A deep dive into bond market jargon

The Indian bond market, after operating as a playground for institutions and wealthy folks for decades, is now opening up to retail investors. Apart from bond intermediaries such as AK Capital and Phillip Capital (India) who have long offered bonds to their private clients, platforms such as Indiabonds, BondsKart, GoldenPi and Wint Wealth have now arrived on the scene. They allow retail investors to buy corporate bonds, both from the primary and secondary markets, through a friendly online interface. 

A first-time investor shopping for bonds is bound to be foxed by how different this market is from equities and the plethora of choices it offers. 

Here’s an explainer to help you cut through the jungle of jargon and make the right choices.

NCDs vs FCDs

Wondering why bonds issued by companies in India are called NCDs? Well, they are called NCDs or non-convertible debentures because their cousins – PCDs (Partly Convertible Debentures) and FCDs (Fully Convertible Debentures) are also prevalent.  

NCDs are plain vanilla bonds which represent a loan to the company. Once you buy the bond, the company pays you interest and pays back your principal on maturity. FCDs and PCDs are bonds that initially behave like bonds and pay interest. After a specific number of years, they convert fully or partly into shares of the company that issued them. The conversion price and date are usually mentioned in the offer document. 

The law allows both listed companies and unlisted ones to issue NCDs. NCDs can be listed on the debt segment of the stock exchange or remain unlisted.

Odd lots vs Market lots

In India, the debt market is dominated by the big guys. The Market Lot segment of the exchanges’ debt platform is reserved for institutions and players transacting in amounts of Rs 5 crore or more. Retail investors seeking to buy or sell bonds need to go to the Odd Lot segment, where transactions starting from Rs 10,000 and going up to Rs 5 crore are permitted.

When you look to buy NCDs from online platforms or brokers, NCDs available in Odd Lots have lower minimum investment amounts than those available in Market Lots.

Primary vs secondary markets

When you buy a bond that is being issued by a company through the public issue or private placement route, this is a primary offer. If you buy a bond from another investor or bond broker, that becomes a secondary market trade. 

Bond trades in the secondary market may happen through two routes. They may happen on the debt segment of the stock exchanges. Or they may happen through off-market negotiated deals between investors, which are called Over-The-Counter or OTC trades. The majority of secondary market trades in bonds happen in the OTC market. However, OTC trades need to the be reported to the exchanges so that they are captured in the exchange data. 

Online bond platforms and bond brokers sometimes source bonds from the secondary market and offer them to their clients.

Public issues versus private placements

Have you noticed that, unlike equity IPOs, very few bond IPOs are advertised? This is because a majority of companies in India which borrow via bonds raise money through private placements rather than public issues. 

Recently, Power Finance Corporation made a public offer of NCDs. When companies make public issues of bonds that are open to all, they are required to follow an elaborate process of preparing a voluminous prospectus, file it with SEBI, advertise it and so on. 

Companies like to cut out all this red tape. Therefore, over 95% of the bond offers in India are made through the private placement route. A private placement is when a company raises money from a select group of people (up to 200) and institutions. They can be made with fewer formalities and at short notice, by issuing an Information Memorandum (IM) instead of a prospectus. Privately placed bonds are sold by bond brokers, investment banks and wealth managers to their clients.   

Public issues of NCDs need to be mandatorily listed on the exchanges, but privately placed ones can remain unlisted. Minimum subscription amounts for public NCD issues are usually at Rs 10,000 but the minimum investments for privately placed NCDs can be set much higher.

Listed vs Unlisted NCDs

NCDs can be listed on the exchanges or unlisted. Unlisted NCDs are usually available from wealth managers, bond dealers or other bond market intermediaries. As per recent SEBI regulations, online bond platforms can only offer listed NCDs. 

To the investor, listed NCDs offer material advantages over unlisted ones. One, listed NCDs are regulated by SEBI while unlisted ones are only subject to Company Law. Two, investors can exit listed NCDs before maturity at the exchange-traded price. But do note that not all listed NCDs get traded. 

Usually, NCDs from PSUs and AAA-rated companies are regularly traded, while most others see infrequent trading. Unlisted NCDs can usually be exited only at maturity. At times, the bond dealer, broker or market intermediary who sold you an unlisted bond may buy it back, but there’s no guarantee. 

Three, if you invest in a listed NCD, you get regular disclosures from the company on its financials and other material events on its website and through the exchange. SEBI requires companies listing NCDs on the exchanges to follow higher disclosure norms under its ILDS and LODR regulations.

At the time of listing, the company must file annual reports for the last three years and latest audited half year results. Thereafter, it needs to inform the exchange of interest and maturity proceeds falling due, with any default or delay. On a half-yearly basis, the company needs to disclose its credit ratings, debt-equity ratio, asset cover, debt service and interest coverage ratio, debenture redemption reserve and net worth. These disclosures apply even to unlisted or private companies that list their NCDs. See this sample of the disclosures made by IFCI on its website.

Coupon vs yield

The coupon rate is the interest rate that the NCD promises to pay on its face value. The yield is the effective return you stand to make based on the price at which you bought the NCD.

When you buy bonds in primary issues, they are offered at face value and the coupon rate mentioned in the offer is also the return you get. For instance, unlisted Vivriti Capital recently made a public issue of Rs 250 crore (with an option to raise another Rs 250 crore), for listed NCDs with a face value of Rs 1000 and coupon rate of 10.5% annually. This means that investors can expect to get Rs 1050 annually in interest, which works out to a 10.5% return.

When you buy NCDs from the secondary market, you buy them at a market price. The market price can trade above or below face value. Therefore, the returns you will get should be assessed through the yield rather than the coupon rate. Assume the above NCD starts trading in the secondary market and is traded at Rs 1010. An investor buying 10 NCDs (costing Rs 10,100) would get Rs 1050 in annual interest. This works out to a yield of 10.39% (Rs 1050/10100).

When buying bonds from secondary markets, you may also see bond platforms or dealers mentioning a YTM or Yield-to-Maturity. YTM is the Internal Rate of Return (IRR) calculated after accounting for all the cash flows you can expect to receive from a bond over its entire life, both by way of interest and maturity payments.

Tax-free vs taxable NCDs

Interest received on NCDs is taxable under Indian income tax laws. However, periodically the government allows infrastructure PSUs to offer NCDs that enjoy a special concession – the interest on such NCDs is exempt from tax. Such specially notified bonds issued by PSUs are called tax-free bonds. 

Tax-free bonds are mainly available in the secondary market because it has been many years since the government notified its last tranche of tax-free bonds. Entities such as REC, PFC, HUDCO, IRFC, NHAI and IREDA have issued tax-free bonds that are available in secondary markets. 

All other NCDs, except the above, are described as taxable NCDs. The interest received on NCDs is taxed at slab rates. Capital gains are taxed at slab rates as short-term gains. For listed NCDs, long term capital gain (LTCG) tax kicks in after 1 year holding period and for unlisted ones after 3 years. LTCG applies at 10.3% on listed NCDs and 20.6% on unlisted NCDs. NCDs do not get indexation benefits.

Secured vs unsecured

Companies issuing NCDs can choose to offer secured ones or unsecured ones. Secured NCDs are those where the company’s repayment obligations are fully backed by a security cover. In the event of default, or the company going into liquidation, the security cover can be sold to repay NCD holders. The nature of asset making up the security cover is therefore important. NCDs backed by immovable property, plant and machinery etc are safer than NCDs backed by the company’s receivables.  

Unsecured bonds are not backed by any such security cover and in the event of default or liquidation, repayment will be subject to the availability of surplus assets over liabilities. Normally, unsecured bonds should offer higher interest rates than secured bonds.  While secured bonds are supposed to be safer than unsecured ones in theory, this may not play out in practise. A reputed company may honour its NCD obligations because it intends to, even if they unsecured. A dodgy company may short-change investors even on a secured NCD. When Dewan Housing Finance was liquidated, NCD holders with over Rs 10 lakh holdings had to take a haircut and received bonds in a new entity as payment.

Senior, subordinate and mezz bonds

Bond-holders in a company rank well above equity shareholders on claims, when a company defaults and goes into liquidation. Equity shareholders will get paid only if there’s cash left over after satisfying the claims of all creditors. But all bond-holders are not born equal.

When you buy bonds, they are usually labelled as senior, subordinate or mezzanine bonds. These labels indicate who gets first preference on repayment, in the event of the issuer landing in hot water. The manner in which claims of different stakeholders will be distributed in the event of liquidation, is picturesquely called the ‘waterfall mechanism’. (In a waterfall, the water is cleanest and most plentiful at the top. It progressively diminishes as you go downstream).

Those holding senior bonds get the first shot at the waterfall. They have the first claim on a company’s assets when there’s a restructuring or default. If a company has only limited assets, the money will go to settle senior NCD holders’ claims in full.

Subordinate bond-holders who rank after senior folk, may be forced to take a haircut. Mezzanine bonds are highly risky bonds that are almost like equity holdings in a company. In fact, many mezzanine bonds come with provisos for conversion of debt into equity if the company defaults.

Therefore, as a debt investor you need to look for a higher yield from a subordinate bond compared to a senior bond. Your return expectation from a mezzanine bond should be almost equal to your equity return expectation!