Characteristics of Debt Securities

What this chapter covers

Units 1 to 5 carry 20 marks between them — about 4 marks for this chapter.

LEARNING OBJECTIVES: After studying this chapter, you should know about: Features of Debt Security · Market value of debt securities · Yield to Maturity of debt instruments · Types of Bonds · Features of Fixed and Floating Rate Bonds · Credit Rating · Money Market instruments

3.1 Features of a debt security

A debt security denotes a contract between the issuer (company) and the lender (investor) which allows the issuer to borrow a sum of money at pre-determined terms.

These terms are referred to as the features of a bond and include the principal, coupon (interest rate) and the maturity date of the bond.

Three features — principal, coupon, maturity date.

A naming convention worth knowing: in Indian securities markets, a debt instrument denoting the borrowing of a government or public sector organizations is called a bond and the borrowings by the private corporate sector is called debenture. The terms bonds and debentures are used interchangeably.

The three features

The principal is the amount which is being borrowed by the issuer. The face value or par value of the debenture is the amount of the principal that is due on each debenture at maturity. The face value of a debenture is usually Rs. 100 or Rs. 1,000.

The coupon is the rate of interest to be paid by the borrower to the lender. This is a percentage that is applied to the face value or par value of the bond. The periodicity of interest payment (annual, semi-annual, quarterly or monthly) is also specified.

The first sample question tests this — the coupon is the interest payable on a bond.

The maturity date of a bond refers to the date on which the contract requires the borrower to repay the principal amount. Different combinations of each of these features can be used to create instruments that meet the specific requirements of the borrower or the lender.

Debt against equity

It may, therefore, be emphasised that the debt securities have distinct characteristics in contrast to equities.

The debt holders are lenders to the company, while equity-holders are owners of the company;

The debt securities have fixed maturity period while equities are perpetual in nature;

The returns to debt holders are fixed at the time of issuance, whereas the equity-holders are entitled to residual profit, but not guaranteed;

The debt holders enjoy preference over equity-holders in receiving back payments in case of winding up of the company.

Four differences — status, maturity, return, priority.

3.2 Market value of a debt security

As stated earlier, the face value or par value of a debt instrument is its book value that represents the principal amount of the borrowing which is to be repaid to the investor at the time of maturity. If the debt instrument is traded in the market before its maturity, the value at which such trade is executed is called the market value of the debt instrument.

Market value may be higher or lower than the face value of the debt instrument. Market value fluctuates due to market dynamics such as demand-supply condition, market interest rate scenario etc.

The third sample question turns on the interest rate part of that sentence — bond prices are inversely related to interest rate movements. When market rates rise, an existing bond paying a lower coupon becomes less attractive, so its price falls; when rates fall, its price rises.

3.3 Yield from debt instruments

The return to an investor in bonds is known as yield. The returns to an investor in bonds, is primarily made up of the coupon payments. However, if the investor acquires or sells the bond at a price that is different from the par value it generates capital gains or loss, as the case may be. The returns to the investor in such a case can vary from the coupon.

Therefore, the coupon rate of the bond is not an indicator of the returns on the bond, but merely helps in computing what cash flows would accrue periodically, to the investor.

The term 'yield', rather than 'coupon rate', is used to denote the returns to the investor.

Current yield

Current yield simply compares the coupon of a bond with its market price (Coupon of the bond divided by its market price). For example, if a bond paying an annual coupon of 12 percent is trading in the market for Rs. 109.50, then the current yield is: 12/109.5 = 10.95 percent. Current yield is a measure of return of a bond.

Note the arithmetic: the coupon of 12 (that is, Rs. 12 on a Rs. 100 face value) divided by the market price of Rs. 109.50 gives 10.95 per cent.

Yield to Maturity

Yield to maturity (YTM) is a popular and extensively used method for computing the return on a bond investment. Every bond is made up of a set of cash flows that accrue at various points in time, from the time the bond is acquired, until it is sold or redeemed.

Therefore, using the principle of finance to value the bond, the price at which the series of future cash flows should sell is the sum of the discounted value of these cash flows. The rate which equates the discounted value of the cash flows with the price of the bond is the yield to maturity of the bond.

YTM is the rate that equates discounted cash flows with the bond's price — a fuller measure than current yield, since it takes in the redemption amount and the timing of every payment.

3.4 Types of debt securities

i. Convertible debt securities

As already discussed in Unit 1, convertible debt securities are hybrid instruments with features both of debt and equity. These securities pay the pre-determined coupon payments to the holders and on maturity the same is converted into equity based on pre-defined terms. The convertible debt securities are more suitable for low credit rating companies and companies with high growth potentials.

Advantage to Issuers: As it is a low-cost financing compared to other financing means, issuers are required to pay lower coupons to the lenders and also on maturity, repayment of principal amount need not be made as the security is converted into equity.

Advantage to Investors: Though the investors are paid a lower coupon rate, compared to other debt securities, the potential to earn capital appreciation on the converted security (equity) compensates the receipt of lower interest rate.

However, there involves a risk of dilution of stake of the existing shareholders in the company on conversion of the debt securities.

ii. Zero coupon bond

In such a bond, no coupons are paid or specified. The bond is issued at a discount to its face value. There are no intermittent payments of interest. When such a bond is issued for a very long tenor, the issue price is at a steep discount to the redemption value. Such a zero coupon bond is also called a deep discount bond.

The effective or implied interest earned by the buyer is the difference between the face value and the discounted price at which the bond is bought. There are also instances of zero coupon bonds being issued at par, and redeemed with interest at a premium. The essential feature of this type of bonds is the absence of periodic interest payments. They are suitable for financing projects with long gestation periods.

**The fourth sample question pairs the deep discount bond, a long term instrument, with the treasury bill, a short term one.

iii. Fixed rate bonds

Fixed rate bonds pay a pre-defined interest that are payable at specified intervals. Such bonds are also called as the plain vanilla bonds. A plain vanilla bond will have a fixed term to maturity with coupon being paid at pre-defined periods and the principal amount is repaid on maturity. The bond is usually issued at its face value and redeemed at par.

The simple variations to this structure could be a slightly varied issue price, higher or lower than par and a slightly altered redemption price, higher or lower than par. In some cases, the frequency of the interest payment could vary, from monthly, to quarterly and annual. All these variations still come under the plain vanilla definition of a bond, where the interest is paid at a fixed rate periodically, and principal returned when the bond is retired.

iv. Floating rate bonds

Instead of a pre-determined rate at which coupons are paid, it is possible to structure bonds, where the rate of interest is reset periodically, based on a benchmark rate such as RBI Repo Rate. Such bonds whose coupon rate is not fixed, but reset with reference to a benchmark rate, are called floating rate bonds.

The fifth sample question tests this — the reference rate for resetting the coupon is the benchmark rate.

For example, a company can issue a 5 year floating rate bond, with the rates being reset semi-annually with reference to the 1 year yield on central government securities and a 50 basis point mark-up. In this bond, the coupon rate is reset every six months based on the 1-year benchmark rate on government securities.

The other names, by which floating rate bonds are known, are variable rate bonds and adjustable rate bonds. These terms are generally used in the case of bonds whose coupon rates are reset at longer time intervals of a year and above. These bonds are common in the housing loan markets.

v. Inflation indexed bonds

Inflation Indexed Bonds (IIB) are a category of floating rate bonds where the benchmark is the inflation rate. Such instruments are generally government securities issued by the RBI that provides inflation protected returns to the investors.

A sub-type of the floating rate bond, with inflation as the benchmark.

vi. Amortising bonds

The structure of some bonds may be such that the principal is not repaid at the end/maturity, but over the life of the bond. A bond in which payments that are made by the borrower includes both interest and principal, is called an amortising bond. Auto loans, consumer loans and home loans are examples of amortising bonds. The maturity of the amortising bond refers only to the last payment in the amortising schedule, because the principal is repaid over time i.e. redemption in more than one instalment.

"Maturity" here means only the last instalment.

vii. Asset-backed securities

Asset backed securities represent a class of fixed income products, created out of pooling together assets, and creating bonds that represent participation in the cash flows from the asset pool. For example, select housing loans of a loan originator (say, a housing finance company) can be pooled, and bonds can be created, which represent a claim on the repayments made by home loan borrowers. Such bonds are called mortgage–backed securities. In some markets like India, these bonds are known as structured obligations (SO). Assets with regular streams of cash flows are ideally suited for creating asset-backed securities.

viii. Other types of bonds

Some of other structures are: (a) deferred interest bonds, where the borrower could defer the payment of coupons in the initial 1 to 3 year period; (b) Step-up bonds, where the coupon is stepped up periodically, so that the interest burden in the initial years is lower, and increases over time.

3.5 Classification of the debt market

There are two broad ways in which bond markets can be segmented.

Based on the type of borrower, we can segment the market between the bonds issued by governments, and those issued by non-government agencies like banks, corporations and other such entities.

Based on the tenor of the instrument, we can segment the bond markets as short-term, medium term and long term.

These are not mutually exclusive segments. The government issues bonds to meet its requirements for various periods as does the private sector. Each issued bond has an issuer and a tenor.

Government Securities comprises the central government bonds, and quasi-government bonds issued by local governments, state governments and municipal bodies. Government securities do not have credit or default risk.

No credit or default risk — the essential feature of a government security.

Corporate bond markets comprise pre-dominantly of short-term commercial papers and long-term bonds. Another segment comprises of short-term paper issued by banks, in the form of certificates of deposit. The rate at which the non-government segment borrows depends upon the credit quality of the borrower. The credit or default risk of the borrower is defined by the credit rating of the bond. Higher the credit rating, lower is the risk of default.

The second sample question follows from that last sentence — a bond with a higher credit rating pays a lower rate of interest.

3.6 Credit rating

The biggest risk faced by investors in debt securities is the possibility of the borrower not honouring their commitment on payment of interest on the borrowing and repayment of the principal on maturity of the instruments.

The ability of the borrower to meet its obligation will depend upon factors internal and external to the business. Lenders therefore evaluate these factors associated with the borrower before entering into the transaction. The decision of a lender on whether or not to lend to a borrower and at what cost would be determined by the risk associated with the borrower. This risk of the possibility of a default on obligations by the borrower is called the credit risk of the borrower.

The credit risk of a borrower is evaluated by credit rating agencies. Credit rating agencies have to be registered with SEBI and abide by the regulations laid down in SEBI (Credit Rating Agencies) Regulations, 1999 in the conduct of such evaluations.

The credit rating agencies consider all the qualitative and quantitative factors that impact the business of the borrower and consequently their ability to meet their financial obligations. The appraisal is done by industry experts and the information collected not only from the borrower but from other sources as well. Based on their appraisal, the rating committee of the credit rating agency will assign a rating to the borrowing.

Rating is therefore an exercise that converts into a symbol the ability and willingness of the company to service the instrument proposed to be issued.

Ability and willingness — both are assessed.

The credit rating assigned to an instrument is not static but is dynamic. This means that the credit risk associated with a borrowing may change over time. Credit rating agencies are required by SEBI to constantly monitor factors that affect the status of the instrument and to reassign a rating if the credit quality of the instrument improves or deteriorates.

Provisional ratings

A rating will be considered as provisional, and not final, in cases where certain compliances that are crucial to the assignment of credit rating are yet to be complied with or certain documentations remain to be executed at the time of rating. All provisional ratings ('long term' or 'short term') for debt instruments need to be prefixed as 'provisional' before the rating symbol in all communications-- rating letter, press release and rating rationale.

Prefixed, in every communication.

I. Long term debt instruments

Long term debt instruments: The instruments with original maturity exceeding one year. Rating symbols should have CRA's first name as prefix.

Modifiers {"+" (plus) / "-"(minus)} can be used with the rating symbols for the categories AA to C. The modifiers reflect the comparative standing within the category.

Note that AAA and D take no modifier — only AA to C.

II. Short term debt instruments

Short term debt instruments: The instruments with original maturity of upto one year.

Modifier {"+" (plus)} can be used with the rating symbols for the categories A1 to A4.

Only a plus here — no minus.

III. Long term debt mutual fund schemes

Long term debt mutual fund schemes: The debt mutual fund schemes that have an original maturity exceeding one year.

AAAmfs highest degree of safety · AAmfs high · Amfs adequate · BBBmfs moderate degree of safety · BBmfs moderate risk of default · Bmfs high risk of default · Cmfs very high risk of default — all regarding timely receipt of payments from the investments that they have made.

Modifiers {"+" (plus) / "-"(minus)} can be used with the rating symbols for the categories AAmfs to Cmfs.

Note there is no "Dmfs" in this scale.

IV. Short term debt mutual fund schemes

Short term debt mutual fund schemes: The debt mutual fund schemes that have an original maturity of upto one year.

A1mfs very strong · A2mfs moderate · A3mfs adequate · A4mfs minimal degree of safety.

Modifiers {"+" (plus)} can be used with the rating symbols for the categories A1mfs to A4mfs.

Two suffixes and a scale

Further to the above, the credit rating agencies suffix 'CE' i.e. Credit Enhancement, to the rating of instruments having explicit credit enhancement. In addition to this, SEBI has introduced Expected Loss based Rating Scale for rating of projects/ instruments associated with infrastructure sector.

3.6.1 Unrated bonds

Bonds that do not have any current or valid rating by an external rating agency are unrated bonds. Since unrated instruments are more illiquid than rated instruments, the yield of such unrated instruments is higher. SEBI has provided guidelines for mutual funds on investments in unrated debt instruments.

Illiquid, so higher yield.

3.7 Money market instruments

Money market refers to the market where instruments with a maturity of less than one year are issued and traded. Money market participants are generally commercial banks and the central bank. The money market is the platform for banks and government to finance their short-term capital requirements.

It is a wholesale market with large volumes. It is considered the most liquid of all financial markets with borrowing and lending transactions done for shorter periods such as one day.

Instruments in money markets include Commercial papers, Certificates of deposit, Treasury Bills etc. that are due to mature within 365 days, and long-term government debt.

Three named instruments — commercial paper, certificates of deposit and treasury bills — maturing within 365 days.

The chapter's sample questions confirm that the coupon of a bond refers to the interest payable on it; that a bond with a higher credit rating pays lower interest rates; that bond prices are inversely related to interest rate movements; that treasury bills are short term debt securities while deep discount bonds are long term ones; and that the benchmark rate is the reference rate for resetting the coupon rate.