Long-term Instruments: Debt Capital (Bonds and Debentures)

Securities with maturity period more than a year are known as long-term financial instruments.

There are three main long-term financial instruments; they are:

Common stocks (equity shares or ordinary shares)

Debt capital (bonds, debentures or long-term loan)

Preference stocks (preference shares)

Debt Capital (Debentures and Bonds)

Here, debt means long-term debt.

Debts capital means loan capital collected or raised by debenture, corporate bonds, long-term bank loan etc.

A limited company collects beginning capital from equity shares capital then it can collect capital from debt.

The company may require additional money for its expansion, growth, diversification and modernization.

For this purpose, the company can borrow debt capital from public.

Debentures or bonds are medium term or long-term loan from public.

Keep in Mind (KIM)

DEBENTURES

Debentures are issued by a limited company to raise medium term loan.

Amount of debenture can be used for expenses or future expansions of the business.

Debentures can be transferred to anyone.

The owners of debentures are called debenture holders.

Debenture holders do not have voting right in the company’s general meetings.

Debentures are simply loans taken by the companies and they do not provide the ownership in the company.

These are unsecured loans.

The company is not bound to return the principal amount on the maturity.

There are different types of debentures.

Out of them, mainly there are two types of debentures.

They are convertible and non-convertible.

The convertible debentures can be converted into new debentures, equity share or preference shares.

Non-convertible debentures do not convert into equity shares and other types of debentures.

Thus, these debentures can yield a higher interest rate

BONDS  

When limited company issues bonds, they are known corporate bonds.

The government also issues bonds.

They are known government bonds or municipality bonds.

Bonds are secured with the fixed assets of the company.

These bonds are issued by the companies for meeting expenses and future expansions.

The borrower pays interest at regular intervals.

The principal amount will be returned on maturity. 

It is known redemption of bonds.

Difference between Bonds and Debentures

Both bonds and debentures are long-term loan instruments.

They are issued to raise capital from the public.

They have some similarities but following are main differences:

Definition 

“Debentures are a debt or loan raised by a company under the seal of the company.”

According to Company Act, “A trustee is necessary to raise or issue debentures or debt capital.”

Keep in Mind (KIM)

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Features of Debentures or Corporate Bond

The company that issues debentures is known borrower.

The person or company who purchases debenture is known lender or subscriber.

Principal

Principal is the value of the debenture. It is also called the par value or face value of the debenture.

In Nepal, generally face value of one debenture is Rs 1,000.

Debentures can be issued at par, at discount or at premium

Coupon rate

Coupon rate means interest rate of debenture.

Interest rate of debenture is prefixed. It is paid always on face value.

It is payable annually, half yearly or quarterly

Maturity

It is the date on which the borrower has agreed to repay the principal amount to lender.

Term-to-maturity refers to the number of years remaining for the debenture to mature.

The term-to-maturity changes every day from date of issue of the debenture until its maturity.

Convertible

Convertible bonds or debentures are converted into new type of bonds, equity or preference shares.

This conversation may be at par, discount or premium.

Collateral

Collateral is the property pledged to get loan by corporations from general public or business enterprises.

While issuing bonds collateral is essential.

Keep in Mind (KIM)

For example

CG2018; 11% bonds refer to a Central Government bond maturing in the year 2018 and paying a coupon of 11%. Central Government bonds have a face value of Rs 1,000 and normally pay coupon semi-annually, this bond will pay Rs 55 as six-monthly coupon, until maturity. 

Types of Debentures

The types of debentures are given below:

Registered debentures

The debenture that cannot be transferred to another person is known registered debentures.

The person who has such debentures, his name and address is registered with the company.

He has right to get interest and principal amount of these debentures.

Bearer debentures

This is also known unregistered or coupon debentures.

The person who has such debentures, he is the owner of debentures.

He has right to get interest and principal amount of these debentures.

Redeemable debentures

These type debentures can be redeemed or repaid after its maturity period. 

The company is bound to pay the principal amount of debentures to debenture holders within specified time.

Irredeemable debentures

These type debentures cannot be redeemed or repaid during the life of the company.

This is also called perpetual debenture. Interest is paid every year.

The principal amount is paid only at the time of winding-up the company.

Convertible debentures

These types debenture holders have right to convert their debentures into new debentures, equity shares or preference shares.

Conversion may be at par, discount or premium.

Non-convertible debentures

These types debenture holders has not right to convert their debentures into new debentures, equity shares or preference shares.

Secured debentures

This is also called mortgage debentures.

To issue these debentures, fixed assets deposit as security.

If the company cannot repay principal amount, debenture holders can realize their amount by selling fixed assets.

Unsecured debentures

This is also called naked or simple debentures.

These typed of debenture holders are not given any security for issuing debentures.

They are only creditors of the company.

First debentures

These types of debenture holders have authority to claim on the assets of the company.

They have priority to repayment of principle amount before other debenture holders.

Second debentures

These types’ debenture holders can claim on assets after first debenture holders.

These debentures are issued against specific assets already used as security.

Collateral security debentures

These debentures are issued to take loan from bank or financial institute.

Generally, values of debentures are more than loan.

But interest is calculated on loan not on deposited debentures.

If the company cannot pay its loan and interest within time, bank or financial institute automatically becomes debenture holders and the company has to pay more interest.

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Types of Corporate Bonds

There are various types of bonds in the financial market; some of them are summarized below:

Mortgage bonds

The long-term debts secured by the collateral of specific fixed assets are known as mortgage bonds.

Generally, fixed assets are land and building, machinery and equipment.

If the company is unable to pay the principal of the bond, the bondholders can take their money by selling fixed assets.

Unsecured bonds or debentures

Debenture is an unsecured bond issued by a company without pledging any specific assets as collateral.

The use of debenture depends on the nature of asset of the firm and general credit strength.

Therefore, debenture holders are general creditors of the firm.

Convertible bonds

The bond which can be converted into equity share is called convertible bond. 

Convertible bond also may be converted into new types bonds and preference share.

Conversion depends on the desire of the bondholders.

Such rights are specified in the indenture.

This conversion may be at par, discount or premium.

Callable bonds

If company can call bond holders for redemption before maturity, it is known callable bond.

When the company thinks that interest rates will fall in the near future, it may call the bond.

After paying off the principal amount of bonds, the company issues new bonds at the lower interest rate.

Income bond

It is a type of bond in which return is given according to income level of the company.

Some income bonds have cumulative interest in feature.

It means unpaid interest of preceding years is paid when the company will have sufficient earnings.

These types of bonds are not in the Nepalese market.

Zero coupon bonds

The bonds, which have no coupon rate and sold at a discount basis is called zero coupon bond.

This bond is also called pure discount bond.

The investors receive attractive returns from the difference between issue price (sold price) and par value.

Companies prefer to issue zero coupon bonds when their cash flows are not regular.

Junk bond

A junk bond has a relatively high risk of default.

Junk bonds are riskier than most other types of bonds. Junk bond pays high interest rate.

Therefore, this bond is also known as a high yield bond or speculative bond.

Normally, these bonds are issued by those companies whose financial strength is not so good.

Floating rate bond

When interest rates of the bonds are fluctuating due to inflation, it is known floating rate bonds.

Generally, interest rate is adjusted every six months based on market interest rate.

Company can issue floating rate bonds instead of issuing fixed interest rate.

In instable interest rate environment, company uses floating rate bonds to reduce risk.

Advantages of Corporate Bond

The main advantages of corporate bond are as follows: 

(A) From the view point of company (issuer)

Less costly

While comparing with the equity shares, issue of debts is less costly.

On equity share, company has to pay dividend upto life time of the company but debt is callable or redeemable.

Therefore, it is less risky investment.

Tax deductible

Interest paid to the bondholders is a tax deductible expense.

It reduces the tax liabilities of the company.

Deducted tax must be deposited to state or central government.

In other words, while paying interest on debts, tax should be deducted.

Flexibility

The corporation can bring flexibility in its capital structure by issuing bonds because the call provision can be kept in bond indenture.

Some loans can be repaid before maturity.

Limited cost

The cost of the loan is definitely limited. When the company earns high profit, the bond holders cannot receive additional interest.

Therefore, the bond holders receive only definite income whereas; the ordinary shareholders receive more income.

(B) From the view point of investors

Low risk

The bonds are low risky to the investors because most of the bonds are secured with the fixed assets.

Secured bonds are safe investment for the investors.

Fixed income

There is fixed interest rate on the bond, except in income bond.

Therefore, the investors receive fixed regular income from bonds. 

Conversion

Some bonds are convertible.

In such situation, the bondholders can convert their bonds into common stocks, new bonds or preferred stocks.

Liquidity

The bonds are more marketable than shares.

Bonds can be sold easily in the share market.

Thus, the investors are able to get higher liquidity.

Disadvantages of Corporate Bond

The main disadvantages of long term debt are as follows:

(A) From the view point of company (issuer)

Increased financial risk

Long-term debts increase the financial leverage of the company.

It may be unfavourable to those companies which have fluctuating sales and earnings.

Bondholder can take the company into liquidation if they do not get regular interest and principal at maturity.

Limit of the loan

There is a limit to raise fund through the long-term debt. Standard equity and loan ratio is 3:2.

According to the financial policy, the loan ratio should not cross the limit.

If loan is taken more than this limit, the cost of the loan increases.

Cash outflows

Generally, long-term debt has a fixed maturity period.

The debt must be repaid on that period.

It needs sufficient cash outflows.

Large amount of cash outflow will negatively affect financial position of the company. 

(B) From the view point of investors

Limited income

Long-term debts contain fixed interest rate.

The debt holders will not receive extra profit.

They receive limited income as interest even the company earns large profit.

Therefore, their income is limited.

No voting rights

The debt holders do not have voting rights in the affairs of the company. 

They cannot elect the board of directors.

Low return

As compared to preferred stock and common stock, the bond or debt has the lower rate of return.

The debt holders will not receive extra interest even the company earns large profit.

Keep in Mind (KIM)

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Long-term Instruments: Common Stock (Equity Shares and Ordinary Shares)

Securities with maturity period more than a year are known as long-term financial instruments.

There are three main long-term financial instruments; they are:

Common stocks (equity shares or ordinary shares)

Debt capital (bonds, debentures or long-term loan)

Preference stocks (preference shares)

Common Stock (Equity Shares and Ordinary Shares)

Common stock or equity share is an ownership document.

It is issued by a limited company (joint Stock Company) to raise equity capital.

Every limited company is established with the help of equity shares.

In other words no equity shares, no limited company.

Total or authorized capital of the company is divided into small fractions.

These fractions are called shares.

The person who purchases shares of the company is known shareholder.

Shares are transferable to other persons and companies.

Common stock is also called ordinary share, common share or equity share.

The dividend rates on these shares are not pre-determined.

Equity shareholders can get dividend only after interest on debentures and dividend on preference shares is paid.

At the time of liquidation (winding up), equity shareholders get capital only after paying all the debts and preference share capital.

Therefore, common shareholders have residual right on income and capital of the company.

(A) Importance of equity shares to the company

No need to pay dividend when company incur loss.

No need to refund money to equity shareholders, equity share capital can be used by the company till the firm remains in existence.

The directors are elected by equity shareholders for effective management.

(B) Importance of equity shares to the shareholders

Every shareholder has a right of voting to elect the directors of the company.

If company earns more/high profit, equity shareholders can enjoy it.

Equity shareholders can easily sell or transfer the ownership to other investors/organizations.

Features of Common Stock

The main features of common stock are as follows:

Permanent capital

Equity share capital remains permanently with the company.

It is returned only when the company is wound up.

Therefore, equity shareholders are the permanent investors.

Owners

Equity shareholders are the actual owners of the company.

They invest initial capital.

They bear the highest risk.

Transferable

Equity shares are transferable.

Ownership of equity shares can be transferred with or without consideration to other shareholders.

Dividend

Equity shareholders do not get fixed rate of dividend.

Dividend payable to equity shareholders is an appropriation of profit.

If company does not earn profit any year, equity shareholders may not get dividend.

Voting right

Equity shareholders have voting right according to their shares.

Equity shareholders have the legal power to elect board of directors (BOD).

They can replace them if the board fails to protect interest of the shareholders.

Equity shareholders have the right to control the affairs of the company.

Limited liabilities

Equity shareholders have limited liabilities upto their investment.

If company bears heavy loss, equity shareholders do not need to invest more than their shares investment.

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Advantages of Common Stock

The advantages of common stock to issuer and investor are as follows:

(A) From the view point of company (issuer)

Minimum restrictions

The firm has minimum restrictions from common stock financing.

The firm has no legal obligation to pay dividend.

The company has to pay a dividend to the common stock if it makes earnings.

Maturity  

There is no fixed maturity period for common stock.

Hence, it reduces the obligation of repayment in future.

Sold easily  

Common stocks can be sold easily from the primary market.

It is attractive to certain investor due to more expected return than in preferred stock and bond.

Increasing in borrowing capacity  

Common stock helps to increase the future borrowing capacity of the firm.

If the equity capital is more, the financial manager receives flexibility.

It becomes easier to borrow fund in future.

(B) From the view point of investors

More income  

The common stockholders are residual claimers.

Hence, they receive all portion of profit left after making all other payments.

Bonus share is also received in common stock.

Participation in management  

Common stockholders can participate in management using their voting rights.

Thus, they can control the company.

They elect board of directors for their benefit.

Best investment  

It is said that higher the risk higher the gain.

Investors who take risk by investing in equity shares are able to take huge benefit from it.

Ownership  

Common stockholders are the real owners of the company.

They have voting rights.

Therefore, they have the right of ownership.

While buying the common stock, the investor receives share certificate at which the number of shares and the price of share are mentioned.

Disadvantages of Common Stock

The main disadvantages of common stock are as follows:

(A) From the view point of company (issuer)

High cost

Common stock is an expensive source of long-term finance. 

The shareholders expectation of return is generally high.

It needs large flotation costs as underwriting commission, brokerage fee and other expenses.

Heavy dividend

The company has to pay large amount of dividend from profit.

Thus, the company may not be able to maintain different type of funds (reserves) for future investment.

No tax benefit

Common stock dividend is not tax deductible.

In other words, while calculating the taxable income of the firm, the dividend cannot be deducted as expenditure.

Obstacle in management

Equity shareholders have voting rights.

Due to large number of equity shareholders and right on management, they can form group.

Grouping may create obstacle in management and decision making.             

Over capitalization

The amount of capital collected from equity capital cannot be refunded easily like debt or preferred stock.

Due to high capital than required, the company may have to face the problem of over capitalization.

We know the fact that idle money earns nothing.

(B) By the view of investor

Irregular income

There is no fixed dividend rate in common stocks.

The income of investors is irregular and uncertain.

There is no legal obligation to provide dividend.

Sometimes, the board of director may decide not to give dividend.

Last priority

Common stockholders have last priority in the liquidation.

In other words, the common stock holders receive what is left after distributing to the preferred stock holders and bond holders.

Loss in capital  

The income of the company decreases during periods of recession.

Due to this, the rate of dividend of common stock decreases and market price of common stock also decreases.

Thus, the investors will lose their capital.

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Rights and Privileges of Common Stockholders  

Rights and privilege of shareholder vary from state to state and country to country.

But some common rights are given below:

Right on income and assets

Common stockholders (equity shareholders) have the right on profit of the organization.

Similarly, they have right on remaining fund after paying all liabilities.

Thus equity shareholders have right on income and assets.     

Voting right

Every equity shareholder has voting right to elect managing directors.

Each shareholder has one voting right. In the absence of shareholder, proxy vote can be used.

After managing director is elected, he does work in favour of shareholders.

Dividend

Equity shareholder receives dividend on his shares.

Dividend is paid from profit.

If there is loss in any accounting year, shareholders cannot receive dividend.

There is no guarantee of dividend.

Transfer of ownership

Shareholders can transfer their right of shares to other persons/organizations.

The right to transfer of ownership is ordinary.

It can be done with the help of share brokers (secondary market).

Share broker charges fees for this work.

Authority to inspect books and records

Shareholders have authority to inspect books of accounting.

Although all the limited companies publish their financial statements at the end of accounting period yet shareholders can inspect documents at any working time of the company. 

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Derivatives

Derivatives are financial instruments whose value is derived from other underlying assets.

There are mainly four types of derivative contracts; they are futures, forwards, options and swaps.

However, swaps are complex instruments that are not traded in the SAARC Countries stock market.

Futures contract

This is a standardized contract between two parties to buy or sell an asset at a specified time in the future at a specified price.

Futures are standardized exchange traded contracts.

Futures’ trading is of interest to those who wish to:

Speculate by taking a view on the market and buying or selling accordingly

Prefer Price Risk Transfer through hedging

Take advantage of the leverage offered by paying a small fraction of the total contract as margin

Forward contract

A forwards contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date.

Since, forward contracts are not traded on a centralized exchange; they are regarded as over the counter instruments.

A forward contract settlement can occur in cash or on delivery basis.

Forward contracts are non-standardized.

It is interesting to those who wish to hedge by customizing the contract to any commodity, amount or delivery date.

Options contracts

Option contract is the most important part of derivatives contract.

An option contract gives the right but not an obligation to buy or sell the underlying assets.

The buyer of the options pays the premium to buy the right from the seller, who receives the premium with an obligation to sell the underlying assets if the buyer exercises his right.

Options can be traded in both in stock exchange and OTC market.

Options can be divided into two types; they are call and put.

Swaps

A swap is a derivative contract made between two parties to exchange cash flows in the future.

Interest rate swaps and currency swaps are the most popular swap contracts.

They are traded over the counters (OTC) between financial institutions.

These contracts are not traded on exchanges.

Generally, retail investors do not trade in swaps.

In derivative contracts, futures and options together are considered to be the best hedging instrument.

Swaps can be used to speculate the price movement and make maximum profit out of it.

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Futures Contract and Forward Contract

(A) Futures contract

Futures contract are standardized contracts.

They are traded on stock exchange at specified price.

They are bought or sold underlying instrument at certain date in future,

Futures contract does not carry any credit risk because the clearing house acts as counter-party to both parties in the contract.

To further reduce the credit exposure with margins, it required to be maintained by all participants all the time; for this purpose all positions are marked-to-market daily,

(B) Forward contract

Forward contract is an agreement between two parties and it is traded over-the-counter (OTC).

Forward contracts do not have such mechanisms in place.

A forward contract is an agreement between two parties to buy or sell underlying assets at specified date, at agreed rate in future.

This is because forward contracts are settled only at the time of delivery (future time).

The credit exposure keeps on increasing since profit or loss is realized only at the time of settlement.

In derivatives market, the lot size is predefined; therefore, one cannot buy a contract for a single share in futures.

This does not hold true in forward markets as these contracts are customized based on an individual’s requirement.

Therefore, future contracts are highly standardized contracts; they are traded in the secondary markets.

In the secondary market, participants in the futures can easily buy or sell their contract to another party who is willing to buy it.

In the contrast, forwards are unregulated; so there is essentially no secondary market for them.

Differences between Future Contract and Forward Contact

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Real Assets

Before starting financial assets, we should know about real assets.

Real assets are tangible or physical assets; they can be seen and touched.

They must have monetary value; these assets can be purchased or sold.

There are different types of real assets.

They are land, building, houses, cars, computers, machinery, equipment, furniture, stocks, cash, gold, silver etc.

They are used to generate income.

In other words, real assets help to increase income for organization.

Plant and machinery are used in manufacturing process.

They are destroyed only by accident and/or due to wear-and-tear over the time.

They are depreciable except land and gold.

They are less marketable; we cannot sell real assets whenever we need.

Real assets are shown in assets side of balance sheet.

Meaning of Financial Assets

Financial assets are not existed in physical form.

These assets represent the ownership right in a piece of paper.

Investing in financial assets can yield dividends and interest income (from investors’ point of view).

Financial assets help to increase capital of an organization (from borrowers’ point of view).

In other words, using financial assets an organization can increase its production and expand its market.

Some examples of financial assets are common or ordinary shares, preference shares, bonds (debentures), certificates of deposit, bank balances, annuities and mutual funds.

Financial assets are much easier to trade and manage than real assets.

Financial markets make valuation of financial securities.

Financial assets are not depreciable.

They are shown in assets side (as investment) as well as liabilities side (securities issued to raise fund) of balance sheet. 

Financial assets arise in the process of borrowing and lending money and represent a claim against future earnings.

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Characteristics of Financial Assets

The main characteristics of financial assets are given below:

No physical existence

Financial assets do not have physical existence.

They represent the ownership right through a piece of paper.

It is also known certificate of ownership.

If you purchase shares of any limited company, share certificate is the evidence of ownership.

More liquid

Financial assets are more liquid than physical assets.

They can be easily converted into cash by selling in secondary market.

No production capacity

Financial assets do not have productive capacity of their own.

They generate income by investing in real assets.

Easily movable  

Financial assets can be easily carried from one place to another place.

They are ownership certificates. Ownership can be easily transferred.

Assets and liabilities

Financial assets are asset for one party and liabilities for another.

The shares are assets for you (buyer) and liabilities for issuing company.

Differences between Real Assets and Financial Assets

There are many differences between financial assets and real assets; out of them some important differences are given below:

Differences between Real Assets and Financial Assets

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Instruments of Financial Assets

Financial instruments are easily tradable packages of capital.

They represent legal agreement and monetary value.

Financial instruments can be classified into:

On the basis of maturity period

On the basis of ownership

On the basis of return

On the basis of issuer

(A) ON THE BASIS OF MATURITY PERIOD

Financial assets (instruments) can be divided into two parts on the basis of maturity period.

They are long-term securities and short-term securities.

Long-term securities

The financial securities which have maturity period more than one year are known as long-term instruments.  They are common stock, preferred stock, bond etc.

Short-term securities

The financial securities which have maturity period less than one year are known as short term instruments. They are commercial paper, treasury bills, banker’s acceptance etc.  

(B) ON THE BASIS OF OWNERSHIP

Financial assets (instruments) can be divided into two parts on the basis of ownership.

They are ownership financial instruments and creditor ship financial instruments.

Creditorship securities

Those financial assets that make the holders creditors of the company are known as creditor ship financial instruments.

They are debentures, commercial papers etc.

Ownership securities

Those financial instruments which represent the ownership right are known ownership financial instruments.

They are common stock, preferred stock, mutual fund etc.

(C) ON THE BASIS OF RETURN

Financial assets (instruments) can be divided into two parts on the basis of return generated by them.

They are fixed return financial instruments and variable return financial instruments.

Fixed return securities

The financial instruments which have fixed rate of return are known as fixed return financial instruments.

They are preferred stock, bond, commercial paper etc.

Variable return securities

The financial instruments which do not have fixed rate of return are known variable return financial instruments.

Common stocks, floating rate notes and income bonds are the examples of variable return securities.

(D) ON THE BASIS OF ISSUER

Financial assets (instruments) can be divided into two parts on the basis of issuer.

They are corporate financial instruments and government financial instruments.

Corporate securities

The financial instruments which are issued by corporate sectors (companies) are known as corporate financial instruments.

They are common stocks, preferred stock, corporate bonds, commercial papers etc. 

Government securities

The financial instruments which are issued by government are known as government financial instruments.

They are government bonds, treasury bills, development bonds, municipality bonds etc. 

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