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ACCA FM: functions of stock and bond markets

This outcome covers what stock markets and corporate bond markets do: raise new money (primary) and let investors trade existing securities (secondary). The examiner likes it because it tests whether you know who actually receives the cash in each market.

The rule

The primary market is where new securities are issued and the issuer receives cash. The secondary market is where existing securities are traded between investors, so the issuer receives nothing. Secondary trading gives liquidity, an exit for investors and a quoted price. A bond's coupon is fixed at issue, so when market yields rise the price falls until the yield on the market price equals the new required return. That market yield is the current cost of new debt of similar risk.

Worked example

Callwise Co issues a 6% bond, nominal value 100, redeemable at par in 5 years, and receives 100 per bond (primary market). Market rates then rise from 6% to 8%. Investors trade the bond among themselves (secondary market). Price at 8%: Coupons: 6 x 3.993 = 23.96 Redemption: 100 x 0.681 = 68.10 Price = 23.96 + 68.10 = 92.06, about 92. Effects: - Callwise Co still received 100 at issue and still pays 6 a year plus 100 at redemption. - An investor who bought at 100 has a capital loss of about 8 per bond. - New debt of similar risk would cost Callwise Co about 8%.
Remember: secondary market price movements change investors' wealth and the company's cost of new finance, but not the cash the company already raised or its contractual payments.

Where candidates lose marks

Try it: 4 questions

Hopvale Brewing Co is an unlisted craft brewery. Its directors plan to obtain a stock market listing and sell new shares to the public to fund a new production site. They state three aims: (1) raise new capital for expansion; (2) allow early private investors to sell their shares after the listing if they wish; (3) obtain a quoted market price for the company's shares. Which of the following correctly classifies these aims as primary market or secondary market functions?
Answer: B. The primary market is where new securities are issued and cash is raised by the issuer. The secondary market is where existing securities are traded between investors, with no new cash going to the company.
(1) Raising new capital by issuing new shares is a primary market function.
(2) Early investors selling their existing shares to other investors is a secondary market function. The company receives nothing from these trades. Listing makes the exit possible, but the exit is not a primary function.
(3) A continuously quoted share price comes from ongoing trading of existing shares, so it is a secondary market function.
So the answer is Primary: (1) only; Secondary: (2) and (3).
Why the others are wrong: 'Primary (1) and (2)' treats the exit as primary because it happens around the time of the listing, which is the main trap. 'Primary (1) and (3)' wrongly treats the quoted price as created by the issue rather than by trading. 'All three primary' ignores the distinction altogether.
Callwise Co issued a 6% bond with a nominal value of 100, redeemable at par in five years' time, and received 100 per bond at issue. Market interest rates for similar-risk debt have since risen from 6% to 8%, and the bond is traded on a secondary market at a price of 92 (approximately 6 x 3.993 + 100 x 0.681 at 8%). Which of the following best interprets the fall in price?
Answer: A. The issuer received 100 per bond at issue. Trades on the secondary market are between investors, so the price fall does not change the cash Callwise Co received, and it does not change the contractual payments: the coupon stays at 6 per 100 nominal and redemption is at 100.
The price fell because the bond's fixed cash flows are now discounted at the higher market yield of 8%: 6 x 3.993 + 100 x 0.681 = 23.96 + 68.10 = 92.06, approximately 92. Investors who bought at 100 and hold the bond have a capital loss of about 8 per bond (realised if sold).
The market yield of 8% is the current cost of new debt of similar risk, so new borrowing would cost about 8%.
Why the others are wrong: the 'cash gain' option confuses a lower market price with a gain to the issuer, which has no cash effect unless it actually repurchases bonds, and wrongly gives 6% for new debt. The 'existing cost has risen to 8%' option wrongly assumes the contractual coupon changes. The 'must compensate' option wrongly assumes the issuer owes bondholders for market price falls, and again wrongly gives 6%.
Boxwell Packaging Co has bonds in issue that are traded on a corporate bond market. An analyst makes four statements about corporate bond markets. Which statement is NOT true?
Answer: D. The coupon rate is fixed when the bond is issued, as a percentage of nominal value. Investors' required yield changes with market interest rates and the issuer's credit risk. The market price of the bond moves so that the yield on the market price equals the current required return. The coupon and the required yield therefore only coincide if the bond trades at par, and they are generally different after issue.
The other statements are true:
- The secondary bond market lets investors trade bonds after issue.
- Secured bonds have a charge over assets and rank ahead of unsecured creditors on liquidation.
- Because coupons are fixed, a rise in market rates reduces the present value of the bond's cash flows, so the price falls.
The trap is to assume the fixed coupon moves with the market yield, when it is the price that adjusts.
Autoparts Co and Gearbox Co each have corporate bonds with similar maturity and coupon rate that are traded on a bond market. Autoparts Co's bonds have a high credit rating and a yield of 4.5%. Gearbox Co's bonds have a lower credit rating and a yield of 7.0%. Which TWO of the following correctly explain the difference in yields and the role of the bond market in pricing risk?
Select the two that apply (each shows on its own).
Answer: B, D. Yield is the return investors require for holding a bond. Investors demand a higher return for higher default (credit) risk. Gearbox Co's lower rating means higher perceived risk, so investors only buy its bonds at a lower price. With the same coupon and maturity, a lower price means a higher yield. This is how the bond market prices risk: trading between investors sets prices, and hence yields, to reflect credit risk.
Correct: the option that links the higher yield to compensation for default risk, and the option that describes the market setting a lower price and so a higher yield for riskier bonds.
Wrong: 'financially stronger' reads the high yield as a sign of quality when it signals higher risk, which is the main trap. 'Longer maturity' contradicts the stem, which says maturity and coupon are similar. 'Market guarantees repayment' is wrong because a bond market provides trading and pricing, not a guarantee of repayment by the issuer.

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Questions students ask

What is the difference between primary and secondary markets in ACCA FM?

The primary market is where new securities are issued and the company receives the cash. The secondary market is where investors trade existing securities and the company receives nothing from the trades.

Why do bond prices fall when interest rates rise?

The coupon and redemption value are fixed, so they are discounted at a higher market yield, which gives a lower present value. The price falls until its yield equals the new required return.

Why does a company care about its share or bond price if it is not selling securities?

The secondary market price shows the return investors require, which indicates the cost of new finance. It also makes the securities liquid, so investors are more willing to buy them at issue.