Characteristics of Debt Securities

What this chapter covers

Chapter 3 carries 6 marks out of 100 — 6% of the paper.

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 point of Indian usage: 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.

Government borrows through bonds, private companies through debentures — though the words are used interchangeably in practice.

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.

Note that the coupon is applied to face value, never to market price — the same principle as dividend in Chapter 2.

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 — four contrasts

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 return 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.

Lender against owner; fixed term against perpetuity; fixed return against residual; priority against last in line.

3.2 Market value of a debt security

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.

Two different numbers. Face value is fixed and determines both the coupon amount and the redemption amount; market value moves with demand, supply and interest rates.

3.3 Yield from debt instruments

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 coupon tells you the cash flow, not the return.

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. 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*100 = 10.96 percent.

Note what happened. A 12 per cent coupon bond bought above par yields less than 12 per cent — because the investor paid Rs. 109.50 to receive Rs. 12 a year.

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 discount rate that makes the present value of all future cash flows equal to the bond's price — and it is the yield an investor earns by holding the bond to maturity.

3.4 Types of debt securities

i. Convertible Debt Securities

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: It is a low cost financing compared to other financing means, issuers 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.

And a cost falling on someone else: 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.

One variant to note: there are also instances of zero coupon bonds being issued at par, and redeemed with interest at a premium.

So a zero coupon bond is not always issued at a discount — but it is never issued at a premium, which is what the sample question tests.

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 defining feature is the absence of periodic interest, not the discount.

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.

Minor variations in price or frequency do not take a bond out of the plain vanilla category — what matters is that the rate is fixed.

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 worked 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.

A benchmark plus a spread, reset at intervals.

Other names: 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 which provides inflation protected returns to the investors.

A sub-category of floating rate bonds — the benchmark simply happens to be inflation.

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.

And a point about its maturity date: 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.

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.

The illustration: 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

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.

Both ease the early years — one by postponing coupons, the other by starting them low.

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.

And the two cut across each other: 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 — which is why they serve as the benchmark for other borrowing.

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.

And what determines the cost: 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.

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.

Who evaluates it: 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.

How they work: 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.

And the definition to remember: rating is therefore an exercise that converts the ability and willingness of the company to service the instrument proposed to be issued into a symbol.

Ability and willingness — both — reduced to a symbol.

Ratings change: 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.

The standardised symbols

SEBI has standardized the rating symbols used by the credit rating agencies so that investors are able to easily gauge the level of credit risk assigned to an instrument.

Rating symbols should have CRA's first name as prefix in every category.

I. Long term debt instruments — the instruments with original maturity exceeding one year

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 the range — AA to C. Neither AAA nor D takes a modifier.

II. 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 in the short term scale — no minus.

III and IV. Mutual fund schemes. The same two scales, suffixed mfs — AAAmfs down to Cmfs for long term schemes (modifiers... for the categories AAmfs to Cmfs), and A1mfs to A4mfs for short term schemes (modifiers {"+" (plus)}... for the categories A1mfs to A4mfs). These describe timely receipt of payments from the investments that they have made.

Two further refinements: the credit rating agencies suffix 'CE' i.e. Credit Enhancement, to the rating of instruments having explicit credit enhancement, and 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.

Less liquidity, higher yield — the investor is paid for the uncertainty.

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.

Wholesale, large volumes, most liquid — and periods as short as one day.

3.7.1 Commercial Paper

Commercial Paper (CP), an unsecured money market instrument issued in the form of a promissory note, was introduced in India in 1990 with a view to enable highly rated corporate borrowers to diversify their sources of short-term borrowings and provide an additional instrument to the investors.

Unsecured, a promissory note, introduced in 1990.

Who else may issue: subsequently, primary dealers (PDs) and all-India financial institutions (FIs) were also permitted to issue CP to enable them to meet their short-term funding requirements.

The limit: the aggregate amount of CP that can be issued by an issuer shall at all times be within the limit as approved by its Board of Directors or the quantum indicated by the Credit Rating Agency (CRA) for the specified rating, whichever is lower.

Whichever is lower — the board's limit or the rating agency's.

Who may invest: individuals, banks, other corporate bodies (registered or incorporated in India) and unincorporated bodies, Non-Resident Indians and Foreign Portfolio Investors (FPIs) shall be eligible to invest in CPs. FPIs are subject to SEBI's conditions and to the Foreign Exchange Management Act, 1999, the Foreign Exchange (Deposit) Regulations, 2000 and the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000.

Why it is used: commercial paper has emerged as an effective instrument for all corporate companies to avail the short-term funds from the money market within the shortest possible time limit by avoiding the hassles of direct negotiation with the commercial banks for availing the short-term loans.

3.7.2 Certificate of Deposit

Certificate of Deposit (CD) is a negotiable money market instrument and issued in dematerialised form or as a Usance Promissory Note against funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India (RBI).

Who may issue: (i) scheduled commercial banks (excluding Regional Rural Banks and Local Area Banks); and (ii) select All-India Financial Institutions (FIs) that have been permitted by RBI to raise short-term resources within the umbrella limit.

The minimum: minimum amount of a CD should be Rs.1 lakh, i.e., the minimum deposit that could be accepted from a single subscriber should not be less than Rs.1 lakh, and in multiples of Rs. 1 lakh thereafter.

Who may subscribe: individuals, corporations, companies (including banks and PDs), trusts, funds, associations, etc. Non-Resident Indians (NRIs) may also subscribe to CDs, but only on non-repatriable basis, which should be clearly stated on the Certificate. Such CDs cannot be endorsed to another NRI in the secondary market.

The tenors, which differ by issuer:

The maturity period of CDs issued by banks should not be less than 7 days and not more than one year, from the date of issue.

The FIs can issue CDs for a period not less than 1 year and not exceeding 3 years from the date of issue.

Banks: 7 days to 1 year. Financial institutions: 1 year to 3 years.

3.7.3 Treasury Bills

Treasury bills or T-bills, which are money market instruments, are short term debt instruments issued by the Government of India and are presently issued in three tenors, namely, 91 day, 182 day and 364 day.

Three tenors — 91, 182 and 364 days.

Treasury bills are zero coupon securities and pay no interest. Instead, they are issued at a discount and redeemed at the face value at maturity.

The worked example: a 91 day Treasury bill of Rs. 100/- (face value) may be issued at say Rs. 98.20, that is, at a discount of Rs. 1.80 (i.e. 100-98.20) and would be redeemed at the face value of Rs. 100/-. The return to the investors is the difference between the maturity value or the face value (i.e. Rs. 100) and the issue price (i.e. Rs. 98.20).

T-bills are the classic zero coupon security — and being government paper, they carry no credit or default risk.

The sample questions confirm that the coupon is the interest payable on a bond; that a bond with a higher credit rating pays a lower interest rate; that bond prices are inversely related to interest rate movements; that it is false that a zero coupon bond is always issued at a premium; and that it is true that the YTM is the yield an investor will earn on holding a bond to maturity.