What are the Terminologies in the Debt Market?

Before delving into Debt Market, let’s first understand what is Debt in share market? While Equity is a form of ownership in capital, Debt is a form of capital borrowed by the issuer from investors without the ownership rights by paying a regular fixed interest to the investors.

What is the Debt Market?

A Debt Market is a financial platform where Debt securities are issued by companies and the government are traded by investors. These Debt securities are issued for the purpose of raising capital for business operations, infrastructure development and others. Debt securities like Treasury Bills, government bonds and corporate bonds are traded usually at discounted price to investors for a coupon rate. Investors will be receiving coupon payments at coupon rate as periodic interest payments.

Debt securities are usually considered as less risk securities with a regular income and hence considered as a safe investment option.

What are the terminologies in the Debt Market? 

Debt Capital

Debt capital represents funds lent by investors seeking a regular fixed rate of income through a predetermined fixed interest rate called coupon rate. These lenders expect the borrowed money to be repaid after a specified period. Debt can be obtained through bank loans, institutional borrowing, or issuing debt securities.

For example, if a company requires Rs. 100 crores, it can either take a bank loan for the entire amount, with the bank being the sole lender, or it can broaden its investor base by breaking down the loan into smaller denominations. In this scenario, if the company issues 1 crore securities, each with a value of Rs. 100, an investor contributing Rs. 1000 would receive 10 securities. This approach limits each investor's exposure to the extent of their investment.

Debt Securities

A debt security is a contractual agreement between the issuer (company) and the lender (investor), allowing the issuer to borrow a predetermined sum of money under specific terms. These terms, collectively known as the characteristics of a debt security, encompass the principal, coupon, maturity of the security, and any provided security for the lending. Every debt security grants investors the entitlement to coupon payments and principal repayment as outlined in the debt contract.

There are two types of Debt , they are Secured and Unsecured Debt.

Secured Debt, a subset of debt securities, provides investors with rights over the assets of the issuing company. In case of non-payment on interest or principal, these assets can be liquidated to compensate the investors. However, this protection is not applicable to investors with unsecured Debt.

Debt Securities can be issued either privately or through publicly.

Debt securities can be privately placed among a select group of investors or offered to the public through a public issue. Publicly issued debt securities are required to be listed on stock exchanges like the National Stock Exchange or Bombay Stock Exchange for trading in the secondary market. On the other hand, unlisted securities must be held until maturity or traded in the Over the Counter (OTC) market.

Commonly used terms in debt instruments include:

Face Value: 

The face value in the debt market is the nominal value assigned to a debt security at the time of issuance. It represents the principal amount that the issuer promises to repay to the investor at maturity. This face value is crucial for calculating interest payments and determining the security's market price.

Coupon Rate: 

The coupon rate in the debt market is the fixed annual interest rate expressed as a percentage of the bond's face value. It determines the periodic interest payments made to bondholders. A higher coupon rate indicates a higher interest payment, providing investors with a steady income stream.

Current Yield: 

Current Yield in the debt market is a measure of the annual return an investor can expect, calculated by dividing the bond's annual interest by its current market price. It provides a snapshot of the income generated from a bond relative to its current market value, offering insights into short-term returns for investors. A higher current yield typically indicates a more favourable income potential.

Yield to Maturity (YTM): 

Yield to Maturity (YTM) is a key metric in the debt market, representing the total return anticipated if a bond is held until maturity, considering its current market price, interest rate, and coupon payments. It reflects the annualized rate of return an investor can expect from the bond over its entire lifespan. YTM is crucial for evaluating the attractiveness of fixed-income securities.

Modified Duration (M Duration): 

Modified Duration (M Duration) in the debt market measures the sensitivity of a bond's price to changes in interest rates. It provides an estimate of the percentage change in the bond's price for a 1% change in yield. Higher modified duration indicates higher interest rate risk for the bond.

Convexity: 

Convexity in the debt market measures the curvature in the relationship between bond prices and interest rates. It provides insight into how a bond's duration changes with fluctuating interest rates, offering a more nuanced understanding beyond traditional duration measures. Investors use convexity to refine interest rate risk management in bond portfolios.

Credit Rating: 

Credit rating in the debt market evaluates the creditworthiness of issuers. Assigned by rating agencies, these ratings help investors assess the risk associated with a debt security. Higher ratings indicate lower credit risk, influencing investment decisions.

Issuer:

In the debt market, an issuer is a company or entity that issues debt securities to raise capital. The issuer enters into a contractual agreement with investors, outlining terms such as principal, coupon payments, and maturity. Investors, in turn, provide funds to the issuer in exchange for the debt securities.

Callable Bond: 

A callable bond is a type of debt security that allows the issuer to redeem the bond before its maturity date. This feature provides flexibility for the issuer but introduces the risk of early redemption for the bondholder. Callable bonds typically offer higher interest rates to compensate for this added risk.

Puttable Bond:

A Puttable Bond is a type of debt security where the bondholder has the option to sell the bond back to the issuer before maturity. This feature provides investors with flexibility, allowing them to sell the bond if market conditions or their investment strategy change. The put option typically comes with specific terms and conditions outlined in the bond agreement.

Duration:

Duration in the debt market refers to the sensitivity of a bond's price to changes in interest rates. A higher duration implies greater risk to interest rate fluctuations. Investors use duration as a key metric to assess and manage interest rate risk in their fixed-income portfolios.

Yield Curve: 

The yield curve in the debt market depicts the relationship between interest rates and the maturity of debt securities. It typically slopes upward, indicating higher yields for longer-term securities. Inverted or flat yield curves may signal economic trends and impact investment strategies.

Debenture: 

Debentures are debt instruments issued by companies to raise capital in the financial market. Investors who purchase debentures become creditors to the issuing company, receiving fixed interest payments and the return of principal at maturity. Debentures are a common form of long-term borrowing for businesses.

Treasury Bills (T-Bills)

Treasury Bills, or T-Bills, are short-term debt instruments issued by governments to raise funds. They have maturities typically ranging from a few days to one year, making them popular for investors seeking low-risk, short-term investments. T-Bills are sold at a discount and do not pay regular interest; instead, investors earn a return through the difference between the purchase price and the face value at maturity.

Corporate bonds:

Corporate bonds are debt securities issued by companies to raise capital in the debt market. Investors purchase these bonds, lending money to the company in exchange for periodic interest payments and the return of the principal amount at maturity. Corporate bonds play a crucial role in diversifying investment portfolios and are traded in the secondary market.

Government Bonds:

Government bonds are fixed-income securities issued by a government to raise capital. They are considered low-risk investments and pay periodic interest to bondholders. Government bonds play a crucial role in the debt market, offering a secure option for investors seeking stability.

Default: 

Default in the debt market occurs when a borrower fails to meet their scheduled interest or principal payments. This non-compliance may lead to financial repercussions for the lender and potential liquidation of collateral in secured debt cases. Defaults can impact investor confidence and influence the overall dynamics of the debt market.

Understanding these terminologies is crucial for investors in the debt market, aiding in assessing risks and returns associated with various debt instruments.

Frequently Asked Questions

Explain Coupon Rate

Interest paid on the bond/debt security is called the Coupon rate, articulated as a percentage of its face value. The actual amount of money that the investor receives as interest is equal to the product of the face value and the coupon rate.

Consequently, an 8.24% GS2018 read as 8.24% coupon bearing Government Security (G-Sec) maturing in 2018 with a face value of Rs. 1000, would pay Rs. 82.40 as a coupon (interest) each year, till maturity, to the investor. G-Secs pay interest semi-annually.

Under these circumstances, the investor would get Rs. 41.2 (82.4/2) every 6 months. The last coupon payment will be received on the maturity date and the principal (par value).

All the way through the period for which the bond is held, the investor would receive coupon payments. These coupons may be re-invested to earn interest at the rate widespread at the time of re-investment.

Moreover, the investor will make a gain or loss at the time of selling the bond based on whether the sale price is higher or lower than his purchase price.

Adding all these three incomes and expressing it as a percentage of the cost price will be treated as the HPR for the investor.

When an investor purchases a bond at Rs. 104 and earns Rs. 8 as a coupon, which is reinvested at 7% for 1 year by him, eventually, he sells the bonds at RS. 110 after 1 year, then his

HPR Would Be:

HPR = [(8) + (8 * 7%) + (110-104)]/ 104 = 14.00%

HPR is a single-period return and does not annualize the return to the investors.

Explain Yield To Maturity(YTM)

Yield to Maturity or YTM is a more complete and broadly used measure of return calculation of debt security than the current yield. This process considers all future cash flows coming from the bond -coupons plus the principal repayment and associates the present values of these cash flows to the prevailing market price of the bond.

The rate that associates the present outflow (the price of the bond that the investor needs to pay to purchase the bond) with the current value of future inflows (coupons plus principal) is called YTM. Consequently, it can be implicit as the bond's Internal Rate of Return (IRR)

The YTM can be calculated by trial and error method by pointing to diverse rates in the equation and arriving at the one that associates the market price to the present value of the expected cash flows from the bond. Regardless of the fact that it is better than the current yield and is extensively used, YTM has its limitations. It primarily presumes that the investor will hold the bond until maturity, which may or may not be the circumstance.

Secondly, it presumes that the coupons received at regular intervals are reinvested for the remaining tenor of the bond at the same rate throughout the tenor. This hypothesis entails that interest rates would stay the same for the entire tenor and that the rates would also be the same across tenors, which indicates that the yield curve would be still and flat.

This hypothesis takes YTM away from being realistic. On the other hand, YTM has its reward, the biggest of which being that it is an uncomplicated and quick calculation, and therefore it is widely used.

Elaborate on Duration 

Duration measures the understanding of the price of a bond to changes in interest rates.

Bonds with high duration experience more significant increases in value when interest rates turn down and more significant losses when rates rise than bonds with lower duration.

Duration is the weighted average maturity of the bond, where the present values of the future cash flows are used as weights. Duration consequently incorporates the tenor, coupon, and yield in its calculation.

Higher the time to maturity, higher the Duration, and higher the bond's interest rate risk.

Lower the coupon rate, higher the Duration, and higher the bond's interest rate risk. And, Lower the yield, higher the Duration, and higher the interest rate risk of the bond.

Therefore, Duration is a very suitable interest rate risk measure for bonds. The higher the duration, the higher the sensitivity of bond prices vis an interest rate.

The duration of a bond is not a stagnant number but will change with a change in the tenor and yield of the bond. As a bond comes closer to maturity, its Duration also decreases and makes the bond less risky.

How to Calculate Modified Duration (M Duration)?

Modified Duration measures the collision of changes in interest rates on the bond's price.

While Duration gives us the sensitivity of bond prices to changes in interest rates, Modified Duration provides us with the magnitude of this change.

M Duration Is Calculated As:

M Duration (D*) = - Duration/ (1 + YTM)

The negative sign relates to the inverse relationship between bond prices and interest rates.

When interest rates rise, bondholders go through a drop in the price of bonds they hold, 

which pay a lower coupon rate on their principal, contrasting to new bonds, which would be issued in line with higher interest rates. New buyers of bonds would not pay the same price for the old bonds, as for the same investment in new bonds, they would get a higher coupon.

To bring both the bonds to the same level, the prices of old bonds would fall so that the yield on these bonds is the same as the yield on the new ones. Likewise, when rates drop, the old bonds with high coupon rates would become striking for the same reason.

Change in price of a bond would be calculated as the product of M Duration and percentage change in yield.

Suppose a bond has an M Duration of 4.3, then a slight change of 0.25% (25 basis points or 25 bps) would mean the bond's price would change by (4.3 * 25/100) = 1.075% in the opposite direction.

What is Convexity in the Debt Market?

The collision of change in interest rates on bond prices is inverse but not linear. This way, bond prices go down when rates go up, but they don't drop as much as they would rise when rates go down by the same magnitude. Consequently, an increase in bond prices is more than its drop, for the same movement in interest rates in downward and upward directions correspondingly.

This sole property of bond prices is called Convexity. It must be eminent that M Duration is applicable only for small changes in interest rates as for larger changes; it would show a straight-line movement in prices, which would be incorrect.

Therefore, M Duration is only useful at that point where the straight line would be peripheral to the price yield curve. Bond fund managers look for bonds with high convexity as these do not drop much in rising interest rate circumstances but rise more when rates are falling.