Issuance trading and funding - Primary markets and securitiz...

Learning Outcomes

This article explains how capital is raised and funded in primary markets, including:

• The mechanics of issuing new securities in the primary market, such as initial offerings of bonds and shares and the cash-flow implications for issuers and investors.
• The differences between public offerings and private placements, with emphasis on regulatory requirements, typical investors, liquidity outcomes, and when each method is strategically preferred.
• The respective responsibilities of issuers, underwriters, bookrunners, and syndicates in structuring, pricing, and distributing new issues, and how underwriting risk is allocated.
• The main types of primary equity and bond offerings (IPOs, seasoned offers, rights issues, shelf registrations, and auctions) and how they are used.
• The securitization process from asset pooling and transfer to an SPV through structuring, tranching, and selling asset-backed and mortgage-backed securities.
• How tranching, credit enhancement, and SPV structures redistribute credit risk, alter funding costs, and affect the supply of investable securities.
• The benefits and potential drawbacks of securitization for originators, investors, and the broader financial system, including impacts on the use of debt financing, regulatory capital, transparency, and system-wide risk.
• How these primary market and securitization concepts are examined in CFA Level 1 questions, with focus on definitions, process steps, and comparative features that are frequently tested.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are required to understand the fundamentals of capital raising, security issuance, and securitization, with a focus on the following syllabus points:

• Explain the function of the primary market and different ways securities are brought to market.
• Distinguish between public offerings and private placements as methods of security issuance.
• Describe the roles of issuers, underwriters, syndicates, and bookrunners in new issues.
• Explain underwriting, bookbuilding, and syndication in the context of security issuance.
• Describe alternative issuance methods, such as fixed-price offerings and auctions, especially for government bonds.
• Define securitization and differentiate mortgage-backed and asset-backed securities.
• Explain the purpose of pooling assets and tranching in securitization.
• Describe forms of credit enhancement and how they affect the risk of securitized products.
• Assess the benefits and limitations of securitization for issuers and investors.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the primary function of the primary market in the context of corporate finance?
   1. To provide liquidity by enabling investors to trade existing securities.
   2. To set benchmark interest rates for the economy.
   3. To allow issuers to raise new capital by selling securities to investors.
   4. To facilitate trading in derivative instruments such as options and futures.
2. How does a private placement most clearly differ from a public offering?
   1. Private placements are always equity issues, while public offerings are always debt issues.
   2. Private placements are sold to a limited group of qualified investors with lighter disclosure, while public offerings are widely distributed and heavily regulated.
   3. Private placements are issued only by governments, while public offerings are issued only by corporations.
   4. Private placements are always more liquid than public offerings.
3. Who is primarily responsible for bookbuilding in a new securities offering?
   1. The securities regulator.
   2. The issuer’s board of directors.
   3. The lead underwriter (bookrunner).
   4. The stock exchange where the issue will be listed.
4. What is the main purpose of forming tranches in a securitization deal?
   1. To guarantee that all investors receive the same yield.
   2. To separate cash flows and credit risk into layers that appeal to different investor risk preferences.
   3. To eliminate default risk entirely for all investors.
   4. To ensure that only equity investors bear all asset-level risk.

Introduction

The primary market is where issuers such as corporations and governments raise new capital by selling securities to investors. These issuances use a variety of distribution channels and intermediary participants. Securitization involves pooling financial assets and issuing securities backed by these pools, leading to deeper funding markets, risk transfer, and new opportunities for both issuers and investors.

Key Term: primary market
The market where issuers sell new securities to investors, raising funds for investment or operations.

After securities are first sold in the primary market, they may subsequently trade among investors in the secondary market.

Key Term: secondary market
The market in which previously issued securities are traded between investors; the issuer does not receive proceeds from these trades.

For CFA Level 1, you should be able to:

• Describe the main ways securities are initially sold to investors.
• Identify who does what in an issuance (issuer, underwriter, bookrunner, syndicate members).
• Explain at a high level how securitized products are created and why they exist.

The following sections build from basic primary market mechanics to securitization structures, focusing on the key definitions and process steps that are commonly tested.

The Primary Market: Security Issuance Fundamentals

Role of the Primary Market and Cash-Flow View

The primary market links savers (investors) with borrowers (issuers). When a new security is issued:

• The issuer receives cash from investors and issues securities (shares or bonds) in return.
• Investors pay cash and receive the new securities.
• After issuance, periodic cash flows (coupon payments, dividends, and redemption of principal) flow from the issuer (or the obligor on the security) to the investors.

In secondary market trading, no new capital is raised:

• Investors trade existing securities among themselves.
• The issuer does not receive cash or pay anything at the time of trade (other than any usual ongoing payments like coupons or dividends when they fall due).

This distinction is frequently tested: primary market transactions change the issuer’s capital structure and cash position; secondary market transactions do not.

Issuance can involve:

• Equity (shares).
• Debt (bonds, notes, commercial paper).
• Hybrid securities (convertible bonds, preferred shares).

Within equity issuance, it is useful to distinguish:

Key Term: initial public offering (IPO)
The first time a company’s shares are offered to the public and typically listed on a stock exchange.

Key Term: seasoned equity offering (SEO)
A public share offering by a company whose shares are already listed and publicly traded.

Key Term: rights offering
An issue of new shares to existing shareholders, usually at a discount, in proportion to their current holdings, giving them the right (but not the obligation) to buy before the shares are offered to others.

For debt, large issuers such as governments and major corporations may also use shelf registrations.

Key Term: shelf registration
A regulatory arrangement that allows an issuer to register a large amount of securities in advance and then issue portions of that amount over time without filing a new prospectus for each tranche.

Public Offerings and Private Placements

New securities (bonds, shares, or other forms) are introduced to the market through either public offerings or private placements.

• In a public offering, the issue is made widely available to any qualifying investor. The transaction is typically managed by an investment bank acting as an underwriter, subject to disclosure and registration requirements, and is accompanied by a prospectus.
• A private placement involves the sale of securities to a select group—often institutional or sophisticated investors—without the full public disclosure obligations. These offerings are faster and less regulated but usually result in less trading liquidity post-issuance.

Key Term: public offering
Sale of new securities to the general public, usually requiring registration with a regulator and a prospectus.

Key Term: private placement
Sale of new securities directly to select investors, typically exempt from public registration and sold mainly to institutional or qualified investors.

Public offerings:

• Require detailed disclosure and review by securities regulators.
• Are typically listed on an exchange (for equity) or widely quoted (for bonds).
• Provide broader access to capital and generally higher post-issue liquidity.
• Involve higher issuance costs and longer lead times.

Private placements:

• Involve tailored contracts negotiated with a small number of investors.
• Have lower direct issuance costs and can be completed quickly.
• Often carry higher yields to compensate investors for lower liquidity and higher information risk.
• May include more restrictive covenants, since investors can negotiate terms directly.

For the exam, you should be able to identify situations where a firm might prefer one method over the other:

• Small or time-sensitive issues, or issues by smaller or unrated firms, often use private placement.
• Large, well-known issuers raising substantial amounts of capital typically use public offerings.

Underwriting, Bookbuilding, and Syndication

Investment banks frequently act as underwriters, taking on the risk of placing the new issue, sometimes committing to buy any unsold portion. Large deals are often managed by a syndicate—a temporary group of banks or dealers. The lead manager, called the bookrunner, coordinates the syndicate and manages the bookbuilding process.

Key Term: underwriting
An arrangement where an intermediary, usually an investment bank, agrees to help sell a new issue, sometimes guaranteeing a minimum amount of proceeds to the issuer.

Key Term: syndicate
A group of investment banks and dealers that work together to underwrite and distribute a security offering.

Key Term: bookrunner
The lead underwriter responsible for organizing an offering and managing order collection, pricing, and allocation.

Underwriting can take several forms:

• Firm commitment: the underwriter buys the entire issue from the issuer and then resells to investors, assuming the risk of not being able to sell at the expected price.
• Best efforts: the underwriter agrees only to use its best efforts to sell the securities; the issuer bears the risk if the securities cannot be sold.
• Bought deal: the underwriter commits to buying the entire issue from the issuer before marketing it, often used in bond markets for speed.
• Standby underwriting: in a rights offering, the underwriter guarantees to buy any shares that existing shareholders do not subscribe to.

Key Term: firm commitment underwriting
An underwriting arrangement in which the underwriter purchases the entire issuance from the issuer, guaranteeing the issuer a fixed amount of proceeds.

Key Term: best efforts underwriting
An underwriting arrangement in which the underwriter agrees only to place as much of the issue as possible without guaranteeing the sale of the entire issue.

Key Term: bought deal
An arrangement in which the underwriter buys the entire issue from the issuer before marketing it, assuming full placement risk.

Key Term: standby underwriting
An underwriting agreement commonly used in rights offerings, where the underwriter agrees to purchase any shares not taken up by existing shareholders.

• Underwriting can be "firm commitment" (bank guarantees proceeds by buying the whole issue) or "best efforts" (bank only tries to place with no guarantee).
• Bookbuilding is used to gather orders from investors, indicating their demand and preferred prices or quantities.
• The bookrunner is responsible for collecting these indications, analyzing demand, setting the issue price, and determining final allocations.

Key Term: bookbuilding
The process of soliciting investor demand and price indications for a new issue to determine the final offer price and allocation.

The bookbuilding process typically involves:

• Marketing the issue to potential investors (a “roadshow” for equity, investor calls for bonds).
• Collecting indications of interest (non-binding orders with price/quantity).
• Assessing overall demand at different price levels.
• Setting the final issue price and size.
• Allocating securities to investors, often favoring long-term, buy-and-hold investors.

The underwriting spread (difference between the price paid by investors and the price received by the issuer) compensates underwriters for their services and risk.

Other Primary Market Issuance Methods

Not all issues are brought to market via bookbuilding.

• Fixed-price offerings: the issuer announces a price in advance. Investors submit subscriptions at that price, and the issue may be scaled back if oversubscribed.
• Auctions: common for government bonds, where investors submit bids and the final price or yield is determined by auction rules.

Key Term: auction
An issuance method in which investors submit bids specifying quantities and yields/prices, and the final issue yield/price is determined by the auction mechanism (single-price or multiple-price).

Government bond auctions:

• Single-price (uniform-price): all successful bidders pay the same price (or receive the same yield), usually set at the highest yield accepted.
• Multiple-price (discriminatory): winning bidders pay the price (or receive the yield) they individually bid.

For CFA Level 1, you should recognize that auctions are especially important for sovereign issuers, while bookbuilding and firm commitment underwriting are more typical for corporate and many equity issues.

Worked Example 1.1

A technology company wants to issue $100 million in bonds. It hires an investment bank on a firm commitment basis to underwrite and distribute the bonds. How is risk allocated between the issuer and the underwriter?

Answer:
Under a firm commitment, the underwriter purchases the entire $100 million of bonds from the issuer at an agreed price and then resells them to investors. The issuer locks in the proceeds and is largely protected from demand risk. The underwriter bears the risk of any unsold bonds or of having to sell them to investors at a lower price than expected.

Worked Example 1.2

A large company raises funds through a private placement to a small group of pension funds. What is a likely advantage of this method?

Answer:
The company can negotiate terms directly with the pension funds and complete the issuance more quickly and with lower regulatory and distribution costs than a public offering. However, the resulting securities are likely to be less liquid, so investors may demand a higher yield.

Worked Example 1.3

A company plans a rights offering to existing shareholders. The investment bank provides a standby underwriting commitment. What risk does the underwriter assume?

Answer:
In a standby commitment, the underwriter agrees to buy any shares not subscribed for by existing shareholders. If shareholder take-up is low, the underwriter must purchase a large number of shares at the offer price, bearing the risk that their market value may be lower.

Exam Warning

On the exam, do not confuse the primary market (where securities are first sold by issuers to investors) with the secondary market (where investors trade previously issued securities with each other, and issuers receive no direct funds). Questions often test this distinction using simple cash-flow diagrams.

Securitization: Pooling and Tranching

Securitization enables issuers to transform pools of assets, such as loans or receivables, into securities backed by these assets. This process widens funding sources, redistributes and separates risk, and makes previously illiquid assets marketable.

Key Term: securitization
The financial process of pooling financial assets and issuing tradable securities backed by the cash flows from those assets.

Common pooled assets include:

• Residential and commercial mortgages.
• Auto loans and leases.
• Credit card receivables.
• Student loans and other consumer loans.
• Corporate loans or bonds.

The securitized products created include:

Key Term: asset-backed security (ABS)
A bond or note backed by a pool of non-mortgage financial assets, such as auto loans, credit card receivables, or student loans.

Key Term: mortgage-backed security (MBS)
An asset-backed security specifically collateralized by a pool of mortgages, typically residential or commercial.

Securitization Process

The securitization process usually involves several key parties and steps.

1. Asset Pooling

   The originator (often a bank or finance company) holds a large number of similar loans or receivables.

   Key Term: originator
   The institution that originally creates (originates) the loans or receivables that will be pooled and securitized.

   • Loans are grouped into a pool with broadly similar characteristics (maturity, interest rate type, credit quality).
   • The pool is large enough to diversify idiosyncratic (borrower-specific) risk.

2. Transfer to an SPV

   The pool is sold to a special purpose vehicle (SPV), also called a special purpose entity (SPE), which becomes legally separate from the originator.

   Key Term: special purpose vehicle (SPV)
   A separate legal entity created solely to acquire financial assets from the originator and issue securities backed by those assets; often structured to be bankruptcy-remote from the originator.

   The transfer should be a “true sale,” so:

   • The assets are removed from the originator’s balance sheet.
   • SPV investors are protected if the originator later defaults.

3. Structuring and Tranching

   The SPV structures the pool into classes of securities, or "tranches," each with different seniority, credit risk, and expected yield.

   Key Term: tranche
   A portion or class of a securitization structure with defined risk, return, and payment priority.

   • Senior tranches are paid first and have higher credit ratings and lower yields.
   • Mezzanine tranches have intermediate priority and risk.
   • Junior (subordinated) or equity tranches absorb initial losses and thus carry the highest yields.

4. Issuance, Servicing, and Payment

   The SPV sells these securities to investors, who receive cash flows from the pooled assets per the priority specified by their tranche.

   • A servicer, often the originator, collects payments from borrowers and passes them to the SPV.

   Key Term: servicer
   The entity responsible for collecting payments on the pooled loans (e.g., principal, interest) and forwarding them to the SPV for distribution to investors.

   • A trustee and other agents oversee compliance with the legal structure.

Key Term: pass-through security
A securitized instrument in which investors receive a pro-rata share of the cash flows (interest and principal) from the asset pool, after servicing and other fees.

Many MBS are structured as pass-through securities, but more complex structures (such as collateralized mortgage obligations) use additional tranching.

Tranching and Credit Structuring

Securitization allows distribution of risk by splitting cash flows into tranches. Senior tranches are paid first and offer lower risk and yields; subordinate (junior) tranches absorb losses first and offer higher yields. This process enables the creation of securities tailored to different investor risk appetites.

Risk can be separated in two main ways:

• Credit tranching: tranches differ in loss priority.
• Time tranching: tranches differ in timing of principal repayments (some are paid earlier, others later).

Key Term: credit enhancement
Any structural feature or external support that improves the credit quality of securitized securities relative to the supporting asset pool.

Credit enhancement can be:

• Internal, built into the securitization structure.
• External, provided by a third party.

Key Term: internal credit enhancement
Credit support that arises from the structure of the securitization itself, such as subordination, reserve funds, overcollateralization, or excess spread.

Key Term: external credit enhancement
Credit support provided by a third party, such as a guarantee or insurance policy from a bank or insurer.

Common internal enhancements include:

• Subordination: junior tranches absorb losses before senior tranches.

  Key Term: subordination
  A structure where lower-priority (junior) tranches absorb losses before higher-priority (senior) tranches, thereby protecting the senior tranches.

• Overcollateralization: the value of the asset pool exceeds the total par amount of securities issued.

  Key Term: overcollateralization
  When the face value of the asset pool is greater than the face value of the issued securities, providing a buffer against losses.

• Reserve funds (cash collateral accounts): cash set aside at issuance to absorb future losses or shortfalls.

  Key Term: reserve fund
  A cash account funded at or after issuance that can be used to cover losses or temporary shortfalls in cash flows to investors.

• Excess spread: the difference between the interest earned on the asset pool and the interest paid on the securities, after expenses.

  Key Term: excess spread
  The residual interest income remaining after paying servicing fees and interest to investors; this can be used to absorb credit losses.

Securitization structures are designed so that senior tranches may obtain very high credit ratings (e.g., AAA) even when the individual loans in the pool are riskier, because sufficient protection is provided by the junior tranches and other credit enhancements.

Prepayment Risk and MBS

Mortgages and some other loans can often be prepaid by borrowers before maturity.

Key Term: prepayment risk
The risk that borrowers repay loans earlier or later than expected, causing actual cash flows on securitized products (especially MBS) to differ from expected cash flows.

In MBS:

• Falling interest rates typically increase prepayments as borrowers refinance, shortening the life of the security.
• Rising rates can reduce prepayments, extending the life of the security.

While detailed modeling is beyond Level 1, you should understand that prepayment risk affects the timing and amount of cash flows to MBS investors.

Securitized Bonds versus Covered Bonds

A related funding instrument is the covered bond.

Key Term: covered bond
A bond backed by a segregated pool of high-quality assets that remains on the issuer’s balance sheet; investors have recourse both to the cover pool and to the issuer.

Key differences compared with securitization:

• In securitization, assets are transferred to an SPV and removed from the originator’s balance sheet; investors rely mainly on cash flows from the asset pool.
• In covered bonds, assets remain on the issuer’s balance sheet; investors have dual recourse (to the pool and the issuer).
• Covered bonds are common in some European markets and often used to fund mortgage lending.

Benefits and Stakeholders in Securitization

Securitization affects several stakeholders.

Originators

Originators (often banks) benefit from:

• Funding diversification: they can raise funds from capital markets, not just deposits.
• Potentially lower funding costs: by creating highly rated senior tranches, they may borrow at lower rates than their own unsecured debt.
• Risk transfer: depending on the structure, some credit and prepayment risk is transferred to investors.
• Regulatory capital relief: by removing assets from their balance sheet, they may reduce risk-weighted assets and capital requirements (subject to regulation).
• Balance sheet management: securitization can free up capacity to originate new loans.

However, originators may still retain some risk via:

• Holdings of junior tranches.
• Representations and warranties about asset quality.
• Servicing responsibilities and reputational concerns.

Investors

Investors gain:

• Access to asset classes not otherwise easily investable (e.g., diversified pools of mortgages).
• A wide range of risk-return profiles, maturities, and structures.
• Potentially attractive risk-adjusted yields due to diversification and credit enhancement.

At the same time, investors face:

• Complexity risk: structures can be difficult to analyze, especially for junior tranches.
• Model and prepayment risk, especially in MBS.
• Liquidity risk: some securitized issues trade less frequently than benchmark government bonds.
• Reliance on credit ratings: which may not fully capture all risks.

The Financial System

At the system level, securitization:

• Increases the supply of investable fixed-income instruments.
• Improves liquidity and risk sharing across investors.
• Enables banks to recycle capital and potentially increase credit supply to the real economy.

But it can also:

• Increase overall indebtedness and opacity if risks are poorly understood.
• Contribute to system-wide risk, as observed during the global financial crisis, when complex mortgage-related securities amplified losses.

Worked Example 1.4

A bank has a pool of commercial loans it wishes to remove from its balance sheet. It sells the loans to an SPV, which issues $80 million of senior ABS and $20 million of junior ABS. Total loans in the pool have a principal value of $105 million. What types of internal credit enhancement are present?

Answer:
There are two forms of internal credit enhancement. First, subordination: the $20 million junior tranche will absorb losses before the $80 million senior tranche. Second, overcollateralization: the asset pool ($105 million) exceeds the total ABS issued ($100 million), providing a $5 million loss buffer before investors lose principal.

Worked Example 1.5

An MBS investor holds a senior tranche that is protected by subordinated tranches and a reserve fund. Rising interest rates reduce mortgage prepayments. Which risks are most affected?

Answer:
Rising rates reduce prepayments, so prepayment risk manifests as extension risk: the investor receives principal more slowly than expected. Credit risk is partly mitigated by subordination and the reserve fund, but the investor still faces some credit risk if losses exhaust the junior tranches and reserve. Market (interest rate) risk also increases, as the longer effective maturity makes the security more sensitive to rate changes.

Worked Example 1.6

A bank has a pool of commercial loans it wishes to remove from its balance sheet. It sells the loans to an SPV, which issues ABS in senior and junior tranches. What advantage does the bank gain?

Answer:
The bank receives cash from the SPV, which it can use for new lending or other purposes. Because the loans are sold in a true sale, they may be removed from the bank’s balance sheet, improving regulatory capital ratios. Much of the credit risk is transferred to ABS investors, particularly those holding the junior tranches that absorb initial losses.

Revision Tip

Remember: Senior tranches in securitizations usually receive payments first and are safer, but junior tranches offer higher yields and bear initial losses. Exam questions often ask which tranche is most exposed to credit risk or which investors are likely to demand the highest yield.

Summary

Primary markets are where new securities are brought to market by issuers for raising capital. Public offerings reach a wide group of investors under formal regulation, while private placements target qualified investors under lighter regulation and may be less liquid. Intermediaries such as underwriters, bookrunners, and syndicates play critical roles in structuring, pricing, and distributing new issues, with underwriting arrangements determining how placement risk is shared.

Securitization packages financial assets into marketable securities, distributing risk through tranching and credit enhancement and enabling new funding sources. Pools of loans are transferred to bankruptcy-remote SPVs, which issue ABS or MBS to investors. Senior tranches are designed to be relatively safe, while junior tranches absorb losses and offer higher returns. Securitization benefits originators, investors, and the broader financial system, but also introduces complexity and potential system-wide risks.

Understanding primary market mechanisms and securitization is essential for interpreting funding, trading, and risk in modern finance and is a recurring topic in CFA Level 1 questions.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the function of the primary market for raising new capital and how it differs from the secondary market.
• Distinguish public offerings from private placements in security issuance, including typical investors, regulation, and liquidity.
• Describe initial public offerings, seasoned equity offerings, rights offerings, and shelf registrations.
• Describe the roles of underwriter, syndicate, bookrunner, and issuer in new issues.
• Explain firm commitment, best efforts, bought deals, and standby underwriting arrangements.
• Explain the bookbuilding process and contrast it with fixed-price offerings and auctions.
• Define securitization, originator, SPV, and servicer.
• Define and differentiate ABS, MBS, pass-through securities, and covered bonds at a high level.
• Explain tranching, credit enhancement, and common internal and external credit support mechanisms.
• Identify benefits of securitization for originators (funding, risk transfer, capital relief) and for investors (access, diversification).
• Recognize key risks of securitization, including complexity, prepayment risk, and potential system-wide risk.
• Recognize the difference between primary and secondary market transactions in terms of cash flows for issuers and investors.

Key Terms and Concepts

• primary market
• secondary market
• initial public offering (IPO)
• seasoned equity offering (SEO)
• rights offering
• shelf registration
• public offering
• private placement
• underwriting
• syndicate
• bookrunner
• firm commitment underwriting
• best efforts underwriting
• bought deal
• standby underwriting
• bookbuilding
• auction
• securitization
• asset-backed security (ABS)
• mortgage-backed security (MBS)
• pass-through security
• credit enhancement
• internal credit enhancement
• external credit enhancement
• prepayment risk
• covered bond