Features of debt securities, Finance Basics

In order to value a debt security correctly, we must understand the terms and conditions of debt securities precisely. These terms define the contractual rights of the debt security holder and of the issuer, and determine the cash flows that the debt security holder will receive. The terms facilitate easy description of the salient features of debt securities.

Bond Indentures

A bond indenture is a contract between the issuer and the bondholder, and it specifies the provisions relating to the issue.

Covenant

A Covenant can be defined as the agreed terms and conditions between a borrower and a lender. It is a contractual provision in a bond indenture that allows and limits a borrower from taking certain actions. Two types of covenants are seen in a lending agreement, affirmative covenants (promise of the borrower to meet certain obligations like paying interest, principal, taxes, etc.) and negative covenants (restrictions to the borrowers from taking certain actions).

Maturity

The maturity date of the bond is the date on which the bond is repaid and extinguished. A bond is often described by specifying the coupon rate, the name of the issuer and the maturity date. For example, 11.5% GoI 2010 denotes a bond with a coupon rate of 11.5% issued by the Government of India (GoI) maturing in 2010. The holder of this bond will receive 11.5% interest every year till 2010 and also receive the principal amount of the bond in the year 2010.

Some bonds do not repay the principal amount in one installment but spread it out over several years. In this case, the date of the last installment is often taken as the maturity date though the very notion of a maturity date becomes less useful in this case. Maturity date is specified in the bond indenture. A borrower can make a provision in the indenture that allows either the issuer of the bondholder or the borrower to alter a bonds’s term to maturity.

The maturity at issue refers to the time to maturity from the date of issue of the bond and the residual maturity refers to the time to maturity at any subsequent point of time. For example, a bond with a maturity date of 2005 issued in 1990 has a maturity at issue of 15 years, but in 2000 its residual maturity is only 5 years.

Par Value

The face value of the debt security can be thought of as the principal amount on which interest is paid by the issuer. It is the amount the issuer is willing to repay the bondholder on the maturity date, i.e., at the end of the life of a bond. This is also often the price at which the bond is originally issued by the issuer. It is also referred to as par value, principal, redemption value and maturity value.

Coupon Rate

Bonds pay interest periodically at a pre-specified rate of interest. The annual rate at which this interest is paid is known as the coupon rate or simply the coupon. Interest may be paid monthly, quarterly, half-yearly, annually or at some other frequency. For example, a bond with a face value of Rs.1,000 with a 10% coupon payable semi-annually will pay Rs.50 as interest every six months. The dates on which the interest payments are made are known as coupon due dates. Coupon rate is also known as nominal rate. In addition to indicating the coupon payments that the investor can expect to receive over the term of the bond, the coupon rate also affect’s price sensitivity to changes in market interest rates.

 

         Coupon = Coupon rate x Par value of bond.

Accrued Interest

When an investor buys a bond in between coupon payments, he is supposed to compensate the seller with the coupon interest earned on the bond from the last coupon payment date to the settlement date. This amount of interest is called accrued interest, so the buyer pays the seller the agreed price plus the accrued interest. This is known as full price. The price of the bond without the accrued interest is known as clean price.

A bond in which the buyer must pay the seller accrued interest is said to be trading cum-coupon. If the buyer forgoes the next coupon payment, the bond is said to be trading ex-coupon. In the government bond market in India, and in most other bond markets around the world, the buyer has to pay accrued interest to the seller.

Suppose a bond pays interest semi-annually on July 1 and January 1. If a person sells the bond on May 1, he gets no interest for the four months from January 1 to April 30 for which he held the bond, while the buyer would get six months interest on July 1 though he held it only for two months (May 1 to June 30). The interest for the period from the last coupon due date to the date of the sale is known as accrued interest. In the above illustration, if the bond has a face value of Rs.100 and carries a coupon of 12%, then the accrued interest would amount to Rs.100 x 12/100 x 4/12 = Rs.4.

It is often a convention in the bond markets that the buyer pays the accrued interest to the seller in addition to the price. In other words, the actual cash price paid is equal to the quoted price plus the accrued interest. In India, this practice is prevalent in the government bonds market, but not in the corporate bonds market. In the above illustration, if the quoted price is Rs.98 then under this convention, the actual cash price would be Rs.98 + 4 = Rs.102.

Conversion Privilege

In convertible bonds, bondholders get a right to convert their bonds for a specific number of shares of the bond issuer. This privilege allows bondholders to take advantage of favorable movements in the price of the issuer’s shares.

Put Provision

An issue with a put provision included in the agreement grants the bondholder the right to sell bonds back to the issuer at a pre-specified rate and date. The specified rate is known as put price. Normally the put price is equal or close to the par value of the bond. However, in zero coupon bonds put price is less than the par value. When market interest rate rises above the coupon rate, then the bondholder uses his right under the put provision and forces the issuer to redeem the bond at the put price. He can then invest the proceeds form the bonds in higher interest rate instruments. 

Posted Date: 9/8/2012 4:04:36 AM | Location : United States







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