PRIMARY MARKET – RESERVE BANK OF INDIA (RBI)
The primary market deals with the issuance of securities. RBI acts as a banking and debt manager to the central and state governments.
The RBI issues government debt based on
1. Market liquidity conditions
2. The maturity of the existing issues and desired maturity
3. Yields in the primary and secondary market
4. Fiscal Deficit.
RBI releases an Issuance Calendar to help investors plan to invest in government securities.
Here is a sample: http://pib.nic.in/newsite/PrintRelease.aspx?relid=188040
The issuance by RBI may be a reissue of existing securities or issue of new securities. The issuance is carried through auction. In the case of reissuance, as the coupon and maturity are already known, the market participants are required to bid on the price. On the other hand, in case of new issue RBI announces the tenor and amount and the investors are required to bid on the security by quoting the desired yield.
RBI auctions securities in both by Uniform Price Method at which all participants are allotted securities at the same price which is the highest at which issuer can get the whole issue subscribed or Multiple Price Method at which securities are allocated at different prices and yields quoted by the investors.
SECONDARY MARKET - CLEARING CORPORATION OF INDIA (CCIL)
CCIL has created Negotiated Dealing System (NDS) which is an electronic platform for trading of government securities. CCIL also developed the NDS-Call platform which is used for trading in call money and NDS-Auction which is used for Treasury Bills auction for RBI.
Once RBI issues government securities, they are available for trading on the NDS Order Matching System (NDS-OM). In the secondary market for the government securities, CCIL acts as a counterparty to both buyers and sellers and guarantees settlement.
NDS- OM: https://www.ccilindia.com/OMMWCG.aspx
INTEREST RATE RISK
Consider that a bond of Rs. 1000 which pays an annual coupon of Rs. 100 (10% coupon) is issued at par i.e. at Rs. 1000. Just after the bond was issued, market interest rates increased and bonds of similar maturity are now issued with 12% coupon. What is expected to happen to the previously issued bond?
The demand in the secondary market for the earlier issued bond with a 10% coupon will decrease because new investors can buy comparable bonds with a higher coupon. So, the holders of the bonds issued with a 10% coupon will have to sell the bond at a discount. This means the price of a bond is inversely related to the market interest rates.
Note: For the bondholders who are holding the bond until maturity, the market interest rates do not create any issue. The coupon payments and the face value of the bond do not change. So, depending on the credit risk, the future cash flows for the bondholder who is holding until maturity is unchanged.
This relationship is captured by a measure called Duration which measures the sensitivity of the bond price to the yield. A bond with longer term has a higher duration than similar bond with shorter-term i.e. longer-term bonds are more exposed to more interest rate risk.
Also, zero coupon bonds have more duration than comparable coupon bond i.e. zero coupon bonds are more exposed to interest rate risk.
Floating rate bonds, for which the coupon rate is reset based on the interest rates, are most exposed to interest rate risk just after the coupon rate is reset.
Learn about the Bond Terms: https://www.wisejay.com/openhouse/249/Investing-in-Bonds-Part1-Introduction-and-features
YIELD CURVE RISK
A yield curve is the relationship of the maturity of a bond and the yield of the bond. In a normal market condition, the longer term bonds have a higher yield. Why? Due to increased risk with a longer maturity. The longer you are invested in a bond, the higher the uncertainty you are accepting to the purchasing power – the interest rates may increase and/or the inflation may increase. Anyways, the slope of the yield curve i.e the relationship between maturity and yield may change with economic conditions.
Yield curve risk is associated with the possibility of change in the yield curve slope may change.
Assume that you invested in a bond which gives 6% annual return. Although, after a year you figured out that the inflation for that period was 6.5%. From the outset it may seem that you earned 6%, effectively you lost 0.5% purchasing power of your money. Inflation risk deals with the uncertainty associated with the purchasing power of returns from a bond. In this case, nominal return from the bond is 6% and the real return is around -0.5%. Inflation risk is the uncertainty of the real return.
Learn More about Bond Returns: https://www.wisejay.com/openhouse/250/Investing-in-Bonds-Part2-Bond-Returns-Current-Yield-Yield-to-Maturity-Realised-Yield
DEFAULT OR CREDIT RISK
When you are buying a bond, you are lending money to the bond issuer who agrees to pay back the money in terms of coupons and the face value of the bond. Now, the bond can be secured by some assets or you are relying completely on the future financial health of the issuer. There is a probability that the issuer fails to or refuses to make the interest (coupon) payments and/or pay back the principal. This uncertainty over issuer’s capability or willingness to make the contractual payments is called the Credit Risk or Default Risk.
The government issued bonds are considered free from default risk because the government can simply print money to pay back the dues. Credit risk for corporate bonds is represented by the Credit Rating of the bond.
More about Credit Rating: https://www.wisejay.com/openhouse/68/Understanding-Credit-Rating-in-India
Reinvestment risk arises due to the uncertainty of the rate at which bondholders can invest the proceeds from the bond.
The reinvestment risk is lower for a coupon bond than a zero coupon bond, why? As the number of cash flows is more in case of coupon bonds, it increases the uncertainty about the prevailing market interest rates at the time of cash flows.
The reinvestment risk is also associated with callable bonds as the call option is most likely to be exercised when the market rates are lower than the rate at which the bond was issued.
Liquidity risk is related to the ability of a bondholder sell the bond easily and inexpensively. It depends on a number of active buyers and sellers in the market. Indian bond market is known to be illiquid. That is why bond investors in India are exposed to high liquidity risk. Sometimes the liquidity risk can be due to legal restriction over the transfer of an asset. For example, National Saving Certificates cannot be transferred to another person.
Call risk is related to callable bonds. As discussed above, the chance that a callable bond will be called back increases with lowering market interest rates. This means the bondholder will be forced to reinvest the proceeds at a lower market rate. This is called call risk.
SOME OTHER TYPE OF BOND RISKS
Depending on the type of bond, there can many other risks associated with a bonus.
One example is exchange rate risk which is a risk associated with currency exchange rates for investors investing in bonds denominated in a different currency than their domestic currency.
Another example is sovereign risk associated with government bonds issued by the government of a different country than the investor.
SOURCES OF BOND RETURNS
There are three kinds of returns from a bond discussed below. To explain the return types let us take an example of a bond of face value Rs. 1000 and term of 5 years which pays a quarterly coupon of Rs. 20. You purchased the bond for Rs. 950 when it was issued.
1. Periodic Payments – Coupon payments
Coupons are periodic payments- generally fixed but can be variable if the bond is a floating rate bond and/or coupons are indexed to inflation.
In the case of the above example, the quarterly coupon is Rs. 20 i.e. annual coupon is Rs. 80 and the annual coupon rate is 8%.
Note: For more about coupons and other features of bonds
2. Capital Gain or Loss
If bonds are held to maturity, then the holder receives the face value of the bond. In case of a transfer before the maturity, the holder receives the market price of the bond. In case of exercise of call or put option – the holder receives the call price or the put price.
The difference between the acquisition price and the maturity or transfer price is the capital gains. In case of the above example, if the bond is held till maturity the capital gain is Rs.50 (Rs. 1000 – Rs. 950) but if it is sold before maturity for some reason at a price say Rs. 940 then there is a capital loss of Rs. 10.
3. Reinvestment income
This is a less understood return implication. Consider the above-mentioned bond of face value Rs. 1000 which pays a quarterly coupon of Rs. 20 and issued at Rs. 950. How can we compare this with a bond which does not pay any coupon but issued at Rs.900?
We can do this assuming that all the coupons are reinvested till the maturity of the bond and then compare the internal rate of return for both the bonds. This internal rate of return is called the Yield to Maturity of a bond which we will discuss later. The point here is that reinvestment of coupons is an important source of return for a bond. Depending on the prevailing market rates, the coupons can be reinvested at a lower or higher rate than assumed which will impact the total return of the bond.
TYPES OF YIELD
1. Current Yield
Current Yield is the simplest bond return measure. Current Yield only measures the annual interest income on the money invested.
Current Yield = Annual Cash Coupon / Bond Price
In case of our example of the bond purchased at Rs. 950 which pays quarterly coupon on Rs. 20 ,
Current Yield = (Rs. 20 X 4 ) / Rs. 950 = 8.42%
The problem with Current Yield that does not consider the capital gain and it cannot be used to calculate return from a zero coupon bond.
2. Yield to Maturity (YTM)
YTM is the annualised internal rate of return of a bond. The internal rate of return is the discount rate at which the net present value of all the cash flows for a project or investment is zero. In case of a bond, YTM is the rate if used to discount all the future cash flows (coupons and face value of the bond) till maturity, the sum of the present value of the cash flows should be equal to the bond price.
Let us take the example of the bond of face value Rs. 1000 and term of 5 years (20 quarters) issued at Rs. 950 and pays a quarterly coupon of Rs. 20. So, according to the YTM definition
Rs. 950 = (Rs. 20 / ( 1 + (YTM/4))) + (Rs. 20 / ( 1 + (YTM/4))^2) + (Rs. 20 / ( 1 + (YTM/4))^3)
+.......+ ((Rs. 20 + Rs. 1000) / ( 1 + (YTM/4))^20)
With trial and error, we can calculate the YTM as 9.26%.
Let us now assume that the bond was issued at par i.e. at Rs. 1000 and replace Rs.950 in the above formula to Rs. 1000. We will find at YTM of 8% i.e. the annual coupon rate.
If we assume that the bond was issued at a premium, say at Rs. 1050, the YTM becomes 6.8% i.e. less than the annual coupon rate of 8%.
So, the intuition is that for a bond issued at a discount the YTM is more than the annual coupon rate, for a bond issued at par, the YTM is equal to the annual coupon rate and for a bond issued at a premium, the YTM is less than the annual coupon rate.
3. Yield to Call (YTC) and Yield to Put (YTP)
Consider the above mentioned bond is a callable bond and can be called after 4 years (16 quarters) at a call price Rs. 1025. Now,
Rs. 950 = (Rs. 20 / ( 1 + (YTC/4))) + (Rs. 20 / ( 1 + (YTC/4))^2) + (Rs. 20 / ( 1 + (YTC/4))^3)
+.......+ ((Rs. 20 + Rs. 1025) / ( 1 + (YTC/4))^20)
YTC = 10.05%
Similarly, we can calculate the YTP for a putable bond.
Note: More about callable bond here
4. Realised Yield
A basic assumption in Yield to Maturity calculations is that the coupons are reinvested at the YTM which may be a stretch assumption given the market rates may vary significantly.
The Realised Yield, one the other hand, is the compounded return from the bond in the lifetime of the bond. The Realised Yield includes the effect of actual reinvestment rates in the calculation of return.
If the market interest rates are unchanged for the whole life of the bond and the coupons can be reinvested at the YTM, then the Realised Yield is equal to YTM. If the coupons are reinvested at a lower rate than the YTM then Realised Yield is lower than the YTM. If the coupons are reinvested at a higher rate than the YTM then then Realised Yiled is higher than the YTM.
When it comes to debt instruments Fixed Deposits and National Saving Certificates (NSC) are pretty well known to the retail investors of India but bonds are much less understood. This series will cover various tenets of bonds.
WHAT IS A BOND?
In simple language, a bond is a loan from the bond buyer to the bond issuer. Bonds are different from fixed deposits or NSCs in the way that the face value of a bond is not the amount you invest in it but the amount you receive at maturity of the bond. Bonds are generally issued at a discount to the face value and may or may not make periodic interest payments known as coupon payments. We will learn about the different features of bonds in the following section.
1. Face Value
Face value is the nominal value mentioned on the security. In the case of Bonds, the face value of the security is the amount receivable at the maturity of the bond.
If the bond is issued at a lower price than the face value it is called that the bond is issued at a discount. If the bond is issued at a price higher than the face value, it is called that the bond is issued at a premium and if the bond is issued at the face value, it is called than the bond is issued at par.
2. Tenure or Maturity
It is the period from issue to maturity of the security.
3. Coupon and Coupon Rate
The coupon rate is the rate of annual yield paid by the bond. The coupon payment may be monthly, quarterly, semiannual or annual. The coupon rate defines the annual payment. For example a 10% coupon rate for Rs. 1000 bond would mean Rs. 100 annual coupon payment, Rs. 50 semiannual coupon payment, Rs. 25 quarterly coupon payment and Rs. 8.33 monthly coupon payment.
A zero coupon bond means a bond which does not pay any coupon i.e. there is no cash-flow before maturity. That does not mean that a zero-coupon bond does not offer any return. Zero coupon bonds are issued at a discount to the face value and the bondholders receive the face value at maturity. The difference between the issue price and face value i.e. the discount is the return if the investor holds the bond till maturity.
4. Fixed Rate and Floating Rate
In case of a fixed rate bond the yield is fixed and does not change. Refer to the above example. The coupon rate is fixed at 10%.
In case of a floating rate bond, the yield is set relative to some policy rate such as repo rate.
Bonds may be callable a putable.
A callable bond gives the issuer the right but not obligation to call back the bond i.e. prepay the bondholder and end the bond contract paying an amount called call price. This means when the market interest rate for a bond of a similar kind (similar credit risk etc.) is lower than the interest rate at which the bond was issued, the issuer has the incentive to call back the current bond and issue new bonds at lower interest rates. The bondholders are exposed to reinvestment risk i.e. they can be forced to reinvest the prepaid money from the callable bond at a lower interest rate. The bondholders may be compensated for the reinvestment risk with slightly higher than the required yield and/or a call price slightly higher than the face value of the bond.
A putable bond is the opposite of a callable bond. A putable bond gives the bond-holder right but not obligation to redeem the bond before the maturity at a put price. This means when the market interest rate for a bond of a similar kind (similar credit risk etc.) is higher than the interest rate at which the bond was issued, the bond-holder has the incentive to redeem current bond and buy new bonds of higher yield. This is obviously beneficial for the bond-holder. A puttable bond may pay a slightly lower interest rate than comparable non-putable bond and/or the put price may be lower than the face value.
6. Secured of unsecured bonds
Secured bonds carry collateral on some asset owned by the issuer. The asset can be some property, equipment or income streams. This means that in case the issuer fails to pay promised interest or the principal back, the bond-holder can liquidate the collateral to recoup some money.
An unsecured bond or a debenture does not have anything collateral. The expected repayment is completely based on the creditworthiness of the issuer.
7. Indexed bond
Before we try to understand indexed bonds, let us understand nominal and real interest rates. Consider security pays 5% annual return but the inflation (say Consumer Price Index) for this period is 4.5%. Effectively, you earned purchasing power of 0.5% because everything is 4.5% more expensive after one year. This is the basic idea of nominal and real interest rates. Nominal interest rate gives the interest rate without the consideration of inflation and the real interest rate considers the effect of inflation.
An indexed bond considers the effect of inflation either in terms of the Wholesale Price Index (WPI) or Consumer Price Index (CPI). The principal for such bond is adjusted for inflation by multiplying it with Index Ratio (IR) and then the coupon is calculated on the basis of adjusted principal and real coupon rate. The principal can also be adjusted for inflation at maturity.
Let us consider the example of inflation-indexed bonds issued by RBI in 2013 (link mentioned below). The real coupon rate is 1.5%. Now, if the inflation index goes from 100 to 106 is one year, the Index Ratio is 1.06. If the principal of the bond is Rs. 100, inflation-adjusted principal is Rs. 106 and the coupon after one year equals to Rs. 1.59 i.e. (Rs. 106 x 1.5%).
Now, in the second year, the inflation index is at 111.8. The Index Ratios is 1.118 (i.e. 111.8/100). The adjusted principal is 111.8 and the coupon payment is Rs. 1.68 (i.e. 111.8 x 1.5%). This process is followed for all coupon payments.
At the maturity, the principal is adjusted by the index ratio and an amount higher of the adjusted principal or the face value of the bond is paid back.
RBI Inflation-Indexed Bond-
Before we get into the types of Government Securities and their risk-return characteristic, it is worthwhile to know some basic terms used for fixed income instruments. Fixed Income instruments are securities which offer a prefixed return, unlike equities. Examples are National Saving Certificates (NSCs), bonds, debentures, CDs etc. They are basically loans to the issuer by the investors.
TERMS USED FOR FIXED INCOME INSTRUMENTS
1. Face Value
Face value is the nominal value mentioned on the security. The significance of face value may differ from one security to another. In the case of Bonds, the face value of the security is the amount receivable at the maturity of the bond. Whereas in case of an NSC, the face value is the value at which the security is issued.
In case of bonds, if the security is issued at a lower price than the face value the bond is issued at a discount, If the bond is issued at a price higher than the face value, it is issued at a premium and if the bond is issued at the face value, it issued at par.
2. Tenure or Maturity
It is the period from issue to maturity of the security.
Fixed income security of tenure up to one year is called a money market security.
3. Coupon and Coupon Rate
The coupon rate is the rate of annual yield paid by fixed income security. The coupon payment may be monthly, quarterly, semiannual or annual. The coupon rate defines the annual payment. For example a 10% coupon rate for Rs. 1000 bond would mean Rs. 100 annual coupon payment, Rs. 50 semiannual coupon payment, Rs. 25 quarterly coupon payment and Rs. 8.33 monthly coupon payment.
A zero coupon bond means a bond which does not pay any coupon i.e. there is no cash-flow before maturity. That does not mean that a zero-coupon does not offer any return. Zero coupon bonds are issued at a discount to the face value and the bondholders receive the face value at maturity. The difference between the issue price and face value i.e. the discount is the return if the investor holds the bond till maturity.
4. Fixed Rate and Floating Rate
In the case of fixed rate security, the yield is fixed and does not change. Refer to the above example. The coupon rate is fixed at 10%.
In the case of floating rate security, the yield is set relative to some policy rate such as repo rate.
Now let us get back to the G-Secs.
SOME TYPES OF G-SECs
1. Government Bonds
Government Bonds are fixed income securities with tenure for more than a year. These bonds can be fixed rate or floating rate bonds. These bonds can also be zero coupon bonds i.e. may not pay any coupon but issued at a discount to the face value.
2. Treasury Bills
Treasury Bills or T-Bills are money market instruments i.e. their tenure is less than a year. In India, T-Bills with tenure of 91 days, 182 days and 364 days are issued. T-Bills are zero-coupon securities and issued at a discount to the face value.
3. Certificate of Deposit (CD)
Certificates of Deposit are money market instruments (i.e. tenure of less than a year) issued by the banks and financial institutions allowed by the RBI, against the deposited amount. CDs can be issued in demat format or in the form of promissory notes. CDs can be issued to individuals, companies, trusts, funds, associations and NRIs on a non-repatriable basis. Generally, CDs are issued in the denomination of Rs. 1 lakh.
4. Commercial Paper (CP)
Commercial papers are unsecured money market instruments (i.e. tenure of less than a year) issued in the form of promissory notes. Companies including NBFCs issue commercial papers to fund their short term liquidity needs. The tenure for commercial papers vary from seven days to a year and they are issued in the denomination of Rs. 5 lakhs and multiples. The interest rate for commercial papers depends on the credit rating.
5. Other Securities
Saving instruments such as savings bonds and NSCs also fall under G-sec.
Special securities such as Oil Bonds, Food Corporation of India Bonds, fertiliser bonds, power bonds also fall under G-Sec.
There is a common misunderstanding that government securities are completely risk-free. This misunderstanding arises from a limited understanding of risk.
Fixed income securities can be exposed to various types of risk namely default/credit risk, interest rate risk, inflation risk, liquidity risk etc.
Default or credit risk is the risk that the borrower fails to payback totally or partially. In the case of government securities there no default risk.
Interest rate risk arises due to fluctuation in the market interest rates. This risk increases for security with longer duration (interest rate sensitivity). Duration of a security increases with a higher term and lower coupon frequency. A person, holding the government security till maturity, is not exposed to the interest rate risk because the payment at maturity is assured but if a person wants to sell the security before the maturity then she is exposed to the interest rate risk.
Inflation risk arises due to the loss of purchasing power of money due to inflation. As the government securities do not pay and default premium (part of interest rate to compensate the investor for less than perfect credit rating of the issuer), the interest rates offered are lower than the similar securities issued by private companies. This means that the government securities are exposed to inflation risk if they are not indexed to inflation. It is also possible to earn a lower return than the inflation i.e. destruction of purchasing power.
Liquidity risk arises when the money gets locked-in for a long period of time. This risk increases with increasing tenure of the security and lack of trading opportunities. Indian bond market is not matured enough and liquidation of government securities before maturity is often very difficult increasing the liquidity risk. Some securities can increase this risk by making the securities non-transferable. It not possible to liquidate such securities before their maturity without realising lower returns.
WHAT IS A GOVERNMENT SECURITY (G-SEC)?
Like private sector companies, the central and state governments also need to raise capital to spend in building and maintaining the public infrastructure or for other purposes. For this reason, the central and state governments issue different securities such as T-Bill and State Development Loans (SDLs). These are called Government Securities. As per the Government Securities Act 2006, a Government Security is defined as “security created and issued by the Government for the purpose of raising a public loan or for any other purpose as may be notified by the Government in the Official Gazette..”. These securities are tradable securities.
FORMS OF G-SEC
As per section 3 of the Government Securities Act 2006, G-Secs can be of the following form
(i) a Government promissory note payable to or to the order of a certain persons
(ii) a bearer bond payable to bearer
(iii) a stock
(iv) a bond held in a bond ledger account
G-SECs IN INDIA
In India, the central government issues both short term (less than a year maturity) debt securities in the form of Treasury Bills or bonds and long term dated securities.
The state governments issue only bonds and dated securities in the form of State Development Loans (SDLs).
HOW TO INVEST?
Although G-Secs provide various benefits such as guarantee by the government, availability in various maturities and coupon options, they are still not very popular in the retail investors due to lack of liquidity in the secondary market. This means that it is difficult for a retail investor to liquidate the securities before its maturity. The second issue is the lack of understanding about the debt investing concepts.
Anyways, in 2001 RBI introduced non-competitive bidding (NDS-OM) in the G-Secs opening a path for the retail investors to invest in the G-secs. NSE (NSE GoBID) and Zerodha also introduced platforms for G-Sec trading. The minimum investment is Rs. 10,000 for both current and the investor must have a demat account.
We will dive into risk-return patterns of different G-Secs in next post...
NDS- OM: https://www.ccilindia.com/OMHome.aspx
NSE GoBID - https://www.nseindia.com/products/content/debt/ncbp/Mode_to_nscp.htm
Zerodha - https://coin.zerodha.com/gsec
WHAT IS A CONVERTIBLE BOND?
A convertible bond is a bond which can be mandatorily/optionally converted fully/partially to common stocks. The bond comes with a call or a put option. A call option gives the issuer option to call back the bond and pay the bondholders in the form of shares. A put option gives the bondholder the right to redeem the bond and claim shares of the company as payment.
WHAT IS A FOREIGN CURRENCY CONVERTIBLE BOND (FCCB)?
An FCCB is a convertible bond issued in a currency other than the local currency of the country the company is listed to the non-residents. For example, an Indian company issues a USD denominated convertible bonds in the USA. The interest and the principal repayment for such a bond will in USD.
WHAT IS IN IT FOR THE INVESTORS AND THE ISSUERS?
1. For the Investors
For an investor, the FCCBs offer two kinds of benefits –
1. Benefits associated with investing in a foreign currency bond and
2. Benefits associated with investing in a convertible bond.
The primary benefit associated with a foreign currency bond is an opportunity to earn higher interest than the domestic market. Generally, FCCBs are issued in low-interest rate countries by companies located in high-interest-rate countries.
A convertible bond offers a potential benefit of conversion to equity.
2. For the issuers
FCCBs are generally issued by multinational companies who deal with multiple currencies. For such companies, FCCBs offers a way to mitigate the currency risk by raising money in the country of operation. Also, an importer can manage the currency risk by raising money from which they are importing.
As mentioned before, FCCBs are often issued in low-interest rate countries by companies located in high-interest-rate countries. The companies can offer lower interest rates than their domestic countries which still can be attractive in the country in which the bonds are being issued. For example, an India company issuing FCCBs in the USA may offer lower interest rates than the Indian market which will still be attractive to the investors in the USA.
RISK ASSOCIATED WITH FCCBs
1. For Investors
In case of an FCCB which is mandatorily convertible, the bondholders do not have any say on the conversion event. It is possible that the conversion of the bond to shares happen when the market price of the shares are considerably lower than the price at which the bonds were issued. This may result in a considerable loss for the investors.
2. For issuers.
In the case of optionally convertible FCCBs, a drastic decrease in the share price may create a situation where the bondholders do not have any incentive for the conversion. This leaves the company with a loan in foreign currency which may strain the finances. This is especially problematic when the currency of the domestic currency depreciates in comparison to the foreign currency as the FCCBs are issued in as FCCBs are exposed to the currency risk.
REGULATION IN INDIA
FCCBs are regulated by notifications under the RBI Foreign Exchange Management Act (FEMA). As per notification no. FEMA 55 /2002-RB dated 2nd March 2002, Indian companies can issue FCCBs up to USD 50 million without seeking any permission from the regulators. For issues, more than US 50 million but less than US 100 million needs the permission of RBI. For issues, more than US 100 million needs the permission of the Ministry of Finance.
The minimum maturity should be 5 years and any call or put option associated with the FCCB cannot be exercised before 5 years.
WHAT IS A DEBENTURE?
In simple language, a debenture is an unsecured loan where the debenture holder holds the right to receive fixed periodic interest payments and the principal back after a predefined period. Debentures are NOT SECURED by any collateral and the interest rates are determined by the general creditworthiness of the issuer.
WHAT IS A CONVERTIBLE DEBENTURE?
A convertible debenture is an unsecured loan which can be or must be converted fully or partially to equity or preference shares. The number of shares which can be received at the conversion is determined at the time of the issue of the debenture.
TYPES – FULLY AND PARTIALLY CONVERTIBLE
1. Fully Convertible Debentures
In case of a fully convertible debenture, the whole debenture is converted to a predefined number of equity or preference shares and the debenture ceases to exist.
2. Partially Convertible Debentures
In case of a partially convertible debenture, only part of the debenture will be converted to a predefined number of shares and other part remains as a debenture.
TYPES – COMPULSARILY AND OPTIONALLY CONVERTIBLE
1. Compulsorily Convertible Debentures
A compulsorily convertible debenture must be converted to shares after a predefined period.
2. Optionally Convertible Debentures
The debenture holder has the option whether or not to convert the debenture into shares.
BENEFITS AND LIMITATIONS
1. For the debenture holders
It is difficult to value the equity of a company which cannot be considered as going concern such as a startup or a company in financial distress. Convertible debentures give investors an option to invest in such companies. Periodic interest payments also give some assured payback.
But, investors should be cautious about the financials of the company. Generally, companies with liquidity issues and lower credit rating issue convertible debentures. The conversion gives the opportunity to share the upside but the investors should do enough due diligence to make sure that there are at least some chances of an upside. Financially distressed companies may issue convertible debentures just to lower cost of debt and the debenture holders may get any benefit from the conversion.
2. For the issuers
Given the high risk associated with companies who cannot be considered a going concern, raising capital becomes difficult. Convertible debentures help these companies raise capital as the debenture holders perceive lower risk with the periodic interest payments.
In case of a compulsorily convertible debenture, the issuer manages the liquidity of the company as the debentures are paid back in kind i.e. in the form of shares. Also, the interest rate for the convertible debentures are lower than non-convertible debentures for the perceived benefit that they can be converted to equity i.e. can benefit from the upside in case the company shared performs well.
Also, the interest payments reduce the taxable income for the company and thus income tax.
Although, issuing convertible debentures instead of equity means that the company will have to make interest payments. For companies with strained liquidity such as a startup, the periodic interest payments can be problematic.
WHAT IS EMPLOYEE STOCK PURCHASE PLAN (ESPP)?
ESPP is formal plans under which the company offers own shares to employees as part of a public issue or otherwise or through a trust. The shares are generally issued at a discount to the prevailing price
A section of employees (based on shares already held and how long the employee is employed with the company) is offered the ESPP. The employees can enrol for the ESPP during the Enrollment period. A fund is accumulated during the offering period (from the date the plan is offered to the date of purchase) through fixed payroll deductions and the shares are purchased on behalf of the participating employees at the end of the offering period. Shares are generally purchased at a discount. A Lookback price which is calculated at the minimum price of the share during the offering period can be calculated and then a discount can be applied.
Purchased shares are subjected to lock-in for a minimum of one year as per section 22 of the SEBI (Share Based Employee Benefits) Regulations 2014. The exception is when shares are issued as part of a public issue and shares are issued at the same price of the public issue- the lock-in is not applicable in this case.
TAX IMPLICATIONS FOR EMPLOYEES
The discount (to the fair market price) at which the shares are issued is considered as perquisite and taxed as such.
Short Term or Long Term capital gains is applicable when the employee decides to sell the shares.
STOCK APPRECIATION RIGHTs (SARs)
SARs are a type of employee incentive plan through which the employees benefit from the appreciation of the stock price of the company over a specified period of time. This is a way companies can align the employees with the overall goal of the company. Similar to ESOPs, SARs have vesting or lock-in period which is minimum one year in India as per section 24(1) of the SEBI (Share-Based Employee Benefits) Regulations 2014.
Unlike stock options, SARs does not require the employees to pay the strike/exercise price. SARs are paid as bonus which is linked to the appreciation in the stock price of the company.
In the case of SARs, the employees may be paid in cash (discussed below).
Also, unlike Sweat Equity, employees do not receive equity in the company when SARs are allocated.
TYPES OF SARs
1. Stock-Settled SARs
In the case of the Stock-Settled SARs, the appreciation of the share price is paid in the form of shares of the company. Take, for example, a company XYZ issues SARs when the share price is Rs. 10. Suppose an employee received SAR for 1000 shares. Now, after one year of lock-in, the SARs are eligible to be vested. The stock price now is Rs. 20. So, the appreciation for the 1000 share is Rs. 10,000. The employee will receive (Rs. 10,000 / Rs. 20) = 500 shares of XYZ.
2. Cash-Settled SARs
In the case of the Cash- Settled SARs, the appreciation of the share price is paid in the form of cash. Referring to the above example, Rs. 10,000 will be paid out to the employee.
PHANTOM STOCK OPTIONS
Phantom Stock Option is just another name for the Cash-Settled SAR. The Phantom Stock Option is a better option for the employer than ESOP or Stock-Settled SAR because employees do not get any voting rights but still, the compensation is aligned to the stock performance. So, basically, Phantom Stock Options are cash bonus for the appreciation of the stock price.
TYPE OF PHANTOM STOCK OPTIONS
1. Appreciation only
Appreciation only Phantom Stock Options pay an amount equal to the appreciation of the stock price from the time of issuance to the settlement.
2. Fully Paid
These Phantom Stock Options pay an amount equal to the stock price at the time settlement.