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DEBT INSTRUMENTS

Debt instruments - FAQ

To meet the long term and short term needs of finance, firms issue various kinds of Securities to the public. Securities represent claims on a stream of income and /or particular assets.Debentures are debt securities, and there is a wide range of them. Market loans are raised by the government and public sector institutions through debt securities. Equity shares issued by cooperates are ownership securities. Preference shares are a hybrid security. It is a mixture of an ownership security and debt security.

DEBENTURES
A debenture is a document which either creates a debt or acknowledges it. Debenture issued by a company is in the form of a certificate acknowledging indebtedness. The debentures are issued under the Company's Common Seal. Debentures are one of a series issued to a number of lenders. The date of repayment is specified in the debentures. Debentures are issued against a charge on the assets of the Company. Debentures holders have no right to vote at the meetings of the companies.

KINDS OF DEBENTURES
(a)Bearer Debentures:
They are registered and are payable to the bearer. They are negotiable instruments and are transferable by delivery.

(b) Registered Debentures:
They are payable to the registered holder whose name appears both on the debentures and in the Register of Debenture Holders maintained by the company. Registered Debentures can be transferred but have to be registered again. Registered Debentures are not negotiable instruments. A registered debenture contains a commitment to pay the principal sum and interest. It also has a description of the charge and a statement that it is Issued subject to the conditions endorsed therein.

(c) Secured Debentures:
Debentures which create a change on the assets of the company which may be fixed or floating are known as secured Debentures. The term "bonds" and "debentures"(secured) are used interchangeably in common parlance. In USA, BOND is a long term contract which is secured, whereas a debentures is an unsecured one.

(d) Unsecured or Naked Debentures:
Debentures which are issued without any charge on assets are insecured or naked debentures. The holders are like unsecured creditors and may see the company for the recovery of debt.

(e) Redeemable Debentures:
Normally debentures are issued on the condition that they shall be redeemed after a certain period. They can however, be reissued after redemption.

(f) Perpetual Debentures:
When debentures are irredeemable they are called perpetual. Perpetual Debentures cannot be issued in India at present.

(g) Convertible Debentures:
If an option is given to convert debentures into equity shares at the stated rate of exchange after a specified period, they are called convertible debentures. Convertible Debentures have become very popular in India. On conversion the holders cease to be lenders and become owners.

Debentures are usually issued in a series with a pari passu (at the same rate) clause which entitles them to be discharged rateably though issued at different times. New series of debentures cannot rank pari passu with the old series unless the old series provides so.

New debt instruments issued by public limited companies are participating debentures, convertible debentures with options, third party convertible debentures convertible debentures redeemable at premiums, debt equity swaps and zero coupon convertible notes. These are discussed below:

(h) Participating Debentures:
They are unsecured corporate debt securities which participate in the profits of the company. They might find investors if issued by existing dividend paying companies.

(i) Convertible Debentures with options:
They are a derivative of convertible debentures with an embedded option, providing flexibility to the issuer as well as the investor to exit from the terms of the issue. The coupon rate is specified at the time of issue.

(j) Third Party Convertible Debentures:
They are debt with a warrant allowing the investor to subscribe to the equity of third firm at a preferential price visa vis the market price. Interest rate on third party convertible debentures is lower than pure debt on account of the conversion option.

(k) Convertible-Debentures Redeemable at a Premium:
Convertible Debentures are issued at face value with 'a put option entitling investors to sell the bond to the issuer at a premium. They are basically similar to convertible debentures but embody less risk.

(I) Debt-Equity Swaps:
Debt-Equity Swaps are an offer from an issuer of debt to swap it for equity. The instrument is quite risky for the investor because the anticipated capital appreciation may not materialise.

(m) Deep discount Bonds:
They are designed to meet the long term funds requirements of the issuer and investors who are not looking for immediate return and can be sold with a long maturity of 25-30 years at a deep discount on the face value of debentures. IDBI deep discount bonds for Rs 1 lakh repayable after 25 years were sold at a discount price of Rs. 2,700.

(n) Zero-Coupon Convertible Note:
A zero-coupon convertible note can be converted into shares. If choice is exercised investors forego all accured and unpaid interest. The zero-coupon convertible notes are quite sensitive to changes in interest rates.

(o) Secured Premium Notes (SPN) with Detachable Warrants:
SPN which is issued along with a detachable warrant, is redeemable after a notice period, say four to seven years. The warrants attached to it ensures the holder the right to apply and get allotted equity shares; provided the SPN is fully paid.

There is a lock-in period for SPN during which no interest will be paid for an invested amount. The SPN holder has an option to sell back the SPN to the company at par value after the lock in period. If the holder exercises this option, no interest/ premium will be paid on redemption. In case the SPN holder holds its further, the holder wili be repaid the principal amount along with the additional amount of interest/ premium on redemption in instalments as decided by the company. The conversion of detachable warrants into equity shares will have to be done within the time limit notified by the company.

(p) Floating Rate Bonds:
The rate on the floating Rate Bond is linked to a benchmark interest rate like the prime rate in USA or LIBOR in eurocurrency market. The State Bank of India's floating rate bond was linked to maximum interest on term deposits which was 10 percent. Floating rate is quoted in terms of a margin above or below the bench mark rate. The-floor rate in the State Bank of India case was 12 per cent. Interest rates linked to the bench mark ensure that neither the borrower nor the lender suffer from the changes in interest rates. When rates are fixed, they are likely to be inequitable to the borrower when interest rates fall subsequently, and the same bonds are likely to be inequitable to the lender when interest rates rise subsequently.


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WARRANTS
A warrant is a security issued by a company granting the holder of the warrant the right to purchase a specified number of, shares at a specified price any time prior to an expirable date. Warrants may be issued with debentures or equity shares. The specific rights are set out in the warrant. The main features-of a warrant are number of shares entitled, expiry date and state price / exercise price. Expiry date of warrants, generally in USA, is 5 to 10 years from the original issue date. The exercise price is 10 to 30 percent above the prevailing market price. The Warrants have a secondary market. The minimum value of a warrant represents the exchange value between the current price of the share and the shares purchased at the exercise price. Warrants have no flotation costs and when they are exercised the firm receives additional funds at a price lower than the current market, yet about those prevailing at issue time. New or growing firms and venture capitalists issue warrants. They are also issued in mergers and acquisitions. Warrants are called sweeteners and have been issued in the recent past by several companies in India. Debentures issued with warrants, like convertible debentures, carry lower coupon rates.

NON-CONVERTIBLE DEBENTURES (NCDs) WITH DETACHABLE EQUITY WARRANTS
The holder of NCDs with detachable equity warrants is given an option to buy a specific number of shares from the company at a predetermined price within a definite time-frame.

The warrants attached to NCDs will be issued subject to full payment of NCD is a value. There is a specific lock-in period after which there detachable option to apply for equities. If the option to apply for equities is not exercised, the unapplied portion of shares would be disposed off by the company at its liberty.

ZERO-INTEREST FULLY CONVERTIBLE DEBENTURES (FCDs)
The investors in zero-interest fully convertible debentures will not be paid any interest. However, there is a notified period after which fully paid FCDs will be automatically and compulsorily converted into shares.

There is a lock-in period upto which no interest will be paid. Conversion is allowed only for fully paid FCDs. In the event of the company going for rights issue prior to the allotment of equity resulting from the conversion of equity shares into FCDs, FCD holders shall be offered securities as may be determined by the company.

SECURED ZERO-INTEREST PARTLY CONVERTIBLE DEBENTURES (PCDs) WITH DETACHABLE AND SEPARATELY TRADEABLE WARRANTS:
This instrument has two parts; A and B. Part A is convertible into equity shares at a fixed amount on the date of allotment. Part B is non-convertible, to be redeemed at par at the end of a specific period from the date of allotment. Part B will carry a detachable and separately tradeable warrant which will provide an option to the warrant holder to receive equity shares for every warrant held at a price as worked out by the company.

FULLY CONVERTIBLE DEBENTURES (FCDs) WITH INTEREST (OPTIONAL)
This instrurnent does not yield interest in the initial period of say, 6 months. After this period option is given to the holder of FCDs to apply for equity at a "premium" for which no additional amourit needs to be paid. The option has to be indicated in the application form itself. However, interest on FCDs is payable at a determined rate from the date of first conversion to the second / final conversion and in lieu of it, equity shares are issued.


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OTHER DEBT SECURITIES IN VOGUE ABROAD
1. INCOME BONDS:
Here interest is paid only when cash flows are adequate. Income Bonds are like cumulative preference shares on which the fixed dividend is not paid if there is no profit in a year, but is carried forward and paid in the following year. On Income Bonds, there is no default if interest is not paid. Unlike dividend on cumulative preference shares, interest on income bond is tax deductible. Income Bonds are issued abroad by companies in reorganisation or by firms whose financial situation does not make it feasible to issue bonds with a fixed interest payment

2. ASSET-BACKED SECURITIES:
Assets-backed securities are a category of marketable securities that are collateralised by financial assets such as instalment loan contracts. Asset-backed financing involves a process called securitisation. Securitisation is a disintermediation process in which credit from financial intermediaries is replaced by marketable debentures that can be issued at lower cost. Financial assets are pooled so that debentures can be sold to third parties to finance the pool. Repos are the oldest asset-backed security in our country. In USA, securitisation has been undertaken for insured mortgages (Ginnie Mae, 1970), mortgage backed loans, student loans (Sallie Mae 1973), trade credit receivable backed bonds (1982), equipment leasing backed bonds (1984), certificates of automobile receivable securities (1985) and small business administration loans. More recently, credit card receivables have been securitised. The decade of the eighties witnessed large expansion of asset backed security financing.

3. JUNK BONDS:
Junk Bond is a high risk, high yield bond to finance either a leveraged buyout (LBO), a merger of a company in financial distress. Coupon rates range from 16 to 25 per cent. Old line established companies which were inefficient and. financed conservatively were objects of take over and restructuring. To finance such take-over, high yield bonds were sold. Attractive deals were put together establishing their feasibility in terms of adequacy of cash flows to meet interest payments. Michael Milken (the JUNK BOND KING) of Drexel Buraham Lambert was the real developer of the market. The junk bond market was tarnished by the fines ($ 650 million) levied in 1989 on the investment banking firm Drexel Burnham Lambert for various Securities Law violations and thus was forced into bankruptcy in 1990 and the indictment of Milken in 1990 on charges of fraud $ 600 million fines and penalties.


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SEBI GUIDELINES FOR DEBENTURES
Fully Convertible Debentures (FCD):
SEBI restricts the conversion period to 36 months. Credit rating is required if the conversion is made after 18 months. Conversion beyond 36 months is permissible only if the conversion is made optional with "put" and "call" option. It may be noted that an option is merely an instrument that gives its owner the right to buy or sell shares of a company within a specified period of time. Options are a derivative instrument which have a beneficial impact all round. They stabilise share price by reducing its volatility and provide a hedge against risk for the investor. They are likely to be popular in this country. Premium on Conversion of Debentures:
Premium on conversion has to be predetermined and stated in the prospectus. The company is free to determine the rate of interest payable.

Debenture Redemption Reserve:
In the case of non-convertible debentures, a Debenture Redemption Reserve has to be created. A moratorium upto the date of commercial production is provided for the creation of the Debenture Redemption Reserve in respect of debenture raised for project finance. Debenture Redemption Reserve may be created either in equal instalments or with higher amounts in the remaining period, if profits permit. Companies are allowed to distribute dividends out of general reserves in certain years if the residual profits after transfer to the Debenture Redemption Reserve are inadequate to distribute reasonable dividend. The Debenture. Redemption Reserve will treated as part of general reserve for consideration of bonus issue proposals and for price fixation related to post-tax relurn. In the case of new companies, distribution of dividend requires the approval of the trustees to the issue and the lead institution. Debenture redemption can be taken up only after 50 per cent of the amount of the debenture issue is created. Drawal from the Debenture Redemption Reserve is permissible only after 10 per cent of the debenture liability has been actually redeemed by the company. Dividends exceeding 20 per cent cannot be declared by existing companies without the prior permission of the lead institution or as per loan convenants if the cornpany does not-comply with institutional condition regarding interest and debt service coverage ratio. The company is free to redeem debentures in greater number of instalments. The first instalment may start from the fifth instead of the seventh year.

Debenture Trustees:
The names of the debenture trustees must be stated in the prospectus. The trust deed should be executed within six months of the close of the issue.

Conversion Option:
Any conversion in part or whole of the debenture will be optional at the hands of the debenture holder, if the conversion takes place at or after 18 months from the date of allotment but before 36 months.

Nonconvertible Debentures (NCDs) and Partly Convertible Debentures (PCDs) Debentures of less than 18 months Duration:
If the maturity period of debentures is less than 18 months, it is hot necessary to create a charge or appoint a trustee or create a Debenture Redemption Reserve. If no charge is created on such debentures they are unsecured and are treated as "deposits". the issuer has to comply with the requirements of the Companies (Acceptance of Deposits) Rules, 1975. The otfer document should disclose this.

Prospectus and PCDs / NCDs:
In the case of PCDs, the premium amount at the time of conversion shall be predetermined and stated in the prospectus. Redemption amount, period of maturity, yield on redemption of PCDs/NCDs shall be indicated in the prospectus. The prospectus should indicate the discount on the non-convertible portion of the PCD in case they are traded and the procedure for their purchase on spot trading basis must be stated in the prospectus.

Roll-over of Non-convertible Portion:
Roll-over of non-convertible portion of PCD/NCD with or without change in interest rate can be done only on positive consent and not on passive consent. It is compulsory for companies to give an option to those debentures holders who want to withdraw and encash their debentures. Before roll-over, execution of fresh trust deed for non convertible debenture or non convertible portion of PCD is required. A company has to obtain credit rating six months prior to the date of redemption and communicate it to the debenture holder. A company desirous of roll-over of its NCD or non convertible portion of PCDs has to submit the letter of information containing credit rating, debenture holders resolution, option for conversion and such other items SEBI may prescribe from time to time to SEBI for vetting.

Discloses for issue of Debentures:
The discloures relating to raising of debentures should include, among others, existing and future debt equity ratios, servicing behaviour on existing debentures, payment of due interest on due dates on term loans and debentures, certificates from a financial institution or banker about their no objection for a second or pari passu charge being created in favour of the trustees to the proposed debevnture issue.

Protection of Debenture Holders' Interest:
Trustees to the debenture issue should be vested with requisite powers to protect the interest of debenture holders including a right to appoint a nominee director on the board of the cornpany in consultation with the debenture holders. The progress in respect of debentures raised for project finance / modernisation / expansion / diversification / normal capital expenditure is to be monitored by the lead institution / investment institution. In regard to debentures issued for working capital, the lead bank for the company should do the monitoring. Institutional debenture holder and trustees should obtain a certificate from the company's auditors about the utilisation of funds during the period of implementation of the project.

In the case of debentures for working capital, a certificate has to be obtained at the end of each accounting year. Issues by companies belonging to the groups for replemishing funds or to acquire share holding in other companies is not permitted.

The company issuing debentures has to file with SEBI certificates from its bankers that the assets on which security is to be created are free from encumbrances and the necessary permission to mortgage the assets have been obtained or a no objection certificate from the financial institution or bank'for a second or pari passu charge in cases where assets are encumbered. The security should be created within six months from the date of issue of the debentures. If the company. for any reason, is not in a position to create a security within 12 months from the date of issue of the debentures, a penal interest of 2 per cent has to be paid to debenture holders. If the security is not created even after 18 months, a meeting of debenture holders should be called within 21 days to explain the reason why, and.the date by which, the security would be created.

The trustees to the Debenture Issue will superwise the implementation of the conditions regarding the creation of security for the debentures, and regarding the Debenture Redemption Reserve.

Past Issues of FCDs and PCDs:
In the case of FCDs and PCDs issued in the past where conversion was to be made at a price to be determined by the Controller of Capital Issues at a later date, SEBI has laid down the procedure :- The price of conversion and the time of conversion should be determined bythe company in a duly organised meeting of the debentureholders and shareholders. The decision in the meeting has to be certified by the shareholders Such conversion will be optional. The dissenting shareholders shall have the right to continue as debentureholders if the terms of conversion are not acceptable to them. The letter of option should be vetted by SEBI.

New types of Debentures
New types of Debentures mentioned by SEBI are deep discount bonds, debentures with warrants and secured premium notes. While making an issue of any new financial instrument, the issuer of capital shall make adequate disclosures regarding the terms and conditions, redemptions, security, conversion and any other relevant features of the instruments.


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COMMERCIAL PAPER
Commercial Paper is one of the non-bank sources of working capital finance. It is a money market instrument, unlike debentures which are capital market instruments. Corporate Borrowers, especially the large and financially sound, can diversify their short term borrowing by the issue of Commercial Paper. Commercial Paper is especially attractive for companies with cyclical cash flows and for cash rich companies during periods of greater cash inflows than overdraft or cash credit since monitoring is more convenient. The raising of funds through Commercial Paper is regulated by the directions of the Reserve Bank of India. The issue of commercial paper is regulated by Non-banking Companies (Acceptance of Deposits through Commercial Paper) Directions, 1989 which came into force on January 1, 1990. Scheduled Banks have emerged as significant holders of Commercial paper. The secondary market is yet to develop. The commercial papers of a few companies are traded on the National Stock Exchange.

Issue of Commercial Paper
Commercial Paper can be issued by a company whose
(i) tangible net worth (paid-up capital plus free reserves) is not less than Rs 4 crores
(ii) fund based working capital limits are not less than Rs. 4 crores
(iii) Specified Credit Rating of P2 is obtained from CRISIL, A2 from ICRA and PR2 from CARE
(iv) Borrowal health is classified under health code No. 1 and
(v) Current ratio is 1.33: 1.

Usance
Commercial Paper should be issued for a minimum period of three months and maximum of one year (with effect from October 1993). No grace period is allowed for payment and if the maturity date falls on a holiday it should be paid on the previous working day. Every issue of commercial paper is treated as a fresh issue.

Denomination:
Commercial Paper is issued in denominations of Rs. 5 lakhs. But the minimum lot or investment is Rs 25 lakhs (face value) per investor. The secondary market transactions can be for Rs. 5 lakhs or multiples thereof. The total amount proposed to be issued should be raised within two weeks from the date on which the proposal is taken on record by the bank. The paper may be issued in a single day or in parts on different dates in which case each paper should have the same maturity date.

Ceiling
The aggregate amount that can be raised by commercial paper should not exceed 75 per cent of the company's fund based working capital.

Mode of Issue and Discount Rate
Commercial Paper should be in the form of usance promissory note negotiable by endorsement and delivery. It can be issued at such discount to face value as may be decided by the issuing company.

Issue Expenses
Issue expenses consisting of dealers fees, rating agency fees and other relevant expenses as well as the charges derived by tpe bank for providing stand-by facilities should be borne by the company.

Investors
Commercial Paper may be issued to any person, bank, company or other registered (in India) corporate body and incorporated body. Issue to NRI can only be on non-repatriable basis and is not transferable. The paper issued to NRI should state that it is non-repatriable and non-endorseable.

Procedure for Issue
Commercial Paper is issued only through the bankers who have sanctioned working capital limits to the company. It is counted as a part of working capital. Unlike public deposit, commercial paper really cannot augment working capital resources. There is no increase in the overall short term borrowing facilities.

Every company proposing to issue commercial paper should submit the proposal in the form prescribed by the RBI to the bank which provides working capital along with the credit rating of the company. The bank Scrutinises the application and on being satisfied that eligibility criteria are met and conditions stipulated are met will has to be privately place the issue within two weeks by the company or through the good offices of a merchant banker. The initial investor pays the discounted value of the paper to the account of the issuing company with the bank in writing. The working capital limit is correspondingly reduced by the bank. the company must advise RBI, through the bank, of the amount of commercial paper issued within three days.

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