DEBT INSTRUMENTS.pptx

DEBT INSTRUMENTS.pptx

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  DEBT INSTRUMENTS
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  FUNDAMENTAL FEATURES • Debtinstruments are contracts in which one party lends money to another on pre- determined terms with regard to rate of interest to be paid by the borrower to the lender, the periodicity of such interest payment, and the repayment of the principal amount borrowed (either in installments or in bullet).
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  PRINCIPAL FEATURES OFA BOND • Maturity: Maturity of a bond refers to the date on which the bond matures, or the date on which the borrower has agreed to repay (redeem) the principal amount to the lender. • Term To Maturity: Term to maturity, on the other hand, refers to the number of years remaining for the bond to mature. For instance, on February 17, 2004, the term to maturity of the bond maturing on May 23, 2008 will be 4.27 years. The general day count convention in bond market is 30/360European which assumes total 360 days in a year and 30 days in a month. • Coupon: refers to the periodic interest payments that are made by the borrower (who is also the issuer of the bond) to the lender (the subscriber of the bond) and the coupons are stated upfront either directly specifying the number (e.g.8%) or indirectly tying with a benchmark rate (e.g. MIBOR+0.5%). Coupon rate is the rate at which interest is paid, and is usually represented as a percentage of the par value of a bond. • Principal is the amount that has been borrowed, and is also called the par value or face value of the bond. Typical face values in the bond market are Rs. 100. Ex- GS CG2008 11.40%
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  Classification of Bonds •Generally bonds with tenors of 1-5 years are called short-term bonds; bonds with tenors ranging from 4 to 10 years are medium term bonds and above 10 years are long term bonds. In India, the Central Government has issued up to 30 year bonds.
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  MODIFYING THE COUPONOF A BOND • Zero Coupon Bond: In such a bond, no coupons are paid. The bond is instead issued at a discount to its face value, at which it will be redeemed. 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.
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  Treasury Strips: In theUnited States, government dealer firms buy coupon paying treasury bonds, and create out of each cash flow of such a bond, a separate zero coupon bond. For example, a 7-year coupon-paying bond comprises of 14 cash flows, representing half-yearly coupons and the repayment of principal on maturity. Dealer firms split this bond into 14 zero coupon bonds, each one with a differing maturity and sell them separately, to buyers with varying tenor preferences. Such bonds are known as treasury strips. (Strips is an acronym for Separate Trading of Registered Interest and Principal Securities). We do not have treasury strips yet in the Indian markets. RBI and Government are making efforts to develop market for strips in government securities.
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  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 re-set periodically, based on a benchmark rate. Such bonds whose coupon rate is not fixed, but reset with reference to a benchmark rate, are called floating rate bonds. • For example, IDBI issued a 5 year floating rate bond, in July 1997, with the rates being re-set semi-annually with reference to the 10 year yield on Central Government securities and a 50 basis point mark-up. • Some floating rate bonds also have caps and floors, which represent the upper and lower limits within which the floating rates can vary. Floating rate bonds, whose coupon rates are bound by both a cap and floor, are called as range notes, because the coupon rates vary within a certain range.
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  MODIFYING THE TERMTO MATURITY OF A BOND • Callable Bonds: Bonds that allow the issuer to alter the tenor of a bond, by redeeming it prior to the original maturity date, are called callable bonds. • Puttable Bonds: Bonds that provide the investor with the right to seek redemption from the issuer, prior to the maturity date, are called puttable bonds. • Convertible Bonds: A convertible bond provides the investor the option to convert the value of the outstanding bond into equity of the borrowing firm, on pre-specified terms. Exercising this option leads to redemption of the bond prior to maturity, and its replacement with equity. At the time of the bond’s issue, the indenture clearly specifies the conversion ratio and the conversion price. The conversion ratio refers to the number of equity shares, which will be issued in exchange for the bond that is being converted.
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  MODIFYING THE PRINCIPALREPAYMENT OF A BOND • 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 payment made by the borrower over the life of the bond, includes both interest and principal, is called an amortising bond. Auto loans, consumer loans and home loans are examples of amortising bonds. • Bonds with Sinking Fund Provisions: In certain bond indentures, there is a provision that calls upon the issuer to retire some amount of the outstanding bonds every year. This is done either by buying some of the outstanding bonds in the market, or as is more common, by creating a separate fund, which calls the bonds on behalf of the issuer. Such provisions that enable retiring bonds over their lives are called sinking fund provisions.