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What are Debt Instruments?

What are Financial Instruments?

Glossary of Financial Instrument Terms

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WHAT ARE DEBT INSTRUMENTS?
Debt instruments, such as notes, bonds, and debentures, are generally entitled to receive payments which are senior in priority to preferred or common stockholders. Debt instruments may be secured by certain assets of the corporation or may be unsecured (i.e., backed by a simple pledge of the corporation's credit).

Debt instruments generally have no right to participate in the overall appreciation in value of the corporation. Debt instruments may also be long-term or short-term in duration, and carry variable or fixed interest rates. Debt instruments may impose certain affirmative or negative obligations upon the corporation, including restrictions on the ability of the corporation to complete certain transactions (such as incurring other indebtedness or issuing capital stock).

Several advantages to issuing debt instruments include -- predictability of payments to investors, no dissolution in management's interest in corporate growth and voting power, and investors assume less risk of loss in their investment.

Disadvantages include -- potential restrictions on operations, limitations on the use of working capital due to debt service obligations, and tying up assets through pledges as collateral.

Both debt and equity financing instruments may be convertible into different types of securities. Debt instruments may be convertible into either common or preferred stock and preferred stock may be convertible into common stock.

A convertibility feature attached to a debt or equity instrument may be attractive to an issuing company since it may bear a lower interest rate and dividend payment. Convertible instruments afford maximum flexibility to investors allowing them to shift the risks and rewards of their investment at some point in the future after initial investment.

There are numerous considerations involved in the planning process to issue debt or equity instruments to investors. The planner should take into account the various types of instruments which may be issued and the respective advantages and disadvantages of each type from both the viewpoint of incumbent management as well as prospective investors. Both near-term and long-term objectives for each should be maximized when developing financing strategies.

A tradable form of a loan is normally termed as Debt Instruments. They are usually obligations of issuer with regards to certain future cash flows representing interest and principal, which the issuer would pay to the legal owner of the instrument. There are various types of fixed income instruments, which cater to the needs of both investors and issuers. These instruments can be classified on the basis of interest, time duration, etc. Further, there are also derived fixed income instruments. Certain hedge instruments are also available that reduce risk. The classification of fixed instruments is given below:

Fixed Income Products

• Deposit
• Fixed Deposit

Interest Based Bonds

• Coupon Bonds
• Zero Coupon Bonds

Derived Instruments

These instruments are not direct debt instruments. Instead they derive their value from other debt instruments.

• Mortgage Bonds
• Pass Through Certificates (PTCs)
• Participation Certificates (PCs)

Benchmarked Instruments

There are certain debt instruments; wherein the fixed income earned is based on some bench mark rate. For instance, the Floating Interest rate Bonds are benchmarked to either the LIBOR, MIBOR etc.

• Floating Interest Rate
• Inflation linked Bonds (Inflation Index Bonds)

Money Market Instruments

• Call/Notice Money
• Treasury Bills
• Inter-Bank Term Money
• Certificate of Deposits
• Inter Corporate Deposits
• Commercial Papers
• Commercial Bills

Hedging Instruments

There are certain hedge instruments that help to reduce the risk of investing in Fixed income instruments.

• Interest Rate Swaps
• Interest Rate Options
• Swaptions

Corporate Debentures

A Debenture is a debt security issued by a company (called the Issuer), which offers to pay interest in lieu of the money borrowed for a certain period. In essence it represents a loan taken by the issuer who pays an agreed rate of interest during the lifetime of the instrument and repays the principal normally, unless otherwise agreed, on maturity.

These are long-term debt instruments issued by private sector companies. These are issued in denomination as low as Rs. 1000 and have maturity ranging between one and ten years. Long maturity debentures are rarely issued, as investors are not comfortable with such maturities.

Debentures enable investors to reap the dual benefits of adequate security and good returns. Unlike Fixed and Bank Deposit they can be transferred from one party to another by using transfer form. Debentures are normally issued in physical form. However, corporates/PSUs have started issuing debentures in Demat form. Generally, debentures are less liquid as compared to PSU bonds and their liquidity is inversely proportional to the residual maturity. Debentures can be secured or unsecured.

Debentures are divided into different categories on the basis of:

1. Convertibility of the instrument
2. Security

• Non Convertible Debentures (NCD)
• Partly Convertible Debentures (PCD)
• Fully Convertible Debentures (FCD)
• Optionally Convertible Debentures (OCD)
• Secured Debentures
• Unsecured Debentures

Ready Forward Contracts / Repo

Uses of Repo

Fixed Income Products

Deposit

Deposits serve as medium of saving and as a means of payment and are a very important variable in the national economy. A bank basically has three types of deposits.

• Time deposits are those funds that are deposited by savers on the basis of obtaining the same on the maturity of certain period of time.
• Saving deposits are deposits that are maintained on a continuous basis on which the bank offers a certain interest. There is certain limit on the number of withdrawals from the account by means of a cheque on this account. Interest is allowed on minimum monthly balances and not on daily basis.
• Current Account - A current account is a running account. This account does not provide any interest and hence the account provides no limit on the number of withdrawals from this account.

Fixed Deposit

Fixed Deposits are sums accepted by most of the NBFCs, corporates and banks. The amount of deposits that may be raised by NBFCs and corporates is linked to its net worth and rating. However, the interest rate that may be offered by a NBFC & corporate is regulated. The maximum interest rate that may be offered by these companies is 15%, provided the company has submitted its application for registration and has two years of good track record after its incorporation. The deposits offered by NBFCs are not insured whereas the deposits accepted by most banks are insured upto a maximum of Rs.1,00,000.

Interest - based bonds

Coupon Bonds

Bonds typically pay interest periodically at the pre specified rate of interest. The annual rate at which the interest is paid is known as the coupon rate or simply the coupon. Interest is usually paid every half-year though some bonds pay interest monthly, quarterly, annually or at some other frequency. The dates on which the interest payments are made are known as the coupon due dates.

Zero Coupon Bonds

A plain bond is offered at its face value, earns a stream of interest till redemption and is redeemed with or without a premium on maturity. A zero coupon bond is issued at a discount to its face value with no periodic interest and is redeemed at face value on maturity.

Derived Instruments

These instruments are not direct debt instruments. Instead they derive value from other debt instruments. Mortgage bonds, Pass Through Certificates etc fall under this category.

Mortgage Bonds.

Mortgage backed bond is a collateralized term-debt offering. A pledged collateral backs every issue of such bonds. An eligible collateral will be a property that can be pledged as a security. The bonds are secured by a first charge on the pledged collateral and delivered to the trustee of the issue. This ensures that a smooth liquidation takes place in the event of default on the part of the issuer of bonds. The terms of these bonds are like any other bonds in the market with semi-annual or quarterly payments of interest and final bullet payment of principal.

Pass Through Certificates (PTCs)

When mortgages are pooled together and undivided interest in the pool is sold, pass-through securities are created. The term 'undivided' in this context means that each holder of the security has a proportionate interest in each cash flow generated in the pool. The pass-through securities promise that the cash flow from the underlying mortgages would be passed through to the holders of the securities in the form of monthly payments of interest and principal.

Participation Certificates (PCs)

These are strictly inter-bank instruments confined to the Scheduled Commercial Banks. There are 2 types:

1)                  PCs with Risk Sharing - This instrument provides flexibility in the Credit portfolio of banks. These PCs are issued for 91-180 days in respect of certain types of Loan Advances. Interest is to be determined between the issuing and the participating bank freely.

2)                  PCs without Risk Sharing - This instrument are a money market instrument with tenure not exceeding 90 days. The two contracting banks determine the interests on such PCs.

Benchmarked Instruments

There are certain debt instruments, wherein the income earned is based on a benchmark. For instance, the Floating Interest rate Bonds are benchmarked to either the LIBOR, MIBOR etc.

Floating Interest Rate

Floating rate of interest simply means that the rate of interest is variable. Periodically, the interest rate payable for the next period is set with reference to a benchmark market rate agreed upon by both the lender and the borrower. The benchmark market rate in India is NSE MIBOR and in the overseas markets its LIBOR or US Treasury Bill Rate. For- e.g., A LIBOR +1% indicates that the interest earned on that bond will be 100 basis points higher than the going LIBOR rate at that particular time.

Inflation linked bonds.

A bond is considered indexed for inflation if the payment of coupons is indexed by reference to the change in the value of a general price or wage index over the term of the instrument. The options are that either the interest payments are adjusted for inflation or the principal repayment or both.

Money Market Activities

Call/Notice Money

Call/Notice money is an amount borrowed or lent on demand for a very short period. If the period is more than one day and upto 14 days it is called 'Notice money' otherwise the amount is known as ‘Call money'. Intervening holidays and/or Sundays are excluded for this purpose. No collateral security is required to cover these transactions. The call market enables the banks and institutions to even out their day-to-day deficits and surpluses of money. Commercial banks, Co-operative Banks and primary dealers are allowed to borrow and lend in this market for adjusting their cash reserve requirements with the RBI. Specified All-India Financial Institutions, Mutual Funds and certain specified entities are allowed to access Call/Notice money only as lenders. It is a completely inter-bank market hence non-bank entities are not allowed access to this market. Interest rates in the call and notice money market is market determined. In view of the short tenure of such transactions, both the borrowers and the lenders are required to have current accounts with the Reserve Bank of India. It serves as an outlet for deploying funds on short-term basis to the lenders having steady inflow of funds.

Treasury Bills

In the short term, the lowest risk category instruments are the Treasury Bills (TBs) issued by Central government. RBI on behalf of central government issues them at a prefixed day and for a fixed amount. The TBs are issued with varying maturity usually not exceeding more than one year.

91 - day T-bill – (Tenor is of 91 days) Its auction is on every Wednesday of the week and issued on following Friday. The notified amount for this auction is Rs. 500 crore.

182 - day T-bill – (Tenor is of 182 days) Its auction is on every alternate Wednesday (which is not a reporting week) and issued on Friday. The notified amount for this auction is Rs. 500 crore.

364 - Day T-bill – (Tenor is of 364 days) Its auction is on every alternate Wednesday (which is a reporting week) and issued on Friday. The notified amount for this auction is Rs. 1000 crore.

A considerable part of the central government's borrowing happens through Treasury Bills of various maturities. Based on the bids received at the auctions, RBI decides the cut off yield and accepts all bids below this yield.

Banks are the major investors in these instruments as they can park their short-term surpluses and also since it forms part of their SLR investments. Besides banks other investors in TBs are insurance companies, primary dealers, mutual funds, FIs and FIIs.

These TBs, which are issued at a discount, can be traded in the market. Most of the time, unless the investor requests specifically, they are issued not as securities but as entries in the Subsidiary General Ledger (SGL), which is maintained by RBI. The transactions cost on TBs are non-existent and trading is considerably high in each bill, immediately after its issue and immediately before its redemption.

The yield on TBs is mainly dependent on the rates prevalent in Call/Notice market. Low yield on TBs, generally a result of high liquidity in banking system as indicated by low call rates, would divert the funds from this market to other markets. This would be particularly so, if banks already hold the minimum stipulated amount (SLR) in government paper.

Inter-bank Term Money

Inter bank market for deposits of maturity beyond 14 days and upto three months is referred to as the term money market. The specified entities are not allowed to lend beyond 14 days. The development of the term money market is inevitable due to the following reasons:

• Declining spread in lending operations
• Volatility in the call money market
• Growing desire for fixed interest rates borrowing by corporate
• Move towards fuller integration between forex and money market
• Stringent guidelines by regulators/management of the institutions

Certificate of Deposits

After treasury bills, the next lowest risk category investment option is the certificate of deposit (CD) issued by banks and FIs.

Allowed in 1989, CDs were one of RBI's measures to deregulate the cost of funds for banks and FIs. A CD is a negotiable promissory note, secure and short term (upto a year) in nature. A CD is issued at a discount to the face value, the discount rate being negotiated between the issuer and the investor. Though RBI allows CDs upto one-year maturity, the maturity most quoted in the market is for 90 days.

The secondary market for this instrument does not have much depth but the instrument itself is highly secure.

CDs are issued by banks and FIs mainly to augment funds by attracting deposits from corporates, high net worth individuals, trusts, etc. the issue of CDs reached a high in the last two years as banks faced with a reducing deposit base secured funds by these means. Banks, which do not have large branch networks with lower deposit base, use this instrument to raise funds.

The rates on these deposits are determined by various factors. Low call rates would mean higher liquidity in the market. Also the interest rate on one-year bank deposits acts as a lower barrier for the rates in the market.

Inter-corporate Deposits

Apart from CPs, corporates also have access to another market called the Inter Corporate Deposits (ICD) market. An ICD is an unsecured loan extended by one corporate to another. Existing mainly as a refuge for low rated corporates, this market allows funds surplus corporates to lend to other corporates. Also the better-rated corporates can borrow from the banking system and lend in this market. As the cost of funds for a corporate in much higher than a bank, the rates in this market are higher than those in the other markets. ICDs are unsecured, and hence the risk inherent in high. The ICD market is not well organised with very little information available publicly about transaction details.

Commercial Papers

CPs are negotiable short-term unsecured promissory notes with fixed maturities, issued by well rated companies generally sold at a discount basis. Companies can issue CPs either directly to the investors or through banks / merchant banks (called dealers). These are basically instruments evidencing the liability of the issuer to pay the holder in due course a fixed amount (face value of the instrument) on the specified due date.

These instruments are normally issued in the multiples of five crore for 30/45/60/90/120/180/270/364 days maturity.

Commercial Bills

Bills of exchange are negotiable instruments drawn by the seller (drawer) of the goods on the buyer (drawee) of the goods for the value of the goods delivered. These bills are called trade bills. These trade bills are called commercial bills when they are accepted by commercial banks.

The RBI introduced the Bills Market scheme (BMS) in 1952 and the scheme was later modified into New Bills Market scheme (NBMS) in 1970. Under the scheme, commercial banks can rediscount the bills, which were originally discounted by them, with approved institutions (viz., Commercial Banks, Development Financial Institutions, Mutual Funds, Primary Dealer, etc.).

With the intention of reducing paper movements and facilitate multiple rediscounting, the RBI introduced an instrument called Derivative Usance Promissory Notes (DUPN). So the need for physical transfer of bills has been waived and the bank that originally discounts the bills only draws DUPN. These DUPNs are sold to investors in convenient lots of maturities (from 15 days upto 90 days) on the basis of genuine trade bills, discounted by the discounting bank.

Hedging Mechanism

There are certain hedge instruments that help to reduce the risk of investing in Fixed income instruments.

Interest Rate Swaps

A standard fixed to floating interest rate swap is an agreement between two parties in which each contracts to make payments to the other on particular dates in the future till a specified termination date. One party, known as the fixed rate payer, makes fixed payments all of which are determined at the outset. The other party known as the floating rate payer will make payments the size of which depends upon the future evolution of a specified interest rate index.

Interest rate options

Interest rate options are of two types, call option and put option. A call option on interest rate gives the holder the right to borrow funds for a specified duration at a specified interest rate without an obligation to do so. A put option on interest rate gives the holder the right to invest funds for a specified duration at a specified return without an obligation to do so. In both cases, the buyer of the option must pay the seller an up-front premium stated as a fraction of the face value of the contract.

Swaptions.
Swaptions are options to enter into a swap at a specified future date, the terms of the swap being fixed at the time the swaption is transacted.

Corporate Debenture

A Debenture is a debt security issued by a company (called the Issuer), which offers to pay interest in lieu of the money borrowed for a specific period. In essence it represents a loan taken by the issuer who pays an agreed rate of interest during the lifetime of the instrument and repays the principal normally, unless otherwise agreed, on maturity.
These are long-term debt instruments issued by private sector companies. These are issued in denominations as low as Rs 1000 and have maturity ranging between one and ten years. Long maturity debentures are rarely issued, as investors are not comfortable with such maturities.

Debentures enable investors to reap the dual benefits of adequate security and good returns. Unlike other fixed income instruments such as Fixed Deposits, Bank Deposits they can be transferred from one party to another by using transfer form. Debentures are normally issued in physical form. However, corporates/PSUs have started issuing debentures in Demat form. Generally, debentures are less liquid as compared to PSU bonds and their liquidity is inversely proportional to the residual maturity. Debentures can be secured or unsecured.

Debentures are divided into different categories on the basis of:

1. Convertibility of the instrument
2. Security

Debentures can be classified on the basis of convertibility into:

Non-Convertible Debentures (NCD): This type of security retains all the characteristic of a debt instruments and it cannot be converted into any other form of security (mainly equity).

Partly Convertible Debentures (PCD): A part of this instrument can be converted into Equity share in the future at the instance of issuer. The issuer decides the ratio of the conversion at the time of subscription.

Fully convertible Debentures (FCD): These instruments are fully convertible into Equity shares at the issuer's notice. The issuer decides the ratio of conversion. Upon conversion the investors enjoy the same status as ordinary shareholders of the company.

Optionally Convertible Debentures (OCD): The investor has the option to either convert these debentures into shares at price decided by the issuer/agreed upon at the time of issue.

On basis of Security, debentures are classified into:

Secured Debentures: These instruments are secured by a charge on the fixed assets of the issuing company. So if the issuer fails on payment of either the principal or interest amount, his assets can be sold to repay the liability to the investors. This is usually in the form of a first mortgage or charge on the fixed assets of the company on a pari passu basis with other first charge holders like financial institutions etc. Sometimes, the charge can also be a second charge instead of a first charge. Most of the times the charge is created on behalf of the entire pool of debenture holders by a trustee specifically appointed for the purpose.

Unsecured Debentures: These instruments are unsecured in the sense that if the issuer defaults on payment of the interest or principal amount, the investor has to be along with other unsecured creditors of the company.

Ready Forward Contracts / Repos

It is a transaction in which two parties agree to sell and repurchase the same security. Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a predetermined price. Such a transaction is called a Repo when viewed from the prospective of the seller of securities (the party acquiring fund) and Reverse Repo when described from the point of view of the supplier of funds. Thus, whether a given agreement is termed as Repo or a Reverse Repo depends on which party initiated the transaction.

The lender or buyer in a Repo is entitled to receive compensation for use of funds provided to the counter party. Effectively the seller of the security borrows money for a period of time (Repo period) at a particular rate of interest mutually agreed with the buyer of the security who has lent the funds to the seller. The rate of interest agreed upon is called the Repo rate. The Repo rate is negotiated by the counter parties independently of the coupon rate or rates of the underlying securities and is influenced by overall money market conditions.

The Repo/Reverse Repo transaction can only be done at Mumbai between parties approved by RBI and in securities as approved by RBI (Treasury Bills, Central/State Govt securities).

Uses of Repo

• It helps banks to invest surplus cash
• It helps investor achieve money market returns with sovereign risk.
• It helps borrower to raise funds at better rates
• An SLR surplus and CRR deficit bank can use the Repo deals as a convenient way of adjusting SLR/CRR positions simultaneously.
• RBI uses Repo and Reverse repo as instruments for liquidity adjustment in the system.