6.2 Characteristics of bonds and equities

1.5 per cent (6p/£4). Notice that if the market price of the share rises, dividends

being unchanged, the dividend yield will fall; it will rise, dividends unchanged, when

the share price falls. Notice also the elementary point that we cannot judge a share

to be ‘cheap’ or ‘dear’ just by looking at its price. Penny shares may be regarded as

dear if they pay no dividend; a share at £5 may pay a sufciently large dividend to

have a large dividend yield. It might then be thought of as cheap.

Earnings which are retained within the rm may also benet shareholders in

the long run. One could make a case for saying the higher the retained earnings, the

higher the rate of new investment, the more rapid the growth of the rm and the

more rapid the capital appreciation of its shares. Accepting this argument means that

a share should be valued according to both the dividend which is paid now and the

earnings retained ‘on the shareholders’ behalf’. This is the purpose of calculating an

earnings yield, in this example 2.0 per cent ((£4m/50 million)/£4).

The price/earnings ratio is the reciprocal of the earnings yield. Accordingly, it

conveys the same information but avoids the use of percentages. Notice the use to

which such a measure may be put. If a rm has a high P/E ratio, the indication is

that the market values it highly for some reason other than current earnings. The

usual presumption is that future earnings are likely to grow rapidly and the price

has been bid up in anticipation. In the circumstances one might therefore regard

the share as ‘dear’. Shares of another company in the same sector might be judged

‘cheap’ if their P/E ratio were low by comparison (for no obvious reason).

6.2.3The trading of bonds and equities

As with money market instruments, we can distinguish primary markets for bonds and

equities – markets in which newly issued instruments are bought – and secondary

markets – markets in which existing or secondhand instruments are traded. In this

section we look at primary and secondary markets for bonds and then for equities.

In most bond markets throughout the world there are differences between the

institutional arrangements for the issue and trading of government bonds and corpor-

ate bonds. This is because (as we have seen) governments are very large borrowers.

Thus it is essential that they should always be assured of being able to sell the debt

they require and thus that there should be an active market in which investors have the

utmost condence. It is a characteristic of government bond markets, therefore, that

they are subject to a high level of supervision and regulation, either by the central

bank or by some agency of government. The different institutional arrangements have

little effect upon the characteristics of the bonds and certainly have no effect upon

the mathematics of bond pricing, yield calculations, etc. Since it is the government

bond that dominates in the UK, and because there have recently been a number of

changes in the arrangements for trading in government bonds, we shall start there

and add some words about the corporate bond market at the end.

The primary market for government bonds involves the UK government’s Debt

Management Ofce or DMO and a group of sixteen ‘Gilt Edge Market Makers’ or

GEMMs. The DMO is an executive agency of the UK Treasury. It began operations in

April 1998, taking over the government debt operations which previously had been

157

....

FINM_C06.qxd 1/18/07 11:32 AM Page 158

Chapter 6 • The capital markets

carried out by the Bank of England (see section 3.1). The methods by which it issues

new government debt remain unchanged from those previously used by the Bank,

and the DMO continues to use the systems developed by the Bank for settling trans-

actions in new debt and for registering ownership (of new and existing debt).

The DMO is responsible for deciding the type of bonds to be issued, the terms

of the issue and the timing of such issues. The traditional method, still used, is the

sale by tender in which the DMO offers a specied quantity of stock for sale on a

particular day at a minimum price and invites bids. If the offer is undersubscribed,

all bids are accepted; if it is oversubscribed, the highest bids are accepted but at a

common price – usually the minimum bid price necessary to clear the sale. If the

offer is undersubscribed, the DMO retains the unsold stock and releases it onto the

market subsequently, when conditions permit. Stock issued in such a way is known

as tap stock.

The second method of issue involves the auction of stock in which no minimum

price is set. The stock is sold to the highest bidders at the price they bid. This is a

method which was rst used in 1987 and represents a distinct stage in the evolution

of debt management policy. From the point of view of the money supply and credit

aggregates, sales by auction have the advantage that the DMO can be condent that

it will be able to sell a given volumeof debt since the price will adjust to ensure that

this is so. Thus, the desire to sell a given volume of stock consistent with targets for the

money supply can generally be met. With a sale by tender the price is set, with the

result that the volume of sales becomes uncertain. The two methods simply illustrate

the age-old principle that one can control the price or the quantity, but not both.

The third method of issue is for the DMO to ‘buy’ the stock itself and to release it

to the market as conditions permit: the ‘tap’ method of issue.

When new issues are made, many of the bonds will be bought by GEMMs. These

are usually part of a securities dealing rm (itself often part of a major banking group)

which will deal in all types of securities. However, GEMMs’ activities must be kept

separate from the company’s other securities trading. They must not themselves deal

in equities. They can deal in corporate bonds, but not in bonds which have the option

to convert to equities. They are subject to capital adequacy requirements, laid down

by the DMO. They are committed to making ‘continuous and effective two-way prices’

at which they are prepared to deal up to a specied market size.

In return for these obligations, they have borrowing facilities at the Bank of

England, access to a system of ‘inter-dealer brokers’, and a facility for making ‘late’

bids at government bond auctions. Inter-dealer brokers (IDBs) are intermediaries who

buy and sell stock from and to GEMMs in conditions of anonymity. This enables a

GEMM which has purchased (for example) a large quantity of one particular bond

to sell parts of it to other GEMMs without their knowing that it has excess stock and

deliberately lowering their bid prices. All of these intricate arrangements are meant

to ensure that there is always a ready and stable market for government bonds.

New issues of government bonds may be bought by anyone – many will go directly

to banks and other nancial institutions – but the DMO–GEMM relationship ensures

that whatever the interest shown by the rest of the nancial system, the government

can always borrow on reasonable terms.

158

....

FINM_C06.qxd 1/18/07 11:32 AM Page 159