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Chapter 3: Terminology In Equity And Debt Markets

Chapter 3: Terminology In Equity And Debt Markets – NISM-Series-XV Research Analyst Exam Study Notes Download PDF Book

Understanding Security Markets: Equity and Debt Instruments

Security markets enable investors to deploy surplus funds into investment instruments that are pre-defined, regulated, and typically liquid in secondary markets. These instruments are primarily categorised into two types: Equity and Debt. Equity capital is used indefinitely by a company, whereas debt capital is borrowed for a specific period. Equity investors are business owners and participate in its management without guaranteed returns, while debt investors are lenders with fixed returns and no management role.

Topic Pointers:

  1. Equity Securities:
    • Nature: Long-term capital available for indefinite use.
    • Returns: No fixed return or guarantee of principal return. Earnings depend on business performance.
    • Role in Business: Investors are owners and partake in management.
    • Risks and Rewards: High volatility, higher potential returns, benefit from residual profits.
  2. Debt Securities:
    • Nature: Short-term, borrowed capital with a set repayment time.
    • Returns: Fixed interest rate and principal repayment at maturity.
    • Role in Business: Investors are lenders without a management role.
    • Risks and Rewards: Lower risk, steady income, preference in claims over business assets but limited to fixed returns.
  3. Comparative Analysis:
    • Risk Profile: Equity is riskier but offers growth potential; Debt is safer with steady returns.
    • Return Potential: Equity can yield higher returns but is uncertain; Debt offers lower but stable returns.
    • Investor Preference: Choice depends on risk tolerance, investment horizon, and return expectations.
  4. Investment Strategies:
    • Diversification: Balancing between equity and debt based on individual financial goals and risk appetite.

Example: A business borrows funds at 12% interest and earns a 14% return on assets. Debt investors receive a fixed 12% return, whereas equity investors benefit from the additional 2% profit. Conversely, if returns fall below borrowing costs, equity investors bear the loss, illustrating the higher risk and reward nature of equity investment compared to debt.

What are Equity and Debt Securities

Security markets enable investors to invest surplus funds in pre-defined investment instruments issued under regulatory supervision. There are two types of securities – equity and debt. Equity represents ownership in a business, while debt represents lending to a business.

Topic Pointers:

  1. Equity Capital
    • Ownership capital, available as long as needed
    • No fixed returns, residual profits belong to equity investors
    • Higher potential returns but higher risk
    • Participate in management
  2. Debt Capital
    • Borrowed capital, needs to be returned after specified time
    • Earn fixed interest rate (coupons) and return of principal at maturity
    • Lower risk than equity
    • Do not participate in management
  3. Investor Choice
    • Debt – lower risk, stable but lower returns
    • Equity – higher risk, volatile but potential for higher returns
    • Investors allocate between debt and equity based on risk appetite, time horizon etc.

Example: If a business borrows at 12% and earns 14% return on assets, debt investors get 12% as promised and equity investors get the excess 2% returns. But equity investors also bear losses if returns are under 12%.

What is Face Value (FV)

The nominal price assigned to a share by the company is its face value. The equity capital is calculated by multiplying the total number of shares by the face value per share.

Topic Pointers:

Face Value and Share Capital

  • Face value is the nominal value assigned to each share
  • Share capital = Number of shares x Face value per share

Issuance of Shares

  • Shares may be issued to investors at face value or at a premium or discount to face value

Change in Face Value

  • Face value remains same unless company decides to split or consolidate shares
  • In a split, face value reduces and number of shares rise
  • In a consolidation, face value rises and number of shares fall

Importance of Face Value

  • Face value is used to calculate dividend amount
  • Dividend percentage is applied on the face value

Example: A company has 1 lakh shares with Rs 10 Face Value. Equity capital is 1 lakh x Rs 10 = Rs 10 lakhs. If it declares 30% dividend, dividend per share is 30% of Rs 10 Face Value i.e. Rs 3 per share.

What is Book Value

Book value is the net worth of a company, i.e. assets minus liabilities. Book value per share is calculated by dividing the net worth by total number of outstanding shares.

Topic Pointers:

Net Worth

  • Assets (at book value) minus Liabilities
  • Book value is the recorded value in books, may differ from market value

Book Value per share

  • Book Value / Number of outstanding shares

Significance

  • Theoretical value per share if company is liquidated
  • Depends on company’s ability to realise book value of assets to pay off liabilities

Example: A company has assets worth Rs 100 cr, liabilities of Rs 40 cr, and 20 lakh outstanding shares Net worth = Assets – Liabilities = Rs 100 cr – Rs 40cr = Rs 60 cr Book value per share = Net worth / No. of shares = Rs 60 cr / 20 lakh = Rs 30

So the book value per share is Rs 30. This is the theoretical value per share if it is liquidated by realising asset values.

What is Market Value

Market value is the current market price of a company’s share. Market capitalization is the market value of all outstanding shares and is calculated as market price per share * total outstanding shares.

Topic Pointers:

Market Price : Current price at which share trades in the market

Market Capitalization : Number of outstanding shares * Market price per share

What affects market price?

  • Expected future performance
  • Market sentiments
  • Liquidity
  • Demand/Supply

Example: A company has 50 lakh outstanding shares trading at Rs 100 per share. Market capitalization = 50 lakh x Rs 100 = Rs 500 crores

This means the market value of all its shares based on current market price is Rs 500 crores.

What is Replacement Value

Replacement value refers to the market value of all assets that an existing company owns, if a new company were to set up the same infrastructure and plants.

Topic Pointers:

  1. Replacement Value
    • Cost of setting up the same assets and infrastructure from scratch
    • Applicable to plant, property, and equipment
  2. Difference from Book Value
    • Book value: Historical cost less depreciation
    • Replacement value: Current market value of assets
  3. Significance
    • Indicates current worth of company’s assets
    • Useful for investors and analysts

Example: If a company has machinery that has a book value of Rs 50 lakhs (cost minus depreciation),. The current market value of similar new machinery is Rs 80 lakhs. The replacement value of the machinery is Rs 80 lakhs.”

What is Intrinsic Value

Intrinsic value is the present value of all expected future free cash flows from an asset. It refers to the inherent value of the business based on its fundamentals.

Topic Pointers:

Intrinsic Value of Equity Share

Present value of all future cash flows to equity investors

  • Reflects true worth of the business

Key Points

  • Based on future cash flows, not accounting book value
  • Involves discounting expected cash flows to present
  • Depends on estimates of future performance

Significance in Investing

    • Price paid compared to intrinsic value determines if investment is worthwhile
  • Margin of safety = Intrinsic value – Purchase price

Example: A stock with expected free cash flows of Rs 10/share for the next 5 years can have intrinsic value of Rs 40 if discounted at a 15% rate. If available for Rs 30, it gives a margin of safety.

What is Market Value vs. Intrinsic Value

Intrinsic value is the estimated worth of a company/share based on future earnings potential. Market price is the current trading price influenced by various valuation estimates and market factors.

Topic Pointers:

  • Intrinsic value is the intrinsic worth of a share estimated using future cash flows and earnings potential of the company.
  • Market price is the current trading price of the share influenced by demand and supply forces in the stock market.
  • Intrinsic value can be equal to, less than, or more than the market price at any given time.
  • If intrinsic value is estimated to be more than market price, the share is said to be undervalued.
  • If intrinsic value is estimated to be less than market price, the share is said to be overvalued.
  • Investment strategies aim to buy undervalued shares that have room to rise and sell overvalued shares.
  • However, accurately estimating intrinsic value consistently is difficult as it involves predicting future company performance.
  • Equity investing involves both quantitative and qualitative analysis of management quality, strategies, finances to identify undervalued companies. It is as much an art as it is a science.
  • Stock markets feature complex human behaviour as estimates drive demand and supply of shares.

What is Market Capitalization

Market capitalization, or Market Cap is the total dollar market value of a company’s outstanding shares. It is calculated by multiplying the current market price of the company’s shares by the total number of shares outstanding.

Topic Pointers:

  • Market Cap = Current Market Price per share x Total No. of Outstanding Shares
  1. Market Cap indicates the size and value of a company in the stock market.
  2. As stock prices change, the Market Cap of companies fluctuates continuously.
  3. Stocks are often categorised based on their Market Cap – Large Cap, Mid Cap, Small Cap.
  4. Large Cap refers to top 50-100 companies with the highest Market Cap which enjoy maximum liquidity.
  5. Mid Cap refers to the next 200-500 companies with reasonable liquidity.
  6. Small Cap refers to remaining companies with smaller Market Cap and lower liquidity.
  7. Ratio of the country’s total stock market capitalization to its GDP indicates the importance of the stock market.

Example:

If a company has issued 1,00,000 shares trading at Rs. 20 per share, then: 

Market Cap = No. of shares x Current price
= 1,00,000 x Rs. 20 = Rs. 20,00,000

What is Enterprise Value

Enterprise Value is the overall value of a company’s operations and capital. It is calculated as the sum of the market value of common equity, preferred equity, debt, and other capital, minus cash and cash equivalents.

Topic Pointers:

  • EV = Market value of common equity + Market value of preferred stock + Total debt – Cash and cash equivalents
  1. Market value of listed securities is taken at current market price.
  2. For unlisted securities like preferred stock and debt, book/balance sheet value can be considered.
  3. EV represents the total amount required to acquire the company and take over its operations.

Example:

Market capitalization of common shares = Rs. 34 crores (No. of shares x Current market price)
Preferred stock and debt shown at book value of Rs. 8.5 crores and Rs. 6.4 crores, respectively.

Cash and investments = Rs. 2.5 crores + Rs. 1.4 crores

Therefore, Enterprise Value = Rs. 34 + Rs. 8.5 + Rs. 6.4 – Rs. 2.5 – Rs. 1.4 = Rs. 45 crores.

What is Earnings – Historical, Trailing, and Forward

Earnings refer to profits of a business and can be measured at different levels. Historical earnings are of past years, trailing earnings are of the last 4 quarters, and forward earnings are projected future profits.

Topic Pointers:

  1. Net Profits = Earnings available for equity shareholders
  2. EBIT = Earnings before interest and tax, available for equity and debt holders
  3. EBITDA = Earnings before interest, tax, depreciation, and amortisation for replacing assets
  4. Historical Earnings = Profits of past years
  5. Trailing Earnings = Aggregate profits of the last 4 quarters calculated on a rolling basis
  6. Forward Earnings = Projected future profits based on estimations

What is Earnings Per Share (EPS)

Earnings per share (EPS) is the net profit earned by a company for every outstanding share issued. It indicates the profitability of the company and earnings for shareholders.

Topic Pointers:

  • EPS calculates how much net profit the company has earned for each of its outstanding shares.
  • Higher EPS indicates higher profitability and better return for shareholders.
  • EPS helps determine the market price per share.
  • For a company with:
    • Net Profit: Rs. 10 Lakh
    • Outstanding Shares: 2 Lakh
  • The EPS would be: EPS = 10,00,000 / 2,00,000 = Rs. 5

Example: A company has net profit of Rs. 50 lakhs and has outstanding shares of 10 lakhs. EPS = Net Profit / Outstanding Shares = 50,00,000 / 10,00,000 = Rs. 5 So the EPS of the company is Rs. 5. This means the company has earned a profit of Rs. 5 per share.

What is Dividend Per Share (DPS)

Dividend per share (DPS) refers to the portion of net profit that a company distributes as dividend to its shareholders for each outstanding share.

Topic Pointers:

  • Dividend is declared as a percentage of the face value of the shares.
  • It is the part of net profit that the company shares with its shareholders.
  • DPS calculates dividend distributed per outstanding share.
  • If a company declares 40% dividend and face value is Rs 10 per share:
    • Dividend = Face value x Dividend percentage
    • = Rs 10 x 40% = Rs 4 per share.
  • This dividend per share is called the DPS.

Example: A company has a face value of Rs 20 per share and declares 30% dividend.

  • Face value per share = Rs 20
  • Dividend percentage = 30%
  • Dividend per share:
    • = Face value x Dividend percentage
    • = Rs 20 x 30% = Rs 6. So the DPS is Rs 6.

What is Price to Earnings Ratio (PE Ratio)

Price to Earnings (PE) ratio is a valuation metric that measures the market price a stock is trading at relative to the earnings per share it generates.

Topic Pointers:

  • PE ratio calculates how much investors are willing to pay for the earnings of a company.
  • PE ratio indicates the multiple that a stock is trading at relative to its earnings.
  • Higher PE ratio suggests investors expect higher growth and are willing to pay more for the stock.
  • PE ratio based on historical earnings has limited significance. Prices change dynamically while earnings are updated quarterly.
  • Focus is on ‘prospective PE’ – how much current price reflects future expected earnings.
  • When earnings are expected to grow, the market will pay a higher PE multiple.
  • Index PE ratio helps determine if the overall market is overvalued or undervalued.
  • PE falls when the market corrects and uncertainty about future earnings rises.
  • Value investors target stocks with low PE ratios to purchase them cheap.
  • Higher PE for established, stable large companies compared to small, risky companies.

Example: A company has a market price per share of Rs.100 and earnings per share of Rs.10. 

Its PE ratio is = Market price per share / Earnings per share = 100/10 = 10 So the stock is trading at 10 times its earnings per share.

What is Price to Sales Ratio (P/S Ratio)

Price to sales (P/S) ratio is a valuation metric that measures the price investors pay for each rupee of a company’s sales.

Topic Pointers:

  • P/S Ratio calculates how much investors value a company’s sales.
  • It is calculated as:

OR

  • Lower P/S ratio indicates the stock is undervalued relative to its peers.
  • However, future growth potential and risks can result in premium or discount valuation.
  • Drop in revenue growth rate is a key risk for such stocks.
  • P/S ratio should be compared within similar companies and industries.
  • Useful valuation metric for companies making temporary losses, when earnings-based ratios become meaningless.

Example: A company has:

  • Annual Sales: Rs. 1 Crore
  • Outstanding Shares: 10 Lakhs
  • Current Market Price: Rs. 40
  • Annual Sales per Share:
    • = Annual Sales / Outstanding Shares
    • = 1 Crore / 10 Lakhs
    • = Rs. 10
  • P/S Ratio = Current Market Price / Annual Sales per Share = 40 / 10 = 4

So the P/S ratio of the company is 4.

What is Price-to-Book Value Ratio (P/BV)

The Price-to-Book Value Ratio (P/BV) is a financial metric used to compare a company’s current market price to its book value. The book value is calculated by dividing a company’s net worth (capital plus reserves) by the number of outstanding shares.

Topic Pointers:

  • Understanding Book Value: Represents the accounting value per share in a company’s books, calculated as net worth (capital plus reserves) per share. It’s the historical cost of assets minus depreciation, not their realisable value.
  • Limitations: The primary limitation of book value is that it reflects historical costs rather than current realisable or liquidation values. However, for companies with sustained profitability and reserve building, it’s a valuable indicator.
  • Net Worth: A crucial component of book value, net worth includes both capital and reserves.
  • P/BV Calculation: The ratio is determined by dividing the company’s Current Market Price (CMP) by its book value.
  • Indications of P/BV:
    • A P/BV less than 1 suggests that a company is trading below its book value, potentially indicating an undervalued stock.
    • A P/BV greater than 1 implies a stock trading above its book value.
  • Interpretation Caution: Stocks with a P/BV less than 1 are not always undervalued due to various factors like poor past investments.
  • Application in Negative Earnings: P/BV is useful for valuing stocks where earnings are negative and P/E ratio cannot be applied.
  • Industry Relevance: Particularly relevant in industries like banking; less so in service industries with limited tangible assets.

Example:

Given Data:

  • Equity Capital: Rs. 10 Lakhs
  • Reserves & Surplus: Rs. 50 Lakhs
  • Number of shares outstanding: 6 lakhs
  • Current Market Price: Rs. 20

Book Value Calculation:

  • Net Worth/Number of Shares Outstanding = (Rs. 10 Lakhs + Rs. 50 Lakhs)/6 Lakhs = Rs. 10

P/BV Calculation:

  • P/BV = CMP/BV = 20/10 = 2x
  • The P/BV ratio of the company is 2 times.

What is Differential Voting Rights (DVR)

Differential Voting Rights (DVR) are shares in a company that carry fewer voting rights than common shares. These shares are designed to allow companies to raise capital without significantly diluting the voting power of existing shareholders.

Topic Pointers:

  • Voting Rights Difference: DVRs carry less than 1 voting right per share, unlike common shares which typically have one vote per share.
  • Attractiveness to Certain Investors: Ideal for investors primarily interested in dividends and capital appreciation, without a focus on voting rights.
  • Varied Voting Rights: The specific number of voting rights attached to a DVR varies from one company to another.
  • Trading and Pricing: DVRs are traded separately from common shares and often at a discount to the common shares of the same company.
  • Regulatory Framework: The Companies Act, 2013, sets forth the conditions under which companies can issue DVRs. This includes requirements like:
    • A history of paying dividends of at least 10% in the preceding 3 years.
    • DVRs should not exceed 25% of the total post-issue paid-up capital.
  • Usage in India: Notable Indian companies like Tata Motors and Pantaloons have issued DVRs, demonstrating their practical application in the market.

What are the Terminology in Debt Market

Debt capital refers to funds provided by lenders who expect regular compensation in the form of fixed interest, with the principal amount returned after a specified period. Debt can be sourced through borrowing from banks or by issuing debt securities.

Topic Pointers:

  • Debt Capital: Capital raised through borrowing, characterised by regular interest payments and principal repayment at maturity.
  • Methods of Raising Debt:
    • Bank Loans: Direct borrowing from a bank or a consortium of banks.
    • Debt Securities: Issuing securities to a wider pool of investors, breaking down the loan amount into smaller units.
  • Debt Securities: Contracts between an issuer (company) and a lender (investor), stipulating terms like principal, coupon (interest rate), maturity, and collateral, if any.
  • Investor Rights:
    • Coupon Payments: Regular interest payments to the investor.
    • Principal Repayment: Return of the borrowed amount at maturity.
    • Secured Debt: Offers rights over the issuer’s assets in case of default.
    • Unsecured Debt: Does not provide asset security to investors.
  • Distribution of Debt Securities:
    • Private Placement: Issued to a select group of investors.
    • Public Issue: Offered to the general public, often listed on stock exchanges for trading.
  • Trading Venues:
    • Stock Exchanges: For publicly issued, listed securities.
    • Over The Counter (OTC) Market: For unlisted securities, traded until maturity.

Example: For example, if a company needs to borrow Rs. 100 crore, it can opt for a bank loan or issue one crore debt securities each valued at Rs. 100. An investor contributing Rs. 1000 would receive 10 securities, with their exposure limited to their investment amount.

What is Face Value

Face Value is the nominal or par value of a debt instrument, representing the amount of loan each paper stands for. It is crucial for determining the amount of interest paid over the term of the debt.

Topic Pointers:

  • Essential Debt Component: Face Value is a fundamental element in understanding a debt instrument.
  • Representation of Loan Amount: Indicates the actual loan value each debt paper or security represents.
  • Basis for Interest Calculation: Interest payments on the debt are calculated as a percentage of this face value.
  • Denominations: Can vary, commonly found in denominations like Rs. 100, Rs. 1000, or other specified amounts.

What is Coupon Rate

The Coupon Rate is the interest rate paid on a bond or debt security, expressed as a percentage of its face value. It determines the actual amount of interest income received by the investor.

Topic Pointers:

  • Interest Rate Indicator: Represents the rate at which interest is paid on the bond or debt security.
  • Calculation of Interest Payment: The interest amount paid to the investor is calculated as the product of the face value of the bond and the coupon rate.
  • Periodicity of Payments: Interest payments can be structured differently, such as semi-annual payments in the case of Government Securities (G-Secs).
  • Maturity Consideration:The final coupon payment is typically made on the maturity date of the bond, along with the repayment of the principal or par value.

Example: A bond named 8.24GS2018 (signifying an 8.24% coupon bearing Government Security maturing in 2018) with a face value of Rs. 1000.

Interest Calculation:

  • Annual Coupon Payment: 8.24% of Rs. 1000 = Rs. 82.40
  • Semi-Annual Payments: Rs. 82.40 divided by 2 = Rs. 41.2 every six 

What is Maturity in Bond Markets

Maturity, also known as tenor or term to maturity, refers to the tenure or lifespan of a loan or bond. It represents the period at the end of which the bond matures and the principal is due to be repaid.

Topic Pointers:

  • Tenure of a Loan/Bond: Maturity is the duration for which the bond is issued.
  • Significance for Investors: Maturity is a critical factor affecting bond prices and associated market risks.
    • Shorter maturity bonds are generally less sensitive to interest rate changes.
    • Longer maturity bonds may experience more significant price fluctuations with interest rate changes.
  • Variety in Maturities: Bonds can have a wide range of maturities:
    • Short-term: Examples include Treasury Bills (T-Bills) issued by the Government of India for periods like 91, 182, and 364 days.
    • Long-term: Government securities (G-Secs) and other bonds can have maturities extending up to 30 years or more.
    • Perpetual Bonds: These do not have a fixed maturity date.
  • Decreasing Term to Maturity: As each day passes, the term to maturity reduces, becoming zero on the bond’s maturity date.
  • Redemption: On the maturity date, the bond is redeemed, and the principal amount is repaid to the bondholders.

Example: In the provided example, a bond is mentioned with a maturity year of 2018, indicating the year in which the bond will mature and the principal amount is to be repaid.

What is Principal in Debt Securities

Principal in the context of debt securities refers to the amount borrowed by the issuer and represented by the security. It equates to the initial investment made by an investor, typically reflected in the security’s face value, which is returned in full upon redemption.

Topic Pointers:

  • Amount of Borrowing: The principal is the sum borrowed by the issuer via the debt security.
  • Initial Investment: Represents the investor’s initial outlay when purchasing the bond at issuance, mirrored by the bond’s face value.
  • Redemption and Repayment: Upon maturity, the issuer repays the entire principal to the investor.
  • Trading Price vs. Face Value:
    • In secondary markets, the trading price of the bond may differ from its face value.
    • The issuer’s obligation is to repay the face value as the principal, regardless of the price at which the bond was bought in the secondary market.

What is Redemption of a Bond

Redemption of a bond occurs when it reaches maturity, signifying the end of the contractual relationship between the bond issuer and the investor. At this point, the issuer repays the principal amount and makes the final coupon payment, following which the bond ceases to exist.

Topic Pointers:

  • Maturity of Bond: Redemption is the process that takes place when a bond reaches its maturity date.
  • Termination of Contract: It marks the end of the bond contract between the issuer and the investor.
  • Repayment of Principal: The issuer repays the principal amount of the bond to the investor at redemption.
  • Final Coupon Payment: Along with the principal, the issuer also makes the last interest payment based on the bond’s coupon rate.
  • Ceasing of Bond’s Existence: After redemption, the bond effectively ‘matures’ and no longer exists as a financial instrument.

What is Holding Period Returns (HPR)

Holding Period Return (HPR) is the total return earned on an investment over the period it was held by an investor. It includes income from coupon payments, reinvestment of these coupons, and gains or losses from the sale of the bond.

Topic Pointers:

  • Period-Specific Returns: HPR measures the return on an investment during the specific time it was held by an investor.
  • Acquisition and Sale: Can be calculated for bonds bought either from the issuer at issuance or from the secondary market, and held until maturity or sold earlier.
  • Components of HPR:
    • Coupon Payments: Regular interest payments received during the holding period.
    • Reinvestment of Coupons: Interest earned from reinvesting these coupons at the prevailing rate.
    • Capital Gains or Losses: Difference between the purchase and sale price of the bond.
  • Calculation Method: HPR is calculated as the sum of all incomes (coupons, reinvestment interest, capital gains/losses) expressed as a percentage of the purchase price.
  • Non-Annualized Measure: HPR is a single-period return and does not annualize the return.

Example: An investor buys a bond for Rs. 104 and receives a coupon of Rs. 8. The coupon is reinvested at a 7% rate for one year. The bond is then sold for Rs. 110 after one year. The HPR in this case would be calculated as: HPR = [(8) + (8 * 7%) + (110-104)]/ 104 = 14.00%

What is Current Yield

Current Yield is a method of calculating the return on a debt security by dividing its annual coupon by the current market price of the bond. The result is then expressed as a percentage.

Topic Pointers:

  • Yield Calculation: Involves dividing the annual coupon payment by the bond’s current market price.
  • Expressed as Percentage: The result of the calculation is presented as a yield percentage.
  • Limitation: Does not consider future cash flows from the bond, such as the repayment of principal at maturity.
  • Comparison with Stocks: Analogous to the dividend yield in stock investments.
  • Not Widely Used: Due to its drawback of not accounting for future cash flows, it’s less commonly used than other methods.

Example: For a bond 8.24GS2018 trading at Rs. 104, the current yield is calculated as follows: Current Yield = (8.24 / 104) = 0.07923 = 7.92%

What is Yield to Maturity (YTM)

Yield to Maturity (YTM) is a comprehensive measure for calculating the return on a debt security. It accounts for all future cash flows from the bond, including both coupons and principal repayment, and equates the present values of these cash flows to the bond’s current market price.

Topic Pointers:

  • Incorporates Future Cash Flows: Considers all cash flows, including interest payments and the repayment of principal.
  • Calculation Method: Equates the present value of future inflows (coupons plus principal) to the current price of the bond.
  • Internal Rate of Return: YTM can be conceptualised as the Internal Rate of Return (IRR) for the bond.
  • Calculation Techniques: Often calculated using trial and error or financial functions like XIRR in Excel.
  • Assumptions and Limitations:
    • Assumes the bond is held until maturity.
    • Assumes reinvestment of coupons at a constant rate, implying a static and flat yield curve.
    • These assumptions may not align with real-world conditions, affecting practicality.
  • Advantages: Despite limitations, YTM is favoured for its simplicity and quick computation.

What is Duration in Bond Markets

Duration in the context of bond markets is a measure of the sensitivity of a bond’s price to changes in interest rates. It is calculated as the weighted average maturity of a bond’s cash flows, with the present values of these cash flows serving as the weights.

Topic Pointers:

  • Interest Rate Sensitivity: Indicates how much a bond’s price will change in response to interest rate fluctuations.
  • Influence of Duration:
    • High Duration: Bonds with higher duration are more sensitive to interest rate changes, experiencing greater price changes.
    • Low Duration: Bonds with lower duration have less sensitivity to interest rate changes.
  • Calculation Components: Includes the bond’s tenor, coupon rate, and yield.
  • Factors Affecting Duration:
    • Time to Maturity: Longer maturities lead to higher durations and increased interest rate risk.
    • Coupon Rate: Lower coupon rates result in higher durations and greater interest rate risk.
    • Yield: Lower yields increase the duration and the associated interest rate risk.
  • Risk Measurement Tool: Duration is a crucial tool for assessing a bond’s interest rate risk.
  • Dynamic Nature: Duration changes over time as the bond’s tenor and yield change.
    • As a bond nears maturity, its duration decreases, reducing its interest rate risk.

What are the Types of Bonds

Bonds are financial securities representing a loan and are characterised by three main features: Principal, Maturity, and Coupon. The types of bonds vary based on modifications of these features and the nature of the issuer.

Topic Pointers:

  • Principal: The amount borrowed or the face value of the bond.
  • Maturity: The duration or term for which the loan is taken, indicating when the bond will be repaid.
  • Coupon: The interest rate paid on the bond, determining the periodic interest payments.
  • Variations in Bond Types:
    • Modifications in principal, maturity, and coupon lead to different bond types.
    • Variation in these features allows for the creation of diverse bond instruments catering to different investment strategies and risk profiles.
  • Issuer-Based Classification:
    • Bonds can also be classified based on the type and creditworthiness of the issuer.
    • This includes government bonds, corporate bonds, municipal bonds, and others, each with distinct risk and return profiles.
  • Purpose of Diverse Types:
    • To meet various investment objectives.
    • To provide options for different risk tolerances among investors.

What is Zero-Coupon Bond

A Zero-Coupon Bond, also known as ‘Zeroes’, is a type of bond that does not pay periodic coupons throughout its term. These bonds are issued at a discount to their face value and are redeemed at par. The return to investors comes from the difference between the issue price and the redemption value, rather than from periodic interest payments.

Topic Pointers:

  • Nature of Returns: Zero-Coupon Bonds offer returns not as periodic interest payments but as the difference between the issue and redemption prices.
  • Issuance and Redemption: Issued at a discount to face value, these bonds are redeemed at their face (par) value.
  • Interest Rate Risk: They inherently carry more interest rate risk compared to coupon-paying bonds of the same maturity, due to their higher duration.
  • Cash Flow Management for Issuers: Useful for issuers to manage cash flow, as they do not require intermittent coupon payments. This allows cash retention for business use over a longer term.
  • Repayment Structure: Repayment is made in a lump sum (bullet payment) at the bond’s maturity.
  • Types and Examples: Examples include Treasury Bills (T-Bills), Commercial Papers (CPs), and Certificates of Deposit (CDs). These are typically short-term (less than 1 year) and fall under Money Market instruments.
  • Deep Discount Bonds: Long-tenure Zero-Coupon Bonds are issued at a steep discount and are known as Deep Discount Bonds, such as Kisan Vikas Patra (KVPs) and bonds issued by IDBI.

Example: Case Study: ETHL Communications Holdings Ltd.’s Zero-Coupon Bond Issue in October 2009. Details:

  • Issuer: ETHL Communications Holdings Ltd.
  • Security Type: Zero coupon bond, secured by receivables.
  • Issue Date: October 2009.
  • Maturity Dates: Series 1 in July 2011, Series 2 in December 2011, with a maturity value of Rs.100.
  • Issue Price and Rates: Series 1 at Rs. 85.80 (Implied rate 9.15%), Series 2 at Rs. 82.55 (Implied rate 9.25%).

What is Floating-Rate Bonds

Floating-Rate Bonds are bonds where the coupon rate is variable and reset periodically based on a predefined benchmark, such as the inflation index, inter-bank rates, or call rates. This feature aligns the interest payments with current market rates.

Topic Pointers:

  • Variable Coupon Rate: Unlike fixed-rate (vanilla) bonds, the coupon rates of Floating-Rate Bonds are adjusted periodically in line with a chosen benchmark.
  • Benchmarks for Reset: These benchmarks can include inflation indices, inter-bank rates, call rates, or other relevant market indicators.
  • Adjustment Frequency: The reset of the coupon rate typically happens every six months, ensuring the interest reflects current market rates.
  • Interest Rate Risk: These bonds have a lower interest rate or price risk due to the constant adjustment of their coupon rates.
  • Advantage in Rising Interest Rates: In environments where interest rates are increasing, Floating-Rate Bonds are beneficial as they continuously adjust to the prevailing market rates.
  • Caps and Floors: Some Floating-Rate Bonds have maximum (Cap) and minimum (Floor) limits on their coupon rates.
  • Inverse Floaters: A variant in developed markets, inverse floaters have coupon rates that move inversely to the benchmark rate.

Example: Housing loans with variable or floating interest rates serve as a practical example of the application of this concept in everyday financial products.

What is Convertible Bonds

Convertible Bonds are debt instruments that offer investors the option to convert their investment into the equity of the issuing company at a later date. These securities combine characteristics of both debt and equity.

Topic Pointers:

  • Conversion Option: Investors can convert the bond into the issuer company’s equity.
  • Details Specified at Issue: The issuer outlines the conversion terms during the bond issue, which include:
    • Conversion Date: The date by or before which the bond can be converted.
    • Conversion Ratio: Number of shares an investor receives per debenture.
    • Conversion Price: The price at which shares are allotted upon conversion, usually at a discount to the market price.
    • Conversion Proportion: The portion of the debenture that will be converted into equity shares.
  • Types of Convertible Bonds:
    • Compulsory Convertible Bonds: Must be converted into equity.
    • Optionally Convertible Bonds: Conversion into equity is optional.
    • Fully vs. Partly Convertible: In fully convertible bonds, the entire value is converted into equity, whereas in partly convertible bonds, only a portion is converted and the rest continues as a bond.
  • Financial Impact:
    • On Issuer’s Balance Sheet: Conversion reduces debt and increases equity capital, potentially diluting earnings per share (EPS).
    • On Investors: Investors get both bond (debt) and equity exposure, earning coupon income initially and potentially benefiting from equity appreciation post-conversion.
  • Advantages for Issuer: Lower coupon rate compared to pure debt instruments, potential avoidance of debt repayment at maturity through equity issuance.
  • Disadvantages for Issuer: Dilution of existing shareholders’ stakes upon issuing new shares.
  • Investor Benefits: Combines benefits of debt (coupon income) and equity (potential capital appreciation).

What is Principal-Protected Note (PPN)

Principal-Protected Note (PPN) is a complex debt product designed to protect the principal amount invested by an investor, provided the investment is held to maturity. It combines investment in debt and potentially high-yielding assets like equity, derivatives, or commodities.

Topic Pointers:

  • Principal Protection: Aims to safeguard the principal amount if held until maturity.
  • Investment Strategy:
    • Debt Component: A portion of the investment is allocated to debt, ensuring it matures to the principal amount at the term’s end.
    • Growth Component: The remainder is invested in assets like equity, derivatives, or commodities for higher return potential.
  • Nature of Product: Despite being marketed as a debt instrument, PPN is a synthetic product derived from a mix of debt and derivative structures.
  • Target Investors: Suitable for risk-averse investors seeking exposure to high-return products while protecting the downside.
  • Credit Risk: Principal protection does not eliminate the credit risk associated with the issuer’s financial health.
  • Structured Instruments: PPNs are often issued by Non-Banking Finance Companies (NBFCs) under titles like Equity Linked Bonds (ELBs) or Commodity Linked Bonds (CLBs).
  • Market Presence: Some of these structured instruments are listed on Stock Exchanges.

What is Inflation-Protected Securities

Inflation-Protected Securities are government-issued debt instruments designed to provide returns adjusted for inflation, thereby protecting investors, especially those reliant on fixed incomes, against the negative real returns during high inflation periods.

Topic Pointers:

  • Context and Need: Fixed income debt instruments risk negative real returns in high inflation periods, impacting investors like retired individuals who rely on such investments for income.
  • Inflation Indexed Bonds (IIB):
    • Issued by the RBI, these bonds offer inflation-protected returns.
    • Both principal and interest payments are adjusted for inflation.
    • Real Coupon Rate: A fixed real rate is applied to the inflation-adjusted principal on each payment date.
    • Maturity Payment: The greater of the face value or inflation-adjusted principal is paid at maturity.
    • Inflation Adjustment Mechanism: The principal adjustment is based on an index ratio, calculated using the Wholesale Price Index (WPI). The index ratio is the reference index on the settlement date divided by the reference index on the issue date.
  • Inflation-Indexed National Saving Securities-Cumulative 2013:
    • Targeted at retail investors, including individuals, minors, HUFs, and charities.
    • Tenor: 10 years.
    • Interest Details: Fixed interest of 1.5%, compounded every six months, with adjustments based on the Consumer Price Index (CPI).
    • Interest and Principal Payment: Interest is compounded and added to the principal, payable at maturity.
    • Floor Rate: A fixed rate of interest is guaranteed, even in deflation scenarios.
    • Taxation: Interest is subject to taxation as per the investor’s tax status.

What is Foreign Currency Bonds

Foreign currency bonds are bonds issued by a company in a currency other than its home country’s currency.

Topic Pointers:

  • Currency Difference: Issued in a foreign currency, distinct from the issuer’s home country currency.
  • Emerging Market Preference: Companies in emerging markets often issue bonds in USD or other stable currencies of economically mature countries.
  • Advantage: Attraction due to lower interest rates in mature economies’ currencies.
  • Foreign Currency Risk: Creates a risk for issuers if the foreign currency appreciates against their local currency, increasing the repayment amount in local terms.
  • Hedging Considerations:
    • Using derivatives to hedge foreign currency risk may negate the benefits of lower interest rates.
    • Hedging is a balancing act between managing risk and maintaining interest rate advantages.
  • Practical Implications: Companies must weigh the benefits of lower interest rates against the potential risks of currency fluctuations.

Example: Delhi International Airport Limited (a subsidiary of GMR Infrastructure Ltd) issued USD bonds in February 2020.

  • Relevance: Illustrates a real-world application of foreign currency bonds by a company in an emerging market.

What is External Bonds

External bonds, also known as Eurobonds, are bonds issued in a currency different from the currency of the country where they are issued.

Topic Pointers:

  • Currency Distinction: Issued in a currency that is not the native currency of the issuing country.
  • Eurobond Example: A U.S. dollar-denominated bond issued in Kuwait is a Eurobond because the bond’s currency (USD) differs from the local currency (Kuwaiti Dinar).
  • Masala Bonds: These are a specific type of external bond denominated in Indian Rupees (INR), issued outside of India.
  • First Issuance of Masala Bonds: The International Finance Corporation first issued Masala bonds in November 2014, listed on the London Stock Exchange.
  • Currency Risk Shift:
    • Foreign Currency Bonds: The issuer bears the currency risk.
    • Masala Bonds: The investor bears the currency risk. If INR depreciates against the currency of the investor’s country, the return in the investor’s local currency decreases.

What is Perpetual Bonds

Perpetual bonds are a type of bond without a stated maturity date, meaning the issuer is not obligated to redeem them. Investors receive periodic coupons, and the issuer may buy back or call these bonds at their discretion, particularly if they are callable bonds.

Topic Pointers:

  • No Maturity Date: Perpetual bonds do not have a fixed maturity, differentiating them from traditional bonds.
  • Issuer’s Obligation: The issuer is not required to redeem these bonds.
  • Periodic Coupons: Investors are entitled to regular coupon payments.
  • Callable Feature: Issuers can repurchase or call these bonds, especially if they are issued as callable bonds.
  • Use in Banking Sector: Banks in India issue perpetual bonds to raise additional Tier 1 (AT1) capital, adhering to Basel III norms.
  • AT1 Capital Criteria: Perpetual bonds must meet specific requirements to qualify as AT1 capital under Basel III norms.
  • Risks and Differences Compared to Normal Bonds:
    • Subordination: They are subordinate to other debts like deposits and loans from banks.
    • Coupon Payment Conditions: Coupons are paid only from distributable profits; in the absence of such profits, the coupon cannot be paid.
    • Non-Cumulative Coupons: Unpaid coupons do not accumulate for future payment.

Equity Conversion: In certain pre-specified contingent events, the bonds can be converted into equity by the issuer.

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