Debt terminology is not uniform across markets. A term that means a secured instrument in one country can mean an unsecured one in another, and names such as debenture, note and bond are used loosely. The syllabus advises analysts to always be aware of the terminology relevant to the country they are working in, by examining and reading thoroughly the features of the specific instrument rather than trusting its name.
One family, three surnames
When a company or a government borrows from investors rather than a bank, the instrument is a debenture, a bond or a note. The syllabus is candid that the three words are used interchangeably and then warns that structure, collateral, country of usage and maturity can all differ, so an analyst should read the actual terms of the actual instrument rather than trust the label.
The rough map: bonds is the umbrella word in the United States and debentures in the United Kingdom. Notes usually means shorter or medium maturities, though nothing is watertight. Bonds lean toward government issuers with long maturities beyond ten years (gilts, in British usage); debentures lean toward corporates. A debenture may be secured, backed by collateral, or unsecured.
Issued by companies, governments, special purpose vehicles and other entities. Investors: institutional and individual. Medium: direct issuance, through a stock exchange if the instrument is listed. Regulators: the RBI and SEBI, together with the Companies Act regulators, the MCA and the NCLT.
Convertible or not
The first fork in the debt family is whether the instrument can turn into equity.
So a debenture can be pure debt or quasi-equity depending on its conversion terms. The hybrids topic returns to convertibles in detail, including the optionally convertible variety.
Debt for less than a year
Three instruments raise money for periods not exceeding one year, and the exam pairs each with its issuer:
- Treasury bills, issued by the government
- Commercial paper, issued by companies with high credit ratings
- Certificates of deposit, issued by banks
Commercial paper sounds like something a bank would issue and certificates of deposit sound like something a company might sell. It is the other way round: banks issue certificates of deposit, highly rated companies issue commercial paper, and only the government issues Treasury bills.
Domestic, foreign, euro: four questions
Bonds can also be sorted by geography and currency. The syllabus gives four questions to ask: who is issuing, in which country's market, in what currency, and what is that country's home currency. The answers produce three labels.
A euro bond need not be issued in Europe and need not be in euros. The word only signals a mismatch between the bond's currency and the currency of the place of issue. Dollar bonds sold in Kuwait are euro bonds. Dollar bonds sold in New York are foreign bonds.
Foreign currency bonds and who carries the currency risk
Companies in emerging markets are tempted to borrow in dollars or other hard currencies because the interest rates are much lower. The syllabus cites Delhi International Airport Limited, a GMR Infrastructure special purpose vehicle, issuing dollar bonds in the United States in February 2020. Such bonds can even carry a conversion feature.
The catch is currency risk. If the dollar strengthens against the rupee before repayment, the issuer needs more rupees to buy the same dollars. A cheap loan can become an expensive one without the interest rate moving at all.
An Indian issuer borrows 100 million dollars when a dollar costs 75 rupees, so the loan is worth 750 crore rupees. At repayment the dollar costs 85 rupees. The same 100 million dollars now costs 850 crore rupees. The extra 100 crore is pure currency loss, on top of the interest paid.
Masala bonds flip the risk
A masala bond is a euro bond denominated in Indian rupees: issued outside India, but the investor is paid in rupees. The first was issued in November 2014 by the International Finance Corporation and listed on the London Stock Exchange.
Because the bond is in rupees, the Indian issuer has no currency exposure. The foreign investor has all of it: if the rupee weakens against the investor's home currency, the rupees received buy less at home. The syllabus contrasts this directly with foreign currency bonds, where the currency risk sits with the issuer.
Foreign currency bond issued by an Indian company: the issuer carries the currency risk. Masala bond: the foreign investor carries it. The exam asks this as a direct comparison.
- Debentures, bonds and notes all raise debt. Bonds is the umbrella term in the US, debentures in the UK; notes are usually shorter; bonds are more often government paper with maturities beyond ten years (gilts in the UK), debentures more often corporate.
- Fully convertible debentures turn entirely into equity; partly convertible ones turn partly and redeem the rest; non-convertible debentures are pure debt repaid at maturity.
- Debt under one year: Treasury bills (government), commercial paper (highly rated companies), certificates of deposit (banks).
- A foreign bond is issued abroad in that country's own currency; a euro bond is issued abroad in a currency that is not that country's; a masala bond is a rupee euro bond, which moves the currency risk to the foreign investor.