1. Term Loans, Debentures/Bonds and Securitisation
Chapter 23
Term Loans, Debentures/Bonds and Securitisation
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2. TERM LOANS, DEBENTURES/BONDS AND SECURITISATION
Debentures/Bonds/Notes
Securitisation
Solved Problem
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Term Loans
Term (long-term) loan is a loan made by a bank/financial institution to a business having an initial maturity of more than 1 year.
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Features of Term Loans
Maturity  
The maturity period of term loans is typically longer in case of sanctions by financial institutions in the range of 6-10 years in comparison to 3-5 years of bank advances. However, they are rescheduled to enable corporates/borrowers tide over temporary financial exigencies.
Negotiated
The term loans are negotiated loans between the borrowers and the lenders. They are akin to private placement of debentures in contrast to their public offering to investors
Security  
All term loans are secured. While the assets financed by term loans serve as primary security, all the other present and future assets of the company provide collateral/secondary security for the term loan.
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Covenants
To protect their interest, the financial institutions reinforce the asset security stipulation with a number of restrictive terms and conditions. These are known as covenants. They are both positive/affirmative and negative in the sense of what the borrower should and should not do in the conduct of its operations and fall broadly into four sets as respectively related to assets, liabilities, cashflows and control.
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Negative Covenants
Asset-Related Covenants are intended to ensure the maintenance of a minimum asset base by the borrowers. Included in this set of covenants are:
Maintenance of working capital position in terms of a minimum current ratio,
Restriction on creation of further charge on asset,
Ban on sale of fixed assets without the lenders concurrence/approval.
Liability-Related Covenants  may, inter alia, include:
Restrain on the incurrence of additional debt/repayment of existing loan, say, without the concurrence/prior approval of the lender/financial institution,
Reduction in debt-equity ratio by issue of additional capital, and
Prohibition on disposal of promoters shareholding.
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Cashflow Related Covenants  which are intended to restrain cash outflows of the borrowers may include:
Restriction on new projects/expansion without prior approval of the financial institution,
Limitation on dividend payment to a certain amount/rate and prior approval of the financial institutions for declaration of higher amount/rate,
Arrangement to bring additional funds as unsecured loans/deposits to meet overrun/shortfall, and
Ceiling on managerial salary and perks.
Control Related Covenants  aim at ensuring competent management for the borrowers. This set of covenants may include
Boroadbasing of board of directors and finalisation of management set-up in consultation with the financial institution,
Effective organisational changes and appointment of suitable professional staff, and
Appointment of nominee directors to represent the financial institutions and safeguard their interests.
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Positive Covenants
In addition to the foregoing negative covenants, certain positive/affirmative covenants stating what the borrowing firm should do during the term of a loan are also included in a loan agreement. They provide, inter alia, for
furnishing of periodical reports/financial statements to the lenders,
maintenance of a minimum level of working capital,
creation of sinking fund for redemption of debt and
maintenance of certain net worth.
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Repayment Schedule/Loan Amortisation 
The term loans have to be amortised according to predetermined schedule. The payment/repayment has two components:
Interest and
Repayment of principal.
The interest component of loan amortisation is a legally enforceable contractual obligation. The borrowers have to pay a commitment charge on the unutilised amount.
Typically, the principal is repayable over 6-10 years period after an initial grace period of 1-2 years. Whereas the mode of repayment of term loans is equal semi-annual instalments in case of institutional borrowings, the term loans from banks are repayable in equal quarterly instalments.
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TABLE 1  Loan Amortisation Schedule (Equal Principal Repayment)
(Rs thousands)
Year
Beginning loan
Principal repayment
Interest (0.14)
Loan payment
Ending loan 
(1)
(2)
(3)
(4)
(5)
(6) 1
60.00
7.50
8.40
15.90
52.50 2
7.35
14.85
45.00 3
6.30
13.80
37.50 4
5.25
12.75
30.00 5
4.20
11.70
22.50 6
3.15
10.65
15.00 7
2.10
9.60 8
7.60
1.05
8.55
0.00
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The debt servicing/loan amortisation pattern involving equal instalment (interest + repayment of principal) is portrayed in Table 2.
TABLE 2  Loan Amortisation Schedule (Equal Instalment)
Year
Beginning loan
Payment
Interest (0.14)
Principal repayment
[3 – 4]
Ending loan 
[2 – 5]  
(1)
(2)
(3)
(4)
(5)
(6) 1
Rs 60,000
Rs 12,934
Rs 8,400
Rs 4,535
Rs 55,466 2
55,466
12,934
7,776
5,168
50,298 3
7,042
5,896
44,406 4
6,216
6,718
37,688 5
5,276
7,658
30,030 6
4,204
8,730
21,300 7
2,982
9,952
11,348 8
1,588
11,346
@ Payment instalment = (Rs 60,000/PVIFA 8,14) = (Rs 60,000/4.6389) = Rs 12,934
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Term Loan Procedure  The procedure associated with a term loan involves the following principal steps:
The borrower submits an application form which seeks comprehensive information about the project. The application form covers the following aspects:
Promoters’ background,
Particulars of the industrial concern,
Particulars of the project (capacity, process, technical arrangements, management, location, land and buildings, plant and machinery, raw materials, effluents, labour, housing, and schedule of implementation),
Cost of project,
Means of financing,
Marketing and selling arrangements,
Profitability and cash flow,
Economic considerations, and
Government consents.
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Project Appraisal  
Financial institutions appraise a project from the marketing, technical, financial, economic, and managerial angles. The principal issues considered and the criteria employed in such appraisal are discussed below.
Market Appraisal  
The importance of the potential market and the need to develop a suitable marketing strategy cannot be over-emphasised. Hence, efforts are made to (i) examine the reasonableness of the demand projections, (ii) assess the adequacy of the marketing infrastructure in terms of promotional effort, distribution network, transport facilities, stock levels and so on, and (iii) judge the knowledge, experience, and competence of the key marketing personnel.
Technical Appraisal  
The technical review done by the financial institutions focuses mainly on the following aspects: (i) product mix, (ii) capacity, (iii) process of manufacture, (iv) engineering know-how and technical collaboration, (v) raw materials and consumables, (vi) location and site, (vii) building, (viii) plant and equipment, (ix) manpower requirements, and (x) break-even point.
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Financial Appraisal  The financial appraisal seeks to assess the following:
Reasonableness of the Estimate of Capital Cost  While assessing the capital cost estimates, efforts are made to ensure that (i) padding or under-estimation of costs is avoided, (ii) specification of machinery is proper, (iii) proper quotation are obtained from potential suppliers, (iv) contingencies are provided, and (v) inflation factors are considered.
Reasonableness of the Estimate of Working Results  The estimate of working results is sought to be based on (i) a realistic market demand forecast, (ii) price computations for inputs and outputs that are based on current quotations and inflationary factors, (iii) an approximate time schedule for capacity utilisation, and (iv) cost projections that distinguish between fixed and variable costs.
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Adequacy of Rate of Return  The general norms for financial desirability are as follows: (i) internal rate of return, 15 per cent, (ii) return on investment, per cent after tax, (iii) debt-service coverage ratio, 1.5 to 2. In applying these norms, however, a certain degree of flexibility is shown on the basis of the nature of the project, the risks inherent in the project, and the status of the promoter.
Appropriateness of the Financing Pattern  The institutions consider the following in assessing the financial pattern: (i) a general debt-equity ratio norm of 1.5:1, (ii) a requirement that promoters should contribute a certain percentage of the project cost, (iii) stock exchange listing requirements, and (iv) the means of the promoter and his capacity to contribute a reasonable share of the project finance.
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Managerial Appraisal  In order to judge the managerial capability of the promoters, the following aspects are considered:
Resourcefulness This is judged in terms of the prior experience of the promoters, the progress achieved in organising various aspects of the project, and the skill with which the project is presented.
Understanding This is assessed in terms of the credibility of the project plan (including, inter alia, the organisation structure, the staffing plan, the estimated costs, the financing pattern, the assessment of various inputs, and the marketing programme) and the details furnished to the financial institutions.
Commitment This is gauged by the resources (financial, managerial, material, and other) applied to the project and the zeal with which the objectives of the project, short-term as well as long-term, are pursued. Managerial review also involves an assessment of the calibre of the key technical and managerial personnel working on the projects, the schedule for training them, and the remuneration structure for rewarding and motivating them.
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17. Debentures/Bonds/Notes
Debenture/bond is a debt instrument indicating that a company has borrowed certain sum of money and promises to repay it in future under clearly defined terms.
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Attributes
As a long-term source of borrowing, debentures have some contrasting features compared to equities .
Trust Indenture  When a debenture is sold to investing public, a trustee is appointed through an indenture/trust deed.
Trust (bond) indenture is a complex and lengthy legal document stating the conditions under which a bond has been issued.
Trustee is a bank/financial institution/insurance company/ firm of attorneys that acts as the third party to a bond/debenture indenture to ensure that the issue does not default on its contractual responsibility to the bond/ debentureholders.
Interest The debentures carry a fixed (coupon) rate of interest, the payment of which is legally binding/enforceable. The debenture interest is tax-deductible and is payable annually/semi-annually/quarterly.
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Maturity 
It indicates the length of time for redemption of par value. A company can choose the maturity period, though the redemption period for non-convertible debentures is typically 7-10 years. The redemption of debentures can be accomplished in either of two ways:
(1) Debentures redemption reserve (sinking fund)
A DRR has to be created for the redemption of all debentures with a maturity period exceeding 18 months equivalent to at least 50 per cent of the amount of issue/redemption before commencement of redemption.
(2) Call and put (buy-back) provision.
The call/buy-back provision provides an option to the issuing company to redeem the debentures at a specified price before maturity. The call price may be more than the par/face value by usually 5 per cent, the difference being call premium. The put option is a right to the debenture-holder to seek redemption at specified time at predetermined prices.
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Security 
Debentures are generally secured by a charge on the present and future immovable assets of the company by way of an equitable mortgage
Convertibility  
Apart from pure non-convertible debentures (NCDs), debentures can also be converted into equity shares at the option of the debenture-holders. The conversion ratio and the period during which conversion can be affected are specified at the time of the issue of the debenture itself. The convertible debentures may be fully convertible (FCDs) or partly convertible (PCDs). The FCDs carry interest rates lower than the normal rate on NCDs; they may even have a zero rate of interest. The PCDs have two parts:
Convertible part,
Non-convertible part.
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Credit Rating  
To ensure timely payment of interest and redemption of principal by a borrower, all debentures must be compulsorily rated by one or more of the four credit rating agencies, namely, Crisil, Icra, Care and FITCH India.
Claim on Income and Assets 
The payment of interest and repayment of principal is a contractual obligation enforceable by law. Failure/default would lead to bankruptcy of the company. The claim of debenture-holders on income and assets ranks pari passu with other secured debt and higher than that of shareholders–preference as well as equity.
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Evaluation
Advantages  
The advantages for company are (i) lower cost due to lower risk and tax-deductibility of interest payments, (ii) no dilution of control as debentures do not carry voting rights. For the investors, debentures offer stable return, have a fixed maturity, are protected by the debenture trust deed and enjoy preferential claim on the assets in relation to shareholders.
Disadvantages 
The disadvantages for the company are the restrictive covenants in the trust deed, legally enforceable contractual obligations in respect of interest payments and repayments, increased financial risk and the associated high cost of equity. The debenture-holders have no voting rights and debenture prices are vulnerable to change in interest rates.
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Innovative Debt Instruments
In order to improve the attractiveness of bonds/debentures, some new features are added. As a result, a wide range of innovative debt instruments have emerged in India in recent years. Some of the important ones among these are discussed below.
Zero Interest Bonds/Debentures (ZIB/D)  
Also known as zero coupon bonds/debentures, ZIBs do not carry any explicit/coupon rate of interest. They are sold at a discount from their maturity value. The difference between the face value of the bond and the acquisition cost is the gain/return to the investors. The implicit rate of return/interest on such bonds can be computed by Equation 1.
Acquisition price = Maturity (face) value/(1 + i)n (1)
Where I = rate of interest
n = maturity period (years)
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Deep Discount Bond (DDB)  
A deep discount bond is a form of ZIB. It is issued at a deep/steep discount over its face value. It implies that the interest (coupon) rate is far less than the yield to maturity. The DDB appreciates to its face value over the maturity period.
The DDBs are being issued by the public financial institutions in India, namely, IDBI, SIDBI and so on.
Secured Premium Notes (SPNs) 
The SPN is a secured debenture redeemable at a premium over the face value/purchase price. The SPN is a tradeable instrument. A typical example is the SPN issued by TISCO in Its salient features were
Each SPN had a face value of Rs 300. No interest would accrue during the first year after allotment.
During years 4-7, principal will be repaid in annual instalment of Rs 75. In addition, Rs 75 will be paid each year as interest and redemption premium.
A warrant was attached to the SPN entitling the holder to acquire one equity share for cash by payment of Rs 100.
The holder was given an option to sell back the SPN at the par value of Rs 300.
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The before tax rate of return on the SPN = per cent, that is
Floating Rate Bonds (FRBs)  
The interest on such bonds is not fixed. It is floating and is linked to a benchmark rate such as interest on treasury bills, bank rate, maximum rate on term deposits.
Callable/Puttable Bonds/Debentures/Bond Refunding 
Beginning from 1992 when the Industrial Development Bank of India issued bonds with call features, several callable/puttable bonds have emerged in the country in recent years. The call provisions provide flexibility to the company to redeem them prematurely. Generally, firms issue bonds presumably at lower rate of interest when market conditions are favourable to redeem such bonds.
Evaluation  
The bond refunding decision can be analysed as a capital budgeting decision. If the present value of the stream of net cash savings exceeds the initial cash outlay, the debt should be refunded.
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Example 1 : The 22 per cent outstanding bonds of the Bharat Industries Ltd (BIL) amount to Rs 50 crores, with a remaining maturity of 5 years. It can now issue fresh bonds of 5 year maturity at a coupon rate of 20 per cent. The existing bonds can be refunded at a premium (call premium) of 5 per cent. The flotation costs (issue expenses + discount) on new bonds are expected to be 5 per cent. The unamortised portion of the issue expenses on existing bonds is 1.5 crore. They would be written off as soon as the existing bonds are called/refunded.
If the BIL is in 35 per cent tax bracket, would you advise it to call the bond?
Solution  
(Amount in Rs crore)
Annual net cash savings (Working note 2)
0.71
PVIFA (10,13) (Working note 3)
3.517
Present value of annual net cash savings
2.497
Less: Initial outlay ((Working note 1)
3.600
NPV (bond refunding)
(1.103)
It is not advisable to call the bond as the NPV is negative.
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Working Notes
(1)(a)Cost of calling/refunding existing bonds
   Face value
     Plus: Call premium (5 per cent)
(b)Net proceeds of new bonds
   Gross proceeds
   Less: Flotation costs
(c)Tax savings on expenses
   Call premium
   Plus: Unamortised issue costs   
Initial outlay [(1a) – (1b) – (1c)]
(2)(a)Annual net cash outflow on existing bonds
  Interest expenses
Less: Tax savings on interest expenses and amortisation of issue costs : 0.35 [ (1.5/5)]
(b)Annual net cash outflow on new bonds
   Interest expenses
Less: Tax savings on interest expenses and amortisation of issue costs : 0.35 [ (2.5/5)]
     Annual net cash savings [(2a) – (2b)]
2.5
1.5
4.0 × (0.35 tax)
50.0
11.00
3.96
10.00
3.67
52.5
47.5
1.40
3.60
7.04
6.33
0.71
(3)Present value interest factor of 5 year annuity, using a 13 per cent after tax [0.20 (1 – 0.35)] cost of new bonds = 3.517
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Issue of Debt Instruments
A company offering convertible/non-convertible debt instruments through an offer document should, in addition to the other relevant provisions of these guidelines, comply with the following provisions.
Requirement of Credit Rating  
A public or rights issue of all debt instruments (i.e. convertible as well as non-convertible) can be made only if credit rating of a minimum investment grade is obtained from at least two registered credit rating agencies and disclosed in the offer document .
Requirement in Respect of Debenture Trustees  
A company must appoint one/more debenture trustee(s) in accordance with the provisions of the Companies Act before issuing a prospectus/letter of offer to the pubic for subscription of its debentures.
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Creation of Debenture Redemption Reserves (DRR)  A company has to create DRR as per the requirements of the Companies Act for redemption of debentures in accordance with the provisions given below:
If debentures are issued for project finance, the DRR can be created up to the date of com-mercial production, either in equal instalments or higher amounts if profits so permit. In the case of partly convertible debentures, the DRR should be created with respect to the non-convertible portion on the same lines as applicable for fully non-convertible debenture issue. In the case of convertible issues by new companies, the creation of DRR should commence from the year the company earns profits for the remaining life of debentures.
Distribution of Dividends  
In case of companies which have defaulted in payment of interest on debentures or their redemption or in creation of security as per the terms of the issue, distribution of dividend would require approval of the debenture trustees and the lead institution, if any.
Redemption  The issuer company should redeem the debentures as per the offer document.
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Disclosure and Creation of Charge  
The offer document should specifically state the assets on which the security would be created as also the ranking of the charge(s). In the case of second/residual charge or subordinated obligation, the associated risks should also be clearly stated.
Requirement of Letter of Option  
Where the company desires to rollover the debentures issued by it, it should file with the SEBI a copy of the notice of the resolution to be sent to the debenture-holders through a merchant bank prior to despatching the same to the debenture-holders. If a company desires to convert the debentures into equity shares (according to the procedure discussed subsequently), it should file with the SEBI a copy of the letter of option to be sent to the debenture-holders through a merchant bank prior to despatching the same to the debenture-holders.
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Rollover of Non-Convertible Portions of Partly Convertible Debentures (PCDs)/Non-Convertible Debentures (NCDs) By Company Not Being in Default
The non-convertible portions of PCDs/NCDs issued by a listed company, the value of which exceeds Rs 50 lakh, can be rolled over without change in the interest rate subject to (i) Section 121 of the Companies Act and (ii) the following conditions, if the company is not in default: (i) passing of a resolution by postal ballot, having assent of at least 75 per cent of the debentures; (ii) redemption of debentures of all the dissenting holders, (iii) obtaining at least two credit ratings of a minimum investment grade within six months prior to the date of redemption and communicating to the debenture-holders before rollover, (iv) execution of fresh trust deed, and (v) creation of fresh security in respect of roll over debentures.
Rollover of NCDs/PCDs By a Listed Company Being in Default  
The non-convertible portion of PCDs/NCDs by listed companies exceeding Rs 50 lakh can be rolled over without change in the interest rate subject to Section 121 of the Companies Act and the following conditions, namely, (a) a resolution by postal ballot, having assent of at least 75 per cent of the debenture-holders,(b) along with the notice for passing the resolution, send to the debenture-holders auditor’s certificate on the cash flow of the company with comments on its liquidity position, (c) redemption of debentures of all the dissenting debenture-holders, and (d) decision of the debenture trustee about the creation of fresh security and execution of fresh trust deed in respect debentures to be rolled over.
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Additional Disclosures in Respect of Debentures  The offer document should contain:
premium amount on conversion, time of conversion;
in case of PCDs/NCDs, redemption amount, period of maturity, yield on redemption of the PCDs/NCDs;
full information relating to the terms of offer or purchase, including the name(s) of the party offering to purchase, the khokhas (non-convertible portion of PCDs);
the discount at which such an offer is made and the effective price for the investor as a result of such discount;
the existing and future equity and long-term debt ratio;
servicing behaviour on existing debentures, payment of due interest on due dates on term loans and debentures and
a no objection certificate from a financial institution or banker for a second or pari passu charge being created in favour of the trustees to the proposed debenture issues has been obtained.
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Secondary Market for Corporate Debt Securities  Any listed company making issue of debt securities on a private placement basis and listed on a stock exchange should comply with the following:
It should make full disclosures (initial and continuing) in the manner prescribed in Schedule II of the Companies Act, 1956, SEBI (Disclosure and Investor Protection) Guidelines, 2000 and the Listing Agreement with the exchanges.
The debt securities should carry a credit rating of not less than investment grade from a credit rating agency registered with the SEBI.
The company should appoint a debenture trustee registered with the SEBI in respect of the issure of debt securities.
The debt securities should be issued and traded in demat form.
The company should sign a separate listing agreement with the stock exchange in respect of debt securities and comply with the conditions of listing.
All trades with the exception of spot transactions, in a listed debt security, should be ex-ecuted only on the trading platform of a stock exchange.
The trading in privately placed debts should only take place between qualified QIBs and high networth individuals (HNIs), in standard denomination of Rs 10 lakhs.
The requirement of Rule 19(2)(b) of the Securities Contract (Regulation) Rules, 1957 would not be applicable to listing of privately placed debt securities on exchanges, provided all the above requirements are complied with.
If the intermediaries with the SEBI associate themselves with the issuance of private placement of unlisted debt securities, they will be held accountable for such issues.
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Rating of Debt Instruments
Credit rating of debentures by a rating agency is mandatory. It provides a simple system of gradation by which relative capacities of borrowers to make timely payment of payment and repayment of principal on a particular type of debt instrument can be noted. The main elements of the rating methodology are
Business risk analysis
Financial risk analysis
Management risk.
The rating agencies in India are CRISIL, ICRA, CARE and Fitch India.
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Business Risk Analysis  
The rating analysis begins with an assessment of the company’s environment focusing on the strength of the industry prospects, pattern of business cycles as well as the competitive factors affecting the industry. The vulnerability of the industry to Government controls/regulations is assessed. The main industry and business factors assessed include:
Industry Risk  Nature and basis of competition, key success factors, demand and supply position, structure of industry, cyclical/seasonal factors, government policies and so on.
Market Position of the Issuing Entity Within the Industry  Market share, competitive advantages, selling and distribution arrangements, product and customer diversity and so on.
Operating Efficiency of the Borrowing Entity  Locational advantages, labour relationships, cost structure, technological advantages and manufacturing efficiency as compared to competitors and so on.
Legal Position  Terms of the issue document/prospectus, trustees and their responsibilities, systems for timely payment and for protection against fraud/forgery and so on.
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Financial Risk Analysis  
After evaluating the issuer’s competitive position and operating environment, the analysts proceed to analyse the financial strength of the issuer. Financial risk is analysed largely through quantitative means, particularly by using financial ratios. While the past financial performance of the issuer is important, emphasis is placed on the ability of the issuer to maintain/improve its future financial performance. The areas considered in financial analysis include:
Accounting Quality  Overstatement/understatement of profits, auditors qualifications, method of income recognition, inventory valuation and depreciation policies, off Balance sheet liabilities and so on.
Earnings Protection  Sources of future earnings growth, profitability ratios, earnings in relation to fixed income charges and so on.
Adequacy of Cash Flows  In relation to debt and working capital needs, stability of cash flows, capital spending flexibility, working capital management and so on.
Financial Flexibility  Alternative financing plans in times of stress, ability to raise funds, asset deployment potential and so on.
Interest and Tax Sensitivity  Exposure to interest rate changes, tax law changes and hedging against interest rates and so on.
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Management Risk  
A proper assessment of debt protection levels requires an evaluation of the management philosophies and its strategies. The analyst compares the company’s business strategies and financial plans (over a period of time) to provide insights into a management’s abilities with respect to forecasting and implementing of plans. Specific areas reviewed include:
Track record of the management: planning and control systems, depth of managerial talent, succession plans;
Evaluation of capacity to overcome adverse situations; and
Goals, philosophy and strategies.
Rating Symbols
Rating symbol is a symbolic expression of opinion of the rating agency regarding the investment/credit quality/grade of the debt instrument/obligation.
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EXHIBIT 1  CRISIL Rating Symbols
The rating of debentures is mandatory. CRISIL assigns alpha-based rating scale to rupee-denominated debentures. It categorises them into three grades namely, high investment, investment and speculations.
 High Investment Grade  includes:
AAA - (Triple A) Highest Security  The debentures rated AAA are judged to offer the highest safety against timely payment of interest and principal. Though the circumstances providing this degree of safety are likely to change, such changes as can be envisaged are most unlikely to affect adversely the fundamentally strong position of such issues.
AA - (Double A) High Safety  The debentures rated AA are judged to offer high safety against timely payment of interest and principal. They differ in safety from AAA issues only marginally.
 Investment Grades  are divided into:
A - Adequate Safety  The debentures rated A are judged to offer adequate safety against timely payment of interest and principal; however, changes in circumstances can adversely affect such issues more than those in the higher rated categories.
BBB - (Triple B) Moderate Safety  The debentures rated BBB are judged to offer sufficient safety to against timely payment of interest and principal for the present: however, changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal than for debentures in higher rated categories.
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CONTD.
 Speculative Grades  comprise:
BB - (Double B) Inadequate Safety  The debentures rated BB are judged to carry inadequate safety of the timely payment of interest and principal; while they are less susceptible to default than other speculative grade debentures in the immediate future, the uncertainties that the issuer faces could lead to inadequate capacity to make interest and principal payments on time.
B - High Risk  The debentures rated B are judged to have greater susceptibility to default; while currently interest and principal payments are met; adverse business or economic conditions would lead to a lack of ability or willingness to pay interest or principal.
C - Substantial Risk  The debentures rated C are judged to have factors present that make them vulnerable to default; timely payment of interest and principal is possible only if favourable circumstances continue.
D - Default  The debentures rated D are in default and in arrears of interest or principal payments or are expected to default on maturity. Such debentures are extremely speculative and returns from these debentures may be realised only on reorganisation or liquidation.
Note: (1) CRISIl may apply ‘+’ (plus) or ‘–’ (minus) signs for ratings from AA to C to reflect comparative standing within the category. The contents within parenthesis are a guide to the pronunciation of the rating symbols.
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EXHIBIT 2  ICRA Rating Symbols
ICRA symbols classify them into eight investment grades.
LAAA Highest Safety  This indicates a fundamentally strong position. Risk factors are negligible. There may be circumstances adversely affecting the degree of safety but such circumstances, as may be visualised, are not likely to affect the timely payment of principal and interest as per terms.
LAA+, LAA, LAA– High Safety  Risk factors are modest and may vary slightly. The protective factors are strong and the prospects of timely payment of principal and interest as per the terms under adverse circumstances, as may be visualised, differs from LAAA only marginally.
LA+, LA, LA– Adequate Safety  Risk factors vary more and are greater during economic stress. The protective factors are average and any adverse change in circumstances, as may be visualised, may alter the fundamental strength and affect the timely payment of principal and interest as per the terms.
LBBB+, LBBB, LBBB– Moderate Safety  This indicates considerable variability in risk factors. The protective factors are below average. Adverse changes in the business/economic circumstances are likely to affect the timely payment of principal and interest as per the terms.
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CONTD.
LBB+, LBB, LBB- Adequate Safety  The timely payment of interest and principal are more likely to be affected by the present or prospective changes in business/economic circumstances. The protective factors fluctuate in case of economy/business conditions change.
LB+, LB, LB– Risk Prone  Risk factors indicate that obligations may not be met when due. The protective factors are narrow. Adverse changes in the business/economic conditions could result in the inability/unwillingness to service debts on time as per the terms.
LC+, LC, LC- Substantial Risk  There are inherent elements of risk and timely servicing of debts/obligations could be possible only in the case of continued existence of favourable circumstances.
LD Default Extremely Speculative  Indicates either already in default in payment of interest and/or principal as per the terms or expected to default. Recovery is likely only on liquidation or reorganisation.
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Securitisation
Securitisation is the process of pooling and repackaging of homogeneous illiquid financial assets, such as residential mortgage, into marketable securities that can be sold to investors.
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Securitisation Process
Asset are originated through receivables, leases, housing loans or any other form of debt by a company and funded on its balance sheet. The company is normally referred to as the “originator”.
Once a suitably large portfolio of assets has been originated, the assets are analysed as a portfolio and then sold or assigned to a third party, which is normally a special purpose vehicle company (‘SPV’) formed for the specific purpose of funding the assets. It issues debt and purchases receivables from the originator.
The administration of the asset is then subcontracted back to the originator by the SPV.
The SPV issues tradable securities to fund the purchase of assets.
The investors purchase the securities because they are satisfied that the securities would be paid in full and on time from the cash flows available in the asset pool.
The SPV agrees to pay any surpluses which, may arise during its funding of the assets, back to the originator.
As cash flow arise on the assets, these are used by the SPV to repay funds to the investors in the securities.
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Credit Enhancement
Credit enhancement are the various means that attempt to buffer investors against losses on the asset collaterising their investment.
External Credit Enhancements  
They include insurance, third party guarantee and letter of credit.
Insurance  Full insurance is provided against losses on the assets. This tantamounts to a 100 per cent guarantee of a transaction’s principal and interest payments. The issuer of the insurance looks to an initial premium or other support to cover credit losses.
Third-Party Guarantee  This method involves a limited/full guarantee by a third party to cover losses that may arise on the non-performance of the collateral.
Letter of Credit  For structures with credit ratings below the level sought for the issue, a third party provides a letter of credit for a nominal amount. This may provide either full or partial cover of the issuer’s obligation.
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Internal Credit Enhancements  Such form of credit enhancement comprise the following:
Credit Trenching (Senior/Subordinate Structure)  The SPV issues two (or more) tranches of securities and establishes a predetermined priority in their servicing, whereby first losses are borne by the holders of the subordinate tranches (at times the originator itself). Apart from providing comfort to holders of senior debt, credit tranching also permits targeting investors with specific risk-return preferences.
Over-collateralisation  The originator sets aside assets in excess of the collateral required to be assigned to the SPV.
Cash Collateral  This works in much the same way as the over-collateralisation. But since the quality of cash is self-evidently higher and more stable than the quality of assets yet to be turned into cash, the quantum of cash required to meet the desired rating would be lower than asset over-collateral to that extent.
Spread Account  The difference between the yield on the assets and the yield to the investors from the securities is called excess spread. In its simplest form, a spread account traps the excess spread (net of all running costs of securitisation) within the SPV up to a specified amount sufficient to satisfy a given rating or credit equity requirement.
Triggered Amortisation  This works only in structures that permit substitution (for example, rapidly revolving assets such as credit cards)..
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Parties to a Securitisation Transaction
The parties to securitisation deal are (i) primary and (ii) others. There are three primary parties to a securitisation deal, namely, originators, special purpose vehicle (SPV) and investors. The other parties involved are obligors, rating agency, administrator/servicer, agent and trustee, and structurer.
Originator is the entity on whose books the assets to be securitised exist.
SPV (special purpose vehicle) is the entity which would typically buy the assets to be securitised from the originator.
Investors  The investors may be in the form of individuals or institutional investors like FIs, mutual funds, provident funds, pension funds, insurance companies and so on.
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Obligors are the borrowers of the original loan.
Rating Agency  Since the investors take on the risk of the asset pool rather than the originator, an external credit rating plays an important role. The rating process would assess the strength of the cash flow and the mechanism designed to ensure full and timely payment by the process of selection of loans of appropriate credit quality, the extent of credit and liquidity support provided and the strength of the legal framework.
Administrator or Servicer  It collects the payment due from the obligor(s) and passes it to the SPV, follows up with delinquent borrowers and pursues legal remedies available against the defaulting borrowers. Since it receives the instalments and pays it to the SPV, it is also called the Receiving and Paying Agent (RPA).
Receiving and paying agent is one who collects the payment due from the obligors and passes it on to the SPV.
Agent and Trustee  It accepts the responsibility for overseeing that all the parties to the securitisation deal perform in accordance with the securitisation trust agreement. Basically, it is appointed to look after the interest of the investors.
Structurer  Normally, an investment banker is responsible as structurer for bringing together the originator, the credit enhancer(s), the investors and other partners to a securitisation deal. It also works with the originator and helps in structuring deals.
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Asset Characteristics: The assets to be securities should have the following characteristics
Cash Flow  A principal part of the assets should be the right to receive from the debtor(s) on certain dates, that is, the asset can be analysed as a series of cash flows.
Security  If the security available to collateralise the cash flows is valuable, then this security can be realised by a SPV.
Distributed Risk  Assets either have to have a distributed risk characteristic or be backed by suitably-rated credit support.
Homogeneity  Assets have to relatively homogenous, that is, there should not be wide variations in documentation, product type or origination methodology.
No Executory Clauses  The contracts to be securitised must work even if the originator goes bankrupt.
Independence From the Originator  The ongoing performance of the assets must be independent of the existence of the originator.
The securitisation process is depicted in Figure 1.
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Obligor
Originator
Ancillary
service provider
Special purpose
vehicle
Investors
Rating agency
Structure
Consideration for
assets purchased
Credit rating of
securities
Subscription of securities
Issue of securities
Sales of assets
Interest and principal
Figure 1: Securitisation Process
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Instruments of Securitisation
Securitisation can be implemented by three kinds of instruments differing mainly in their maturity characteristics. They are:
(1) Pass through certificates
Pass through certificate is a conduit for sale fo ownership in receivables (mortgages).
(2) Pay through securities
The PTS structure overcomes the single maturity limitations of the pass through certificates. Its structure permits the issuer to restructure receivables flow to offer a range of investment maturities to the investors associated with different yields and risks.
(3) Stripped securities
Under this instrument, securities are classifies as Interest only (IO) or Principally only (PO) securities. The IO holders are paid back out of the interest income only while the PO holders are paid out of principal repayments only.
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Types of Securities
The securities fall into two groups:
Asset Backed Securities (ABS)  
The investors rely on the performance of the assets that collateralise the securities. They do not take an exposure either on the previous owner of the assets (the originator), or the entity issuing the securities (the SPV). Clearly, classifying securities as ‘asset-backed’ seeks to differentiate them from regular securities, which are the liabilities of the entity issuing them. An example of ABS is credit card receivables. Securitisation of credit card receivables is an innovation that has found wide acceptance.
Mortgage Backed Securities (MBS)  
The securities are backed by the mortgage loans, that is, loans secured by specified real estate property, wherein the lender has the right to sell the property, if the borrower defaults.
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Principal Terms of the PTCs 
The NHB in its corporate capacity as also in its capacity as a sole trustee of the SPV Trust would issue securities in the form of Class A and Class B PTCs. The Class B PTCs are subordinated to Class A PTCs and act as a credit enhancement for Class A PTC holders. Only Class A PTCs are available for subscription through the issue. The Class B PTCs would be subscribed to by the HDFC itself (i.e. the originator). Their features are listed in Format 1.
FORMAT 1
Particulars
Class A PTCs
Class B PTCs
(a) Senior/subordinate status
(b) Face value
(c) Pass through rate
(d) Tenure
(e) Schedule payment pattern
(f) Subscribed to by
Senior
Rs 9,94,998
11.35% to 11.85% per
annum payable monthly
83 months
In 83 monthly payouts
comprising principal and
interest
Investors
Subordinate
Rs 10,04,062.14
No fixed interest rate but would receive all residual cash flows from the pool
141 months
Redemption of principal amount would begin only after class A PTCs are extinguished, except in case of prepayments
HDFC (the originator)
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Entering Into Memorandum of Agreement  
The HDFC and the NHB entered into a Memorandum of Agreement on July 7, 2000, to entitle the NHB to take necessary steps to securities the said housing loans, including circulation of the Information Memorandum and collection of subscription amount from investors.
Acquisition of the Housing Loans by the NHB  
The NHB would acquire the amount of balance principal of the housing loans outstanding as on the cut-off date, that is, May 31, 2000, along with the underlying mortgages/other securities, under the deed of assignment.
Pool Selection Criteria  
The loans in the pool comply with the following criteria:
The loans were current at the time of selection,
They have a minimum seasoning of 12 months,
The pool consists of loans where the underlying property is situated in the states of Gujarat, Karnataka, Maharashtra and Tamil Nadu,
The borrowers in the pool are individuals,
Maximum LTV (loan to value) ratio is 80 per cent,
Instalment (EMI) to gross income ratio is less than 40 per cent,
EMIs would not be outstanding for more than one month,
Loan size is in the range of Rs 18,000 to Rs 10 lakh,
Borrowers in the pool have only one loan contract with the HDFC,
The HDFC has not obtained any refinance with respect to these loans.
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Pool Valuation and Consideration for the Assignment  
The consideration for the pool would be the aggregate balance principal of the housing loans being acquired, recorded as outstanding in the books of the HDFC as on that cut-off date.
Registration of Deed of Assignment and Payment of Stamp Duty  
The trust has been declared, the assets would cease to be reflected in the books of the NHB. The entire process of buying the receivables pool along with the underlying mortgage security and declaring the trust would be legally completed on the same day. The housing loans acquired by the NHB would be registered with the sub-registrar of a district in which one of the properties is located, in accordance with the provisions of the Transfer of Property Act, 1882 and the Indian Registration Act, The NHB proposed to register the deed of assignment in the State of Karnataka, where the stamp duty is 0.10 per cent ad valorem, subject to an absolute limit of Rs one lakh.
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Declaration of Trust  
After acquiring the housing loans, the NHB would make an express declaration of trust in respect of the pool, by setting apart and transferring the housing loans along with the underlying securities.
Issues of Pass Through Certificates  
Once the housing loans have been declared as property held in trust, the NHB in its corporate capacity as also trustee for the SPV Trust would issue Pass Through Certificates (PTCs) to investors.
Credit Enhancements 
The structure envisages the following credit enhancements for Class A PTCs: (i) Subordinated Class B PTC pay-out,
(ii) Corporate guarantee from the HDFC, and
(iii) Excess spread.
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Other Details  The other details of the securitisation transaction are as follows.
Recovery on Defaults and Enforcement of Mortgages  
The HDFC would administer the housing loans given to the borrowers, in its capacity as the S&P Agent. Administering of such loans would include follow-up for the recovery of the EMIs from the borrowers in the event of delays.
The trustee (NHB) would empower the HDFC, under the provisions of the servicing and paying agency agreement, to enforce the mortgage securities where required, and institute and file suits and all other legal proceedings as may necessary, to recover the dues from defaulting borrowers.
Treatment of Prepayments on the Loans 
Borrowers are permitted to prepay their loans in full or in part, and may be charged a prepayment penalty for the same. Such prepayments in the securitised receivables pool are passed on entirely to the two classes of PTC-holders
In the event of prepayment in a given month, the amount is passed on entirely to the Class A and Class B PTC-holders in proportion to their respective principal balances outstanding as of the beginning of that month.
Treatment of Conversion of Loans  
In case of conversion by the borrowers of a loan from fixed rate to floating rate or vice-versa, or to a lower fixed rate, the loan would continue to remain in the receivables pool. The profit/loss on account of change in the interest rate would accrue to/be borne by the receivables pool and indirectly the Class PTC-holders. The conversion charge received from borrowers who have exercised the option would accrue to the Class B PTC-holders.
Repayment of Loan by the Borrower  
On the borrower having completed repayment in all respects on the loan, the S&P Agent would intimate the trustee and return the documents relating to the mortgage debt to the borrowers.
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SOLVED PROBLEM
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58. Decision analysis for bond refunding decision
Hindustan Copper Industries (HCI) manufactures copper pipe. It is contemplating calling Rs 3 crore of 30-year, Rs 1,000 bonds (30,000 bonds) issued 5 years ago with a coupon interest rate of 14 per cent. The bonds have a call price of Rs 1,140 and had initially collected proceeds of Rs 2.91 crore due to a discount of Rs 30 per bond. The initial flotation cost was Rs 3,60,000. The HCI intends to sell Rs 3 crore of 12 per cent coupon interest rate, 25-year bonds to raise funds for retiring the old bonds. It intends to sell the new bonds at their par value of Rs 1,000. The estimated flotation costs are Rs 4,40,000. The HCI is in 35 per cent tax bracket and its after cost of debt is 8 per cent. As the new bonds must first be sold and their proceeds then used to retire the old bonds, the HCI expects a 2-month period of overlapping interest during which interest must be paid on both the old and the new bonds. Analyse the feasibility of the bond refunding by the HCI.
Solution  
Decision analysis for bond refunding decision
Present value of annual cashflow savings (Refer working note 2):
Rs 3,81,460 × (PVIF8,25)
Rs 40,72,086
Less: Initial investment (Refer working note 1)
32,57,500
NPV
8,14,586
Decision  The proposed refunding is recommended as it has a positive NPV.
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Working Notes
1. Initial investment:
(a) Call premium:
Before tax [(Rs 1,140 – Rs 1,000) × 30,000 bonds]
Rs 42,00,000
Less: Tax (0.35 × Rs 42,00,000)
14,70,000
After tax cost of call premium
Rs 27,30,000
(b) Flotation cost of new bond
4,40,000
(c) Overlapping interest:
Before tax (0.14 × 2/12/ × Rs 3 crore)
7,00,000
Less: Tax (0.35 × 7,00,000)
2,45,000
4,55,000
(d) Tax savings from unamortised discount on old bond
[25/30 × (Rs 3 crore – 2.91 crore) × 0.35]
(2,62,500)
(e) Tax savings from unamortised flotation cost of old
bond (25/30 × Rs 3,60,000 × 0.35)
(10,5,000)
32,57,500
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2. Annual cash flow savings
(a) Old bond
(i) Interest cost:
Before tax (0.14 × 3 crore)
Rs 42,00,000
Less: Tax (0.35 × Rs 42,00,000)
14,70,000
27,30,000
(ii) Tax savings from amortisation of
discount [(Rs ÷ 30) × 0.35]
(10,500)
(iii) Tax savings from amortisation of
flotation cost [(Rs 3,60,000 ÷ 30) × 0.40)
(4,200)
Annual after tax debt payment (a)
27,15,300
(b) New bond
Before tax (0.12 × 3 crore)
36,00,000
Less: Taxes (0.35 × Rs 36,00,000)
12,60,000
After tax interest cost
23,40,000
flotation cost [Rs 4,40,000 ÷ 25) × 0.35
(6,160)
Annual after-tax debt payment (b)
23,33,840
Annual cash flow savings [(a) – (b)]
3,81,460
@Par value – net proceeds for sale.
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