of

inflation and price changes on their rates of return is rather slight hence they attract a lower rate of

return than all other fixed income securities. Their lower risk makes these types of fixed income

securities attractive to insurance companies, pension funds and commercial banks as investment

outlets.

The return and yield differentials between various types of fixed income securities essentially

arises as a result of the different types of risk that each security bears. These include
Marketability/liquidity Risk of the holder’s inability to dispose of the security when he wants to

and at an attractive price; inflation risk on the value of the fixed income and terminal value of the

security when it matures; default risk of the Issuer of the security in terms of his inability to honor

his interest and principal obligations as and when they are due for payment; interest rate risk arising

from changes in general interest rates in the economy during the tenor of the fixed income security

which could be disadvantageous to the holder if it is an increase or to the issuer if it is a decrease;

and exchange rate risk which arises from changes in the parity value of the local currency in

relation to other international currencies. When exchange rate rises, this can push up production

costs, thus threatening cash flow and the ability of the issuer to honour its interest obligations.

Factors Determining Yields on Fixed Income Securities:-

Several factors determine returns/yields on fixed income securities. These includes

(i) The Level of Interest Rate in the Economy -

When interest rates all, the price of fixed income securities rises and the yield drops. When interest

rates rise, there is the fall in the price of these securities and this gives a boost to their yields. This

is because there is an inverse relationship between the yield and the price of a fixed income

security.

(ii) Borrowers’ Financial Position -

The financial position of other borrowers is lower than that of the Government in terms of absolute

safety of the debts and therefore, investors expect higher yields. The difference between the yield

on Government securities and corporate securities is called the ‘yield gap’.

Thus, Government Development Stock 2002 – Yield…………..12.50%

 Guinness Mortgage Debenture Stock 2002 – Yield…………17.50%

Yield Differential or Gap…………… 5.00%

(iii) Tenor of the Loan -

As the life expectancy/maturity of a loan increases so does the risk and investors expect a higher

yield to compensate for this risk. Investors thus buy longer term bonds when rates are very high

and prefer short-term bonds when interest rates are very low.

(iv) General Economic Outlook –

If there is an expectation of economic boom, low inflation rates and high interest rates in the

economy at large, investors will be attracted to variable income securities. This will depress the

prices of fixed income securities and raise their yields.

(v) Political Factors -

Frequent changes of government, instability, unrest, civil strifes, poor balance of payments and

trade results and other international crises likely to affect the local economy will tend to attract

investors to safer fixed income securities. This will influence their prices upwards and reduce their

yields, since instability leads to depressed business confidence in general.

3. Types of Fixed Income Securities :

Three types of fixed income securities can be identified:

(a) Government Bonds/Stocks-

These are government bonds issued periodically on a medium and long term basis to raise funds

for financing government development programmes. They are regarded as the safest and most

secure because it is assumed that government never defaults on its obligations. Hence, they are
also called Gilt-Edged securities or Gilts. Their safety and low risk results in the low returns and

yields which they offer investors. Interest is usually paid twice a year.

DEBENTURES

These are loan stocks issued by private and public limited liability companies to finance their

modernization and expansion programmes. These bonds are also called industrial loans or

debentures. Since they are issued by companied who are subject to the vagaries of the business

world, they tend to be riskier than government bonds they therefore attract higher yields.

Bonds and debentures are basically long term financial instruments which are secured by

some properties or assets and their values remain fixed irrespective of the fortunes or misfortunes

of the firms that have issued them. They are often backed with the tangible assets of the issuers.

Instruments/Securities utilised in Raising funds from the Capital Market

This is also called financial product. It can be categorized into two broad groups namely,
variables income and fixed income.
We can also categorize them in terms of tenor, short and long term. One of the characteristic
of instrument traded in the market is that they are long term in nature.
Variable income securities are those ones whose income are variables and changes based
on the fortunes and misfortunes of the companies that issued them. The income is variable based
on the performance of the company because they are variable, there is a large dose of volatility
attached to it. The volatility generates risk because of the high risk they attract. They therefore
have high returns to compensate for the risk. Variable income securities are ordinary shares, rights,
bonus, script or capitalisation issues. In investing in variable income securities you must look at
the fundamentals using the EIC framework (Economic Industry and Company fundamentals).
 Fixed income securities are instrument whose income are fixed or specific of the fortune
or misfortune of the issuing company. It is usually a contract between the issuer and the buyer.
Whether the company like it or not it is liable to pay the accrued interest on the security also on
the principal at maturity if that is the agreement, there is no volatility, the income is sure and if the
issuer or company does not pay, it runs the risk of foreclosure of its assets or liquidation in order
to pay the interest on them. Because the income is fixed, the risk is low and the return is also lower
in relation to variable income securities. Fixed income securities tend to be less attractive
compared to variable income securities because of their low returns. However, the most popular
among fixed income securities are bonds and debentures. You have long or medium tenor. The
higher the tenor, the higher the effect of interest rate on the returns they own and therefore, the
higher the risk. The reverse is true for short term and medium tenure securities since they attract
less returns and less likely to be affected by exchange rate and inflation.

Further readings on Fixed Income Securities

1. Preference shares
2. Government bond
3. Debenture
Preference Shares: For preference shares returns are fixed and must be paid in a particular year
except if the interest is a cumulative one.
Government Bond: These are issued by the government and backed by the government. In
Nigeria the debt management office is the agency of government responsible for issuing
government bonds. Peradventure, government is unable to pay, government will issue new bonds
to pay or retire old bonds. The assumption is that the government can never go broke. For instance,
government can raise taxes to raise funds to pay up bonds, this is one of the reasons why federal
and state governments are floating bonds all around in Nigeria. These have helped to deepen the
market, the reasons why the USA is the largest capital market and the most vibrant capital market
in the world is because it runs on debts. By debts we refer to both bonds and debentures such bonds
are referred to as government gilt edged bonds and golden because they have less risk. They also
have returns that are fixed. That’s why they earn lesser returns in capital markets.
Some of these bonds are issued by municipal authorities and they are issued by a city states
e.g. the FCT in Nigeria being a city state can also raise money through municipal bonds, depending
on the credit rating of the municipal authority. Municipal bond can be referred to as “golden and
gilt edge”.
For any of the levels of government to come to the capital market to raise funds, there must
be a mandate to that effect otherwise, it will be illegal. For Nigeria, the government will have the
backing of the National Assembly giving them the mandate to raise funds through bonds. For the
state governments, they must have the approval of the state legislature. Debt instrument issued by
companies are called debentures. They are all bonds. The Americans call them bonds and only
separate them by attaching the word treasury to government bonds. Corporate debentures are risky
compared to government bonds, reason being that they are driven by market fundamentals. Since
they are risky, they attract higher returns compared to government bonds. To be floated, debentures
must have the mandate of the board of directors and shareholders of the company and their
memorandum or articles of association must also permit them to raise such funds. There are various
types of debentures and they vary in level of risk and security attached to them. We have the
following types of debentures:
 Mortgage Debentures: This is the most powerful safest and less risky of all corporate
debentures because, it has been backed by some physical assets of the issuer and if the
issuer is unable to pay, those assets will be liquidated and after the expenses paid
concerning liquidation the rest goes to the investors in such bonds.
 Secured Debenture: This is one secured by an identifiable asset called floating assets or the
general asset of the firm. A secured debenture is a junior debenture to a mortgage
debenture.
 Subordinated Debenture: Is a junior debenture to mortgage debentures and secured
debentures. Until those other two debentures has been paid only then can the holder of the
subordinated debenture get paid.
In the event of a bankruptcy, subordinated debenture usually has a lower priority of claims
in the firm’s assets.
 Naked Debentures: This type is naked with no asset pledged as collateral, it is the least
attractive because it has a higher risk. However, it attracts higher returns. The financial
position in accounting records shows that the debentures are arranged in descending order
of priority claims.
 Redeemable Debenture: Are paid before maturity at the instance of the issuer. If the issuer
is to recall the debenture before maturity, he must pay a premium for such inconvenience.
And in the IPO documents, it must be stated that it is a redeemable debenture.
 Retractable Debenture: Is the opposite of redeemable debenture and is redeemable only at
the instance of the debenture holder, and if the holder must retract, it is usually at a discount.
 Perpetual Debenture: The Americans refer to it as perpetual bonds this is a debenture that
is not redeemable or retractable. There is no time period, it is forever, and as such very
risky. The returns are also very high. Who are the categories of people interested in it?
They are; pension fund administrators and mutual funds administrators.
 Zero Coupon Debenture This is a debenture whose interest rate is zero. Investors invest in
these type of debenture because of the capital gains since they are usually sold at a discount
which is why they are also called “Deep Discount Bonds”. Investors buy it at a discount
and at maturity they get the nominal value. Most high net worth individuals and institutions
who don’t want to pay huge taxes invest in this type of bonds since they have low tax
attached to them.