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

Learning Outcomes

After studying this article, you will be able to explain how capital is raised in primary markets, distinguish public offerings from private placements, outline the issuer and underwriter roles, and describe the securitization process. You will be able to interpret the purpose of tranching, SPVs, and asset-backed securities, and assess the effects of securitization on funding and risk for issuers and investors. This is fundamental knowledge for CFA Level 1 candidates.

CFA Level 1 Syllabus

For CFA Level 1, you are required to understand the fundamentals of capital raising, security issuance, and securitization. Specifically, you should be able to:

• 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.
• Define securitization and differentiate mortgage-backed and asset-backed securities.
• Explain the purpose of pooling assets and tranching in securitization.
• Assess the benefits 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 function of the primary market in the context of corporate finance?
2. How does a private placement differ from a public offering?
3. Who is responsible for bookbuilding in a new securities offering?
4. What is the main purpose of forming tranches in a securitization deal?

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.

The Primary Market: Security Issuance Fundamentals

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.

Key Term: private placement
Sale of new securities directly to select investors, typically exempt from public registration.

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.

• 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: underwriting
An arrangement where an intermediary guarantees the sale or placement of a new securities issue.

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

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

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

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:
The underwriter guarantees proceeds by purchasing the bonds in full and then resells them to investors. The underwriter bears the risk of any unsold balance.

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 complete the issuance quickly and with lower cost, but investors may face less liquidity when trading these securities later.

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).

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.

Securitization Process

1. Asset Pooling: The originator (often a bank) pools together assets such as mortgages, auto loans, or credit card receivables.
2. Transfer to an SPV: The pool is sold to a special purpose vehicle (SPV), which becomes legally separate from the originator.
3. Structuring and Tranching: The SPV structures the pool into classes of securities, or "tranches," each with different seniority, credit risk, and expected yield.
4. Issuance and Payment: The SPV sells these securities to investors, who receive cash flows from the pooled assets in accordance with the priority specified by their tranche.

Key Term: securitization
The financial process of creating tradable securities backed by pools of financial assets.

Key Term: special purpose vehicle (SPV)
A separate legal entity created solely to acquire financial assets and issue securities backed by those assets.

Key Term: tranche
A portion or class of a securitization structure with defined risk and return characteristics and priority in payments.

Key Term: asset-backed security (ABS)
A bond or note backed by a pool of non-mortgage financial assets with predictable cash flows.

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

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.

Benefits and Stakeholders in Securitization

• Originators receive cash upfront, diversify funding, manage risk, and can reduce regulatory capital requirements by transferring assets and their associated risk off their balance sheets.
• Investors gain access to asset classes and risk profiles that may otherwise be unavailable, potentially with favorable risk-adjusted returns.
• The financial system benefits from increased liquidity and funding options, but also faces complexity and heightened risk of mispricing or misunderstanding.

Worked Example 1.3

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 for new lending, may achieve better regulatory capital ratios, and the risk of losses is passed, in part, to ABS investors via the subordinate (junior) tranches.

Revision Tip

Remember: Senior tranches in securitizations usually receive payments first and are safer, but junior tranches offer higher yields and bear initial losses.

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 new issuance. Securitization packages financial assets into marketable securities, distributing risk through tranching and enabling new funding sources. Understanding primary market mechanisms and securitization is essential for interpreting funding, trading, and risk in modern finance.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the function of the primary market for raising new capital.
• Distinguish public offerings from private placements in security issuance.
• Describe the roles of underwriter, syndicate, and bookrunner.
• Explain the bookbuilding process for new offerings.
• Define securitization, SPV, and tranching.
• Identify benefits of securitization for originators and investors.
• Recognize the difference between the primary and secondary market.

Key Terms and Concepts

• primary market
• public offering
• private placement
• underwriting
• bookbuilding
• syndicate
• bookrunner
• securitization
• special purpose vehicle (SPV)
• tranche
• asset-backed security (ABS)
• mortgage-backed security (MBS)