Characteristics of Other Securities

What this chapter covers

Chapter 4 carries 3 marks out of 100 — 3% of the paper.

Learning Objectives: After studying this chapter, you should know about other types of securities such as: Warrants · Convertible Debentures (CDs) · Depository Receipts (DRs) · Foreign Currency Convertible Bonds (FCCBs) · Exchange Traded Funds (ETFs) and Index Funds · Real Estate Investment Trusts (REITs) · Infrastructure Investment Trusts (InvITs)

Why such instruments exist: companies raise capital using equity and debt instruments. The basic features of these instruments can be modified to suit the specific requirements of the borrowers or lenders. Such modifications bring advantages such as wider participation, better management of cash flows and better return prospects.

Three advantages — wider participation, better cash flow management, better return prospects.

4.1 Warrants

Warrants give the investors the right to buy shares of the company in the future. The number of shares that the warrant entitles the holder to subscribe to at a pre-determined date and price are specified at the time of issue.

Conversion/ exercise of the warrants results in increase in share capital.

Warrants may be traded on the stock exchange as a security separate from the debenture with which it was issued.

Note that — a warrant is usually issued with a debenture but can be detached and traded on its own. The first sample question tests this: warrants are usually issued along with debentures.

Warrants usually have a longer lifetime as compared to options contracts which they closely resemble — options being a type of derivatives contract that gives buyer the right to exercise the option to buy or sell the underlying security at a pre-defined date and price.

When a warrant is exercised

Warrants will be exercised if the share price at the time of exercise is higher than the price at which the investors have the right/ option to buy the shares.

The workbook's illustration: assume a warrant enables an investor to buy an equity share of a company at Rs.100. The warrant will be exercised: (a) when it is due to be exercised, (b) if the price of the share in the market is more than Rs.100. If the market price is less than Rs.100, the investor can always buy from the market, rather than use the option to buy the same share at a higher price.

Two conditions — the due date, and a market price above the exercise price. Nobody pays Rs. 100 for something available at Rs. 90.

A use for promoters: warrants may be used by promoters to increase their stake in the company. Issue of warrants is subject to SEBI guidelines and shareholders' approval. The regulations include an upfront payment and a lock in on conversion.

4.2 Convertible debentures

Convertible debentures are debt instruments that can be converted into equity shares of the company at a future date. The security has features of both debt and equity. It pays periodic coupon interest till the date of redemption/ conversion into equity shares, just like any other debt instrument.

At the time of redemption of the debenture, the investors can choose to receive shares of the company instead of cash redemption.

The four conversion terms

The issuer specifies the details of the conversion at the time of making the issue. This will include:

The date on which the conversion will be made.

The ratio of conversion i.e. the number of shares that the investor will be eligible to get for each debenture.

The price at which the shares will be allotted to the investor on conversion. Usually this is at a discount to the market price.

The proportion (full or part) of the debenture that will be converted into equity shares. Accordingly, the debenture may be referred to as Fully Convertible Debenture (FCD) or Partly Convertible Debenture (PCD) or Non-Convertible Debenture (NCD).

Date, ratio, price, proportion — and the fourth gives the three familiar abbreviations.

Note the second sample question. In a partly convertible debenture, only part converts; the non-convertible portion is repaid through cheque/NEFT/IMPS on maturity, like any ordinary debt.

Why each side accepts it

The advantage to the issuer of convertible debenture lies in the fact that convertible debentures usually have a lower coupon rate than pure debt instruments. This is because the yield to the investor in such debenture is not only from the coupon alone but also the possibility of capital appreciation in the investment once the debentures are converted into equity.

Moreover, the issuer does not have to repay the debt on maturity since shares are issued in lieu of repayment, thus saving cash outflow.

Two benefits to the issuer — a lower coupon and no cash repayment.

And the cost to existing shareholders: the shareholding percentage of the existing shareholders gets diluted when fresh shares are issued on conversion. Thus convertible debentures are normally issued on rights basis or with specific approval of existing shareholders. Issue of convertible debentures is governed by SEBI Regulations.

4.3 Depository Receipts

Depository receipts (DRs) are financial instruments that represent shares of a local company but are listed and traded on a stock exchange outside the country. DRs are issued in foreign currency, usually in US Dollars. DRs allow overseas investors to easily invest in a company.

How they come into being: to issue a DR, a specific quantity underlying equity shares of a company are lodged with a custodian bank, which authorises the issue of depository receipts against the shares. Depending on the country of issue and conditions of issue, the DRs can be converted into equity shares.

The third sample question asks who holds the underlying stock — the Depository Bank / Local Custodian.

ADR, GDR, IDR

DRs are called American Depository Receipts (ADRs) if they are listed on a stock exchange in the USA such as the New York Stock Exchange or NASDAQ. If the DRs are listed on a stock exchange outside the US, they are called Global Depository Receipts (GDRs).

When DRs are issued in India and listed on stock exchanges in India with foreign company stocks as underlying shares, these are called Indian Depository Receipts (IDRs).

ADR — in the USA. GDR — outside the US. IDR — in India, over foreign shares.

Note the direction of an IDR — a foreign company's shares made available to Indian investors, the reverse of an ADR or GDR.

And listing standards differ: the listing requirements of stock exchanges can be different in terms of size of the company, state of its finances, shareholding pattern and disclosure requirements.

What each side gets

The company, whose shares are traded as DRs, gets a wider investor base from the international markets. Investors in international markets get easy access to invest in shares of an overseas company.

But one right is withheld: holding DRs, gives investors the right to dividends and capital appreciation from the underlying shares, but not voting rights.

The fourth sample question tests exactly this — DR holders do not have voting rights, though they do receive dividend and capital appreciation.

The steps in issuing DRs

The company has to comply with the listing requirements of the stock exchange and market regulator where they propose to get the DRs listed.

The company appoints a depository bank which will hold the stock and issue DRs against it.

If it is a sponsored issue, the stocks from existing shareholders are acquired and delivered to the local custodian of the depository bank. Else the company issues fresh shares against which the DRs will be issued.

Each DR will represent certain number of underlying shares of the company.

Then: once the custodian confirms that the shares have been received by them, the depository bank in the foreign country will issue the depository receipts to the brokers to trade in the chosen stock exchange where the DRs have been listed.

Note the two routes at step three — a sponsored issue draws on existing shareholders' stock; otherwise the company issues fresh shares.

4.4 Foreign Currency Convertible Bonds

Foreign Currency Convertible Bonds (FCCB) are issued by Indian companies and subscribed to by investors in foreign currency. They carry a fixed interest or coupon rate and are convertible into a certain number of ordinary shares at a preferred price.

The payment of interest and repayment of principal (if required) is in foreign currency.

The fifth sample question tests that sentence — it is true.

The conversion price is usually set at a premium to the current market price of the shares.

Note the contrast with a convertible debenture, where the conversion price is usually... at a discount to the market price. An FCCB is priced at a premium.

Three advantages: FCCBs allow companies to raise debt at lower rates abroad. It also protects the cash flows since maturity is by conversion of debt into equity. Also the time taken to raise FCCBs may be less than what takes to raise pure debt abroad.

Cheaper, cash-flow protecting, and faster.

How it is regulated: issuance of FCCBs is regulated by Reserve Bank of India (RBI) notifications under the Foreign Exchange Management Act (FEMA). The Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism), 1993 lays down the guidelines for such issues. The issue of FCCBs should be within the limits specified by RBI from time to time.

RBI and FEMA, not SEBI — because foreign currency is involved.

4.5 Exchange Traded Funds and Index Funds

Exchange Traded Funds (ETF) are a type of mutual funds that are listed and traded on a stock exchange. ETFs are passive funds that generate returns in line with the index or benchmark. There is no investment strategy used to generate higher returns other than what the index does.

Index Funds are also passive funds but are not traded on stock exchanges. They are expected to offer a return in line with the market because they invest in a portfolio that mimics a market index. The portfolio of index funds consists of the same securities as that of market index in the exact weightages allotted to each security.

Both are passive; only the ETF is listed and traded.

The comparison table

Read the ETF column across — it takes the flexible unit capital of an open-ended fund and the tradability of a close-ended one, with real-time NAV, daily disclosure and cheap intra-day trading.

Exchange traded funds are most popular as index based ETFs. However, other variants are also possible, such as, debt oriented ETFs and Gold ETFs. Exchange Traded Funds offer a low cost investment avenue to its investors.

4.6 Investment Trusts

An Investment Trust, pools the funds of its investors/ shareholders and invests them in a diversified portfolio of securities. Investment Trusts are typically close ended funds which can be traded on a stock exchange. In Indian markets, 2 types of investment trusts are operational under the appropriate SEBI Regulations.

i. Real Estate Investment Trusts (REITs)

REITs are trusts registered with SEBI that invest in commercial real estate assets. The REIT will raise funds through an initial offer and subsequently through follow-on offers, rights issue and institutional placements.

The value of the assets owned or proposed to be owned by a REIT, coming out with an initial offer, will not be less than Rs. 500 crore and the minimum offer size will not be less than Rs.250 crore. The minimum subscription amount in an initial and follow-on offer shall be in the range of Rs. 10,000 to Rs. 15,000. The units are listed on the stock exchange.

Assets Rs. 500 crore; offer Rs. 250 crore; subscription Rs. 10,000 to Rs. 15,000.

ii. Infrastructure Investment Trusts (InvITs)

InvITs are trusts registered with SEBI that invest in the infrastructure sector. The InvIT will raise funds from the public through an initial offer of units. The offer shall be for not less than Rs. 250 crores and the value of the proposed assets of the InvIT shall not be less than Rs. 500 crores. The minimum subscription amount in an initial and follow-on offer shall be in the range of Rs. 10,000 to Rs. 15,000. The units are listed on a stock exchange.

The same three figures — Rs. 500 crore of assets, Rs. 250 crore minimum offer, Rs. 10,000 to Rs. 15,000 subscription. Only the sector differs: commercial real estate for a REIT, infrastructure for an InvIT.

Both were amended with effect from 30.07.2021 — by the SEBI (Real Estate Investment Trusts) (Amendment) Regulations, 2021 and the SEBI (Infrastructure Investment Trusts)(Amendment) Regulations, 2021.

4.7 Alternate Investment Funds

SEBI (Alternative Investment Funds) Regulations define AIFs as any fund established or incorporated in India in the form of a trust or company or a body corporate or a Limited Liability Partnership (LLP). AIFs are privately pooled investment vehicle that collect funds from investors (whether from Indian or foreign sources) for investing in accordance with a defined investment policy for the benefit of its investors.

Four permitted forms — trust, company, body corporate or LLP — and the funds are privately pooled, not raised from the public.

What makes them "alternative": AIF acts as an alternative investment option that invests in alternative assets and strategies. AIF explores alternative investment opportunities and does not follow traditional ways of investing in stocks, bonds or commodities.

The categories: there are 3 categories of AIFs, out of these, Category I and Category II are close-ended funds and only Category III is both open-ended and close-ended fund. In addition to these, SEBI introduced a 'specified AIF' category that includes Corporate Debt Market Development Fund.

Categories I and II close-ended; Category III either.

Recent changes: SEBI issued amendments separating Angel Funds as a dedicated AIF sub-category and stricter norms around investor eligibility, disclosure, governance, and investment thresholds have been introduced. Existing funds have a transition window until September 2026 to comply.

And co-investment: the regulations formally define Coinvestment schemes, allowing accredited investors of Category I and II AIFs to invest alongside the main fund in unlisted companies. These schemes require a shelf placement memorandum and are limited to a single investee company per scheme, ensuring that coinvestor terms are not more favorable than those of the AIF.

One investee company per scheme, and no better terms than the AIF itself gets.

4.8 Corporate Fixed Deposits

The deposit placed by investors with companies for a fixed term carrying a prescribed rate of interest is called Company Fixed Deposit. Financial institutions and Non-Banking Finance Companies (NBFCs) also accept such deposits.

Deposits thus mobilized, are governed by the Companies Act, 2013 under Section 76.

And the warning the workbook attaches: these deposits are unsecured, i.e., if the company defaults, the investor cannot sell the documents to recover his capital, thus making them a risky investment option.

Unsecured, and therefore risky — the depositor has no charge over any asset to fall back on.

The sample questions confirm that warrants are usually issued along with debentures; that the non-convertible portion of a partly convertible debenture is repaid through cheque/NEFT/IMPS on maturity; that the underlying stock in a DR issue is held by the Depository Bank / Local Custodian; that DR holders do not have voting rights; and that it is true that interest and principal on an FCCB are paid in foreign currency.