CHARACTERISTICS OF DEBT SECURITIES

CHARACTERISTICS OF DEBT SECURITIES (Part 1)

Key Concept 1: Features of Debt Security

• Definition: A debt security is a contract between the issuer (company) and the lender (investor) that allows the issuer to borrow a sum of money at pre-determined terms.
• Details: The features of a debt security include the principal, coupon (interest rate), and maturity date. The principal is the amount borrowed, the coupon is the interest rate paid, and the maturity date is when the principal is repaid.

Key Concept 2: Market Value of Debt Securities

• Definition: The market value of a debt security is the price at which it is traded in the market before its maturity.
• Details: Market value may be higher or lower than the face value of the debt security and fluctuates due to market dynamics such as demand-supply conditions and market interest rates.

Key Concept 3: Yield from Debt Instruments

• Definition: The return to an investor in bonds is known as yield.
• Details: Yield includes coupon payments and potential capital gains or losses. The coupon rate is not an indicator of the returns on the bond but helps in computing cash flows.

Key Concept 4: Types of Debt Securities

• Convertible Debt Securities: Hybrid instruments with features of both debt and equity, paying pre-determined coupons and converting to equity on maturity.
• Zero Coupon Bond: Issued at a discount to its face value, with no coupons paid, and the effective interest earned is the difference between the face value and the discounted price.
• Fixed Rate Bonds: Pay a pre-defined interest at specified intervals, also known as plain vanilla bonds.
• Floating Rate Bonds: Coupon rate is reset periodically based on a benchmark rate, such as the RBI Repo Rate.
• Inflation Indexed Bonds: A category of floating rate bonds where the benchmark is the inflation rate.
• Amortising Bonds: Principal is repaid over the life of the bond, with payments including both interest and principal.
• Asset-backed Securities: Created by pooling assets and representing participation in the cash flows from the asset pool.

Key Concept 5: Classification of Debt Market

• Segmentation: Based on the type of borrower (government and non-government) and the tenor of the instrument (short-term, medium-term, and long-term).
• Government Securities: Comprise central government bonds and quasi-government bonds, with no credit or default risk.
• Corporate Bond Markets: Comprise short-term commercial papers and long-term bonds, with the rate depending on the credit quality of the borrower.

Key Concept 6: Credit Rating

• Definition: The evaluation of a borrower's ability to meet its obligations, depending on internal and external factors.
• Details: Credit rating defines the credit or default risk of the borrower, with higher ratings indicating lower risk of default.

Credit Risk and Credit Rating

• Credit Risk: The risk of a borrower defaulting on their financial obligations, which is evaluated by credit rating agencies.
• Credit Rating Agencies: Registered with SEBI, these agencies assess the creditworthiness of borrowers and assign a rating based on their ability to meet financial obligations.

Credit Rating Process

• Evaluation: Credit rating agencies consider qualitative and quantitative factors that impact the borrower's business and ability to meet financial obligations.
• Rating Assignment: A rating committee assigns a rating to the borrowing based on the evaluation, which reflects the borrower's ability and willingness to service the instrument.
• Dynamic Rating: Credit ratings are not static and may change over time as the credit risk associated with the borrowing changes.

SEBI Guidelines on Credit Rating

• Provisional Ratings: SEBI has issued guidelines on provisional ratings, which are considered provisional until all compliances are met and documentations are executed.
• Standardized Rating Symbols: SEBI has standardized rating symbols to help investors gauge the level of credit risk assigned to an instrument.

Rating Symbols and Definitions

• Long Term Debt Instruments:
  • AAA: Highest degree of safety, lowest credit risk
  • AA: High degree of safety, very low credit risk
  • A: Adequate degree of safety, low credit risk
  • BBB: Moderate degree of safety, moderate credit risk
  • BB: Moderate risk of default
  • B: High risk of default
  • C: Very high risk of default
  • D: In default or expected to be in default soon
• Short Term Debt Instruments:
  • A1: Very strong degree of safety, lowest credit risk
  • A2: Strong degree of safety, low credit risk
  • A3: Moderate degree of safety, higher credit risk
  • A4: Minimal degree of safety, very high credit risk
  • D: In default or expected to be in default on maturity
• Long Term Debt Mutual Fund Schemes:
  • AAAmfs: Highest degree of safety
  • AAmfs: High degree of safety
  • Amfs: Adequate degree of safety
  • BBBmfs: Moderate degree of safety
  • BBmfs: Moderate risk of default
  • Bmfs: High risk of default
  • Cmfs: Very high risk of default
• Short Term Debt Mutual Fund Schemes:
  • A1mfs: Very strong degree of safety
  • A2mfs: Moderate degree of safety
  • A3mfs: Adequate degree of safety
  • A4mfs: Minimal degree of safety

Unrated Bonds

• Definition: Bonds without a current or valid rating from an external rating agency.
• Characteristics: Unrated bonds are more illiquid and have higher yields than rated bonds.

Money Market Instruments

• Definition: Instruments with a maturity of less than one year, including commercial papers, certificates of deposit, and treasury bills.
• Characteristics: Money market instruments are used to finance short-term capital requirements and are considered highly liquid.