MODULE – III

Long Term Debt Securities

Ms. Alfia Thaha

MODULE - III
Long term debt securities – Bonds and Debentures –
Characteristics – Types – Risk associated with bond
investment – Valuation of bonds - Bond returns ––
Yield to Maturity (YTM) - Yield to Call (YTC) - bond
management strategies – Duration - Macaulay’s
duration - immunization.
Long term debt
• Long-term debt consists of loans and financial
obligations lasting over one year.
• Long-term debt for a company would include any
financing or leasing obligations that are to come due
in a greater than 12-month period.
• Applies to governments - nations can also have long-
term debt.
Why incur long term debt?
• A company takes on long-term debt in order to acquire
immediate capital.
• For example, startup ventures require substantial funds to
get off the ground and pay for basic expenses such as
research expenses, Insurance, License and Permit
Fees,  Equipment and Supplies and  Advertising and
Promotion. 
• All businesses need to generate income, and long-term debt
is an effective way to get immediate funds to finance and
operations. 
Is Long-Term Debt Helpful or Harmful?

• Debt to equity ratio

• A high debt to equity ratio means the company is funding
most of its ventures with debt.
• If this ratio is too high, the company is at risk
of bankruptcy.
• A low debt to equity ratio is a sign that the company is
growing or thriving, as it is no longer relying on its debt
and is making payments to lower it.
• It consequently has more leverage with other companies
and a better position in the current financial environment. 
Types of Securities in Capital Market
• Fixed Income Securities - Bonds, Debentures and
Preference shares

• Equity Shares
Fixed Income Securities
• A claim on a periodic stream if income over a given
time.
• The holder gets a fixed income during the holding
period from the company issuing the securities. For a
borrower, these are called fixed charge securities or
debt which represents an obligation to repay the
loan.
Bond and Debentures
• A bond or debenture is a basic fixed income security
which is issued by a borrowing unit under a
borrowing arrangement/agreement.
• Coupon rate – rate of interest
• Repayment is made as per the terms and conditions
of the agreement and may be equal to, less than or
more than the face value of the bond.
Bonds
• Issued for 7-10 years
• Some public sector unit bonds carry tax concessions
• Income from bonds from firms in infrastructure
sector like petrochemicals, electricity and railways
are tax –free under Sec 10 of the IT Act.
• Bonds are listed on BSE or NSE
Features of Bond
• Credit Instrument
• Interest Rates
• Collateral
• Maturity Date
• Voting Rights
• Face value and Redemption Value
• Priority in Liquidation
Difference between bonds and debentures
• Bonds are issued by government or public sector enterprises
and debentures are issued by the private sector.
• Issuance of stamp duty on bonds is under Indian Stamp Act
1899, Debenture issuance stamp duty is paid by the state
where the principle mortgage deed is registered. Stamp duty
differs from state to state.
• Transfer stamp duty not paid in case of bonds while it is paid in
case of debentures
• Bond is transferable by endorsement while debentures can be
transferred only through transfer form prescribed under
Companies Act.
Features of debentures
• Fixed interest debt with varying periods of maturity.
• Placed privately or offered through subscription
• May or may not be listed in stock exchange
• If listed, should be prior rated by credit rating
agencies designated by SEBI
• When offered for subscription, a debenture
redemption reserve has to be maintained.
Types of Debt Instruments
• Secured and Unsecured Debentures
• Convertible and Non- Convertible Debentures
• Zero Interest Fully Convertible Debentures (ZFCD)
• Secured Premium Notes (SPN)
• Callable and Putable Bonds
• Floating Rate Bonds
• Deep Discount Bonds
• Junk Bonds
• Inverse Floaters
• Municipal Bonds
• Indexed Bonds
• Government Securities
Secured and Unsecured Debentures
• Secured Debentures – long term source of funds
having fixed or floating charge on the assets of the
company. The security helps in reducing risk of debt
investors.
• Unsecured Debentures – which do not have any
specific charge as security. Unsecured debentures are
issued with a maturity period of 17 months and 29
days.
Convertible and Non- convertible
debentures

• Non- convertible debentures are the purest form of

debt instrument.
• Convertible debentures is one whose full face value or
part of the face value is convertible into another
securities (mostly equity shares)
– Partly convertible debentures
– Fully convertible debentures
– Multi-option convertible debentures
Zero – Interest Fully Convertible Debentures (ZFCD)

• Known as Zero- coupon bonds

• Debenture is fully convertible to equity shares at the
expiry of a given period (not exceeding 3 years) from
the date of issue.
• Return is offered in the form of difference between
the issue price of the ZCFD and the market price of
the converted equity shares.
Secured Premium Notes (SPN)
• During Aug 1992, TISCO issued a special debt
instrument called SPN having face value of Rs 300.
• No interest payable and redeemed in 4 equal
installments of Rs. 150 each.
• Rs. 75 was considered a repayment to principal and the
rest as capital gain.
• Warranty issued – every SPN holder gets 1 equity share
from the company of Rs 100.
Callable and Putable Bonds
• Callable bond – issuer has an option to redeem the
bonds at any time after the initial stipulated period.
Brings benefit to the company.

• Putable bond – holder has an option to get the bond

redeemed at any time after the stipulated period.
Provides flexibility to the lenders.
Floating Rate Bonds
• Also called Floaters

• Interest rate is not fixed but tied to some market rate

called a bench mark.

• Major risk involved in the floaters is the financial

position of the issuing firm.
Deep Discount Bonds (DDBs)
• Is a type of zero interest bonds
• Not convertible
• No coupon rate and no interest is payable during the
life of the DDB.
• Return to the DDB holder is in the form of difference
between the issue price and the realizable maturity
value.
Junk Bonds
• High risk High Yield bonds
• Coupon rate, Interest risk and Principal risk of these
bonds are high.
• Low or no credit rating
• Preferred only by speculators
Municipal Bonds
• Issued by the civic authority of the city
• Basic objective is to raise funds for the development
of infrastructure of the city
• Tax benefits may or may not be available
• Issued to retail investors or institutional investors.
Indexed Bonds
• Bonds on which coupon payments and maturity
payments are tied to a general price index.
• Risk free interest rate or inflation free interest rate.
• Not available in India.
Government Securities
• Also known as G-secs or Gilts
• Payment of interest and repayment of principal
amount is guaranteed by govt.
• Issued, serviced and redeemed by RBI
• Yield known as Risk free rate of interest
Participants of Corporate debt market
• Issuers
– Financial Institutions and banks
– PSU
– Corporate Entities
• Investors – banks and financial institutions, insurance
companies, mutual funds, FIIs and retail investors
Credit Rating Agencies
• Credit rating Information Services of India Ltd.
(CRISIL)
• Investment and Credit Rating Agency of India Ltd.
(ICRA)
• Credit Analysis and Research Ltd. (CARE)
• Duff and Phelps Credit Rating India Pvt Ltd (DPCRI)
• Onida Individual Credit Rating Agency of India
(ONICRA)
Advantages of Debt Market to the Investor

• Regular flow of income

• Governed by legal structure
• Less Risk
Benefits to Financial System
• Wide funding avenues to public sector and private
sector projects and reduce pressure on institutional
financing
• Mobilization of resources by unlocking illiquid retail
investments like gold
• Develops heterogeneous markets
• Assist in development of a reliable yield curve
Risk of the debt securities

• Default risk
• Interest rate risk
• Liquidity risk
• Inflation risk
• Reinvestment rate risk
Bond Yield
• Bond Yield – refers to the % rate of return on the
amount invested in buying one bond.

• May or may not be the same as the coupon rate of

interest.
Factors of Bond yield -
• Par Value – face value or normal value of a bond is
the principal amount of a bond and is stated as the
face of the bond security.
• Coupon rate – rate at which interest on the par value
of the bond is payable as per the payment schedule.
Also called as Nominal yield.
• Maturity
• Market price
Types of Yield
• Yield on bond investment may be calculated in
different ways for different purpose
Bond Yield Purpose
Nominal Yield Measures only the coupon rate
Current Yield Measures the current year rate of return

Yield to Maturity Measures annual rate of return if bond is

held till maturity
Yield to Call Measures annual rate of return if bond is
held till call
Realised Yield Measures the total return over the holding
period
Current Yield
• Also known as basic yield
• Relates the coupon interest rate with the current
market price of the bond.
• Current Yield = Int./B0 * 100
where Int. = Annual Interest Amount
B0 = Current Market Price of Bond
Yield to Maturity (YTM)
• YTM may be defined as the rate of return that will be
earned if the bond is purchased today at the current
market price and is held by the investor till maturity.
• YTM also known as market rate of return on market
rate of interest.

• http://www.moneycontrol.com/fixed-
income/bonds/listed-bonds/
Relationship between YTM and Coupon rate

• If MP = Par Value => YTM = Coupon Rate

• If MP > Par Value => YTM < Coupon Rate

• If MP < Par Value => YTM > Coupon Rate

Relationship between YTM and Coupon rate

• If MP = Par Value => YTM = Coupon Rate

• If MP > Par Value => YTM < Coupon Rate

• If MP < Par Value => YTM > Coupon Rate

Yield to Call (YTC)
• YTC is calculated in the same way as that of YTM, but
only for the periods up to which the date on which
the call can first be exercised.
Yield Spread
• Difference between the YTM of two bonds.
• Yield spread is denoted against a benchmark which is
usually the YTM of risk free bonds.
• Higher credit rating firms would issue bonds with
lower YTM and vice versa.
• A lower YTM mean lower risk and be considered as
highly secured.
Bond Valuation
• Valuation is the process of determining the worth of
an asset.
• Concept of Valuation includes –
– Book Value (BV) – based on accounting concept
and the data given in the balance sheet.
– Market Value (MV) – price prevailing at the stock
exchange.
– Going Concern Value (GV) – value which the buyer
is ready to pay.
Limitation of YTM
• In the process of calculation, all cash flows are
discounted at the same rate, though these cash flows
occur at different point of time.

• Assumption, that the re investment rate at different

points of time would be equal to the YTM is also
called hypothetical.
Bond Valuation (contd.)

– Liquidating Value (LV) – net difference between

the realizable value of all assets and the sum total
of external liabilities.
– Capitalized Value (CV) – sum of the present value
of cash flows from an asset discounted at the RRR.
Required Rate of Return (RRR)
• Minimum rate of return necessary to induce an
investor to hold or buy a security.
• Consists of two elements – risk free rate of return
and risk premium.
Yield Curve
• Depicts the relationship between time to maturity and yields
for a particular category of bonds at a particular point of
time.
• Types –
– Normal yield curve – the yield on short term bonds are
low and rise consistently as maturity lengthens
– Inverse Yield curve - the yield on short term bonds are
high and on longer time maturities, it is declining.
– Humping Yield Curve – there is an increase in the
intermediate term interest rates and the interest rates in
future may be declining.
Yield Curve (contd.)
– Neutral or Flat yield curve - no specific pattern of
future interest rates.
• Assumptions of yield curve
– All the intervening cash flows (interest received)
will be reinvested at a rate equal to the YTM.
Duration
• Is the summary statistic showing the average maturity of
the expected cash flows from the bond.
• Duration is defined as the weighted average of the
lengths of time until the remaining cash flows are
received.
• Is a measure to the interest rate risk of a bond.
• Duration is a relative change in prices with respect to
changes in interest rates.
• Types – Macaulay duration and Modified duration
Macaulay Duration
• It is a measure of time flow of cash from a bond.
• In Macaulay Duration, each time period is weighted
by the present value of the cash flow at that time.
• PV is calculated by discounting the cash flows at the
discount rate equal to YTM of the bond.
• D = (PV x Time)/B0
Modified Duration
• Measure of price sensitivity resulting from the change in
interest rates.
• D* = D/(1+YTM)
• D* can be used to measure Price Sensitivity
• Delta P/P = - D*DeltaY
• Modified duration can be defined as the approximate %
change in price for a 100 basis point change in YTM of a bond.
• Helps in prediction of future bond prices if the yield on bond
is changing.
Immunization
• Major risk involved by bond investors are Price risk
and Reinvestment rate risk.
• Immunization refers to the investment strategy
adopted by an investor to shield his investment from
the interest rate risk exposure.
• Attempts at selection of bond portfolio in such a way
that the effect of two components of risk cancel out
each other exactly.
Immunization (contd.)
• A bond portfolio is said to be immunized for a
holding period if its value at the end of the holding
period irrespective of change in market interest rates
during the holding period is as much as it would have
been, had the interest rates been constant during the
period.
• This can be done by selecting the bonds whose
duration is equal to the investment horizon.
Bond Management Strategies
• Passive Bond Management (buy and hold strategy) –
also known as indexing strategy
• Active Bond Management
– Substitution swap
– Pure Yield Pickup Swap
– Inter Market Spread Swap
• Immunization