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DEBT MARKET
What is debt market? A market where fixed income securities of various types and features are issued and traded is known as a debt market. Fixed income securities include securities issued by central and state governments, municipal, corporations, government bodies and commercial bodies such as financial institutions, banks, public sector units, public limited companies, etc. The securities are structured in nature. Advantages of debt market: To investor:Steady income, Safety, Risk free To financial system:

Types of instruments that are traded in the debt market include the following:

Types of Instrument Government Se urities Publi Se tor onds Private Se tor onds

Debt Instruments: Debt instruments are contracts in which one party lends money to another on pre determined terms with regard to rate of interest to be paid by the borrower to the lender, the periodicity of such interest payment, and the repayment of the principal amount borrowed (either in installments or in bullet). In the Indian securities markets, we generally use the term bond for debt instruments issued by the Central and State governments and public sector organizations, and the term debentures for instruments issued by private corporate sector.

The principal features of a bond are:

a) Maturity b) Coupon c) Principal Maturity of a bond refers to the date on which the bond matures, or the date on which the borrower has agreed to repay (redeem) the principal amount to the lender. The borrowing is extinguished with redemption, and the bond ceases to exist after that date.

Term t mat rit refers t t e number of years remaining for t e bond to mature. Term to maturity of a bond changes every day, from the date of issue of the bond until its maturity. Coupon Rate refers to the periodic interest payments that are made by the borrower (who is also the issuer of the bond) to the lender (the subscriber of the bond) and the coupons are stated upfront either directly specifying the number (e.g.8%) or indirectly tying with a benchmark rate (e.g.M BOR+0.5%). Coupon rate is the rate at which interest is paid, and is usually represented as a percentage of the par value of a bond. Principal is the amount that has been borrowed, and is also called the par value or face value of the bond. The coupon is the product of the principal and the coupon rate. Typical face values in the bond market are Rs. 100 though there are bonds with face values of Rs. 1000 and Rs.100000 and above. All Government bonds have the face value of Rs.100 In many cases, the name of the bond itself conveys the key features of a bond. For example a GS CG2008 11.40% bond refers to a Central Government bond maturing in the year 2008, and paying a coupon of 11.40%. Since Central Government bonds have a face value of Rs.100, and normally pay coupon semi annually, this bond will pay Rs. 5.70 as six- monthly coupon, until maturity, when the bond will be redeemed. The term to maturity of a bond can be calculated on any date, as the distance between such a date and the date of maturity. It is also called the term or the tenor of the bond. For instance, on February 17, 2004, the term to maturity of the bond maturing on May 23, 2008 will be 4.27 years. The general day count convention in bond market is 30/360European which assumes total 360 days in a year and 30 days in a month. Generally bonds with tenors of 1-5 years are called short-term bonds; Bonds with tenors ranging from 4 to 10 years are medium term bonds and above 10 years are long term bonds. In India, the Central Government has issued up to 30 year bonds.

PARTICIPANTS IN THE DEBT MARKETS: Debt markets are pre-dominantly wholesale markets, with dominant institutional investor participation. The market participants in the debt market are: 1. 2. 3. 4. 5. 6. 7. 8. Central Government, Reserve Bank of India, Primary dealers, State Governments, municipalities and local bodies, Public sector units Corporate treasuries Public sector financial institutions Banks

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9. Mutual funds 10. Foreign Institutional Investors 11. Provident funds 12. Charitable Institutions, Trusts and Societies What is SGL? SGL Stand for Subsidiary General Ledger account, it is facility provided by RBI to large banks and financial institutions to hold their investment in government securities and treasury bills in the electronic book-entry form. Such institution can settle their trades for securities held in SGL through a Delivery-Versus-Payments (DVP) mechanism, which ensures movement of funds and securities simultaneously. A. Classification on the basis of Variability of Coupon Q1) Zero coupon bond: A zero-coupon bon (also called a iscount bon or eep discount bond) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity. It does not make periodic interest payments, or have so-called "coupons," hence the term zero-coupon bond. When the bond reaches maturity, its investor receives its par (or face) value. Examples of zero-coupon bonds include government bonds and savings bonds. Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond markets. Short-term zero coupon bonds generally have maturities of less than one year and are called bills. The U.S. Treasury bill market is the most active and liquid debt market in the world. In such a bond, no coupons are paid. The bond is instead issued at a discount to its face value, at which it will be redeemed. There are no intermittent payments of interest. When such a bond is issued for a very long tenor, the issue price is at a steep discount to the redemption value. Such a zero coupon bond is also called a deep discount bond. The effective interest earned by the buyer is the difference between the face value and the discounted price at which the bond is bought. No inflow of cash and No payment of interest.

There are also instances of zero coupon bonds being issued at par, and redeemed with interest at a premium (interest= Re-purchase Issue price) Q2) Floating rate bonds:Bond whose interestamountfluctuates in step with the market interest rates, or some other externalmeasure. Price of floating rate bonds remains relatively stable because neither a capital gain nor a capital loss occurs as marketinterest rates go up or down. Instead of a pre-determined rate at which coupons are paid, it is possible to structure bonds, where the rate of interest is re-set periodically, based on a benchmark rate. Such bonds whose coupon rate is not fixed, but reset with reference to a benchmark rate, are called floating rate bonds

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Coupon rate in some of these bonds also have floors and caps Interest rates are not fixed Example: IDBI issued a 5 year floating rate bond, in July 1997, with the rates being reset semi-annually with reference to the 10 year yield on Central Government securities and a 50 basis point mark-up. In this bond, every six months, the 10-year benchmark rate on government securities is ascertained. The coupon rate IDBI would pay for the next six months is this benchmark rate, plus 50 basis points. The coupon on a floating rate bond thus varies along with the benchmark rate, and is reset periodically.

Q3) Treasury Strips: Treasury strips are more popular in the United States and not yet available in India. Also known as Separate Trading of Registered Interest and Principal Securities, government dealer firms in the United States buy coupon paying treasury bonds and use these cash flows to further create zero coupon bonds. Dealer firms then sell these zero coupon bonds, each one having a different maturity period, in the secondary market. In the United States, government dealer firms buy coupon paying treasury bonds, and create out of each cash flow of such a bond, a separate zero coupon bond. We do not have treasury strips yet in the Indian markets. RBI and Government are making efforts to develop market for strips in governmentsecurities.

A. Classification on the Basis of Variability of Maturity Q4) Callable bonds: A callable bond (also called redeemable bond) is a type of bond (debt security) that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches the date of maturity. The issuer of a callable bond has the right (but not the obligation) to change the tenor of a bond (call option). The inclusion of this feature in the bonds structure provides the issuer the right to fully or partially retire the bond, and is therefore in the nature of call option on the bond. The issuer may redeem a bond fully or partly before the actual maturity date. These options are present in the bond from the time of original bond issue and are known as embedded options. A call option is either a European option or an American option. Under an European option, the issuer can exercise the call option on a bond only on the specified date, whereas under an American option, option can be exercised any time before the specified date. This embedded option helps issuer to reduce the costs when interest rates are falling. When the interest rates are rising it is helpful for the holders. Price of callable bond = Price of straight bond Price of call option;
y y

Price of a callable bond is always lower than the price of a straight bond because the call option adds value to an issuer; Yield on a callable bond is higher than the yield on a straight bond.

Q5) Puttable bonds:Puttable bond (put bond or retractable bond) is a combination of straight bond and embeddedput option. The holder of the Puttable bond has the right, but not

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the obligation, to demand early repayment of the principal. The put option is usually exercisable on specified dates. Bonds that provide the investor with the right to seek redemption from the issuer, prior to the maturity date, are called Puttable bonds. The put options embedded in the bond provides the investor the rights to partially or fully sell the bonds back to the issuer, either on or before pre-specified dates. The actual terms of the put option are stipulated in the original bond indenture. Therefore, an increase in the interest rates poses additional risk to the issuer of bonds with put option (which are redeemed at par) as he will have to lower the re-issue price of the bond to attract investors.

Price of puttable bond = Price of straight bond + Price of put option Price of a Puttable bond is always higher than the price of a straight bond because the put option adds value to an investor; Yield on a puttable bond is lower than the yield on a straight bond.

Q6) Convertible bonds: convertible note (or, if it has a maturity of greater than 10 years, a convertible debenture) is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features. Although it typically has a low coupon rate, the instrument carries additional value through the option to convert the bond to stock, and thereby participate in further growth in the company's equity value. The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments. A convertible bond provides the investor the option to convert the value of the outstanding bond into equity of the borrowing firm, on pre-specified terms. Bonds can be fully converted, such that they are fully redeemed on the date of conversion. Bonds can also be issued as partially convertible, when a part of the bond is redeemed and equity shares are issued in the pre-specified conversion ratio, and the nonconvertible portion continues to remain as a bond.

B. Classification on the basis of Principal Repayment

Q7) Amortizing bonds:

A bond, in which payment made by the borrower over the life of the bond, includes both interest and principal, is called an amortizing bond. The maturity of the amortizing bond refers only to the last payment in the amortizing schedule, because the principal is repaid over time Amortising Bonds are those types of bonds in which the borrower (issuer) repays the principal along with the coupon over the life of the bond. The amortising schedule (repayment of principal) is prepared in such a manner that whole of the principle is repaid by the maturity date of the bond and the last payment is done on the maturity date. For example - auto loans, home loans, consumer loans, etc.

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Q7.1) Bonds with Sinking Fund Provisions:Bonds with Sinking Fund Provisions have a provision as per which the issuer is required to retire some amount of outstanding bonds every year. The issuer has following options for doing so:

i. ii.

By buying from the market By creating a separate fund which calls the bonds on behalf of the issuer

Since the outstanding bonds in the market are continuously retired by the issuer every year by creating a separate fund (more commonly used option), these types of bonds are named as bonds with sinking fund provisions. These bonds also allow the borrowers to repay the principal over the bond life. Q8} Winner curse: A tendency for the winning bid in an auction to exceed the intrinsic value of the item purchased. Because of incomplete information, emotions or any other number of factors regarding the item being auctioned, bidders can have a difficult time determining the item's intrinsic value. As a result, the largest overestimation of an item's value ends up winning the auction. Originally, the term was coined as a result of companies bidding for offshore oil drilling rights in the Gulf of Mexico. In the investing world, the term often applies to initial public offerings The winner of an auction is, of course, the bidder who submits the highest bid. Since the auctioned item is worth roughly the same to all bidders, they are distinguished only by their respective estimates. The winner, then, is the bidder making the highest estimate. If we assume that the average bid is accurate, then the highest bidder overestimates the item's value. Thus, the auction's winner is likely to overpay. Therefore, the loss to a successful bidder is less in a Dutch rather than a French auction. The discriminatory price auction, thus creates a winners curse where a successful bidder is one who has priced his bid higher than the cut-off, but will immediately suffer a loss in the market, if the after-market price is closer to cut-off, rather than his bid. There is a loss in the secondary markets, even in a Dutch auction, if the after-market price is lower than the cut-off. The difference, however, is that the loss is the same for all successful bidders.

Q9) Primary Dealers: pre-approved bank, broker/dealer or other financial institution that is able to make business deals with the U.S. Federal Reserve, such as underwriting new government debt. These dealers must meet certain liquidity and quality requirements as well as provide a valuable flow of information to the Fed about the state of the worldwide markets. Primary dealers - introduced in 1995 in the government securities markets They act as underwriters in the primary debt markets, and as market makers in the secondary debt markets

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Banks permitted to undertake Primary Dealership business departmentally in 2006-07 They enable the participation of a number of constituents in the debt markets. There are now 19 primary dealers in the debt markets Objectives of setting up

To strengthen the infrastructure in the government securities market in order to make it vibrant, liquid and broad-based; To develop underwriting and market making capabilities for government securities outside the Reserve Bank, so that the Reserve Bank couldgradually shed these functions To improve secondary market trading system that would contribute to price discovery, enhance liquidity and turnover and encourage voluntary holding of government securities among a wider investor base and To make primary dealers an effective conduit for conducting open market operations Subsidiaries of scheduled commercial banks and all India financial institutions dedicated predominantly to the securities business and in particular to the government securities market; Company incorporated under the Companies Act, 1956 and engaged predominantly in securities business and in particular the government securities market; Subsidiaries/joint ventures set up by entities incorporated abroad under Foreign Investment Promotion Board (FIPB) approval; and Banks which do not have a partly or wholly owned subsidiary undertaking PD business and fulfill the following criteria: a. Minimum net owned funds (NOF) of Rs.1, 000 crore b. Minimum CRAR of 9 percent. c. Net NPAs of less than 3 percent and a profit making record for the last three years.

The underwriting commitment on dated securities of Central Government will be divided into two parts (i) Minimum Underwriting Commitment (MUC) and ii) Additional Competitive Underwriting (ACU).
Q10) Calc late te to maturity of government securities maturing on 23 marc 2004 on value date 10 June 2000 (leave start date& start from next day) Solution: Start date - June 10, 2000 20 6*30 3year*360 2*30 23 Total Consider 360 days in year and calculate on that basis =1363/360 term to maturity = 3.786 years
   

June 11-30, 2000 July- Dec, 2000 2001-2003 Jan fe ,2004 Marc 01-23, 2004

20 180 1080 60 23 1363

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Q11) Calculation of Zero coupon bonds: Solution: For ex; Face value is 1000, Issued price is 90, Tenure is 5 years Formula to calculate: A= p (1+r) ^n/100 100= 90(1+r) ^5/100 =1000/90=1.111 =1+r/100 = (1.111)1/5 = (1.111)0.20 =1.021 R/100=0.0211 R/100 =0.02109 r= 0.021091*100 =02.1091 R= 2.11 Treasury Bills (Govt. borrowings)Lowest ris category instruments

Issued by RBI on behalf of Government 14-day T-bill - maturity is in 14 days 91-day T-bill - maturity is in 91 days 182-day T-bill - maturity is in 182 days 364-Day T-bill - maturity is in 364 days

M&A Basics

Mergers occur any time two organizations combine into one Acquisitions occur when one firm buys another firm Most mergers are in the form of an acquisition, so these terms are often used as synonyms M&As tend to depress profitability, reduce innovation and increase leverage, at least in the short run Industry Consolidation Occurs as competitors merge together A dominant trend in the U.S. and elsewhere Corporate Raiders Engage in acquisitions, typically against the will of target companies (called hostile) Hostile acquisitions tend to be more expensive May motivate target firm managers to be more responsive to stockholder interests (reduce agency costs)

MARGER AND ACQIUSITION

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Problems with Mergers and Acquisitions High Costs High Premiums Typically Paid By Acquiring Firms Increased Interest Costs from Higher Leverage High Advisory Fees and Other Transaction Costs Poison Pillsthings target companies do so they are less attractive to takeover Strategic Problems High Turnover Among the Managers of the Acquired Firm Short-Term Managerial Distractiontakes managers away from the critical tasks of the core businesses Long-Term Managerial Distractionlose sight of the factors that lead to success in their core businesses Less Innovation No Organizational Fitcultures or systems dont combine well Increased Riskincreased leverage. Also the risk of unsuccessful management Successful Mergers and Acquisitions Low debt Friendly negotiations Complementary resources (relatedness) Cultures and management styles are similar (organizational fit) Post-merger sharing of resources Due diligence before merger Learning occurs

Classifications Mergers and Acquisitions: Horizontal A merger in which two firms in the same industry combine. Often in an attempt to achieve economies of scale and/or scope. Vertical A merger in which one firm acquires a supplier or another firm that is closer to its existing customers. Often in an attempt to control supply or distribution channels. Conglomerate A merger in which two firms in unrelated businesses combine. Purpose is often to diversify the company by combining uncorrelated assets and income streams Cross-border (International) M&A A merger or acquisition involving a Canadian and a foreign firm a either the acquiring or target company.

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 Discounted Cash Flow Analysis Free Cash Flow to Equity

Free cash flow to equity ! net income  /  non  cash items ( amortizati on, deferred taxes , etc.)  /  changes in net working capital ( not including cash and marketable securities )  net capital expenditur es

Equation is the generalized version of the DCF model showing how forecast free cash flows are discounted to the present and then summed.

V0 !

E CFE CFt CF1 CF2   ...  ! 1 2 t E (1  k ) (1  k ) (1  k ) t !1 (1  k )