Bond Market PDF

Debt market The Debt market refers to the market where the borrower’s issue new debt securities and investors buy those new securities or buyers buy the already issued debt securities and sellers sell the various debt instruments already issued by entities like Governments and private firms in lieu...

Debt market The Debt market refers to the market where the borrower’s issue new debt securities and investors buy those new securities or buyers buy the already issued debt securities and sellers sell the various debt instruments already issued by entities like Governments and private firms in lieu of funding availed by them. The development of a vibrant debt market is essential for a country’s economic progress as the debt market helps to reallocate resources from savers to investors (high-risk takers). The banking channel is safer for savers as bank failures are not very common, but the debt market is a market for direct transfer of risk to the lenders. However, unlike the equity market, the debt market exposes an investor or lender to relatively moderate risk as the physical assets of the company is typically secured against such debt. In any economy, the Government generally issues the largest amount of debt to fund its expenditure. The well-developed debt market helps the Government to issue papers at a reasonable cost. A liquid debt market lowers the borrowing cost for all and it provides greater pricing efficiency. Bond market A bond is a financial security issued by a legal entity to raise funds from the financial market and agrees to refund/return the borrowed amount (principal) at the end of the contract period or at various time intervals as given in the indenture along with the promised interest or coupon. Agreed annual interest promised by the issuer on the bond is generally referred to as “Coupon”. A bond is akin to a loan with a maturity and coupon rate paid at various intervals viz. quarterly or half-yearly or annually. Most bonds make semi- annual interest payments, though some may make annual, quarterly or monthly interest payments (except zero coupon bonds which make no interest payment). Typically, par value of the bond is paid on the maturity date. Bonds have fixed maturity dates beyond which they cease to exist as a legal financial instrument. except perpetual bonds, which have no maturity date). On the basis of term to maturity, bonds with a year or less than a year maturity are terms as money market securities. Long-term obligations with maturities in excess of 1 year, are referred to as capital market securities. Thus, long term bonds as they move towards maturity become money market securities. However, it differs from a loan mainly with respect to its tradability. A bond is usually tradable and can change many hands before it matures; whereas a loan usually is not traded or transferred freely. There are a lot of debt issuances that are used by issuers to raise money for their businesses. These also become a source of investment for investors. The part of the market where the debt securities are listed and traded is known as the bond market. The different types of securities here would include bonds, debentures, government securities etc. and it provides a place where secondary trading in these instruments takes place. The bond market is also able to provide the right kind of liquidity for various instruments which helps in further facilitating raising of money through them. The coupon, maturity period and principal value are important intrinsic features of a bond. All G-Secs are normally coupon (interest rate) bearing and have semi-annual coupon or interest payments with a tenor of between 5 to 30 years. Maturity period is also known as tenor or tenure. Another interesting thing about bonds is that unlike equity, companies can issue many different bond issues outstanding at the same time. These bonds can have different maturity periods and coupon rates. While bonds can be classified in many ways, for ease of understanding, the basic classification of bonds can be considered based on the following criteria: 1. Based on issuers; 2. Based on maturity; 3. Based on coupon; 4. Based on currencies; 5. Based on embedded options; 6. Based on priority of claims; 7. Based on purpose of issue; 8. Based on underlying; 9. Based on taxation. Classification of fixed income securities based on the Type of Issuer The borrowers of funds who borrowed by way of issuing of bonds are called Issuers. Bonds are usually gauged for their riskiness based on the issuer’s profile. The value of the bond mainly depends on the ability of the borrower to service the debt obligations as per the bond indenture. Government Bonds / Sovereign Bonds / Gilt edged Bonds A sovereign bond is issued by the government and is typically denominated in the domestic currency to support planned and unplanned expenditures. Government bonds are also known as “sovereign debt” and are generally issued via auctions and traded in the secondary market. Government bonds issued in local currency are considered risk free as the Government, being a sovereign entity, can print the currency to repay its obligation to bondholders. However, as demonstrated during the European debt crisis (2008-2012), Governments may also default in debt payments in case of an emergency situation. Because of their relative low risk, government bonds typically pay lower interest rates than the bonds issued by other issuers in the country. In India, government bonds constitute the largest segment of the fixed income market. This also includes the securities issued by the various State Governments and Union Territories, which are known as State Development Loans (SDLs). Indian Government Securities market (G-sec) also includes the special securities issued by the central and state governments in India. Special securities are issued by the Government for providing various subsidies like oil, fertilizer, bank recapitalization, etc. Municipal Bonds Local authorities may also issue bonds to fund projects such as infrastructure, libraries, or parks. These are known as “municipal bonds”. Municipal bonds are also known as "muni bonds" or "muni". A municipal bond is categorized based on the source of its interest payments and principal repayments. In India, while very few local authorities or municipal authorities have issued such bonds, the market is gradually picking up. Corporate Bonds A Corporate Bond and/or Non-Convertible Debentures (NCDs) is issued by a corporate to raise capital. The performance of the bond during its life depends on future revenues and profitability of the corporate. Debt is typically cheaper source of financing for corporates, and, unlike issuance of more equity, their ownership structure is not diluted. In some cases, the corporate’s physical assets may be used as collateral. Corporate bonds carry higher risk vis-a-vis government bonds and hence the bond holders expect higher interest rates to compensate for the additional risk they take while investing in the bond. Corporates issue short term papers like Commercial papers (CPs) to fund their short-term requirement or for their working capital funding. Classification of fixed income securities based on Maturity Bonds are issued for various maturities depending on the requirement of funds as well as the demand from the investors. Long term bonds are generally costlier than short term loans as the funds are locked in for a longer period of time while investors may suffer from illiquidity. Bonds may be classified in terms of maturities like ultra-short term, short term, medium term and long term. Short term borrowings are typically made for working capital requirement where as long term funds are used for project, capital and infrastructure funding. The returns on bonds by similar rating class of issuers also vary according to the maturity, which forms the basis of yield curve theories. Overnight Debt / Borrowings Overnight Debt / Borrowings Typically, banks borrow overnight funds from the money market as well as from the RBI. These borrowings can be collateralized or clean. Collateralized borrowings cost less vis-à vis clean borrowings. The RBI plays a very important role in this market through absorption or supplying liquidity through banks and Primary Dealers. Ultra-Short-Term Debt (Money Market) Ultra-Short-Term Debt (Money Market) Short term borrowings up to one year are covered under this category. Mostly, money market instruments like Commercial Papers (CP), Certificate of Deposits (CD), Treasury Bills (TB), Cash Management Bills (CMB), etc. belong to this category. Short Term Debt Short Term Debt Bonds with maturity spanning from 1 to 5 years are referred to short term bonds. Bonds maturing within a year are classified under money market instruments as discussed above. Medium Term Debt Medium Term Debt These are bonds maturing in 5 to 12 years. These are also referred to as intermediate bonds. Generally, the bulk of debt issuances take place in this segment. Long Term Debt Long Term Debt These are bonds with maturity beyond 12 years. Mostly Government of India bonds are of long-term maturity. Staggered Maturities Staggered Maturities Some bond issues are packaged as a series of different bonds with different or staggered maturities. Every few years a portion of the bond issue matures and is paid off. Staggering maturities in this fashion allows the issuing company to retire the debt in an orderly fashion without facing a large one-time need for cash, as would be the case if the entire issue were to mature at once. Serial payments pay off bonds according to a staggered maturity schedule. Classification of fixed income securities based on Coupon The promised interest as per the indenture of the bond is referred to as the coupon. The coupon payments on bonds have a pre-determined payment frequency and may be paid annually, semi- annually, quarterly or monthly. Bonds are classified on the basis of coupons, as these are returns on the investment made by the holders. Plain Vanilla Bonds A plain vanilla bond is the simplest form of a bond with a fixed coupon and defined maturity and is usually issued and redeemed at face value. It is also known as a straight bond or a bullet bond. These bonds have intermittent cash flows in the form of coupons received as well as the final cash flow of the face value of the bond on maturity. Zero-Coupon Bonds A Zero-coupon bond (ZCB) is a discounted instrument which does not pay any interest and are redeemed at the face value of the bond at the time of maturity. These bonds are issued at a discount and redeemed at the face value with the difference amounting to the return earned by the investor. ZCBs have a single cash flow at maturity which is equal to the face value of the bond. Common examples of ZCBs in India include Treasury Bills, Cash Management Bills and STRIPS created by separating and trading independently (in other words “stripping off”) the coupons from the final principal payment of normal bonds. ZCBs are highly sensitive to changes in the interest rate as they do not have intervening cash flows and are generally used by long term fixed income investors such as pension funds and insurance companies to gauge and offset the interest rate risk of these firms’ long-term liabilities. Floating Rate Bonds Floating rate bonds (FRBs) do not pay any pre-fixed coupons but are linked to a benchmark interest rate (generally a short-term rate like the 182-day Treasury bill rate etc. in India). The coupon rate is reset on each coupon payment date. When the general interest rate rises in the market, the benchmark interest rises and hence does the coupon on the FRBs. The same situation reverses when the interest rate falls. FRBs typically trade very close to their face value as interest resets happen at regular intervals. These instruments are generally immune to interest rate risk and are considered conservative investments. Inflation Indexed Bonds These are a type of FRBs which protect investors from the adverse effects of rising prices by being indexed to an inflation measure like the WPI (Wholesale Price Index) or CPI (Consumer Price Index) in India. Only the face/par value or both par value and coupons may be indexed against the inflation measure. Step Up/Down Bonds Step up bonds are designed to pay lower coupon in the initial years of the bond and higher coupon towards maturity. These bonds are preferred by issuers like start-ups who expect their cash flows to balloon after some time and hence would like to service the bonds with lower cash flows at the beginning. The investors of these bonds also take higher risk as higher cash flows are expected after some time and hence expect higher interest rate to make the investment attractive. These bonds are generally risky. Step down bonds are the exact opposite of step up bonds. These bonds pay high interest at the beginning of the bond and as the time moves towards maturity, the coupon drops. Such bonds are usually issued by companies where revenues/profits are expected to decline in a phased manner; this may be due to wear and tear of the assets or machinery as in the case of leasing. The step up and step down bonds are used for better cash flow planning of both issuers and investors. Deferred Coupon Bonds: This is a mixture of coupon paying bond and a ZCB. In the initial years, these bonds do not pay any interest, but these bonds pay very high interest after a few years and typically few years before the maturity. The corporates having high gestation period typically prefer this kind of arrangement. Deep Discount Bonds: When a zero-coupon bond is issued at a high discount to the Face Value, it is generally referred to as a Deep Discount bond. Normally, a discount of 20% or more with relatively longer maturity is the main characteristics of the Deep Discount Bond. Typically, infrastructure companies issue such kind of bonds as their gestation period is very long. These bonds carry high risk. Classification of fixed income securities based on Embedded Options An embedded option bond is an instrument with a provision of callability by the issuer and puttability by the investor. The optionality influences the price of the bond as the risk is higher for these bonds. The “Call” feature incorporates the right of the issuer to call back / repay the bond on a specific date. The same way, the “Put” provision of the bond gives the right to seek redemption of the bond by the investor on a particular date. A bond having call provision is likely to be called when the cost of refinancing the bond is low due to fall in interest rates. A bond having “Put” option may encourage the investors to submit the bond for redemption when interest rate rises. The bonds with embedded options are valued using option premia. Straight Bonds A straight bond is a bond that pays interest at regular pre-determined intervals and at maturity pays back the principal that was originally invested. A straight bond is also called a plain vanilla bond or a bullet bond. These bonds pay regular coupon which is typically fixed at the beginning or at the issuance time. It is the most basic form of debt investments. Bond with a Call Option A bond with a call provision gives the right to the bond issuer to call back the bond and pay the borrowed funds to investors before the original maturity date but at the pre-fixed call date. The issuer invokes this right only when the market interest rate is lower than the interest in the callable bond. However, the callable bonds generally require premium to be paid at the time of redemption when called. Bond with a Put Option A bond with a Put provision gives the right to the bond investor to seek redemption of the bond from the issuer before the original maturity date but at the pre-fixed put date. The investor invokes this right only when the market interest rate is higher than the interest in the puttable bond. However, these bonds generally require discount at the time of redemption when the investor chooses to redeem the same before maturity. Bond with Call and Put Option A bond with call and put provision gives right both to bond holder and issuer to redeem the bond before the maturity date. Classification of fixed income securities based on Security All bonds are in essence fungible loans for which returns ultimately depend on the servicing ability of the issuer. Bonds can be secured or unsecured. These can be senior or junior types depending on their claim in the company’s asset at the time of liquidation. Bonds lower in priority of claims offer higher yields to compensate for the risk inherent in them. Bonds may also be secured against specific assets of the user. Hence, it is critical for investors to be aware of the priority in claims of the security they intend to invest in depending on their risk appetite. Secured debt The debt pay-out at the time of liquidation is made according to the seniority of bonds. Junior bonds are typically subordinate to senior bonds. The senior bonds are put at the top of the hierarchy in the structure as the “secured” debt. Secured bonds have collateral ranking and they would be paid first out of the assigned assets which have been collateralized against such debt. This makes it more secure with higher recovery rate vis à-vis lower-level unsecured junior bonds in the event the company defaults. Secured debt holders are paid out first in case of liquidation. Unsecured debt Unsecured debt instruments are issued by companies without any specific collaterals allocated against these issuances. Companies issue such unsecured debt using their name and reputation in the market. These bonds are paid out last if any bankruptcy happens. But senior unsecured debt is paid out first and then the junior unsecured debt is paid out. Subordinated debt Subordinated bonds are issued by companies that pay higher coupon but are riskier as these bonds are paid out just before the equity holders at the time of liquidation. In India, banks issue subordinate bonds to shore up their Tier II capital as per the capital adequacy requirement. Other Instruments o Perpetual (consol bonds): These bonds will not have any maturity date and will continue to pay coupons during the life of the Company. o Convertible Bonds: Convertible bonds are the bonds issued by corporates and such bonds get converted to equity shares at a specified time at a pre-fixed conversion price. The bondholder has the right to convert the said bonds to equity shares and issuing company cannot refuse the conversion as it is agreed at the time of the issuance. o REITs (Real Estate Investment Trusts): REITs are trusts registered with SEBI that invest in commercial real estate assets. The REIT will raise funds through an initial offer and subsequently through follow-on offers, rights issue and institutional placements. o Green bonds: A green bond is a type of fixed-income instrument that is specifically earmarked to raise money for climate and environmental projects. These bonds are typically asset-linked and backed by the issuing entity's balance sheet, so they usually carry the same credit rating as their issuers' other debt obligations. o Tax-free bonds: Tax-free bonds are issued by a government enterprise to raise funds for a particular purpose. As the name suggests, its most attractive feature is its absolute tax exemption on interest as per Section 10 of the Income Tax Act of India, 1961. Tax Saving Bonds: These bonds offer tax benefits to owners, therefore helping them save a certain portion of their overall tax. Tax-saving bonds mainly come with a minimum lock-in period. Note that the interest earned through the bonds are taxable. Advantages of Debt Compared to Equity  Debt is a long-term source of capital for borrowers.  Borrowing through a debt paper by the owner would not reduce the control of the company for the borrower. Lenders of funds generally have priority over equity holders, in case of bankruptcy of the company.  The lender would get the promised interest rate as per the indenture of the issue as well as the principal at the time of maturity. The lenders are indifferent to the profit made by the company that is shared as dividend to the equity holders.  In case of debt, the future obligations are mostly known to the company for making the cash flow planning and repayment planning. Hence, a proper and efficient cash flow management is key to the success of debt management.  Interest or the coupon to be paid on debt is tax-deductible to the company as it is an expense for the company. This tax deductibility reduces weighted average cost of capital for the company. Higher the marginal tax rate of the company, larger is the benefit of such tax savings.  Raising large amount of debt capital through private placement is generally less complicated as it is sold to qualified institutional buyers and unlike public issuances of equity, complex regulations may be avoided.  For its debt obligations, the company is not required to send periodic mailings to large numbers of investors, hold periodic meetings of shareholders, or seek the vote of shareholders before taking certain actions.  Debt is long term and lenders tend to be more committed than the equity holders.  In the long-run, debt is cheaper than equity. The return on investment for equity holders is eventually higher than the interest paid on debt financing. Disadvantages of Debt Compared to Equity  Certain debt instruments may put restrictions on the company's core activities, and at times, exclusivity clauses can harm the company in general.  Unlike equity, debt must be repaid at some point in time resulting in liquidity outflow.  Debt repayment causes cash flow risk for the company and at times the company may not be able to refinance debt or raise money from the market to repay the existing debt if the market condition turns bad.  Debt is a leverage action and high leverage can jeopardize the growth plans of the companies. High leverage may also increase the risk of default. Historically, many good companies have gone into bankruptcy due to the burden of huge debt.  Debt obligations are fixed at the beginning of the issuance with future dates known to both issuers and lenders. These obligations have to be repaid irrespective of the market conditions.  If repayment of debt is not properly planned, the company’s usual operations may get jeopardized because of such debt repayment obligations. At times, unplanned cash flow causes upheave in working capital finance, jeopardizing production plan and operations of the company.  The larger a company's debt-equity ratio, the riskier is the company considered by lenders and investors. Accordingly, there is a limit to the level of debt a business can take in its balance sheet.  Some form of debt like secured debentures require the company to create a lien on the assets of the company or create sinking fund out of operational cash flows which may be burdensome at times, specifically at the time of market stress.