DEBT INSTRUMENTS

FUNDAMENTAL FEATURES
• Debt instruments are contracts in which one
party lends money to another on pre-
determined terms with regard to rate of
interest to be paid by the borrower to the
lender, the periodicity of such interest
payment, and the repayment of the principal
amount borrowed (either in installments or in
bullet).

PRINCIPAL FEATURES OF A BOND
• Maturity: Maturity of a bond refers to the date on which the bond matures,
or the date on which the borrower has agreed to repay (redeem) the
principal amount to the lender.
• Term To Maturity: Term to maturity, on the other hand, refers to the
number of years remaining for the bond to mature. For instance, on
February 17, 2004, the term to maturity of the bond maturing on May 23,
2008 will be 4.27 years. The general day count convention in bond market
is 30/360European which assumes total 360 days in a year and 30 days in a
month.
• Coupon: refers to the periodic interest payments that are made by the
borrower (who is also the issuer of the bond) to the lender (the subscriber of
the bond) and the coupons are stated upfront either directly specifying the
number (e.g.8%) or indirectly tying with a benchmark rate (e.g.
MIBOR+0.5%). Coupon rate is the rate at which interest is paid, and is
usually represented as a percentage of the par value of a bond.
• Principal is the amount that has been borrowed, and is also called the par
value or face value of the bond. Typical face values in the bond market are
Rs. 100. Ex- GS CG2008 11.40%

Classification of Bonds
• Generally bonds with tenors of 1-5 years are
called short-term bonds; bonds with tenors
ranging from 4 to 10 years are medium term
bonds and above 10 years are long term
bonds. In India, the Central Government has
issued up to 30 year bonds.

MODIFYING THE COUPON OF A BOND
• Zero Coupon Bond: In such a bond, no coupons are paid. The
bond is instead issued at a discount to its face value, at which
it will be redeemed. When such a bond is issued for a very
long tenor, the issue price is at a steep discount to the
redemption value. Such a zero coupon bond is also called a
deep discount bond.

Treasury Strips:
In the United States, government dealer firms buy
coupon paying treasury bonds, and create out of each
cash flow of such a bond, a separate zero coupon bond.
For example, a 7-year coupon-paying bond comprises of
14 cash flows, representing half-yearly coupons and the
repayment of principal on maturity. Dealer firms split this
bond into 14 zero coupon bonds, each one with a
differing maturity and sell them separately, to buyers with
varying tenor preferences. Such bonds are known as
treasury strips. (Strips is an acronym for Separate Trading
of Registered Interest and Principal Securities). We do not
have treasury strips yet in the Indian markets. RBI and
Government are making efforts to develop market for
strips in government securities.

Floating Rate Bonds
• Instead of a pre-determined rate at which coupons are
paid, it is possible to structure bonds, where the rate of
interest is re-set periodically, based on a benchmark rate.
Such bonds whose coupon rate is not fixed, but reset with
reference to a benchmark rate, are called floating rate
bonds.
• For example, IDBI issued a 5 year floating rate bond, in July
1997, with the rates being re-set semi-annually with
reference to the 10 year yield on Central Government
securities and a 50 basis point mark-up.
• Some floating rate bonds also have caps and floors, which
represent the upper and lower limits within which the
floating rates can vary. Floating rate bonds, whose coupon
rates are bound by both a cap and floor, are called as range
notes, because the coupon rates vary within a certain
range.

MODIFYING THE TERM TO MATURITY OF A BOND
• Callable Bonds: Bonds that allow the issuer to alter the
tenor of a bond, by redeeming it prior to the original
maturity date, are called callable bonds.
• Puttable Bonds: Bonds that provide the investor with the
right to seek redemption from the issuer, prior to the
maturity date, are called puttable bonds.
• Convertible Bonds: A convertible bond provides the
investor the option to convert the value of the outstanding
bond into equity of the borrowing firm, on pre-specified
terms. Exercising this option leads to redemption of the
bond prior to maturity, and its replacement with equity. At
the time of the bond’s issue, the indenture clearly specifies
the conversion ratio and the conversion price. The
conversion ratio refers to the number of equity shares,
which will be issued in exchange for the bond that is being
converted.

MODIFYING THE PRINCIPAL REPAYMENT OF A BOND
• Amortising Bonds: The structure of some bonds may be such
that the principal is not repaid at the end/maturity, but over
the life of the bond. A bond, in which payment made by the
borrower over the life of the bond, includes both interest and
principal, is called an amortising bond. Auto loans, consumer
loans and home loans are examples of amortising bonds.
• Bonds with Sinking Fund Provisions: In certain bond
indentures, there is a provision that calls upon the issuer to
retire some amount of the outstanding bonds every year. This
is done either by buying some of the outstanding bonds in the
market, or as is more common, by creating a separate fund,
which calls the bonds on behalf of the issuer. Such provisions
that enable retiring bonds over their lives are called sinking
fund provisions.