Liquidity and fungibility of financial instruments
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The Law and Lore of Repackaging
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Equity and debt instruments have formal points of difference worth bearing in mind when considering derivatives and structured notes based on them. In JC’s experience, one tends to be either a “credit guy” or an “equity guy” so a little crib sheet can’t hurt.
Key differences between credit and debt instruments then, starting with the most obvious:
- Subordination: Where each instrument is in capital structure. Equity is at the bottom. Debt instruments feature pretty much anywhere else.
- Upside: The extent to which the instrument reflects business outperformance.
- Term: The term of the instrument.
- Heterogeneity: The number of distinct debt instruments outstanding at any time is large, and they come and go. There is generally one class of equity, and it is always the same.
- Liquidity: How frequently the instruments trade, how observable is the price at which they trade, and in what size.
These things are interrelated.
Subordination
It should not be news that debt instruments, which by nature must be paid off in full before equity holders get anything, sit higher up the capital structure than common equity. That is so by definition. But there’s quite a lot of capital structure — there may be many rungs between the equity at the bottom and the preferred creditors at the top, and instruments on any of these rungs count as debt — but different kinds of debt, fulfilling different capital requirements. To meet these requirements an undertaking may issue debt instruments at different points in its capital structure: it may issue alternative tier one capital notes, which are almost equity like, or subordinated bonds, or senior unsecured bonds, or debt instruments secured over specific assets and businesses. These different debt instruments trade separately, at different prices, and on different markets, between different types of investor.
By contrast, common equity ownership is, well, common: entitlements to the general equity ownership of an undertaking are intrinsically fungible. Now, in unusual cases — partly public family businesses, significant undertakings in politically strategic industries — there may call for different classes of equity stock to preserve voting rights or vouchsafe a majority for citizen investors — but outside these unusual cases, there will generally be one class of common equity, and it will trade freely among non-privileged insiders.
Exposure
It is tempting to think of debt instruments as the “safe” ones, being further up the capital structure, whereas equities, being at the bottom of the barrel, are a volatile play on the company’s ever-present bankruptcy risk.
This is true from the company’s perspective than an investor’s. Often, for the investor, the opposite is true: a senior bondholder locks in its yield at the moment it buys a bond: improvements in the company’s prospects after that time will minimally affect the sale price of the bond, if the investor sells it, but will not be reflected at maturity of the Note. However well the company has performed, you get the principal amount back and that is that.
On the other hand, if the company suffers a catastrophic setback — one enough to tip it into bankruptcy — a bond investor stands to lose its whole investment.
The dynamic for an equity investor is very different. Return is purely a function of corporate performance. By the time the company reaches the point of bankruptcy, the sorrows and misfortunes are fully priced into the instrument: it cannot fall any further: an equity investment is an articulation of the residual value in the company after its credit instruments are repaid.
That being the case, a share offers unlimited upside but a limited downside: the only additional consequence of bankruptcy is that the game us up, and there is no longer a chance that your instrument will regain its former lustre.
The investor who buys an equity on a fair valuation on the brink of bankruptcy stands to lose pretty much nothing, and on those rare occasions when it pulls back, can make a colossal return.
Duration
Likewise, equity instruments are by nature undated: they equate to the residual equity value of the company after all of its debt obligations are satisfied. By contrast, most debt instruments have a short duration. (Certain capital notes and subordinated structures may be perpetual but even these will be redeemed and reissued from time to time). This means that even vanilla senior unsecured notes will change. There maybe several series, issued in different currencies or with different coupons and they are not interchangeable.
That is to say, a lack of fungibility amongst debt instruments.
That translates fairly directly into a lack of liquidity: whereas everyone buys the same common equity instruments, the market for debt instruments of a given issue is fragmented and the instruments themselves frequently change.
Heterogeneity
Asingle issuer may have numerous bond and note issues outstanding at any time with different maturities, coupon rates, and covenants, and these will tend to “roll over” as old bonds mature and new ones are issued. This fragments liquidity vertically, across multiple instruments at a single point in time, and horizontally across a given time period. On the other hand there tends to be a single equity class, and it is perpetual.
Liquidity
Furthermore, senior unsecured debt obligations are less prone to change in value, particularly over the short term, meaning there is less impetus to frequently trade them. For this reason, they tend to trade in larger nominal amounts, less frequently, meaning individual trades can materially impact market prices.[1] The comparative absence of real-time pricing information in debt markets creates friction in matching buyers and sellers, further dampening liquidity.
This liquidity differential is reflected in wider bid-ask spreads, longer execution times, and greater price impact for similar-sized trades in corporate bonds versus equities.
As a result, the bond market tends to be much more of a buy-and-hold-market. Investors tend to buy in bigger size, from issue, rarely entering the secondary market.
Institutional investors like insurance companies, pension funds, and asset managers typically purchase bonds intending to hold them to maturity to match their liabilities or generate steady income streams. Hedge funds as ever, are the exception: their trading strategies seek to capitalise on relative value opportunities, credit mispricing, or technical dislocations in the secondary market. This provides some secondary market liquidity, but it is not a patch on the depth of listed equity markets.
This is all the more so for structured notes, which take portfolios of already illiquid debt instruments and further complicate them with embedded derivatives.
See also
References
- ↑ Though the volatility of instruments is lower, this impact is relative to overall volatility.