Understanding Bond Market Jargons: A Guide to Key Terms and Ratios
Investing in bonds can be a great way to earn fixed returns and diversify your portfolio. However, navigating through the bond market can be challenging, especially for newcomers, as there are a lot of ratios and terms that can be difficult to understand. As a result, investors often struggle to make informed decisions. In this blog, we will try to break down some of the important terms and ratios in the bond market that will help you make sound investment choices.
In the process of investing in Bonds/ NCDs, one often encounters the term “Secured NCD”. A secured NCD/ Bonds mean that these instruments are backed by collateral such as land, building, receivables, or such other assets. The asset is pledged by the borrower to secure the funds raised through the issuance of NCDs. This reduces the risk of the borrower defaulting and provides a sense of security for the investor. Essentially, this means that in the case of default, the investor can recover the funds by selling off the collateralized asset. Due to the reduced risk, secured NCDs typically offer lower interest rates than unsecured NCDs. Secured NCDs are a useful investment option for individuals seeking a balance of risk and return.
Call/ Put Option
Bonds can also be issued with an option wherein the issuer can have the option to buy back (call option) or the investor can have the option to sell the bond (put option) to the issuer during the tenure of the bond. It may be noted that a bond may have put only or call only or both options.
A call option allows the issuer to redeem the bond before its maturity date. Whereas, with the put option in the bond, the holder has the right to demand the principal back from the issuer by surrendering the bond before maturity.
An investor can exercise put options for reasons like immediate cash requirements, changing interest rate scenarios, rating changes, etc. In such a scenario, they tend to seek a shield via the ‘put option’, which provides an exit route to investors. Thus both call/ put options can be valuable tools for managing risks and maximizing returns in the bond market.
The debt ceiling is the maximum amount up to which the states can borrow money through the issue of bonds. This number is usually a percentage of the gross state domestic product (GSDP). A debt ceiling is nothing but the limit prescribed for borrowing funds from the centre to the respective states.
Bid to Cover Ratio
Bid to cover ratio is the ratio of the number of bids or orders received for a particular security issuance vs. the amount issued. The bid-to-cover ratio indicates the demand for an issuance- the higher the ratio, the higher the demand, and the lower the ratio, the lower the demand.
An offer document is a detailed legal document that an issuer company has to compulsorily file before the public issue of non-convertible debentures etc. before SEBI, ROC, and all stock exchanges where the securities ought to be listed. The offer document also known as Prospectus contains all the details about an investment opportunity. It includes information about the issuer, the terms of the investment, the risks involved, and other important details. This document is usually provided to potential investors before they decide to invest in a particular Bond.
The time period in which the selling or redeeming is not allowed. It is basically the minimum time period for which you have to be invested in a particular security and cannot withdraw the funds before the specified time limit. The lock-in period is commonly seen in 54 EC Bonds, ELSS, Public Provident Funds, etc.
Debt to Income Ratio
The debt-to-income ratio represents the borrower’s capability to repay the debt on the basis of their monthly returns. This ratio represents the borrower’s ability to pay the monthly payments and also the overall repayment of money.
It is calculated by total debt divided by the total income earned by the entity. The more debt the entity borrowers the higher risk of default. Thus, the lower the ratio the better it is as it implies higher credibility of the entity.
NPA stands for non-performing assets. Banks and NBFCs are required to record an advance as NPA when a borrower fails to make interest payments or the principal amount for a predetermined time period. As per the provisions laid by RBI, loans or advances are considered non-performing assets if they remain outstanding for 90 days. However, there are various subdivisions like standard assets, sub-standard assets, doubtful debts, and loss assets on the basis of the time period for which the loan is outstanding. A significant amount of NPA can put a financial burden on the company, making it more vulnerable to losses and decreasing its profitability. A high percentage of NPA can adversely affect the company’s ability to grow and profitability.
Debt to equity ratio
The debt-to-equity ratio is a financial metric that provides insights into the financing structure of the company. It measures the company’s overall debt in comparison to the total shareholder’s fund. This ratio helps determine whether the company is more inclined towards debt or equity financing. The formula to calculate the same is total debt divided by total shareholder’s equity. Total debt includes long-term borrowings, short-term debt, and other fixed payments to be made, while the shareholder’s fund means the residual after reducing total assets from all liabilities. A higher ratio indicates the company primarily relies more on external debt financing whereas a lower ratio suggests the company is more tilted toward equity financing. The optimal ratio varies across industries, so it’s crucial to compare the ratio of a company against its peers to determine its financial health.
Interest Coverage Ratio
The Interest Coverage Ratio is a metric used to evaluate the ability of a company to meet its interest expenses. Investors or lenders often use this ratio to assess the ability of a company or borrowing entity to repay the debt along with the interest. A higher Interest Coverage Ratio indicates that a company can fulfill its debt obligations without having to borrow more money or sell assets. A Lower ratio can raise concerns among investors, borrowers, and others regarding the company’s ability to pay timely interest and principal amounts on its borrowings. The formula for calculating the interest coverage ratio is:
Interest Coverage Ratio = Company’s earnings before interest and taxes/ Interest Expense.
Net worth is the difference between an entity or an organization’s total assets and its total liabilities. It represents the value of an individual’s or a company’s financial position and is used to determine their creditworthiness, and financial soundness at the time of making an investment. A Positive net worth indicates that the company has more assets than liabilities it owes and will be able to repay the borrowed funds.
A term sheet is a document that indicates the vital terms and conditions of a proposed investment. The term sheet contains a summary of the offer/ proposed investment and it includes information about the primary business of the issuer, investment structure, the terms of the bond, the coupon rate, the maturity date, the size of the issue, details of an escrow account or redemption reserve for payment of interest and principal amount and such other details.
CMR- Client Master Report
A client master report is a document that contains all the details about the client and it is issued by the broker where the demat account is held by the client. It is a very important document that is required at the time of making an investment. It includes information like the DP Id, Client Id, name of the account holder, bank account details, contact details, etc.
Understanding these terminologies is essential for making informed decisions when investing in bonds. Whether you are a new or a seasoned investor, it is important to familiarize yourself with these terms so that you can make the most of your investment opportunities.