Our previous article touched upon fundamental parameters like face value, coupon rate, Yield to Maturity (YTM), etc. In this article, we will walk you through a few other crucial factors which can affect your investment decisions.
Before investing in any financial instrument, an investor should know about the risk and returns of investing in that instrument. The same goes for the debt instruments. The investor wants to have information on the borrower’s creditworthiness before they invest in the security, and the credit rating of that entity gives this information.
The credit rating agencies generally do credit evaluation and assessment of the governments or companies. These agencies analyse qualitative and quantitative information about the borrower and predict their ability to repay the debt.
Rating agencies conduct an in-depth analysis of the macroeconomic factors like business, growth, operations, technology and economy, etc., along with the microeconomic factors like company’s performance, market share, cash flows, etc. This helps them in providing a rating to the entity.
The rating agencies assign various rating scales based on the type of financial instrument. Some of the scales used for rating are long term scale, short term scale, Structured Finance scale, Credit Enhanced scale, Fixed Deposit scale, Corporate Credit scale and so on. The rating scale of the credit rating agencies for long term securities is as follows:
Below are the links to check out the rating scales of a few of the rating agencies:
The bondholders have a right to take legal action if any of the bond’s covenants are breached, and this means the bondholders are legally protected if the issuer defaults. But how much each bondholder gets and in what priority is decided by the concept of security.
- Secured Debentures
Secured debentures refer to those debentures where a charge is created on the company’s assets for payment in case of default. In the event of default, the bondholders can liquidate the underlying assets and make good any loss on the bond.
- Unsecured Debentures
Unsecured Debentures are not secured by any assets of the company. Although they are not secured by way of creating a charge on assets, these bonds still create an obligation on the company in case of default. Proceeds arising from the liquidation of assets that are not pledged against any lender can be used to clear such obligations in the event of default.
So as you can see, the secured debenture holders have greater protection compared to unsecured debentures. In reality, though the amount which can be recovered depends on various factors.
- Exclusive and Pari Passu Charge
Typically the security of a bond you encounter would be mentioned as an Exclusive charge or Pari Passu Charge.
Exclusive charge means the security under the charge is provided to a particular lender only, and other investors cannot have a charge on the same. Theoretically, you could still create a 2nd ranking Exclusive charge, meaning that another lender has subordinated charge on these assets. Also, 1st ranking or 2nd ranking means exactly as it reads; 1st ranking charge has priority over 2nd ranking in case of liquidation of the asset.
- Pari Passu Charge
Under this, the charge is shared by more than one lender in the ratio of their outstanding amount. The company requires the prior consent of the existing charge holder(s) while creating such a charge.
The seniority of the bond defines the priority in which a firm in bankruptcy pays the debt claims. Generally, the bonds are classified into two types based on seniority: Senior Bonds and Subordinated Bonds. If a company has to file for bankruptcy or face liquidation, the senior debt is paid first, followed by the subordinated debt.
Subordinated Debt: The risk of holding subordinated debt is higher since the company may not have the capital to pay back the subordinated debt holders after paying back to the senior debt holders. And higher the risk, the higher the returns. Therefore, the yield of the subordinated bonds is higher than that of the senior bonds.
Generally, the subordinated debt cannot be secured in nature. But it can further be classified into debt with Tier 1 and Tier 2 capital. In extraordinary circumstances, RBI can wipe off the tier 1 and tier 2 debt, no longer payable to the bondholders. A recent example of the write-down of AT1 Bond was in the case of Yes Bank.
The hierarchy of debt payable to the bondholders in case the company files for bankruptcy and has to liquidate its assets is as shown below:
Listing means the formal admission of securities of a company to the trading platform of the exchange. Bonds can either be listed or unlisted. Listing of the securities can be done either on the Bombay Stock Exchange (BSE) or National Stock Exchange (NSE). Most of the corporate bonds are listed on BSE, while the government bonds are listed on NSE.
Listing of the bond on a stock exchange can happen either through public issue or private placement basis. The public issue involves issuing the debenture publicly open to the retail investors. Issuance through private placement means any offer to subscribe or issue the security to a select group of people who have been identified by the board (or investors investing through an arranger) through private placement offer-cum-application. Private placement of the security can be made to persons not exceeding 200 in a financial year.
There are certain conditions that the issuer has to fulfil for listing the debenture on the stock exchange. The listing application and the disclosures as specified shall be submitted to the stock exchange within 4 days from the date of allotment. The debentures need to be issued in compliance with the regulatory framework of the SEBI and Companies Act. Also, credit rating has to be obtained in respect of such securities from at least one credit rating agency registered with the SEBI.
Based on the risk appetite and yield expectation, bonds can provide an exciting investment opportunity. To know more, contact us today at email@example.com