Preference shares: equity with a debt accent
A preference share is a special class of share that stands ahead of ordinary equity in two queues: dividends, and repayment of capital if the company is wound up. It has a foot in each camp.
| Like equity | Like debt | |
|---|---|---|
| Holder is called | A shareholder, not a creditor | |
| Payment | Called dividend, paid from profit after tax, not an obligation | Pre-determined rate, paid before any equity dividend |
| On winding up | No right over residual assets | Paid before ordinary equity holders |
| Voting | No voting rights |
Varieties: cumulative (an unpaid dividend is carried forward and must be cleared before equity gets anything), non-cumulative (an unpaid dividend lapses), and partly or fully convertible into equity.
The dividend rate is fixed in advance, which makes the instrument look like a bond. It is still a dividend, payable only from profit after tax and only if declared. A company that skips it has not defaulted. An option that calls the preference dividend a contractual obligation is wrong.
Convertible debentures: debt that becomes equity
A convertible debenture pays periodic interest like any debt instrument until, at a pre-defined time, it converts into shares. Three varieties: fully convertible (the whole face value becomes shares), partly convertible (a portion converts and the rest stays as interest-bearing debt until redemption), and optionally convertible, where the holder chooses whether to convert or keep the instrument as debt.
The issue terms fix the conversion date or deadline, the conversion ratio (shares per debenture), the conversion price (usually at a discount to the market price) and, for partly convertible ones, the proportion that converts.
The issuer pays a lower coupon than on plain debt, because part of the investor's return is the chance of appreciation after conversion, and the issuer never has to repay the converted principal since shares are issued instead. The cost is dilution: existing shareholders own a smaller proportion once the new shares appear. The investor gets coupon income while the project is young and equity upside once it matures.
Depository receipts: a foreign share in local clothing
A depository receipt represents shares of a company from another country, traded in the market of the country where the receipt is issued and priced in that country's currency. The mechanics run in three steps.
- 1A company or an investor delivers a quantity of equity shares to a depository, usually a foreign bank, in the country where the receipts will trade.
- 2The depository lodges those shares with its custodian in the company's home country.
- 3The depository issues receipts against the shares to investors in the overseas market.
If the company itself delivers the shares and starts the process, the receipts are sponsored and can be listed on an exchange in the country of issue, subject to that exchange's listing requirements. If an investor delivers the shares, the receipts are unsponsored: they generally cannot trade on an exchange, only over the counter, and face lighter regulatory requirements.
Two-way fungibility, where permitted, means shares bought in the home market can be converted into receipts to trade abroad, and receipts bought abroad can be converted back into shares to trade at home.
The company gains a wider international investor base. Investors get shares they might otherwise be unable to hold, through their own broker, on their own exchange, in their own currency. Holders receive dividends and capital appreciation from the underlying shares but no voting rights, although the syllabus notes SEBI is considering votes for DR holders.
FCCBs
Foreign currency convertible bonds are convertible debt securities, usually dollar-denominated, that Indian companies issue in international markets. They are generally optionally convertible and are issued offshore under guidelines the RBI sets from time to time. Interest and any principal repayment are paid in foreign currency; once the bond converts into equity, dividends are paid in rupees and the currency risk shifts to the investor. FCCBs are regulated by RBI notifications under the Foreign Exchange Management Act; the original framework was the 1993 scheme for FCCBs and ordinary shares issued through the depository receipt mechanism, now carried in the RBI's master direction on foreign investment.
Equity and commodity linked debentures
An equity linked debenture is a floating-rate debt instrument whose interest depends on the return of an underlying equity: an index such as the Nifty 50 or the Sensex, individual shares, or a custom basket. The issuer invests a pre-determined slice of the principal in fixed income to protect the capital and uses the balance to buy options that deliver the equity exposure. The structure aims at full capital protection with a share in equity gains.
Capital protection comes from the fixed-income slice, not from the issuer being unable to fail. Credit risk remains, and rating agencies rate these instruments for exactly that reason. The syllabus also warns that a company using an ELD to raise money for capital expenditure will have very little left for the project after funding the protection and the options, which is why an investment banker or arranger is usually engaged to structure the product.
A commodity linked debenture works the same way with returns tied to a commodity, most often gold or silver: commodity upside with initial capital protected.
Securitised debt: MBS and ABS
Mortgage backed securities and asset backed securities are debt instruments issued against the receivables and cash flows of financial assets. Home loans back MBS; auto loans, rent receivables and credit card receivables back ABS. Collections from the underlying assets pay the interest and principal on the bonds. Securitising turns an illiquid pool of loans into a tradable instrument; the instruments are credit rated and may be listed. The syllabus adds that financial innovation never stops and new products keep arriving.
REITs and InvITs
Real estate investment trusts and infrastructure investment trusts pool investor money into revenue-generating property and infrastructure projects respectively. They are formed as trusts, raise money by issuing units, and enjoy favourable tax treatment when they meet the regulatory requirements. Assets can be held directly or through a special purpose vehicle.
A REIT must hold at least 80% of its assets in revenue-generating real estate. An InvIT must invest at least 90% of its unit capital in revenue-generating infrastructure projects. Both must distribute at least 90% of their distributable surplus cash flow to unit holders.
Commodities: goods that are interchangeable
A commodity is a basic material or good that is largely homogeneous, so one unit substitutes for another of the same type. A bar of gold is a commodity; a gold necklace is not, because a buyer may prefer one design over another even at equal weight and purity. Hard commodities are natural resources that are mined or extracted, such as metals and crude oil; soft commodities are grown, such as grains and pulses.
Commodity prices move with inflation, so holding commodities can protect the real value of money. Most, though, carry large storage costs and make poor direct investments. The syllabus lists four practical routes:
- Preference shares rank ahead of equity for dividend and capital repayment, pay a pre-set dividend out of profit after tax that is not an obligation, and carry no vote and no claim on residual assets. Cumulative ones carry unpaid dividends forward.
- Convertibles pay a coupon until conversion; FCD, PCD and OCD differ in how much converts and who decides. Issuers get a lower coupon and no repayment; existing shareholders get diluted.
- A depository receipt represents a foreign company's shares held by a depository's custodian and trades in local currency abroad. Sponsored DRs can list; unsponsored trade OTC. DR holders get dividends and appreciation but not votes. ADR, IDR, HKDR and GDR are the varieties.
- REITs hold at least 80% in revenue-generating real estate, InvITs at least 90% in revenue-generating infrastructure, and both distribute at least 90% of distributable surplus cash flow.
- Hard commodities are mined or extracted (metals, crude); soft commodities are grown (grains, pulses). Precious metals, commodity ETFs, managed futures and warehouse receipts are the investable routes.