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corporate debt (bond)

What Are Bonds?


Bonds are another word for loans taken out by large organizations, such as corporations, cities, and the U.S. Government. Since these entities are so large, they need to borrow the money from more than one person or bank.Therefore, bonds are a piece of a really big loan. The borrowing organization promises to pay the bond back, and pays interest during the term of the bond. Since large organizations don't like to actually say they are borrowing money, they say they are selling bonds...presumably because it sounds better.Like loans, bonds return interest payments to the bond holder. In the old days, when people actually held paper bonds, they would redeem the interest payments by clipping coupons. Today, most bonds are held by the financial planning institution, and interest is automatically accrued for the life of the bond.Bonds are usually resold before they mature, or reach the end of the loan period. This is how bonds rise and fall in value. Since bonds return a fixed interest payment, they tend to look more attractive when the economy and stocks market decline. When the stock market is doing well, investors are less interested in purchasing bonds, and their value drops.Like stocks, bonds can be packaged into a bond mutual fund. This is a good way for an individual investor to let an experienced mutual fund manager pick the best selection of corporate bonds. A bond fund can also reduce risk through diversification. This way, if one corporation defaults on its bonds, then only a small part of the investment is lost.

THERE ARE MANY TYPES OF BONDS FROM MANY DIFFERENT ISSUERS.


Bonds have many characteristics such as the way they pay their interest, the market they are issued in, the currency they are payable in, protective features and their legal status. Bond issuers may be governments, corporations, special purpose trusts or even non-profit organizations. Usually it is the type of issuer or the particular nature of a bond that sets it apart in its own category. We briefly discuss some of the main types of bonds below:

ASSET-BACKED SECURITIES GOVERNMENT BONDS CORPORATE BONDS INFLATION-LINKED BONDS EUROBONDS U.S. TREASURY INFLATION PROTECTED SECURITIES (TIPS) EXTENDIBLE/RETRACTABLE BONDS MORTGAGE-BACKED SECURITIES FOREIGN CURRENCY BONDS etc.

Benefits of Corporate Bonds Here are some benefits of corporate bonds: Attractive yields: Corporations generally offer higher yields than government bonds of the same maturity. Dependable income: Corporate bonds offer investors the opportunity of a steady income, while preserving the principal. Safety: Credit rating agencies, like Standard & Poor's and Moody's, rate corporate bonds according to associated risk and rewards. Ratings reflect the capability of the issuing authority to deliver timely returns. The higher the rating, the safer the investment. Diversity: An investor can choose from a variety of sectors and credit-quality characteristics. Marketability: Most corporate bonds sell easily and quickly due to the markets size and liquidity.

Drawbacks of Corporate Bonds While corporate bonds offer a higher yield than some other investments, they are also accompanied by higher risks. These include: Interest Rate Risk: Interest rate movements can significantly reduce the value of the bond. Credit Risk: Corporate bonds are not secured by collateral. Thus an investor faces the risk of a corporation failing to meet the debt obligation. Event Risk: Corporate bonds have exposure to event-based risks. Corporate reshuffles, takeovers or restructuring have far reaching consequences on the credit rating and price of such bonds.

Call Risk: Callable corporate bonds can be a nightmare when the issuer declares the purchase of bonds after a stipulated time period. Corporations usually call off a highyielding bond when interestrates plummet. This gives the company a chance to reissue bonds at lower interest rates. In such cases, an investor receives only the par value of the bond

EVENT RISK
Corporate bonds are like no other in that they have an implied event risk. Takeovers, corporate restructuring, and even LBO's can have dramatic consequences to a bonds credit rating and even price. Unless you were acting on inside information, it was nearly impossible to predict these dramatic shifts in a company and therefore; corporate bond issuers were forced to provide additional bond features to remove some of the uncertainty associated with corporate bonds.

EVENT RISK MITIGATION (SPECIAL FEATURES)


Poison pill provisions, floating rate notes, and putable bonds are a few key features that were added to corporate bonds to ease the investors' mind. Poison Pill Provision The poison pill provision is probably the most important risk prevention measure that a corporation can make; it allows shareholders to buy the stock of the acquiring company or more of the same stock at a heavily discounted price, usually half of the market rate, during a takeover situation. The provision attempts to thwart would be takeover attempts by forcing the acquirer to negotiate terms with the board of directors on the terms of the takeover. If the board is amenable to the terms, they will recant the pill. If not, the pill could be triggered; and shareholders can exercise the option to purchase shares at a deep discount. This would have negative ramifications to the acquirer as it would dilute their interest in the company.

Floating Rate Notes


Floating rate notes (FRN) are corporate bonds that have a variable coupon structure to protect purchasers against interest rate risk. The coupon is reset usually every three months using a benchmark index as a basis; usually a short term treasury instrument or LIBOR. Sometimes, floaters will have a floor in place to provide that much more protection to the corporate bond holder against interest rate

movements. The idea behind a floating rate note is to protect the bond holder against rate fluctuations and at the same time keeping the bond value close to par.

Putable Bonds
A corporate bonds with a putable feature allows the bond holder to return, or "tender", the bond back to the issuer at par before the bond's maturity date. This feature is designed to protect a bonds value against interest rate fluctuations. The intervals in which this put feature can be executed are specified in the bond indenture. Effectively, a corporate bond with a putable option turns the security into a shorter term instrument.

demand side scenario:


(A) corporates: since the cash credit system of banks operates in effect like a loan in perpetuity,many corporates prefer it to bond to bond financing where the amount has to be returned on a specific date. also,corporates do not relish the idea of getting a credit rating done to calculate the premium to be charged over the zero-risk government bond of comparable maturity. (B)FIIs: foreigh financial institutions are major players in the equities market. however, due to the ceiling on their investment in the debt market,they are present only in a limited way in bond market. (c) pension funds and the insurance sector: these could be another constituency,but the absence of pension funds and low insurance penetration has meant limited demand for long-term bonds (D)households: households could be a big constituency,but they,too,are almost completely absent from the market,in part due to the lack of an efficient legal system that is critical to investor confidence, and unhappy experience with debenture trustees

supply side scenario:


(A) for too long corporates have got accustomed to raising loans from banks and term lending institutions as they find this route to be relatively hassle-free. they feel that it is far more difficult to raise funds through bond flotation as it involves convincing a larger number of highly demanding

investors, many of whom may be raising far more searching questions about the viability of the projects for which funds are being sought. (B)there is a problem of illiquidity. a large part of the market does not mark to market the corporate bond portfolio. as a result, once any bond goes into the books, it does not come out. this takes away liquidity from the market. (C)trading is concentrated in AAA- rates bonds, as they carry the highest safety and are the most liquid. a large part of the market,including insurance companies, provident funds and banks; have restrictions on private sector paper. and thus the bonds of public sector units are much more liquid than private sector bonds.

The Indian Corporate Bond Market


Introduction 1. The corporate bond market in India has not kept pace with the developments in the equity market, which has matured and grown to global standards. It has suffered from chronic neglect, both in terms of policy and infrastructure, and has been almost entirely restricted to a set of domestic institutional investors. For an active secondary market, there is a need for a wider range of issuers and of investors, and with different perceptions for investment and trading in the secondary markets. 2. With continued pace of economic reforms and growing business confidence together with increasing global recognition of Indias technical capabilities and

economic potential, entrepreneurs are willing to invest in large, global scale projects to enhance infrastructure as well as to promote exports. As capacity utilizations in a wide range of industries have been in excess of 80-90percent, entrepreneurs are now willing to invest capital to grow capacities. This is expected to result in increased competition for financial resources as companies look to expand. 3. India has aggressive targets for GDP growth rate at 8percent-10percent p.a. The investment in infrastructure by both the government and the private sector has been relatively low in the past. Achieving financial closure for large infrastructure projects has often been difficult and time consuming given the quantum of funds required and long gestation periods. Banks continue to be exposed to problems of asset / liability mismatches when they lend long tenor as such long term assets are inevitably funded through significantly shorter tenor liabilities. 4. In future, infrastructure development will be a significant growth driver. Broadening and deepening of the bond market is required to provide long tenor project finance. Indias financial system is still largely dominated by the banking system with a deposit base largely of less than 3 year tenors. A borrower who requires long-term funds (10-15 years) is still dependant on a few providers of such long maturity loans. Infrastructure projects like power, telecom, ports, airports, urban infrastructure, roads etc require long-term funds. Consequently, we need a significant growth in the insurance, pension and provident fund sectors since they are the logical providers of long-term money. Simultaneously, small investors need to be brought into the long-term debt capital market. In the absence of such growth, Indian corporates with large expansion plans would expose themselves to significant refinancing risks.

5. The recent past has witnessed many Indian corporates effecting overseas acquisitions as part of their vision of global growth. The overseas subsidiaries of these companies have accessed foreign currency loan/bond market to fund these acquisitions. The ECB guidelines have been liberalized in 2004 enabling corporates to access the foreign currency loan market to fund overseas acquisitions. This is imparting greater flexibility in funding cross border acquisitions. 6. As demand for funds from the corporate sector grows rapidly, large government borrowings may create a crowding-out situation for the corporate sector.

TYPE OF CORPORATE BOND


Corporate Bond List is a type of corporate bond index through which one can show the various kinds of Corporate Bonds that are available in the market. Some of types of corporate bonds available in the Corporate Bond List are: Convertible Bonds Junk Bonds Strips Bond Treasury Inflation-Adjusted Securities High Yield Bonds Zero Coupon Bonds

CONVERTIBLE BONDS:
Convertible bonds, often simply called converts, are usually debentures that can be converted into common stock of the corporate issuer within a specified time period at the discretion of the investor. Either the number of shares or the share price is specified in the indenture. The number of shares of stock that each bond can be converted to is known as the conversion ratio. Thus, a bond that can be converted into 10 shares of stock has a conversion ratio of 10 to 1, or simply as 10. If the share price is specified in the indenture instead of the number of shares, then the conversion ratio can be found by dividing the par value of the bond$1,000by the share price. Thus, if a share price of $20 is specified, then the conversion ratio is $1,000/$20 = 50 shares. When the bond is first issued, the conversion price is much higher than the stock price.

Some bonds specify different conversion ratios, or different conversion prices, for different time periods. For instance, the indenture may say that in the first 10 years, the bond may be converted to 20 shares, and after that, they may be converted to 40 shares. There is also an anti-dilutive provision where the conversion ratio or conversion price is changed to reflect any stock splits or stock dividends.

The convertibility factor, like many special bond features, lowers the interest rate that the corporation would otherwise have to pay without this feature, and it appeals to investors who want current income, but would like to take advantage of any growth in the corporation. The yield is usually more than any stock dividendthe yield advantage of the convertbut less than a straight bond from the same issuer. The premium over bond value is the difference in price between the convertible bond and a straight bond without the convertibility feature from the same issuer. Factors that increase the premium over bond value are:

The demand from life insurance companies and other institutional investors who may be restricted by law from buying stock. Buying converts allows these institutional investors to possibly earn considerable more than just the yield, while having downside protection. Transaction costs for buying the bond and converting it into stock are lower than buying the stock itself. The longer the duration of the conversion option, the greater the premium. Higher common stock dividends diminish the yield advantage, thus diminishing the premium over bond value.Because convertible bonds are callable, the conversion can be forced by the company if bond prices drop. This eliminates debt and interest payments for the company.

The advantages of convertible bonds to an investor is that it offers appreciation potential if the company does well, and its stock rises; but, if the company suffers, and the stock price declines, the investor can still keep the bond as a bond, and collect interest and principal, or sell it, based on the interest that it pays. If the company ever goes bankrupt, the bondholder will have superior claims over any stockholder.

The disadvantages include a lower interest rate, and the possibility that the bond will be called prior to conversion, or even before when it can be converted, since some bonds restrict conversions to certain time frames.

Conversion Parity The Relationship Of Bond Price To Converted Stock Price


Conversion parity is a term used to describe the relationship of the stock price, multiplied by the conversion factor, to the bond price. For instance, if the bond is currently selling for $1,200 and can be converted into 10 shares of stock, and if the current stock price is $120, then the stock price and bond price are at parity. If the stock is selling for less than $120, then it is selling below parity, and if it is selling for more than $120, then the stock is selling above parity.

When the bond is first issued, the bond price is much higher than the conversion parity price. The difference between the bond price and the conversion parity price is the conversion premium (aka premium over conversion value).

Conversion Premium = Bond Price - (Stock Price x Conversion Ratio) ExampleCalculating The Conversion Premium If a bond, with a conversion ratio of 20, is currently selling in the secondary market for $1,200 and the common stock is selling for $50, what is the conversion premium? Solution: Conversion Premium = $1,200 - ($50 x 20) = $1,200 - $1,000 = $200

A convertible bond is a debt security that gives the investor the option to exchange the bond for common stock in a company after a predetermined date or event. The value of the bond depends upon the issuer's credit and the current interest rate. The most common types of convertible bonds are the vanilla convertible bond, the mandatory convertible bond and the contingent convertible bond.

Vanilla Convertible Bonds


As the name hints at, the vanilla convertible bond is the standard and most common type of convertible bond. These bonds can be converted into common stock when a predetermined event has occurred or when a predetermined period of time has passed. These bonds may not be redeemable before the final maturity date if predetermined share price conditions have not been met.

Mandatory Convertible Bonds


A mandatory convertible bond must be converted into the issuer's common stock before or after the final maturity date. These securities are short-duration securities and provide a higher yield rate to compensate the issuer for the mandatory conversion. A fixed amount of shares the bond can be converted into is also predetermined.

Contingent Convertible Bonds


Contingent convertible bonds are similar to vanilla convertible bonds in that they can be converted when the stock price reaches a certain point (this is referred to as the "strike price"). The difference with contingent convertible bonds is that the stock price must reach a predetermined percentage above the "strike price" before it can be converted by the investor.

Exchangeable Bonds
In a strict sense, exchangeable bonds are not convertible bonds, but are commonly grouped together with convertible bonds. These bonds can be converted into the common stock other than the stock held by the issuer. The stock is usually in another company of the issuer.

What Is a Junk Bond?

From a technical point of view, a junk bond is exactly the same as a regular bond. Junk bonds are an IOU from a corporation or organization that states the amount it will pay you back (principal), the date it will pay you back (maturity date) and the interest (coupon) it will pay you on the borrowed money.Junk bonds differ because of the credit quality of their issuers. All bonds are characterized according to this credit quality and therefore fall into one of two categories of bonds: Investment Grade - These are bonds are issued by low- to medium-risk lenders. A bond rating on investment grade debt usually ranges from AAA to'BBB. Investment grade bonds might not offer huge returns, but the risk of the borrower defaulting on interest payments is much smaller. Junk Bonds - These are the bonds that pay high yields to bondholders because the borrowers don't have any other option. Their credit ratings are less than pristine, making it difficult for them to acquire capital at an inexpensive cost. Junk bonds are typically rated at 'BB'/'Ba' or less. Think of a bond rating as the report card for a company's credit rating. Blue-chip firms that provide a safer investment have a high rating, while risky companies have a low rating.the two major rating agencies, Moody's and Standard and Poor's.Although junk bonds pay high yields, they also carry higherthan-average risk that the company will default on the bond. Historically, average yields on junk bonds have been between 4-6% above those on comparable U.S. Treasuries.

Junk bonds can be broken down into two other categories:

Fallen Angels - This is a bond that was once investment grade but has since been reduced to junk bond status because of the issuing company's poor credit quality. Rising Stars - The opposite of a fallen angel, this is a bond with a rating that has been increased because of the issuing company's improving credit quality. A rising star may still be a junk bond, but it's on its way to being investment quality.

Strip bonds

Strip bonds are created by stripping the principal amount of a bond or debenture from its coupon payments. They are priced at a discount to their maturity value. As an investor, you know what their value will be at maturity and they will provide you with a competitive return. Strip bonds are a good choice if you are saving for the long term and dont need steady income. Thats why they are one of the most effective ways to build a Registered Retirement Savings Account (RRSP):

they provide long-term guaranteed returns, and the longer the time to maturity, the deeper the discount in price. Your compound annual return will be based on the prevailing interest rate at the time you purchase the strip bonds. For example, if you buy a 30-year strip yielding 6%, you are guaranteed that return if you hold it to maturity. You receive no coupon payments, but can cash in the bond for its full face value when it matures. Strip bonds may also be traded over the short term to yield gains when interest rates fluctuate.

Zero Coupon Bonds


Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus the imputed interest, which is discussed below.The maturity dates on zero coupon bonds are usually long-termmany dont mature for ten, fifteen, or more years. These long-term maturity dates allow an investor to plan for a long-range goal, such as paying for a childs college education. With the deep discount, an investor can put up a small amount of money that can grow over many years. Investors can purchase different kinds of zero coupon bonds in the secondary markets that have been issued from a variety of sources, including the U.S. Treasury, corporations, and state and local government entities. Because zero coupon bonds pay no interest until maturity, their prices fluctuate more than other types of bonds in the secondary market. In addition, although no payments are made on zero coupon bonds until they mature, investors may still have to pay federal, state, and local income tax on the imputed or "phantom" interest that accrues each year. Some investors avoid paying tax on the imputed interest by buying municipal zero coupon bonds (if they live in the state where the bond was issued) or purchasing the few corporate zero coupon bonds that have tax-exempt status.

SECURED AND UNSECURED BONDS

Bonds may be secured or unsecured. To be secured is to be backed by collateral. The bond issuer must give this money or physical assets to investors if the bond defaults. A secured bond ensures the bondholder that the assets will be distributed to the bondholders upon default by the issuer. Corporate bonds and municipal bonds may be secured or unsecured. Federal government bonds, however, are unsecured.

Unsecured bonds are called debentures. Instead of securing them with some kind of collateral, the issuer "backs" them with its creditworthiness. Many consider the creditworthiness of the federal government to be the best there is. This is why U.S. Government securities are very popular among investors.

Tax Considerations
Interest income from corporate bonds and capital gains from selling your corporate bond at a profit before it matures are subject to federal, state and local income tax. The tax rate applied to your gain may be different depending on how long you've held the bond and there are complex tax considerations for zero-coupon bonds, so you should consult a tax advisor for advice about your specific situation.

Need for new initiatives (india)


The radical improvements in the quality of the equity markets in India during thelast decade have been directly as an outcome of the initiatives taken in setting upof NSE and NSDL and strengthening of SEBI through various measures includingempowering it with necessary regulatory powers. Despite the fact that the Indianequity markets have a long history of more than a century markets had remainedhighly inefficient, confined mainly to metros and large cities, and non-transparent.They were not considered to be investor friendly. The major equity marketplayers did not show any particular desire to upgrade market standards even afterthe equity markets were opened up to the foreign institutional investors. A limitednumber of powerful market intermediaries who benefited from inefficient andtransparent system were opposed to any type of reforms that would minimise theirclout in the system and eat into their high profits. All the quantum improvements in the quality of markets that took place were afterinstitutional and regulatory initiatives---many of which were not welcomed by the market intermediaries who used to exercise tight control over the management ofstock exchanges---were put in place. Recent Indian

experience further confirms the fact that capital markets left to themselves do not have a tendency to become efficient and vibrant in the absence of outside intervention through appropriate regulatory initiatives as also encouragement from the authorities to bring about institutional reforms. This is for the reason that there are no strong autonomous or in-built forces in the mechanism of the capital markets that help them to upgrade their functional quality. History of financial markets all over the world shows that efficiency and vibrancy of capital markets improves in a slow and gradual fashion and that too over very long periods of time. A number of major improvements in the functioning of the capital market and the quality of their regulation in several developed countries have often been as a result of the response of the authorities to the crisis situations. For instance, the 1929 stock market crash led the US government to set up the Securities Exchange Commission and put in place other related regulatory measures to protect investor interests and safeguard market integrity. It has also been observed that steps taken in response to crisis situations are often delayed, halting, and not adequate enough to deal with the problems effectively. The general approach adopted on the part of the authorities in most parts of the world is not to proactively initiate steps for the development of the capital/financial markets on lines which help in creating healthy and vibrant markets. Under normal conditions which are free from serious crisis situations authorities in most of the countries are unwilling to proactively intervene and try to upgrade quality of the markets as they often presume that market players know what is good for the markets and there is no need for the authorities to intervene and try to shapetheir developments. This approach suffers from some obvious deficiencies. It is also necessary torecognise that there is no universal set of reform measures that could fit situations in all countries at all times. The reform measures intended for a particular segment of the capital/financial market should take into account the basic nature of the market as well its current stage of its development before preparing the market design and rules of the game are being framed. In other words, reforms meant for equity markets may not always be equally relevant for the debt markets. For creating robust corporate debt markets it is desirable that appropriate policy reforms are introduced to encourage building up of necessary market infrastructures that facilitate growth of an active primary market as also a vibrant and transparent secondary market. The recent initiatives that have helped in upgrading the standards of the equity markets would not work equally effectively in the case of the corporate debt market. While Indian equity markets have a history of more than a century the corporate debt market worth the name is a phenomenon of only about a decade. Hence creation of efficient and vibrant corporate debt markets would necessitate working on both sides of the coin: Firstly, the issuer base itself has to be widened in a proactive fashion. Secondly, rules of the game have to be made fair and equitable so that interests of the investors in corporate debt have to be fully protected. it is worth recapitulating briefly the important reforms that have taken place in the G-sec market. When reform measures were introduced by the RBI about a decade ago there was already a large captive base of investors and the floating stock of the government debt was sizeable. The only limitation under which RBI had to introduce reforms in the G-sec market was that it could not be allowed to have the same degree of freedom as the equity markets because of the continuing huge fiscal deficit.

Nonetheless, RBI has succeeded in bringing about several reforms to improve transparency and efficiency of the G-sec market. Before we turn to a discussion on issues related to the corporate debt market and the steps that need to be taken to reform it, it would be worthwhile to note briefly the significant changes that have helped in upgrading the standards of G-sec and money markets

CONCLUSION
The corporate bond market can offer very high yields but they come with a price; extra risk. We spoke about a few ways to mitigate that risk but also run your numbers and remember that treasury equivalents in term may have lower yields but offer different tax structures. Therefore, run your taxable equivalent yield formula and solve for tax exempt yield to see if the corporate bond provides you with the added risk premium when compared to a riskless treasury bond. When buying a corporate bond, be sure to ask the key questions: What is the credit rating? Is there a putable option? Is there a callable option embedded into the bond? How liquid is the bond? Is the corporate bond listed on an exchange