Connecting buyers and sellers with capital markets.
What is it?
A capital market can be likened to a Saturday morning farmers market. They occur at a set time and place, making it possible to connect buyers and sellers. Like a farmers market, buyers have plenty of choices readily available and can comparison shop to ensure they get the best price. Sellers have the benefit of reaching many buyers easily, saving time and money.
But, unlike the buying and selling of produce and baked goods, capital markets facilitate the pairing of those who want capital with those that have it.
A capital market is the sum of all providers and users of capital, all the financial products like stocks and bonds which make the transfer of capital possible, and all the people and organizations which support the process.
Getting in on the action
You are taking part in capital market if you simply put some savings in the bank. That’s because banks take your money and lend it out again to people and companies who want to borrow. They pay you for using your funds, but they make a profit on the difference between what they pay you and what they charge their borrowers. You’ll never get rich or even stay much ahead of inflation by leaving your money in a bank savings account. Of course, savings accounts are easy to access and low risk. When you invest in the capital markets, you take on additional risks with the hopes of getting better returns on your money. One of these risks is called market risk, the chance that the value of your investment will fluctuate, or that it might not be easy to turn into cash when you want it. Another risk is called issuer risk, which is the possibility that the company or government whose securities you invest in will go bankrupt. In general, to get higher returns, you have to take on more risk.
Many people prefer to invest directly in the capital markets to try improving their return. Although myths abound that keep newcomers out of the markets, such as the belief that all securities are too risky or that you have to be rich to invest, individuals in Canada actively invest in stocks and bonds. Keep in mind that an average stock profile in Canada is worth less than $5,000. Yet every person who invests is important to the capital markets. A market where lots of people participate is much more efficient than one with only a few buyers and sellers. Prices are more competitive and people can make deals much faster.
However, the largest investors are often not individuals. Dollars saved by many people are pooled or grouped together and managed under one umbrella by a professional money or fund manager. These large funds are called institutions. An example of an institutional investor is a mutual fund. Individuals invest directly in these funds. However, you could be investing without knowing you are doing it. Pension funds, for example, invest the money you are contributing through your company pension or RRSP. Institutions like these are very active in today’s capital markets. Markets also provide opportunities for foreign investors. Large investors from around the world may find better returns in Canada than in their home country, especially when economic conditions are better here.
Who they’re suited for
The biggest users of capital are governments and businesses. Both of these are very expensive to run. They need a ready source of money.
The three levels of government – federal, provincial and municipal – need money to pay for public services for all Canadians. Services provided by schools and universities, by hospitals, for welfare and unemployment insurance, for road building and maintenance, for garbage pickup and the like are all paid for out of the public purse. Government expenditures are divided between capital projects, large building projects which are intended to serve Canadians for many years, and social services such as government pensions and welfare systems which help individual Canadians. In addition, governments have to pay a lot of interest on money they have already borrowed.
Governments raise money to pay for capital and social programs in lots of ways. The taxes we pay are a big source of funds. Unfortunately, governments are not always good at balancing their budgets so their expenses are sometimes larger than their incomes. When that happens to you or me, we must make up the difference somehow. We can borrow the money or we can sell something. Governments do the same thing.
How governments borrow
Governments can’t just go to the bank as the average person would do. No bank has enough money in its treasury for that! But governments go into debt just the same. Instead of borrowing from a bank, they borrow from the public at large.
The way they borrow is by issuing bonds. A bond is what people in the securities industry call a debt instrument. A home mortgage is also a debt instrument. Debt instruments are simply IOUs that describe the terms of a contract between a borrower and a lender. Such terms usually include a promise of repayment in full by a certain time and an outline of what the cost of borrowing will be.
Governments don’t have to offer any security for their loans but the average person, or even large corporate bond issuers, are expected to pledge some assets, such as a house, to ensure the lender is protected if the borrower walks away. Governments get special treatment because they have the ability to raise taxes to cover their debt payments. That’s pretty effective collateral!
Why governments borrow
Unfortunately, governments have limited assets that they can sell. Federal and provincial governments own land, but much of it is used for roads, airports or parks, or is not marketable. They are able to sell forest, mineral and other rights, but factors like environmental impact prevent governments from developing Canada’s natural resources haphazardly.
Some assets can be sold. When government owns a business, it’s called a crown corporation. They’re unlike public companies and do not have to be profitable to survive. Crown corporations often have responsibilities that serve the public interest, adding extra cost to the business. Over time, the government may decide that the public interest could continue to be served without the crown corporation. When this happens, the government might sell the company and raise money this way. This is called privatization, and has been done with companies like Air Canada and Petro Canada.
Despite this, governments rely heavily on borrowing in the bond market to fund public programs.
Why businesses need capital
Business is the other big user of capital. A business needs an inflow of cash at several times in its life cycle. First, it needs money to get started. There are things to buy for even the simplest business – a desk and file cabinet, perhaps a computer and software. Budding manufacturing businesses need even more up-front cash to pay for everything from raw materials to machinery. As well, there is often a long dry spell before a business makes money and it’s important to have enough resources to last through this start-up period.
Whenever a business is ready to grow or develop, another large cash infusion is required. Perhaps the company must expand its factory and manufacturing capacity in order to fill increasing orders. Perhaps its current equipment is out-of-date. These expenses are usually over and above what the company can pay for out of its profits. But spending this money is usually a good investment because it will help the business make more profit.
A business must also have the funds to pay back any loans it has taken out and to cover any interest payments.
When businesses can’t get needed funds
Businesses that can’t get financing either never get going or stay very small. Most people don’t have the resources to cover the up-front cost of starting and running a business themselves, at least not for very long.
It is important to our economy that promising businesses are not nipped in the bud because they lack funds. Business provides the goods and services that make our lives comfortable and productive. Business also means jobs. In fact, small business in Canada has traditionally been the biggest creator of new jobs.
If the flow of capital to business is hampered, growth and development stops, jobs disappear and the economy stagnates. By investing your savings in the capital market, you are fuelling growth and development and making a productive investment in economic health.
How companies raise money
When someone starts a company, the most obvious way to get money is to borrow either from friends and family or from a bank. As a company grows, banks continue to be useful as a source of funds.
The company can pay for growth out of its profits, if it has any. When these profits are invested back into a company, they are called retained earnings. Retained earnings are an important source of capital for companies of all sizes.
It is also possible to sell a part of a company, or a share, to raise money. Selling shares means that all the buyers become part-owners. They have equity in the company. Equities are just another name for company stocks or shares.
Large companies also have the option of borrowing through debt instruments like bonds.
Bonds & stocks. What’s the difference?
When you buy a bond or another debt instrument, you are lending your money. That means you are a creditor, which is someone who is owed money. You must be paid back in full together with interest. If the company goes out of business, you have a good claim on any assets that may be left over.
As a shareowner, you own part of the company. You have the right to share in the profits and the growth of the company. However, if the company goes under, your claim to what’s left over falls behind any claims of creditors. This makes your investment a little riskier, although that will depend on the particular stock.
Bonds and other debt instruments offer interest or some form of fixed income, which means that you know how much you can expect as a fee for lending your money and you know when you will be paid that income.
Stocks, on the other hand, don’t have to pay any interest, because you are not lending money to the company. You may be paid a dividend, while is a payment like interest, is actually a share of profits. Some kinds of shares always pay a dividend, while others do not. Whether dividends are paid often depends on how well a company is doing. With some stocks, what you are counting on is that the company will grow in value and that your share, as part-owner, will grow in value with it. When you sell it, you will then make a profit or a capital gain.