A loan cut into pieces
Debt capital comes from lenders who want regular compensation at a pre-specified fixed rate and their money back after an agreed period. A company can borrow from a bank or a consortium of banks, or it can reach a far larger pool of investors by issuing debt securities.
A company needs 100 crore. It can take a bank loan, and the bank becomes its lender. Or it can issue one crore debt securities of face value 100 each. An investor bringing 1,000 rupees receives 10 securities, and her exposure is limited to what she invested. The company has spread its borrowing across thousands of lenders.
A debt security is a contract between the issuer and the lender that lets the issuer borrow on pre-determined terms. Those terms are the security's features: the principal, the coupon, the maturity, the frequency of coupon payment and any collateral provided. Every debt security gives the investor the right to coupons and to repayment of principal. Secured debt adds a right over the issuing company's assets: if interest or principal is not paid, those assets can be sold to repay investors. Unsecured debt has no such recourse.
Debt securities may be privately placed with a select group or offered to the public. Publicly issued debt is mandatorily listed on an exchange such as the NSE or BSE so it can trade in the secondary market. Unlisted securities must be held to maturity or traded over the counter.
The syllabus notes that investors in debt papers are at times retired people who have no other source of income. That is the practical reason safety of principal and regularity of coupon matter so much in debt analysis: for many holders the coupon is the household budget, not a return to be reinvested.
Face value
Any bond needs three questions answered: how much was borrowed, for how long, and at what rate. Face value answers the first. It is the nominal or par value of the paper, the amount of loan the security represents, and the base on which every coupon is calculated. It may be 100 rupees, 1,000 rupees or any other denomination. It is the issuer's legal liability, the principal repaid on redemption, and it may equal the investor's initial outlay if the bond was issued at par.
Once a bond trades, its market price wanders away from face value. An investor who bought in the secondary market at 104 or at 96 still receives exactly the face value at maturity. The purchase price affects the investor's return, never the issuer's obligation.
Coupon rate
The coupon rate is the regular fixed payment on the bond, expressed as a percentage of face value. The rupees the investor receives are face value multiplied by the coupon rate. The syllabus asks you not to call the coupon the interest rate: in the profession, interest rate means the broad market rate at which borrowing and lending happen, anchored by the central bank.
8.24GS2018 is a government security with an 8.24% coupon maturing in 2018. On a face value of 1,000 it pays 82.40 a year until maturity. Government securities pay semi-annually, so the holder receives 41.20 every six months, and the last coupon arrives on the maturity date together with the principal.
Maturity
Every loan has a tenure; in bond markets it is the tenor, the maturity or the term to maturity. It is the single largest factor behind changes in a bond's price, and the market risk of a bond investment is tied to it. Tenors run from very short (Treasury bills at 91, 182 and 364 days) to very long (government securities of 30 years or more), and some bonds are perpetual. The term to maturity shrinks every day and reaches zero on the maturity date, when the bond is redeemed.
Market price
A traded bond has a market price that differs from its face value. The market's participants price it by weighing the current level of interest rates, inflation and the default risk they perceive. All three are normally already reflected in the coupon, so the market's real act is to compare the bond's coupon with today's interest rates and pass a verdict.
A bond's value is the sum of its future cash flows discounted at the market interest rate, or at the return investors require. Raise the discount rate and every future rupee is worth less today, so the price falls. Lower the rate and the price rises. When market interest rates increase, bond prices fall; when rates fall, bond prices rise. A 10% coupon bond issued at 100 will quote below 100 once rates in the market have risen.
Redemption
When the bond matures, the issuer redeems it: the principal is repaid, the final coupon is paid, and the bond ceases to exist.
- A debt security is a contract to borrow on pre-determined terms: principal, coupon, maturity, coupon frequency and any collateral. Secured debt gives investors rights over the issuer's assets on default; unsecured does not.
- Publicly issued debt must be listed so it can trade; unlisted debt is held to maturity or traded over the counter.
- Face value is the loan amount and the base for the coupon; the coupon rate is the fixed payment as a percentage of face value; maturity is the tenor and the largest driver of price changes; redemption is the final coupon plus principal, after which the bond ceases.
- Market price is set by comparing the coupon with current market rates, inflation and default risk. Price and interest rates move inversely.