New Financial Instruments
Very few financial instruments are completely new products. Many
are just new features added to the conventional financial instruments
to make them marketable
The conventional financial instruments are equity shares, preference
shares, debentures (partly convertible, fully convertible and non-
convertible). When certain new features are added, a conventional
instrument turns into a new instrument.
New Financial Instruments
- Floating Rate Bonds
- Zero Interest Bonds
- Deep Discount Bonds
- Revolving Underwriting Finance Facility
- Auction Rated Debentures
- Secured Premium Notes with Detachable Warrants
- Non-convertible Debentures with Detachable Equity Warrants
- Secured Zero Interest Partly Convertible Debentures with
Detachable and Separately Tradable warrants
- Fully Convertible Debentures with Interest(Optional)
- Domestic Convertible Bonds
- Differential Shares
- Securitized Paper
- Collateralized Debt Obligations(CDO)
- Inverse Float Bonds
- Perpetual Bonds
- Municipal Bonds
Floating Rate Bonds
Floating Rate Bonds are bonds wherein the interest rate is not fixed
and is linked to an anchor/ benchmark rate.
SBI introduced floating rate bonds firstly for retail investors,
which was linked to the bank’s term deposit rate which served
as the anchor rate.
Treasury bill rate can also be the anchor rate.
Now NSE MIBOR rate is also used as the anchor rate.
Borrower companies issue floating rate bonds with a cap or a
floor. The cap is the maximum interest that the issuer can pay
while the floor is the minimum interest that a subscriber earns.
Floating Rate Bonds are vulnerable to interest risk
Zero Interest Bonds
No periodic payment of interest
Sold at discount to the value
Benefit the issuer as the funds need not be arranged for
payment of interest during the period of the bond
If provided as per the terms, on maturity these bonds are
convertible into equity which entails no outflow for the issuer
or into interest bearing bonds after a period of time.
Bonds do not carry interest, hence not taxable
Attractive for issuer companies with projects having a long
gestation period as there is no immediate interest commitment
and on maturity, the bonds can be converted into equity shares
or non-convertible debentures depending on the capital structure
requirement of the company
Deep Discount Bonds
These are Zero coupon bonds whose maturity is very high, say
15 years onwards and is offered at a discount to the face value
IDBI in 1992 was the first financial institution to offer these
bonds.
These instruments are embedded with ‘call’ and ‘put’ options
which provides for an early redemption facility both to the
issuer and the investor at a predetermined price and date
Revolving Underwriting Finance Facility
These are 91 day debentures with two important, distinct features.
There is an underwriter (a banker or financial institution) who
will be prepared to pick up the lot if it is not fully sold.
After 91 days, the stock will be rolled over, i.e., the debentures
will be redeemed and reauctioned, likewise it can be kept in the
market for upto five years. If, at some stage, there are not
enough takers for the issue, the underwriters step in and pick up
the lot at a previously agreed rate.
These bonds are beneficial to the issuers, underwriters, and investors.
The issuer gets long-term funds at short-term rates, the underwriter
gets a regular fee, and the investor gets a liquid debt instrument
Auction Rated Debentures
Secured, redeemable (after 90 days), non-convertible
instruments.
Interest determined by the market and placed privately with
bids.
ARDs are a hybrid of commercial papers and debentures.
Example:
ANZ Grindlays designed this new instrument for Ashok Leyland
Finance (ALF). This was a three-year instrument which had a zero
coupon rate and was sold at a discount. The company repurchased the
ARDs after three months of the issue and then re-issued them through
fresh auctions. The interest rates were negotiated at quarterly
auctions; this continued for three years. ALF raised Rs.30 crore
through this unique zero coupon instrument. ARD is technically a
short-term instrument but it provides long-term finance for the
company.
Secured Premium Notes with Detachable Warrants
Redeemable after a notified period, say four to seven years.
There is a lock-in period during which no interest is paid.
Attached warrants ensure that the holder has the right to apply
for and to be allotted equity shares, provided the SPN is fully
paid. This conversion is done within the time limit notified by
the company.
The SPN holder has an option to sell back the SPN to the
company at par value after the lock-in period. If the holder
exercises this option, no interest/premium will be paid on
redemption. In case the SPN holder holds it further, he will be
repaid the principal amount along with the additional amount of
interest/premium on redemption in instalments as decided by the
company. SPNs free the firm from the debt-servicing costs in
the initial years.
TISCO and Bombay Dyeing were among the early issuers of
SPNs.
Non-convertible Debentures with Detachable Equity Warrants
Holder of this instrument is given an option to buy a specific
number of shares from the company at a pre-determined price
and time frame.
The warrants attached to the NCDs are issued, subject to full
payment of the NCDs value. There is a specific lock-in period
after which the detachable warrant holders have to exercise their
option to apply for equities. If this option is not exercised, the
unapplied portion of shares would be disposed of by the
company at its liberty.
Escorts, Bombay Dyeing, and Indian Rayon were among the
early issuers of NCDs with warrants attached.
Secured Zero Interest Partly Convertible Debentures with Detachable
and Separately Tradable warrants
This instrument has two parts.
Part A is convertible into equity shares at a fixed amount on the
date of allotment.
Part B is non-convertible, to be redeemed at par at the end of a
specific period from the date of allotment. Part B carries a
detachable and a separate tradable warrant which will provide an
option to the warrant holder to receive an equity share for every
warrant held at a price determined by the company.
Fully Convertible Debentures with Interest (Optional)
No interest for a specified short time period.
After this period, FCD holders have the option to apply for
equities at a ‘premium’ for which no additional amount is
payable.
This option needs to be indicated in the application form itself.
However, interest on FCDs is payable at a determined rate from
the date of conversion to the second/final conversion and equity
shares are issued in lieu of the interest.
Domestic Convertible Bonds
Hybrid securities that allow investors to separate the embedded
equity portion from the bond and trade it separately. Because of
the option to convert debt into equity, issuers can raise debt at a
lower interest rate
Differential Shares
These are shares with differential rights to voting and dividends.
Differential shares can be issued with no voting rights but high
dividends or, with varying rights and dividends.
If the voting right of the shareholder is taken away, the
shareholder is compensated by higher returns.
Originated in Canada and was highly successful.
Introduced in India through the Companies (Second
Amendment) Act, 2000. According to this law, a company can
issue shares with differential rights ‘as to voting or dividend or
otherwise.’
Securitized Paper
Securitisation is a process through which illiquid assets are packaged
and converted into tradable securities known as pass-through
certificates (PTCs).
Securitisation is a process by which a company raises money by
selling off its receivables. These receivables are sold off to cash-
rich investors by converting them into securities. The
receivables are sold at a discount to the investors which
represent the yield.
It is a popular fund-raising technique in the developed markets
such as the US and the UK.
Asset securitisation began in the US in the 1960s with the
pooling of residential mortgages.
Now, this concept extends to a whole range of financial assets
such as receivables and mortgages held by businesses and
financial firms.
These securities are also referred to as asset-backed securities
(ABSs). If the instrument securitised is a housing loan, the
resultant instrument is referred to as mortgage backed securities
(MBSs). In case of bond receivables, they are known as
collateralised bond obligations (CBOs) and in case of industrial
loan receivables, they are referred to as collateralised loan
obligations (CLOs).
In securitisation, the assets to be securitised are identified on the
basis of their creditworthiness. Then, the security is rated by a
specialised credit rating agency. The pool is sold to a special
purpose vehicle (SPV) which acts as a trustee. SPV is the entity
that owns the assets once they are securitised. The assets are
held by the SPV to ensure that the investors’ interest is secure
even if the originator goes bankrupt. The SPV is usually in the
form of a trust. The SPV issues the asset backed security and the
task of collecting the interest due on the underlying asset is left
either to the seller or a third party.
Collateralized Debt Obligations(CDO)
Collateralised debt obligation is securitisation of corporate
obligations such as corporate loans, corporate bonds, and asset-
backed securities.
Collectively, CDO consists of collateralised bond obligations,
collateralised loan obligations, and credit linked notes that
emanate from the same financial family.
Banks and financial institutions use this instrument to meet
regulatory obligations and to increase their revenues
These instruments offer higher yield to investors but the risk of
default is high.
Off-balance sheet financing has earned disrepute globally after
the Enron fiasco. Many CDOs had Enron credit as part of their
underlying exposure and these were defaults.
This instrument is being increasingly used by European banks
and the Bank of Japan besides American banks.
The ICICI Bank’s first CDO issue failed to takeoff in March
2002 and was recalled because of unfavourable market
conditions and lack of regulatory guidelines. In February 2004,
the bank altered the product structure by bringing down the
average maturity of the issue to around two years. ICICI bank
sold corporate loans, given to 15 borrowers of varying sizes
across 11 industries, through this issue to raise new assets as
well as enhance exposure management in terms of specifi c
sectors.
CDOs are new in the Indian market and new products take time
to gain market acceptance. However, with an increase in
investor awareness and setting up of a regulatory framework,
this instrument will be preferred by Indian banks and financial
institutions in times to come.
Inverse Float Bonds
Inverse float bonds are bonds carrying a floating rate of interest
that is inversely related to short-term interest rates.
The floating rate could be the Mibor (Mumbai inter-bank offer
rate) or some other rate. If the Mibor falls, the return for the
investor rises and vice versa.
The actual rate payable on these bonds is arrived at by
subtracting the floating rate from a fixed benchmark rate.
Suppose the fixed benchmark rate is 12 per cent and the six-
month Mibor is 6 per cent, then the interest rate payable on
these bonds is 6 per cent (12–6).
Inverse float bonds were introduced in the US market in 1990.
In India, the Aditya Birla Group, Grasim, and Hindalco issued
inverse float bonds in August 2002. The Cholamandalam
Investment and Finance Company Limited (CIFCL) were the
first non-banking finance company to raise funds through the
issue of inverse floaters
Perpetual Bonds
These debt instruments do not have a maturity date.
The investors receive interest payments for perpetuity.
The bonds can be issued to retail investors with market making
to ensure liquidity.
In case of liquidation, holders of perpetual bonds are paid
second last, after all other depositors and creditors but before
equity shareholders.
Being permanent in nature, they qualify as Tier I capital (i.e.,
equity and free reserves) of banks.
Another hybrid instrument similar to perpetual bonds is
perpetual preference shares
Municipal Bonds
These are debt securities issued by the municipal corporation of
a city to raise funds for financing their growing investment
needs for a host of infrastructure projects.
Large municipalities were able to tap the market through
issuance of such municipal bonds.
Mostly, these bonds were made saleable through government
guarantee.
The Ahmedabad Municipal Corporation was the first urban local
body to raise funds through municipal bonds. It was the first
urban local body to receive a general obligation rating for its
municipal bonds in February 1996 and raise funds through
municipal bonds without a state government guarantee.
In December 1997, The Bangalore Mahanagar Pallike (BMP)
also issued municipal bonds for Rs. 125 crore, with seven-year
maturity and a coupon of 13 per cent per annum.
