Debt Instruments

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1.

Debt Instruments

A contractual arrangement in which the issuer agrees to pay interest and repay the
borrowed amount after a specified period of time is a debt instrument. Certain features
common to all debt instruments are:

 Maturity – the number of years over which the issuer agrees to meet the
contractual obligations is the term to maturity. Debt instruments are classified
on the basis of the time remaining to maturity
 Par value – the face value or principal value of the debt instrument is called
the par value.
 Coupon rate – agreed rate of interest that is paid periodically to the investor
and is calculated as a percentage of the face value. Some of the debt
instruments may not have an explicit coupon rate, for instance zero coupon
bonds. These bonds are issued on discount and redeemed at par. Thus the
difference between the investor’s investment and return is the interest earned.
Coupon rates may be fixed for the term or may be variable.
 Call option – option available to the issuer, specified in the trust indenture, to
‘call in’ the bonds and repay them at pre determined price before maturity.
Call feature acts like a ceiling f or payments. The issuer may call the bonds
before the stated maturity as it may recognize that the interest rates may fall
below the coupon rate and redeeming the bonds and replacing them with
securities of lower coupon rates will be economically beneficial. It is the same
as the prepayment option, where the borrower prepays before scheduled
payments or slated maturity

o Some bonds are issued with ‘call protection feature, i.e they would not be called for
a specified period of time

o Similar to the call option of the issuer there is a put option for the investor, to sell
the securities back to the issuer at a predetermined price and date. The investor may
do so anticipating rise in the interest rates wherein the investor would liquidate the
funds and alternatively invest in place of higher interest

• Refunding provisions – in case where the issuer may not have cash to redeem the
debt instruments the issuer may issue new debt instrument and use the proceeds to
repay the securities or to exercise the call option.

Debt instruments may be of various kinds depending on the repayment:

 Bullet payment – instruments where the issuer agrees to repay the entire
amount

at the maturity date, i.e lumpsum payment is called bullet payment

 Sinking fund payment – instruments where the issuer agrees to retire a


specified

portion of the debt each year is called sinking fund requirement


 Amortization – instruments where there are scheduled principal repayments

before maturity date are called amortizing instruments

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