4. Session Readings (Debt Market)

7/29/2019 4. Session Readings (Debt Market)

1/10

DEBENTURES/ BONDS

A bond or debenture is a long term instrument of debt issued by a business or government. It representsdebt in that the bond buyer actually lends the face amount to the bond issuer. The certificate itself isevidence of a lender creditor relationship. It is a security because unlike a car loan or home -

improvement loan, the debt can be bought and sold in the open market. In fact a bond is a loan intended to

be bought and sold. It is long-term by definition; in order to be called a bond. The term must be longerthan five years. Debt securities with maturities under five years are called bills, notes or other terms.

Since bonds are intended to be bought and sold, all the certificates of a bond issue contain a master loanagreement. This agreement between issuer and investor (or creditor and lender), called the bond

indenture or deed of trust, contains all the information you would normally expect to see in any loanagreement, including the following:

(a) Par Value: The face amount par value. or principal is the amount of the loan - the amount that

the bond issuer has agreed to repay at the bonds maturity.

(b) Coupon Rate and Interest: Bonds are issued with a specified coupon or nominal rate, which is

determined largely by market conditions at the time of the bonds primary offering. Once determined, it is

set contractually for the life of the bond. The amount of the interest payment can be easily calculated bymultiplying the rate of interest (or coupon) by the face value of the bond. For instance, a bond with a faceamount of Rs. 1000 and a coupon of 8% pays the bondholder Rs. 80 a year.

(c) Schedule or Form of Interest Payments: Interest is paid on most bonds at six-month intervals,usually on either the first or the fifteenth of the month. The Rs.80 of annual interest on the bond in the

previous example would probably be paid In two installments of Rs. 40 each.

(d) Maturity Period: A bonds maturity or the length of time until the principal is repaid varies greatlybut is always more than five years. Debt that matures in less than a year is a money market instrument -such as commercial paper or bankers acceptances. While government bonds have maturity periods

extending up to 20-25 years. A short-term bond, on the other hand, may have an initial maturity of five

years. A long- term bond typically matures in 20 to 40 years. The maturity of any bond ispredetermined and stated in the trust indenture. At the time of maturity the par (face) value plus nominalpremium is payable to the bondholder.

(e)Call Feature (if any): A call feature, if specified in the trust indenture, allows the bond Issuer tocall in the bonds and repay them at a predetermined price before maturity. Bond issuers use this featureto protect themselves from paying more interest than they have to for the money they are borrowing.

Companies call in bonds when general interest rates are lower than the coupon rate on the bond, therebyretiring expensive debt and refinancing it at a lower rate.

Illustration 1: Suppose IDBI had issued 6 years Rs. 1000 bonds in 1998 @14% pa. But now the currentinterest rate is around 9% to 10%. If the issuer wants to take ad vantage of the call feature in the bonds

indenture it will call back the earlier issued bonds and reissue them @9% p.a. The sale proceeds of thisnew issue will be used to pay the old debt. In this way IDBI now enjoys a lower cost for its borrowedmoney. Some bonds offer call protection; that is, they are guaranteed not to be called for five to tenyears. Call features can affect bond values by serving as a ceiling for prices. Investors are generally

unwilling to pay more for a bond than its call price, because they are aware that the bond could be calledat a lower call price. If the bond issuer exercises the option to call bonds, the bond holder is usually paid a

premium over par for the inconvenience.


2/10

(f) Refunding: If, when bonds mature, the issuer does not have the cash on hand to repay bondholders; itcan issue new bonds and use the proceeds either to redeem the older bonds or to exercise a call option.

This process is called refunding.

(f) Credit Rating: For issue, both public and rights, of a debt instrument, including convertibles, creditrating irrespective of the maturity or conversion period is mandatory and should be disclosed. The

disclosure should also include the unaccepted credit rating. Two ratings from two different credit ratingagencies registered with SEBI should be obtained in case of public/rights issue of Rs.100 crore and more.All credit ratings obtained during the three years preceding the public/rights issue for any listed security

of the issuing company should also be disclosed in the offer document.

BOND VALUATION MODEL

The holder of a bond receives a fixed annual interest payment for a certain number of years and a fixed

principal repayment (equal to par value) at the time of maturity. So the value of a bond is:

Where,V = value of the bond

I = annual interest payable on the bondF = principal amount (par value) of the bond repayable at the time of maturityn = maturity period of the bond.

Illustration 2: A Rs 1,000 par value bond bearing a coupon rate of 14 per cent matures after 5 years, therequired rate of return on this bond is 13 per cent. Calculate the value of the bond.

Solution

The value of the bond is

V = Rs 140(PVIFAss13%, 5yrs) + Rs 1,000(PVIF13%,5yrs) = Rs 140(3.517) + Rs 1,000(0.543) = Rs 1,035.4

BOND VALUE THEOREMS

Some basic rules which should be remembered with regard to bonds are:

(a) When the required rate of return equals the coupon rate, the bond sells at par value.

(b) When the required rate of return exceeds the coupon rate, the bond sells at a discount. The discount

declines as maturity approaches.

(c) When the required rate of return is less than the coupon rate, the bond sells at a premium. The

premium declines as maturity approaches.

(d) The longer the maturity of a bond, the greater is its price change with a given change in the requiredrate of return.

YIELD TO MATURITY


3/10

If the market price of a Rs 1,000 par value bond, carrying a coupon rate of 9 per cent and maturing after 8years, is Rs 800. What would be the rate of return, if one buys the bond and holds it till its maturity? The

rate of return one earns is called the Yield to Maturity (YTM). The value of kd is

To find the value of kd, several values of kd are considered till the right value is obtained. With a discountrate of 12 percent and putting a value of 12 per cent for kd the right-hand side becomes

Rs 90 (PVIFA12%, 8yrs) + Rs 1,000 (PVIF12%, 8yrs) = Rs 90 (4.968) + Rs 1,000(0.404) = Rs 851.00Since this value is greater than Rs 800 a higher value for kd is opted. Let kd = 14 per cent so that

Rs 90(PVIFA14%,yrs)+ Rs 1,000 (PVIF14%,8yrs) = Rs 90(4.639) + Rs 1,000(0.351) = Rs 768.10Since this value is less than Rs 800 a lower value for kd is used. Let us try kd = 13 per cent.Rs 90(PVIFA13%,8yrs) + Rs 1,000 (PVIF13%,8yrs) = Rs 90 (4.800)+ Rs 1,000(0.376) = Rs 808

Thus kd lies between 13 per cent and 14 per cent. Using linear interpolation in the range of 13 percent to14 percent, kd is equal to 13.2 per cent

13% + (14% - 13%) 808 800 = 13.2%808-7681

Illustration 3: If the price per bond is Rs 90 and the bond has a par value of Rs 100, a coupon rate of 14per cent, and a maturity period of 6 years, calculate its yield to maturity.

Solution

YTM = 14 + (100-90)/6/0.4x100 + 100+0.6x90 = 16.67 per cent

BOND VALUES WITH SEMI-ANNUAL INTEREST

Bonds pay interest semi-annually. This requires the bond valuation equation to be modified as follows:(a) The annual interest payment, I, divided by two to obtain the semi-annual interest payment.(b) The number of years to maturity is multiplied by two to get the number of half-yearly periods.(c) The discount rate divided by two to get the discount rate applicable to half-yearly periods.

The basic bond valuation equation thus becomes:

Where,V = Value of the bondI/2 = Semi-annual interest payment

Kd/2 = Discount rate applicable to a half-year periodF = Par value of the bond repayable at maturity2n = Maturity period expressed in terms of half-yearly periods.

Illustration 4: If a Rs 100 par value bond carries a coupon rate of 12 per cent and a maturity period of 8years and interest payable semi-annually then the value of the bond with required rate of return of 14 percent will be what?


4/10

Solution

V = 16t=1 {6 / (1.07)t} + {100 / (1.07)16} = 6(PVIFA7%, 16yrs) + 100(PVIF7%, 16yrs) = Rs 6(9.447) + Rs

100(0.388) = Rs 95.5

PRICE-YIELD RELATIONSHIP

A basic property of a bond is that its price varies inversely with yield. The reason is simple. As therequired yield increases, the present value of the cash flow decreases; hence the price decreases.Conversely, when the required yield decreases, the present value of the cash flow increases; hence the

price increases. The graph of the price-yield relationship for any callable bond has a convex shape asshown in diagram.

PriceYield Relationship

RELATIONSHIP BETWEEN BOND PRICE AND TIME

Since the price of a bond must equal its par value at maturity (assuming that there is no risk of default),bond prices change with time. For example, a bond that is redeemable for Rs.1000 (which is its par value)after five years when it matures, will have a price of Rs.1,000 at maturity, no matter what the current

price is. If its current price is Rs.1,100, it is said to be a premium bond. If the required yield does notchange between now and the maturity date, the premium will decline over time as shown by curve A inthe following diagram. On the other hand, if the bond has a current price of Rs.900, it is said to be a

discount bond. The discount too will disappear over time as shown by curveB

in the same diagram. Onlywhen the current price is equal to par value in such a case only the bond is said to be a par bondthereis no change in price as time passes, assuming that the required yield does not change between now andthe maturity date. This is reflected by the dashed line in the diagram.

Price Changes with Time


5/10

THE YIELD CURVE

The term structure of interest rates, popularly known as Yield Curve, shows how yield to maturity is

related to term to maturity for bonds that are similar in all respects, except maturity. Consider thefollowing data for Government securities:

The yield curve for the above bonds is shown in the diagram. It slopes upwards indicating that long-termrates are greater than short-term rates. Yield curves, however, do not have to necessarily slope upwards.They may follow any pattern. Four patterns are depicted in the given diagram:

Types of Yield Curve

Another perspective on the term structure of interest rates is provided by the forward interest rates, viz.,

the interest rates applicable to bonds in the future. To get forward interest rates, begin with the one-yearTreasury bill:88,968 = 100,000 / (1 + r1)Where,r1 is the one-year spot rate i.e. the discount rate applicable to a risk less cash flow receivable a year hence.

Solving forr1, we gets r1 = 0.124.


6/10

Next, consider the two-year government security and split its benefits into two parts, the interest ofRs.12,750 receivable at the end of year 1 and Rs.112,750 (representing the interest and principal

repayment) receivable at the end of year 2. The present value of the first part is:

To get the present value of the second years cash flow of Rs.112,750, discount it twice at r1 (the discount

rate for year 1) and r2 (the discount rate for year 2)

r2 is called the forward rate for year two, i.e., the current estimate of the next years one -year spotinterest rate. Since r1, the market price of the bond, and the cash flow associated with the bond are known

the following equation can be set up:

Solving this equation we get r2 = 0.1289To get the forward rate for year 3(r3), set up the equation for the value of the three year bond:


7/10

Solving this equation we get r3=0.1512. This is the forward rate for year three. Continuing in a similarfashion, set up the equation for the value of the four-year bond:

Solving this equation for r4, leads to r4 = 0.1458. The following diagram plots the one-year spot rate andforward rates r2, r3, r4. Notice that while the current spot rate and forward rates are known, the future spotrates are not known they will be revealed as the future unfolds. Given this information on yields to

maturity and forward rates, these are two distinct, yet equivalent, ways of valuing a risk less cash flow.

The 8% bond with 15 years to maturity must sell at a little over Rs. 800 to compete with 10% bonds. The

possibility that interest rates will cause outstanding bond issues to lose value is called Interestrate risk.Yet there is an upside to this risk. If interest rates decline during the five years that the 8% bond isoutstanding, the holder could sell it for enough of a premium to make its YTM rate equal to the lower

yields of recent issues. For instance, should Interest rates decline to 7%, the price of the 8% bond with 15years to maturity will increase by about Rs. 100.

ISSUE OF DEBT INSTRUMENTS

A company offering convertible/non-convertible debt instruments through an offer document should, inaddition to the other relevant provisions of these guidelines, complies with the following provisions-

REQUIREMENT OF CREDIT RATING

A public or rights issue of debt instruments (including convertible instruments) in respect of theirmaturity or conversion period can be made only if the credit rating has been obtained and disclosed in theoffer document. For all issues greater than or equal to Rs.100 crore, two ratings from two different credit

rating agencies should be obtained.

REQUIREMENTS IN RESPECT OF DEBENTURE TRUSTEES

In the case of issue of debentures with maturity of more than 18 months, the issuer should appointdebenture trustees whose name must be stated in the offer document. The issuer company in favor of the

debenture trustees should execute a trust deed within six months of the closure of the issue.

CREATION OF DEBENTURE REDEMPTION RESERVES (DRR)

A company has to create DRR in the case of the issue of debentures with maturity of more than 18months.


8/10

DISTRIBUTION OF DIVIDENDS

In the case of new companies, distribution of dividends would require the approval of the trustees to the

issue and the lead institution, if any. In case of existing companies, prior permission of the lead institutionfor declaring dividend, exceeding 20% as per the loan covenants, is necessary if the company does notcomply with institutional condition regarding interest and debt service coverage ratio.

REDEMPTIONThe issuer company should redeem the debentures as per the offer documents.

DISCLOSURE AND CREATION OF CHARGEThe offer document should specifically state the assets on which the security would be created as also the

ranking of the charge(s). In the case of second/residual charge or subordinated obligation, the risksassociated with should clearly be stated.

FILING OF LETTER OF OPTION

A letter of option containing disclosures with regards to credit rating, debentures holders resolution,option for conversion, justification for conversion price and such other terms which SEBI may prescribe

from time to time should be filed with SEBI through an eligible merchant banker, in case of a roll over of

non-convertible portions of PCD/NCDs, etc.

BOOK BUILDING

Book-building means a process by which a demand for the securities proposed to be issued by a bodycorporate is elicited and built up and the price for such securities is assessed for the determination of thequantum of such securities to be issued by means of notice/ circular / advertisement/ document orinformation memoranda or offer document. An issuer company may make an issue of securities to the

public through a prospectus in the following manner 100% of the net offer to the public through the book building process or 75% of the net offer to the public through the book building process and 25% at the price determined

through the book building.

A company proposing to issue capital through book building has to comply with the requirements ofSEBI in this regard.

The issuer company should appoint the eligible merchant banker(s) as book runner(s)and their namesshould be mentioned in the draft prospectus. The issuer company should enter into an agreement withstock exchange(s) which have the requisite system of on line offer of securities specifying, inter alia, theirinter se rights, duties, responsibilities and obligations. However, the company may apply for listing of its

securities on a stock exchange other than the one through which it offers its securities to the publicthrough the online system. The lead merchant banker(s) should act as lead book runner and other eligiblemerchant banker(s) are termed as co-book runners. In case the issuer company appoints more than one

book runner, the name of all such book runners who have submitted the due diligence certificate to the

SEBI may be mentioned on the front cover page of the prospectus.

The primary responsibility of building the books is that of lead book runner. The book runners mayappoint the SEBI registered intermediaries who are permitted to carry on activity as underwriters assyndicate members.

The book runner(s)/syndicate members should appoint SEBI registered brokers of the stock exchangewho are financially capable of honouring their commitments arising out of defaults of their

clients/investors to accept bids, applications, application money and placing orders with the company.Such brokers would be considered as bidding/collection centres. They should collect the money from


9/10

the client(s) for every order(s) placed by them. On failure of the investors to pay for the allotted shares,they would have to pay the amount. The company for the services would pay them a commission/fee and

the stock exchange(s) must ensure that the broker(s) do not charge a service fee from theirclients/investors.

The draft prospectus containing all the disclosures as laid down by the SEBI in respect of securities to be

offered to the public, should be filed by the lead merchant banker with the SEBI. The red herringprospectus should disclose either the floor price of the securities offered through it or a price band along

with the range within which price can move.

The SEBI, within 21 days of the receipt of the draft prospectus, may suggest modifications to it. The lead

merchant banker would be responsible for ensuring that the modifications/final observations made by theSEBI are incorporated in the prospectus. The issuer company should, after receiving the finalobservations on the offer document from the SEBI, make an advertisement in an English national daily

with wide circulation, one Hindi national newspaper and regional newspaper with wide circulation at theplace where the registered office of the company is situated, containing the salient features of the finaloffer document as specified in the form 2-A of the Companies Act circulated along with the applicationform. The advertisement, in addition to other required information, should also contain the following:

the date of opening and closing of the issue; the method and process of application and allotment; the names/addresses/telephone nos. of the stock brokers and centres for bidding;

On determination of the price, the number of securities to be offered should be determined. Once the finalprice (cut off price) is determined all those bidders whose bids are found to be successful (i.e. at or abovethe final price or cut-off price) would be entitled for the allotment of securities. On determination of theentitlement, the information regarding the same should be intimated immediately to the investors.

PROCEDURE FOR BIDDING

The bid should be open for at least five days and not more than 10 days, which may be extended to 13days in case the price band is revised. The advertisement should also contain the following:

the date of opening and closing of the bidding (not less than five days); the name and addresses of the syndicate members as well as the bidding terminals for accepting the

bids;

the method and process of bidding;

Bidding should be permitted only if an electronically linked transparent facility is used. The syndicate

members should be present at the bidding centres so that at least one electronically linked computerterminal at each bidding centres is available for the purpose of bidding.

In case of issue of 100% of the net offer to the public through 100% book building process i) at least 25%of the net offer to the public should be available for allocation to retail individual investors ii) at least

25% to the non-institutional investors (i.e. investors other than retail individual investors and QIBs) iii)

not more than 50% to QIBs. However 50% of the issue size should be, on a mandatory basis, allotted tothe QIBs in case of public issue by an unlisted company through book building.

After finalisation of the basis of allocation, the Registrar to the issue/issuing company should send the

computer file containing the allocation details along with broker-wise funds pay-in -obligation to thebroker to the issue and the stock exchange(s). The company /lead manager/book runner should announce

and intimate the pay-in day to brokers and stock exchanges. The broker would be responsible to depositthe amount in the escrow account to the extent of allocation of his client in the pay-in date.


10/10

On receipt of the basis of allocation data, the brokers should immediately intimate the allocation to theirclients/applicants. They should ensure that each successful client/applicant pay/submits the duly filled in

and signed application form to them along with the application money by the pay-in date. The marginmoney already paid by the applicant should be adjusted towards the total application money payables.The broker should thereafter hand over the application forms of the successful applicants who paid theapplication money to the stock exchange to be submitted to the Registrar of the issue/company for their

records.

The broker(s) should refund the margin money collected earlier within 3 days of receipt of allocation tothe applicants who did not receive the allocation. They should also give i) details of amount received from

each client/investor and ii) names of those who have not paid the application money to the Registrar/bookrunner/stock exchange. In the event of the successful applicants failing to pay the application money, theconcerned broker should bring in the funds to the extent of the default/shortfall, failing which the

exchange would declare him as a defaulter and initiate action under its byelaws. The book runners whohave underwritten the issue would have to bring in the shortfall.

On pay-in date the clearinghouse would automatically debit the escrow account of each broker to theextent of allocation made to his client/investors, and credit the amount collected to the Issue Account. The

Settlement/Trade Guarantee Fund of the stock exchange cannot be used to honour brokers commitmentsin case of their failure to bring in the funds. The brokers should open EscrowSecurities Account withany depository to receive credit of securities on behalf of clients.

On payment/receipt of the application money towards minimum subscription, the issuing company wouldallot the shares to the applicants as per the applicable guidelines. After the allotment the Registrar to theissue would post the share certificates to the investors or instruct the depository to credit the EscrowSecurities Account of each broker. The broker as an agent would transfer from the escrow account theshares to the clients/applicants depository account after full payment by them and confirm the same to the

book runner/registrar to the issue not later than the day of commencement of trading. Trading wouldcommence within 6 days from the closure of the issue failing which interest at 15% would be paid to the

investors.

4. Session Readings (Debt Market)

Documents

Transcript of 4. Session Readings (Debt Market)