Totality and fragmentation: realism and quest for meaning in the modern world. world

Debt can be created by borrowing from banks and other institutions or by issuing debt securities. For example, if a company wishes to borrow Rs.100 crore, it has two options. If it

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takes a bank loan for the total amount, then the bank is the sole lender to the company.

Alternately, it can access a larger pool of investors by breaking up the loan amount into smaller denominations. If it issues one crore debt securities, each with a face value of Rs.100, then an investor who brings in Rs.1000 would receive 10 securities. The lending exposure of each investor is limited to the extent of his investment.

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 debt security and include the principal, coupon and the maturity of the security:

Principal

The principal is the amount borrowed by the issuer. The face value of the security is the amount of the principal that is due on each debt security. Each investor, therefore, is owed a portion of the principal represented by his investment.

Coupon

The coupon is the rate of interest paid by the borrower. The interest rate is usually specified as a percentage of face value, and depends on factors such as the risk of default of the issuer, the credit policy of the lender, debt maturity and market conditions. The periodicity of interest payment (quarterly, semi-annually, annually) is also agreed upon in the debt contract.

Maturity

The maturity of a bond refers to the date on which the contract requires the borrower to repay the principal amount. Once the bond is redeemed or repaid, it is extinguished and ceases to exist.

Examples of debt securities include debentures, bonds, commercial paper, treasury bills and certificates of deposits. In Indian securities markets, a debt instrument denoting the borrowing of a government or public sector organization is called a bond and that of the private corporate sector is called debenture. Some have also argued that debentures are secured debt instruments, while bonds are unsecured. These differences have vanished over time. The terms, bonds and debentures are usually used interchangeably these days.

All debt securities grant the investor the right to coupon payments and principal repayment as per the debt contract. Some debt securities, called secured debt, also give investors rights over the assets of the issuing company. If there is a default on interest or principal payments, those assets can be sold to repay the investors. Investors with unsecured debt do not enjoy this option.

Some debt securities are listed on stock exchanges such as National Stock Exchange or Bombay Stock Exchange, so they can be traded in the secondary market. Unlisted securities have to be held until maturity.

35 2.10. Types and Structures of Debt Instruments

The basic features of a debt security can be modified to meet the specific requirements of the issuer or lender. The simplest form of debt is known as a plain vanilla bond and requires interest to be paid at a fixed rate periodically, and principal to be returned when the bond matures. The bond is usually issued at its face value, say Rs100, and redeemed at par, the same Rs100.

The plain vanilla bond structure allows slight variations such as higher or lower than par redemption price; or varying the frequency of interest between monthly, quarterly and annual payments. However, there are other ways in which bond structures can be altered so that they are no longer in the plain vanilla category.

Varying Coupon Structures Zero Coupon Bond

A zero coupon bond does not pay any coupons during the term of the bond. The bond is issued at a discount to the face value, and redeemed at face value. The effective interest earned is the difference between face value and the discounted issue price. A zero coupon bond with a long maturity is issued at a very big discount to the face value. Such bonds are also known as deep discount bonds.

In some cases the bond may be issued at face value, and redeemed at a premium. The effective interest earned by an investor is the difference between the redemption value and the face value. The defining characteristic is that there should be no intermediate coupon payments during the term of the bond.

Example: Zero Coupon Bond

In October 2009, ETHL Communications Holdings Ltd. (an Essar Group company) raised Rs. 4280 crore through an issue of zero coupon bonds. The bonds were launched in two separate series of slightly differing maturities.

Issuer: ETHL Communications Holdings Ltd Security: Zero coupon bond, secured by receivables Issue Date: October 2009

Maturity Date: Series 1 in July 2011, Series 2 in December 2011. Maturity value Rs.100 Issue price: Series 1- Rs. 85.80 (Implied rate 9.15%)

Series 2- Rs. 82.55 (Implied rate 9.25%) Floating Rate Bond

Floating rate bonds are instruments where the interest rate is not fixed, but re-set periodically with reference to a pre-decided benchmark rate. For instance, a company can issue a 5-year floating rate bond, with the rates being reset semi-annually at 50 basis points above the 1- year

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yield on central government securities. Every six months, the 1-year benchmark rate on government securities is ascertained from the prevailing market prices. The coupon rate the company would pay for the next six months is calculated as this benchmark rate plus 50 basis points.

Floating rate bonds are also known as 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 market.

Other Variations in Coupon Structure

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.

Callable Bonds

Callable bonds allow the issuer to redeem the bonds prior to their original maturity date. Such bonds have a call option in the bond contract, which lets the issuer alter the tenor of the security. For example, a 10-year bond may be issued with call options at the end of the 5^th year such as in the SBI bond illustration below. Such options give issuers more flexibility in managing their debt capital. If interest rates decline, an issuer can redeem a callable bond and re-issue fresh bonds at a lower interest rate. The investor in a callable bond, however, loses the opportunity to stay invested in a high coupon bond, if the call option is exercised by the issuer.

SBI Bonds 2011 Series 3

Issuer State Bank of India (SBI) Credit Rating Care AAA

Face Value Rs.10,000

Issue Price Rs.10,000

Interest Payment Annual

Coupon 9.75%

Tenor 10 years

Call Option SBI has the option to redeem outstanding principal and interest due after 5 years and one day from the date of allotment

Puttable Bonds

A puttable bond gives the investor the right to seek redemption from the issuer before the original maturity date. For example, a 7-year bond may have a put option at the end of the 5^th year. If interest rates have risen, puttable bonds give investors the ability to exit from low-coupon bonds and re-invest in higher low-coupon bonds.

37 Amortizing Bonds

Amortizing bonds are those in which the principal is not repaid at the end/maturity, but over the life of the bond. Thus the periodic payments made by the borrower include both interest and principal. Auto loans, consumer loans and home loans, in which each installment paid has both interest and principal components, are examples of amortizing bonds. The maturity of the amortizing bond refers only to the last payment in the amortizing schedule, because the principal is repaid over time.

2.10.2 Classification of Debt Instruments

Debt instruments can be classified in two broad ways.

By type of borrower: Securities can be divided into those issued by governments, and those issued by non-government agencies like banks, corporations and other such entities.

By tenor/maturity of the instrument: Securities can be classified as short-term, medium term and long term. Securities with maturities up to one year are issued and traded in the money market. Longer maturities are considered to be part of the capital markets.

These are not mutually exclusive segments. The government issues treasury bills in the money market, and long-term bonds in the capital market to meet its requirements for various periods. Private sector companies issue commercial paper in the money markets and bonds in the long term capital market.

Government Securities include central government bonds, as well as quasi-government bonds issued by local governments, state governments and municipal bodies. Government securities are considered to be free of credit or default risk. This is because the government can unilaterally increase taxes to repay its obligations, borrow easily form other entities, or print notes to repay debt in the extreme case.

Corporate bond markets are dominated by short-term commercial papers and long-term bonds. Banks issue short-term debt securities called certificates of deposit. The rate at which corporates, banks and institutions borrow depends upon the credit quality of the borrower. The credit or default risk of the borrower is measured by the credit rating of the bond. Higher the credit rating, lower the risk of default.

Companies also raise fixed deposits from the retail investors to meet their borrowing requirements. Such deposits are for a fixed term and carry a pre-defined interest rate.

Company deposits are credit rated but unsecured borrowings of companies. Since these are deposits and not a security, there is no liquidity. The investors hold the deposits to maturity.

2.10.2.1 Money Market Securities

The money market includes instruments for raising and investing funds for periods ranging from one day up to one year. Money market securities consist of repos/reverse repos, CBLOs (collateralized borrowing and lending obligations), certificates of deposits, treasury bills, and commercial paper. All these securities are issued at a discount and redeemed at par, and are zero coupon in structure. Money markets also include inter-bank call markets that are overnight lending transactions between banks, inter-bank terms markets that are long term deposits between banks, and inter-corporate deposits, which are short term lending between

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companies. These transactions do not involve creation of a debt security and are therefore not included here. The participants in the money market include banks, primary dealers, financial institutions, mutual funds, provident and pension funds, companies and the government. The purpose of the money market is to enable institutions and companies to meet short-term funding needs by borrowing and lending from each other.

Repos/reverse repos

A repo is a transaction in which one participant borrows money at a pre-determined rate against the collateral of eligible security for a specified period of time. A reverse repo is a lending transaction; a repo in the books of the borrower is a reverse repo in the books of the lender. Eligible collateral for repos and reverse repos are central and state government securities and select corporate bonds.

Collateralized Borrowing and Lending Obligation (CBLO)

A Collateralized Borrowing and Lending Obligation (CBLO) is an instrument used to lend and borrow for short periods, typically one to three days. The debt is fully secured against the collateral of government securities. CBLO is a standardized and traded repo.

Certificates of Deposits (CDs)

Certificates of Deposits (CDs) are short term tradable deposits issued by banks to raise funds.

CDs are different from regular bank deposits because they involve creation of securities. This makes the CD transferable before maturity. However, actual trading in CDs is extremely limited with most investors preferring to hold them to maturity.

Treasury Bills

The central government borrows extensively in the money market for its daily operations through the issue of short-term debt securities called Treasury bills (T-bills). T-bills are issued for maturities of 91 days, 182 days and 364 days. They are issued through an auction process managed by the RBI and listed soon after issue. Banks, mutual funds, insurance companies, provident funds, primary dealers and FIs bid in these auctions.

Commercial Paper

Companies and institutions raise short-term funds in the money market through the issue of commercial paper (CP). Though CPs are required to have a credit rating, they are unsecured corporate loans with a limited secondary market. They can be issued for various maturities of up to 364 days, but the 90-day CP is the most popular.

2.10.2.2 Government Securities

Government securities (G-secs), also called treasury bonds, are predominantly issued to fund the fiscal deficit of the government. G-secs are issued through an electronic auction system managed by the Reserve Bank of India. The RBI publishes a half-yearly issuance calendar that gives market participants information about the amount and tenor of g-secs to be auctioned in that year, along with approximate auction times. Government securities may have tenors ranging from one year to 30 years.

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Fixed coupon bonds, commonly referred to as dated securities, are the most common instrument in the g-sec market. These bonds have a fixed coupon rate, with semi-annual interest payments and are redeemed at par. Other instruments used for government borrowing include treasury bills, floating rate bonds, zero coupon bonds and inflation-indexed bonds.

The interest rate on G-secs sets the benchmark for pricing corporate bonds of varying maturities. Since government borrowing is considered to be free of credit risk, all other borrowers in the system borrow at a spread over the relevant G-sec benchmark rate. For example, if the 10-year G-sec rate is 8.4%, then a company that issues 10 year bonds will pay a higher rate than this benchmark. This premium reflects the additional credit risk faced by investors in corporate debt.

G-Secs are mandated to be listed as soon as they are issued. They constitute the most liquid segment of the Indian long-term debt market. Over 90% of trading activity in this market is accounted for by g-secs. However, trading tends to be concentrated in a few securities, known as benchmark securities (10 yr, 1 yr, 5 yr, 15 yr and 30 yr g-secs are some examples).

2.10.2.3 Corporate Bonds and Debentures

The market for long term corporate debt is made up of two segments:

a. Bonds issued by public sector units (PSU), including public financial institutions, and b. Bonds issued by the private corporate sector

PSU bonds can be further categorized as taxable and tax-free bonds. Tax-free bonds are mainly issued by PSUs in the infrastructure sector. The government may authorize specific PSUs to issue tax-free bonds. Interest income earned from tax-free bonds is not taxable for the investor.

Another category of PSU bonds, called capital gains bonds, are issued by National Highway Authority of Indian (NHAI), NABARD and National Housing Bank and such specifically notified entities. Investment in capital gains bonds allows investors to save tax on long-term capital gains under Section 54 EC of the Indian Income Tax Act.

PSU and institutional bonds dominate overall issuance in the corporate bond market. In terms of sectors, the financial sector accounts for around 70% of total bond issuance, and the manufacturing sector accounts for the remaining 30%.

Corporate bonds are issued at a spread to the G-sec yield. The difference between the two yields is called credit spread. Credit spread depends on the credit rating and the expected default probability associated with the issuing company, its industry of operation as well the overall credit and liquidity situation in the economy. Higher the credit rating, lower the credit spread and lower the rate which bonds can be issued.

Corporate bonds with embedded options, floating-rate interest, conversion options and a variety of structured obligations are issued in the markets. Issues that are retailed may offer varying interest options and bond structures in the same issue (see box).

Issuer: Shriram Transport Finance Corporation

Security: Non-convertible debentures of Rs. 500 crore with option to retain over subscription of up to Rs. 3000 crore

40 Issue open date: July 2, 2014

Issue close date: July 22, 2014

Credit Rating: AA/ Stable from CRISIL Minimum Application: Rs. 10,000/ (10 NCDs)

Series I II III IV VI

Tenure years) 3 5 7 5 3

Interest Payout Frequency

Annual Annual Annual Monthly Cumulative

Coupon Rate 9.85% 10% 10.15% 9.57% **

** Redemption amount Rs. 1368.02/- against face value of Rs.1000/-

2.11. Concepts and Terms Relating to Debt Securities

2.11.1 Time Value of Money

A rupee in hand today is more valuable than a rupee obtained in future. For example, let us compare receiving Rs.1000 today, and receiving it after 2 years. If today’s Rs.1000 is placed in a 2 year bank deposit earning simple interest of 8%, then it will be worth Rs.1080 (principal 1000 + interest 80) at the end of 2 years. This makes today’s Rs.1000 more valuable than the future Rs.1000. Clearly, the value of currently available funds over funds received in the future is due to the return that can be earned by investing current funds. If cash flows that are receivable at different points in time have to be compared, the time value of money has to be taken into account.

As a simple rule, today’s money is capable of growing at a given rate. So it should be compounded before being compared to an amount receivable on a future date. Money receivable on a future date should be discounted at a given rate before being compared to today’s money.

A debt instrument typically features future cash flows in the form of interest and principal returned on maturity. A sum of money is paid today to receive these benefits in the future. To evaluate a debt instrument, the future cash flows are discounted at a rate (known in the debt markets as yield) representing the current fair rate for that tenor and credit quality. These discounted cash flows are summed to arrive at today’s value of the future cash flows (also called the present value of the debt instrument). This is the theoretical fair value of the debt instrument.

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There are two important concepts around time value, also used in valuing debt instruments:

The further ahead in future the cash flow is, the lower its present value. If a bond pays 10%

interest every year, for the next 10 years, the present value of the interest income of Rs.10 receivable in one year will be higher than the present value of the same Rs.10 receivable in the 10^th year, even if the discount rate applied is the same.

The higher the discount rate or yield, the lower the present value. Assume that a bond pays 10% interest for the next 10 years, and the market yield for a comparable bond has moved up to 12%. The future cash flows of this bond will now be discounted at 12% and the bond will be worth much lesser. Alternatively, if the same cash flows are discounted at 8%, the

The higher the discount rate or yield, the lower the present value. Assume that a bond pays 10% interest for the next 10 years, and the market yield for a comparable bond has moved up to 12%. The future cash flows of this bond will now be discounted at 12% and the bond will be worth much lesser. Alternatively, if the same cash flows are discounted at 8%, the