Capital market
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This article is written by Deepanshu, pursuing a Certificate Course in Capital Markets, Securities Laws, Insider Trading and SEBI Litigation from Lawsikho.com.

Introduction

In India, both the stock and debt market play a significant role. They provide a good opportunity for the investors to invest their idle money and gain from the same. These markets are sub-parts of the capital market which includes all the forms of securities issued by any company. Therefore, it becomes important to have a good understanding of what exactly these markets mean to us. This article discusses in brief about what is capital market, stock market, bonds market and their types and role in the economy.

What are capital markets

Capital market, though not defined in any statute, means any marketplace where financial securities can be bought and sold. In addition to stock (i.e. shares), it also includes trading in bonds, derivatives and commodities. It is indeed wider than the securities market and includes all forms of lending and borrowing, whether evidenced by the creation of a negotiable financial instrument. Stock market and bond market are subsets of the capital market. The stock market includes only a particular category of securities i.e. shares, whereas the bond market includes the debt securities, especially the bonds.

As SEBI is the regulator of capital markets in India, all the acts/rules/regulations etc. made by it govern the overall working of the capital markets in India. Some examples of the same are Securities and Exchange Board of India Act, 1992, Securities and Exchange Board of India (Intermediaries) Regulations, 2008, Securities and Exchange Board of India (Merchant Bankers) Regulations, 1992, SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009, Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations 2015, etc. 

Types of capital market

As per the SEBI FAQs dated 25 May 2011, there are 2 segments in which the capital market can be divided. These are called primary markets and secondary markets. 

Primary market – It is the market in which funds are raised by the companies through issue of new securities. These funds could be required either for a new project or for further expansion and diversification. It is through the primary market that funds flow for productive purposes from investors to entrepreneurs. Therefore, the primary market plays a very important role in an economy. It is because of the primary market that a secondary market also exists.

There are various ways in which securities are issued in the primary market. These are as follows:

  • Public Issue – It is the issue of securities (equity or debt) by listed companies to the general public and is governed as per section 23 of the Companies Act 2013 along with the SEBI Issue of Capital and Disclosure Requirements (ICDR) Regulations, 2018. A listed company (as per section 2(52) of the Companies Act 2013) is one which has any of its securities listed on any recognized stock exchange. A public offer is of 2 types:
  1. Initial Public Offer (“IPO”) – It is the issue of securities by any company for the first time to the general public. It is the process through which an unlisted company (which is not listed on any stock exchange) can be listed on a stock exchange by offering its securities to the public in the primary market. An IPO is a significant stage in the growth of many businesses, as it provides them with access to the public capital market and also increases their credibility and exposure. Mindspace Business Parks REIT is the most recent IPO in the market as of now (with the listing date of 07-08-2020).
  2. Further Public Offer (“FPO”) – It is the issue of fresh securities to the general public and it follows the IPO. It is issued when the company is in need of additional funds and thus diversifies the company’s equity base. One of the most recent FPO in the market is the YES Bank FPO.
  • Rights issue – It is the fresh issue of securities to the existing shareholders of the company in proportion to the shares already held by them (pro-rata basis). This issue is given as a matter of right to the existing shareholders. This right is known as the pre-emptive right. The shareholders may accept the additional shares or may deny or accept is partially or fully. It is governed by section 62 of the Companies Act 2013 along with the SEBI ICDR Regulations 2018. Rights issue is the most secure fundraising method and acts as a favorable gateway to raise capital wherein the company can expand its business without any simultaneous increase in debt. Also, it is the fastest and cheapest source for the firm to raise additional capital.
  • Bonus issue – It is the fresh issue of securities to the existing shareholders of the company in proportion to the shares already held by them (pro-rata basis) made without any consideration from them. It is given out of the company’s free reserves or the share premium account. Companies which are short of cash may issue bonus shares rather than cash dividends as a method of providing income to shareholders. Because issuing bonus shares increases the issued share capital of the company, the company is perceived as being bigger than it really is, making it more attractive to investors. In addition, increasing the number of outstanding shares decrease the stock price, thus, making the stock more affordable for retail investors.
  • Private Placement – A private placement is the issuance of securities to a selected group of investors which should not be more than 200 (in a financial year). It is governed by section 42 of the Companies Act 2013. It is of 2 types:
  1. Preferential allotment – In preferential allotment, securities are allotted to an identified set of investors who may be related to the company (like employees) or any outsider. The main reason behind preferential allotment of shares is to facilitate shareholders who are unable to buy large chunks of shares from the market as it is too costly or unfeasible for them. But these shareholders do not get any voting rights and they are paid only when the company earns profit.
  2. Qualified institutional placement – In this type of private placement, there are the qualified institutional buyers (QIB’s) to whom securities are issued. They are huge investors such as mutual fund companies and insurance companies. The only difference between preferential allotment & qualified institutional placement is that in former, securities are issued to anyone irrespective of being an existing shareholder or not. Whereas in latter, securities are issued specifically to the QIB’s.

Secondary market – It is the market where the securities, after being issued to the public in the primary market, are traded (bought or sold) by the investors. This is done majorly by the stock exchanges which provide a platform for the purchase and sale of the securities by the investors. The secondary market is further divided into two categories – 

  1. Spot market – In this market, securities are traded for immediate delivery and payment and therefore transaction is settled instantly. This market is also known as the cash market.
  2. Future market – In this market, securities are traded (in advance) for future delivery and payment. In futures, parties agree before the actual date of performance to buy and sell the securities (also known as underlying assets) at a predetermined price and quantity. This helps in reducing the risk which may arise due to price-fluctuations in the future. If the price fluctuates till the time of the actual performance, it is certain that one party would make profit and the other would suffer some loss. 

For example, Mr. X, a farmer agrees to sell his crop to Mr. A at a specified future date at a price of Rs. 20/kg. Now suppose when that date comes, the market price of his crop falls to Rs.10/kg. Therefore in such a situation, Mr. X (the farmer) would save himself from the loss arising out of future price fluctuation. At the same time, Mr. A would suffer a loss because of the fact that had he not entered into the contract with Mr. X, he could have enjoyed the benefit of low market rates prevailing. On the other hand, if the price of the crop increases, the farmer would suffer a loss and Mr. A would enjoy profits as he would be able to purchase the crop at some price lesser than the prevailing market price.

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Role and importance of the capital market

The main roles of capital market are as follows:

  • Mobilization of savings: Capital market provides a good opportunity for the people having idle savings to invest that for future gains. By investing in the capital market, savings get channelized for more production which further leads to more productivity thus ensuring the development of the economy.
  • Capital formation: Different industries like agricultural, iron industry, etc. require more and more capital over time to expand its operation. This led to demand for more capital and thus results in the capital formation.
  • Speed up economic growth and development: Capital formation helps the industries to attain more output and productivity which indeed helps in more growth and expansion. This creates way for more employment opportunities and speeds up the overall economic growth.
  • New Investment Avenue: Capital markets usually demand for long time investments by the public therefore creating a new investment avenue for them. Instruments such as bonds, equities, units of mutual funds, insurance policies, etc. provide options for investors to invest and earn more.
  • Continuous availability of funds: Capital market usually works through stock exchanges like NSE and BSE. One can trade (buy and sell) securities on these exchanges whenever he/she wants to invest money into the capital market.
  • Service provision: Capital market provides various types of services & this includes long term and medium term loans to industry, underwriting services, consultancy services, export finance, etc. These services help the manufacturing sector in a large spectrum.
  • Barometer:  Capital market is considered as the barometer of the economy as it tells about the economic condition of the country and enables the government to take suitable actions.

What are bonds

Bonds are a kind of debt security in which the issuer is bound to pay a specified rate of interest as agreed upon the terms of payment and repay principal amount at a later time. The bond holder is a kind of creditor to the issuer and therefore, the issuer needs to pay the amount (i.e. face value) back after a specified time (i.e. maturity period). Bonds have a maturity period which can range between some days to many years. Based on this, bonds are classified into long term and short term bonds. Till the time period of maturity, the bond holders receive a regular payment of interest, semi-annually or annually, which is calculated as a certain percentage of the face value and known as a ‘coupon payment.’

There is no statue which specifically defines bonds. However, as per regulation 2(e) of the SEBI (Issue and Listing of Debt Securities) Regulations, 2008, bonds are covered under the exhaustive list of debt securities. These regulations also govern the issue and listing of debt securities (i.e. bonds).

Types of bonds

  • Generally, bonds are classified into 4 types –
  • Government bonds – These are the bonds issued by the Government of India (“GOI”) or Public sector undertakings (“PSU’s”). Generally, these bonds are secured and have a low rate of interest.
  • Corporate bonds – These kinds of bonds are issued by the corporate bodies in India and generally have a higher rate of interest. These can be secured or unsecured however care should be taken before investing here about the credit ratings given by the credit rating agencies to these types of bonds.
  • Banks and other financial institutions bonds – These types of bonds are issued by the banks or any financial institution. Since the financial market is well regulated, the majority of the bond markets are from this segment.
  • Tax saving bonds – These kinds of bonds are issued by the GOI for the benefit of investors in saving their taxes. The investors, along with getting regular interest payment also get tax benefits, thus enjoying a dual advantage as compared to the other types of bonds. 
  • On the basis of interest rates, bonds are classified into the following 3 categories:
  • Fixed interest bonds – As the name suggests, these are the bonds which carry a fixed rate of interest.
  • Floating rate bonds – Unlike the fixed interest bonds, these are the bonds which have a variable rate of interest. The rate of interest is linked to a benchmark and is reset at regular intervals. The interest rate risk is quite low as floating rate bonds pay a higher interest when prevailing rates rise. Since there is no certainty of future income while investing in these kinds of bonds, the best time to invest in these bonds is when rates are low and are expected to rise in the upcoming future. This was evident recently when the GOI announced the issue of floating rate bonds. The rate of interest would be reset every six months and at 0.35% more than the prevailing rate on National Savings Certificates (NSCs).
  • Zero-coupon bonds – It is a kind of debt instrument in which there is no interest payment. These are offered at deep discounts and therefore are also known as deep discount bonds. However, they are redeemable at the face value itself. Thus, the difference amount between the discounted value and the face value indicates the investor’s return.
  • On the basis of convertibility, bonds are classified into these 2 types:
  • Convertible bonds – These types of bonds can be converted into company stocks as and when required by the bondholder.
  • Nonconvertible bonds – These bonds cannot be convertible into stocks.

What is a stock market and its types

Stock market (or share market) means a public market that exists for issuing, buying, and selling stocks that trade on a stock exchange or over-the-counter. Stocks, also known as equities (or equity shares), represent fractional ownership in a company, and the stock market is a place where investors can trade (buy and sell) ownership of such investible assets. An efficiently functioning stock market is considered critical to economic development, as it gives companies the facility to quickly access capital from the public at large. Stocks are generally classified into 3 types based on their market capitalization:

  • Large cap stocks – These are the stock of the big blue chip companies with large reserves of cash at their disposal. It is important to highlight that large cap companies do not mean that they grow rapidly. But it is the small stock companies that tend to outperform them over a longer time period. Generally, the large cap stocks give various benefits to the investors like higher dividends as compared to the smaller and mid cap companies stocks, thus ensuring that the capital is preserved over the long term period.
  • Mid cap stocks – These are the stocks of medium sized companies that have a market capitalization of INR 250 Crore to about INR 4000 crore. The companies have a good potential to grow thus ensuring an increasing dividend to the investors over a long time period.
  • Small cap stocks – These Company’s stocks have market capitalization of less than 250 crore. Investors who are willing to commit to a long term and are not very particular about the current dividends, and are willing to stand their ground during price volatility, can make significant gains in the future.

How are debt instruments different from equity instruments

Through the equity instruments (or equity investment), an investor can become a part owner of a company. Equity is a way to raise additional capital by the way of ownership dilution, for the company. The investors investing in the equity receive the profits of the company in the form of dividend and also get the voting rights. On the other hand, debt instruments are a kind of loan for the company and include debenture, bonds, G-sec, etc. The instrument holder (i.e. the person to whom the debt is due) receives a fixed amount of interest periodically. The debt amount is paid back on the maturity period. Therefore, debt instruments have low risk as the return is fixed and assured, whereas equity instruments have more risk as they are volatile in nature. The return (i.e. dividend) depends on the profits earned by the company and so the return is not fixed in equity. With this backdrop in mind, the main differences between the stock and bond markets are as follows:

Basis

Stock Market

Bond Market

Meaning

It is the market for trading of equity securities

It is the market for trading bonds (debt securities) 

Type of investment

Equity

Debt

Prediction

Focuses more on future price of shares hence, more prediction is involved

Focuses on current interest rates hence, less prediction involved

Issuer

Corporates

Government institutions, financial institutions, companies, etc.

Status

Stockholders are owners of the firm

Bond holders are lender to the firms

Form of Return

Dividend (not guaranteed, depended on profit made by the firm)

Interest (generally fixed)

Risk

High risk

Low risk

Time of maturity

Depends on investors

Fixed at the time of purchase

Why are these markets important

The stock and bond market play a very important role in the economy. It is by the way of these markets and its instruments that the companies can raise funds for their successful operations. When investors invest in stocks and bonds issued by corporations, the firms can put the capital at risk to increase production and create new innovations for consumers. These activities add to the country’s overall capital formation and economic growth along with ensuring the capital appreciation for the investors and payment of interest.

Is the capital market and stock market the same

Capital market, as has been discussed earlier, is a wider market and includes the stock market, debt market, as well as other forms of lending and borrowings  Stock market is a market where the investors trade (buy and sell) equity securities (i.e. shares) of the companies. 

Are bonds affected by the stock market

As a thumb rule, the price of bonds and stocks are inversely proportional to each other. This means that if the price of stocks increases then the price of bonds declines and vice-versa. This happens due to limited resources available in the market. When the economy is booming, consumers make more purchases. This leads to higher aggregate demand and more profits for corporates. In such a situation, investors feel confident about good returns in the stock market and therefore invest their money in stocks, knowing the fact that the stock market is subjected to more risk as compared to the bonds market. 

On the other hand, if the economy is in a slowdown, consumers spend less due to less money in their hand. This leads to a fall in the aggregate demand which results in corporates earning a lower profit. In such a situation, investors often lose their confidence in the stock market and tend towards the bonds as they want a fixed return along with the safety of their principal amount. This is the state when the price of the bonds rise and that of stocks fall.

However, this is not the absolute case. There are times when both the stocks and the bonds market rise together. This happens when there is too much money, or liquidity in the market. Also, there are times when both these markets together suffer from a downfall. COVID-19 pandemic is a good example of the same. The effect of this pandemic on these markets is also discussed below.

What happens to bonds if the stock market crashes

A stock market crash means that investors have lost confidence in the market. This would result in an increase in the price of bonds as investors would want to invest in a safe place with assured returns. High demand for bonds means people will buy even at lower interest rates. This continues till the market recovers itself.

Where to invest – stocks or bonds?

This depends on the age, goals and risk appetite of the investors as well as the prevailing market conditions. If the investor wants safety of the principal amount along with enjoying regular interest and is not much concerned about the inflation, investing in bonds rather than stocks would be more befitting for him. This is more suitable for people in the old age group and for those who are retired from their job. Generally, people of this age have a low risk appetite and want to secure their post-retirement life with a fixed amount of income received periodically. 

On the other hand, for people having younger age and good job, they should invest more in equity as it can give them stellar returns which bonds cannot. People between the age group of 25-40 have a good earning potential and bigger risk appetite. Therefore, investing in equity can increase their chance of earning a good amount of profits received as dividend.

Ideally, an investor’s portfolio should contain a mixture of both the equity and debt securities. For people in younger age, their portfolio should have more equity than debt securities, whereas for older ones, it should have more debt than equity. One more advantage of having a mixed portfolio is that the investor can never suffer from a total loss. As discussed above, the price of stocks and bonds are inversely proportional to each other. This means that when the price of stocks go down, that of bonds increase. This means that even when the stock market crashes, having some investment made in bonds could help an investor to safeguard against a total loss.

Impact of COVID-19 on stocks and bonds market

The stock market has a history of steep ups and downs, crashes and recoveries. Drops in the price of shares are temporary, and each drop provides investors with the chance to enter the market and earn a higher return especially for those with a long term horizon. Also, the higher the fluctuations, the higher chances of getting better returns. While these crises are for real and affect the world economy, historically, such crises have not lasted long, as the world is competent enough to find solutions against these challenges. Regardless the fact that it’s difficult to forecast the magnitude and impact of COVID-19 on the economy, but it is definite that the markets will bounce back soon the crisis gets over.

Same is the case with the bond market. Bond sales have fallen down as companies and investment bankers freeze activity due to the Covid-19 pandemic. Companies are saving as much as they can thereby, reducing the requirement for capital expenditure. It is inevitable that in such a volatile market, companies would face liquidity stress and have limited access to credit. This would consequently increase the probability of companies defaulting on their debt financing. Therefore, the bond market is also under great distress but expected to normalize itself once the pandemic gets over.

Conclusion

In today’s era, rapid growth and development is taking place in the economy and thus, the inflation rate is going higher. To confront this challenging environment, it is important for the people to shift towards a secondary source of income. This is where the capital market plays a significant role as it gives a platform to trade securities and earn from the same. It is advisable to maintain a portfolio containing a mixture of both debt and equity as it helps in avoiding losses in the securities market which is full of risk. 


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