Non Marketable Security Comprehensive Financial Guide

Core Description

• Non-marketable securities are financial assets that cannot be freely bought or sold in public markets and are generally restricted in their transfer or resale.
• Their value, liquidity, and risk profiles differ significantly from marketable securities, requiring careful analysis of issuer credit, legal restrictions, and redemption terms.
• Suitable for capital preservation, liability matching, and diversification, they demand a hold-to-maturity approach, diligent due diligence, and patience due to their illiquidity.

Definition and Background

A non-marketable security is a financial instrument that cannot be readily traded on an open exchange or secondary market. Unlike stocks and bonds listed on public exchanges, these assets are typically acquired directly from the issuer, such as via a private placement or through government programs that stipulate strict ownership and transfer rules. The lack of a public market for these instruments means investors cannot easily liquidate their positions or gauge their current market value through daily price quotes.

Non-marketable securities have a long history. Before organized exchanges were established, capital was often raised through bilateral contracts that included bills, loans, and annuities, most of which were not intended for open-market trading. Over time, governments institutionalized non-marketable instruments, introducing savings bonds for war financing and retail savings, such as U.S. Series E savings bonds and their successors (EE and I bonds). Internationally, products like the U.K.’s Premium Bonds, Germany's Bundesschatzbriefe, and Japan’s postal savings accounts share this characteristic.

In recent decades, private companies, banks, and institutions have increasingly used private placements, non-transferable loans, and restricted shares to raise capital or structure investments. These instruments come with restrictive covenants, documentation requirements, and legal provisions that prevent the free flow of ownership.

Calculation Methods and Applications

Non-marketable securities require unique valuation and analytical techniques due to their restricted markets and opaque pricing:

Discounted Cash Flow (DCF) Analysis

Since market prices are not readily available, discounted cash flow methods are often used. The present value (PV) is calculated by discounting expected future cash flows at a rate that reflects issuer credit risk and liquidity premium.

Formula:
PV = ∑ [CF(t) / (1 + r(t))^t] + RV / (1 + r(n))^n

• CF(t): Cash flow at time t
• r(t): Discount rate including risk-free rate, credit and illiquidity spreads
• RV: Residual value

Yield to Maturity (YTM) and Internal Rate of Return (IRR)

For instruments with predictable cash flows, the yield to maturity or IRR is derived from projected cash flows and current carrying value since market prices are unavailable.

Matrix Pricing and Comparable Yield Approach

Valuation may draw from the yields of similar, marketable securities, adjusting for illiquidity, maturity, seniority, and covenants.

Discounts for Lack of Marketability (DLOM)

A significant feature in non-marketable security valuation is the application of a discount for lack of marketability. Methods such as restricted stock studies, option models (Longstaff’s lookback model, Finnerty’s model), and empirical benchmarks help estimate this discount, which reflects the additional risk from not being able to liquidate the asset easily.

Credit and Embedded Options Analysis

For securities with embedded call or put options, scenario analysis and option-adjusted spread (OAS) calculations are necessary. Credit risk is factored into valuations using metrics like probability of default (PD) and loss given default (LGD), often referencing shadow ratings and external datasets.

Application Examples

• U.S. savings bonds accrue interest and can be valued at amortized cost, subject to redemption schedules and maturity.
• Private promissory notes are evaluated based on counterparty credit, projected payments, and legal enforceability.
• Non-transferable bank certificates use contractual interest rates and redemption terms, with fair value derived from DCF minus DLOM.

Comparison, Advantages, and Common Misconceptions

Comparison: Non-Marketable vs Marketable Securities

Advantages

• Capital Preservation: Many government-issued non-marketable securities offer principal stability and predictable returns, making them attractive for conservative investors.
• Predictable Income: Fixed coupons or accruals, and in some cases, tax advantages or deferrals (e.g., U.S. Series EE/I bonds).
• Diversification: Low correlation to equities and marketable bonds, providing portfolio ballast.
• Bespoke Terms: Tailored covenants and protections may suit specific investor needs.

Disadvantages

• Illiquidity: Selling can be time-consuming, costly, or impossible; redemptions may be inflexible.
• Pricing Opacity: Without active markets, determining fair value requires complex modeling, introducing risk of mispricing.
• Opportunity Cost: Capital is locked up and may miss higher returns in rising markets.

Common Misconceptions

• Myth: Non-marketable = worthless.
  Reality: These instruments have real value, but cannot be traded at will.
• Myth: Only high-risk assets are non-marketable.
  Reality: Many, such as government savings bonds, have a low credit risk but are illiquid.
• Myth: All can be sold at a discount.
  Reality: Some cannot be transferred at all, regardless of price, unless specific legal exceptions apply.
• Myth: All non-marketable securities offer high yields.
  Reality: Returns vary widely. Some offer lower yields in exchange for safety or stability.
• Myth: Government issue means full guarantee.
  Reality: While principal may be safe, liquidity and early exit are not assured.

Practical Guide

Identifying Suitability and Setting Objectives

Investors should determine the role non-marketable securities serve in their portfolios, such as income, risk management, or strategic access. Develop an Investment Policy Statement (IPS) outlining acceptable liquidity limits and single-issuer exposures.

Due Diligence Process

• Analyze issuer creditworthiness, covenant structures, and financial disclosures
• Understand legal documentation, including transfer restrictions and exemption status (e.g., Regulation D)

Managing Liquidity and Allocation

• Size positions considering your cash flow needs
• Avoid over-concentration; allocate only what can be locked for specified durations without jeopardizing liquidity
• Pair non-marketable holdings with liquid assets where possible

Valuation and Reporting

• Rely on DCF and peer-comparable methods, applying appropriate DLOMs
• Keep thorough documentation for audits and tax reporting

Execution and Custody

• Use regulated brokers or direct issuer portals; ensure all identity and compliance requirements are met
• Maintain accurate records of ownership, term sheets, and legends

Ongoing Monitoring

• Track financial health of issuers, and monitor for covenant breaches or impairment signals
• Know the contractual terms for exit—issuer redemption windows, tender offers, or buybacks

Case Study (Virtual Example, Not Investment Advice)

An endowment fund in the United States aims to match future scholarship payouts with secure income streams. It invests USD 2,000,000 in Series I U.S. Savings Bonds. The bonds are non-transferable, can only be redeemed by the purchasing institution, and pay inflation-linked interest semi-annually. Valuation at year-end is performed using the Treasury’s issued accrual schedules rather than market pricing. A backup liquidity plan is maintained with a small allocation to short-term Treasury bills for unforeseen cash needs. This example is for illustration only and does not constitute investment advice.

Resources for Learning and Improvement

Key Academic Texts:

• “Investments” by Bodie, Kane & Marcus (market structure, liquidity, private placements)
• “Investment Valuation” by Aswath Damodaran (valuation models, illiquidity adjustments)
• “Valuing a Business” by Shannon Pratt (private firm and restricted security appraisal)
• Robert Merton’s work on financial intermediation and liquidity risk

Regulatory Guidance:

• SEC Regulation D and Rule 144A publications
• U.S. Treasury and Internal Revenue Service advisories on savings bonds
• European Securities and Markets Authority (ESMA) documents on private offering exclusions

Industry Reports:

• Valuation discount studies from Duff & Phelps, Stout, and Kroll on marketability premiums/discounts
• Rating agency research on covenant and default risk for private debt

Professional Associations:

• American Society of Appraisers (ASA), AICPA, and Royal Institution of Chartered Surveyors (RICS) standards on illiquid assets
• CFA Institute content on liquidity, due diligence, and risk measurement

Data Sources:

• PitchBook, Preqin for private security comparables
• BVR and Mergerstat for transaction and valuation data
• Official issuer portals for government savings bonds

Continuing Education:

• Executive finance programs at leading universities (private capital, bond markets)
• CFA Institute, ASA, and AICPA workshops and webinars on private placements and valuation

FAQs

What is a non-marketable security, exactly?

A non-marketable security is a financial asset that cannot be freely bought or sold in public secondary markets because of legal or contractual restrictions, such as savings bonds, private promissory notes, or restricted stock.

How are non-marketable securities different from marketable securities?

Marketable securities (such as public shares and bonds) are actively traded, with real-time price transparency and broad investor access. Non-marketable securities require private negotiation or issuer consent for transfer, lack continuous pricing, and are often designed for buy-and-hold investing.

Who typically issues non-marketable securities?

Issuers include governments (via savings bonds), private firms (through restricted shares and private placements), banks (with nontransferable certificates), and institutions seeking to limit ownership changes or provide targeted funding.

Can I sell or transfer a non-marketable security?

Often, these securities are either completely non-transferable (for example, U.S. Savings Bonds) or transfer is allowed only under specific conditions (such as inheritance or with issuer consent). Check the contract and relevant laws before planning a transfer.

How are they valued in the absence of a public price?

Valuation typically depends on discounted cash flow analysis, recent comparable private transactions, and application of marketability discounts. Appraisals and periodic impairment tests are commonly used for audit and reporting.

What are the primary risks and rewards?

Key risks are illiquidity, valuation uncertainty, and potential concentration. Rewards may include higher yields, stable income, and in some cases, tax advantages or principal protection if held to maturity.

How is income from non-marketable securities taxed?

Tax treatment varies. Some instruments accrue interest for annual reporting, while others defer tax until redemption. Some national or state-level exemptions may apply. Always keep detailed records and consult up-to-date regulations.

How can an investor purchase and hold non-marketable securities?

Acquisition is typically direct from the issuer, through a private placement, or via specific banking channels. Holdings are registered with the issuer or a transfer agent rather than an exchange.

Conclusion

Non-marketable securities play a specialized role in modern portfolio construction, offering capital stability, predictable income, and the potential for diversification away from traditional, market-traded assets. Their unique structure—characterized by limited liquidity, lack of continuous pricing, and bespoke terms—requires investors to perform in-depth due diligence, maintain robust documentation, and align their investment horizon with the securities’ restricted exit options. While these instruments pose specific challenges around liquidity and valuation transparency, they also offer solutions for liability matching, tax-advantaged savings, and access to private investment opportunities. A well-constructed investment policy, tailored allocation, and access to high-quality resources are essential for the effective integration of non-marketable securities into a diversified portfolio.