Financial Instruments Used in a Capital Market | Financial Management

Financial instruments mean documents that evidence the claims and income or asset as “any contract that gives rise to both a financial asset on one enterprise and a financial liability or equity instrument of another enterprise”.

1. Securities:

‘Securities’ is a general term for a stock exchange investment.

Securities Contract (Regulation) Act, 1956 defines securities as to include:

1. Shares, Scripts, Stocks, Bonds, Debentures.

2. Government Securities.

3. Such other instruments as may be declared by the Central government to be securities.

4. Rights or interests in securities and,

5. Derivatives

6. Securitized instruments

Securities are generally classified into ownership securities and creditorship securities. Equity shares and preference shares are ownership securities. They are also known as capital stock. Creditorship securities are bonds, debentures etc. They are referred to as debt capital.

2. Equity Shares:

Equity Shares are the ordinary shares of a limited company. It is an instrument, a contract, which guarantees a residual interest in the assets of an enterprise after deducting all its liabilities- including dividends on preference shares. Equity shares constitute the ownership capital of a company. Equity holders are the legal owners of a company.

Equity shares are regarded as the cornerstones of the capital structure of a company. They are the source of permanent capital which does not have a maturity date. As the owners of equity shares, the equity shareholders participate in the management of the company through the elected board of directors, and through the voting rights in important decisions. They share the profits and assets in proportion to their holding in the net assets of the company.

Advantages of Equity Shares:

Following are the advantages of equity shares:

1. Permanent Capital:

It provides permanent capital to the company. The capital need not be repaid as long as the company is a going concern.

2. No Fixed Charge on Income:

Payment of dividend is a management policy. Company is not legally bound to declare dividend even if there is sufficient earnings. Dividend payment can be postponed. This adds flexibility.

3. Base for Further Borrowings:

Lenders generally lend on the basis of paid up capital and reserve. This is the net worth of the company. A higher net worth increases financial capability.

4. Trading on Equity is Possible:

When borrowing becomes cheaper, company can borrow money and invest. The whole earnings after the interest belongs to the shareholders.

5. Voting Rights:

As the owners of capital equity shareholders can express their opinion on all important matters through their voting right.

Blue Chip Shares:

These are shares of Blue Chip Companies. Blue Chip Companies are growth oriented companies showing signs of expansion, diversification, modernization of technology etc. They have consistent profitability and profit margins to sustain consistent dividend distribution. Colgate, Hindustan Lever, L&T, Reliance etc. are some examples of blue Ship companies. Thus, blue chips are common stock in a company known nationally for the quality and wide acceptance of its products or services.

Blue chips are of two types viz. emerging blue chip and established blue chips. Emerging blue chip companies are those which are turn-around companies and exhibit potentiality to grow and expand in sales and in net profit. Established blue chips are those companies who are leaders in the Industry like Reliance, Raymonds, TISCO etc.

They have a strong capital base and net worth, organized and professionalized management etc. There are uninterrupted dividends, bonus issues, right issues for investors. Such companies’, shares are worth holding for long and are recommended in all portfolios on investors.

Equity Shares with Detachable Warrants:

Fully paid up shares can be issued with detachable warrants. This will enable the warrant holder to apply for specified number of equity shares at determined price. Detachable warrants are registered separately with the stock exchange and traded separately.

Sweat Equity Shares:

These are equity shares issued by the company to employees or directors at a discount or for consideration other than cash.

3. Preference Shares:

The Companies Act (Sec, 85), 1956 describes preference shares as those which Carry a preferential right to payment of dividend during the life time of the company and Carry a preferential right for repayment of capital in the event of winding up of the company.

Preference shares have the features of equity capital and features of fixed income like debentures. They are paid a fixed dividend before any dividend is declared to the equity holders.

Features of Preference Shares

Following are the features of Preference Shares:

1. Priority to Dividend:

Preference share dividend is payable on a fixed rate. Usually the dividend is a percentage of the par value of the share. It must be paid before any equity dividend is paid.

2. Cumulative Nature:

Cumulative nature means that when dividends are not paid in a particular year they will be accumulated in the coming years. No dividend can be paid on equity shares until all arrears on preference stock are paid up. However, there are non- cumulative preference stock also. In this case, there is no guarantee that the unpaid dividend will be paid in future even if the profitability of the concern improves. Hence, the cumulative feature is necessary to project the right of preference shareholders.

3. Non-Participatory:

This means that the holders of such shares are not entitled for a share in the extra profit earned by the company. Their return will remain at the agreed rate whatever be the profit level of the company. There are, however, occasional issues of participating preferences shares also.

4. Preference as to Assets on Winding Up:

Preference shares are given preference in liquidation. Where the company dissolved, the funds from the sale of the assets go first to the various classes of creditors according to the seniority of their claims. The preference shareholders get the next priority.

5. Convertibility:

Convertible preferences shareholders are allowed to convert their preferential holdings, fully or partly into equity shares at a specified conversion rate during a given period of time. This right of conversion is exercised by preference shareholders mostly to participate in the excess earnings of the company or to gain ownership control.

6. Non-Voting:

Preference shareholders have no voting right on ordinary matters of corporate policy.

Types of Preference Shares:

1. Redeemable Preference Shares:

These shares are redeemed after a given period.

Such shares can be repaid by the company on certain conditions, viz.;

a. The shares must be fully paid up.

b. It must be redeemed either out of profit or out of reserve fund for the purpose.

c. The premium must be paid if any.

A company may opt for redeemable preference shares to avoid fixed liability of payment, increase the earnings of equity shares, to make the capital structure simple or such other reasons.

2. Irredeemable Preference Shares:

These shares are not redeemable except on the liquidation of the company.

3. Convertible Preference Shares:

Such shares can be converted to equity shares at the option of the holder. Hence, these shares are also known as quasi equity shares. Conversion of preference shares in to bonds or debentures is permitted if company wishes. The conversion feature makes preference shares more acceptable to investors. Even though the market for preference shares is not good at a point of time, the convertibility will make it attractive.

4. Participating Preference Shares:

These kinds of shares are entitled to get regular dividend at fixed rate. Moreover, they have a right for surplus of the company beyond a certain limit.

5. Cumulative Preference Shares:

The dividend payable for such shares is fixed at 10%. The dividend not paid in a particular year can be cumulated for the next year in this case.

6. Preference Shares with Warrants:

This instrument has certain number of warrants. The holder of such warrants can apply for equity shares at premium. The application should be made between the third and fifth year from the date of allotment.

7. Fully Convertible Cumulative Preference Shares:

Part of such shares, are automatically converted into equity shares on the date of allotment. The rest of the shares will be redeemed at par or converted in to equity after a lock in period at the option of the investors.

4. Debentures:

Debenture is an instrument under seal evidencing debt. The essence of debenture is admission of indebtedness. It is a debt instrument issued by a company with a promise to pay interest and repay the principal on maturity. Debenture holders are creditors of the company. Sec 2 (12) of the Companies Act, 1956 states that debenture includes debenture stock, bonds and other securities of a company. It is customary to appoint a trustee, usually an investment bank- to protect the interests of the debenture holders. This is necessary as debenture deed would specify the rights of the debenture holders and the obligations of the company.

Types of Debentures:

1. Secured Debentures:

Debentures which create a charge on the property of the company is a secured debenture. The charge may be floating or fixed. The floating charge is not attached to any particular asset of the company. But when the company goes into liquidation the charge becomes fixed. Fixed charge debentures are those where specific asset or group of assets is pledged as security. The details of these charges are to be mentioned in the trust deed.

2. Unsecured Debentures:

These are not protected through any charge by any property or assets of the company. They are also known as naked debentures. Well established and credit worthy companies can issue such shares.

3. Bearer Debentures:

Bearer debentures are payable to bearer and are transferable by mere delivery. Interest coupons are attached to the certificate or bond. As interest date approaches, the appropriate coupon is ‘clipped off by the holder of the bond and deposited in his bank for collection. The bank may forward it to the fiscal agent of the company and proceeds are collected. Such bonds are negotiable by delivery.

4. Registered Debentures:

In the case of registered debentures the name and address of the holder and date of registration are entered in a book kept by the company. The holder of such a debenture bond has nothing to do except to wait for interest payment which is automatically sent him on every payment date.

When such debentures are registered as to principals only, coupons are attached. The holder must detach the coupons for interest payment and collect them as in the case of bearer bonds.

5. Redeemable Debentures:

When the debentures are redeemable, the company has the right to call them before maturity. The debentures can be paid off before maturity, if the company can afford to do so. Redemption can also be brought about by issuing other securities less costly to the company in the place of the old ones.

6. Convertible Debentures:

When an option is given to convert debentures in to equity shares after a specific period, they are called as convertible debentures.

7. Non-Convertible Debentures With Detachable Equity Warrants:

The holders of such debentures can buy a specified number of shares from the company at a predetermined price. The option can be exercised only after a specified period.

5. Bonds:

Bonds are debt instruments that are issued by companies/governments to raise funds for financing their capital requirements. By purchasing a bond, an investor lends money for a fixed period of time at a predetermined interest (coupon) rate. Bonds have a fixed face value, which is the amount to be returned to the investor upon maturity of the bond.

During this period, the investors receive a regular payment of interest, semi-annually or annually, which is calculated as a certain percentage of the face value and known as a ‘coupon payment.’ Bonds can be issued at par, at discount or at premium. A bond, whether issued by a government or a corporation, has a specific maturity date, which can range from a few days to 20-30 years or even more.

Both debentures and bonds mean the same. In Indian parlance, debentures are issued by corporates and bonds by government or semi-government bodies. But now, corporates are also issuing bonds which carry comparatively lower interest rates and preference in repayment at the time of winding up, comparing to debentures.

The government, public sector units and corporates are the dominant issuers in the bond market. Bonds issued by corporates and the Government of India can be traded in the secondary market.

Basically there are two types of bonds viz.:

1. Government Bonds – are fixed income debt instruments issued by the government to finance their capital requirements (fiscal deficit) or development projects.

2. Corporate Bonds – are debt securities issued by public or private corporations that need to raise money for working capital or for capital expenditure needs.

The different types of bonds are:

i. Zero Coupon Bonds:

Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity, the principal/face value is repaid to the holders. No interest (coupon) is paid to the holders. The difference between issue price (discounted price) and redeemable price (face value) itself acts as interest to holders. These types of bonds are also known as Deep Discount Bonds.

ii. Mortgage Bonds:

This is the common type of bond issued by the corporates. Mortgage bonds are secured by physical assets of the corporation such as their building or equipment.

iii. Convertible Bonds:

This type of bond allows the bond holder to convert their bonds into shares of stock of the issuing corporation. Conversion ratio (number of equity shares in lieu of a convertible bond) and the conversion price (determined at the time of conversion) are pre-specified at the time of bonds issue.

iv. Step-Up Bonds:

A bond that pays a lower coupon rate for an initial period which, then increases to a higher coupon rate.

v. Callable and Non-Callable Bonds:

If a bond can be called (redeemed) prior to maturity, the bond is said to be callable. If a bond cannot be called prior to maturity, it is said to be non-callable.

vi. Option Bonds:

In this type, the investors have the option to choose between cumulative or non-cumulative bonds. In the case of cumulative bonds interest is accumulated and is payable on maturity only. In non-cumulative type interest is paid periodically.

vii. Bonds with Warrants:

A warrant allows the holder to buy a number of equity shares at a pre-specified price in future. Bonds are issued with warrants to make it more attractive.

viii. Floating Rate Bonds:

Floating rate bonds are bonds wherein the interest rate is not fixed and is linked to a benchmark rate.

6. Government Securities:

Securities issued by the central government or state governments are referred to as government securities (G-Secs).

A Government security may be issued in one of the following forms, namely:

1. A Government promissory note payable to or to the order of a certain person, or

2. A bearer bond payable to bearer, or

3. A stock, or

4. A bond held in a ‘bond ledger account,

They have the safety and security of investments made in them with regularity of return. These are guaranteed by the government. The papers issued by the Bank of England used to have gift-edged borders. The term is believed to have originated from there. Thus, gilt edged securities or gilt securities have the strong consistent record of earnings and can be relied on the cover dividends and interest.

The central government raises funds through the issue of dated securities (securities with maturity period ranging from two years to 30 years, long-term) and treasury bills (securities with maturity periods of 91 or 364 days, short-term).

State governments go about raising money through State Development Loans (SDLs). Local bodies of various states like municipalities also tap the bond market from time to time.

They are issued in denominations of Rs. 100 or Rs. 1000. The interest is payable half yearly. They are issued through the public debt office of RBI (PDO). The Public Debt Office (PDO) of RBI manages the government issues. G-secs may be issued in Physical form or in dematerialised form. They are issued by RBI in consultation with Government, through auctions conducted electronically.

Types of Government Securities:

Following are the types of Government Securities:

1. Promissory Notes:

Promissory Notes are instruments containing the promises of the Government to pay interest at a specified rate. Interests are usually paid half yearly. Interest is payable to the holder only on presentation of the promissory notes. They are transferable by endorsement and delivery.

2. Stock Certificates (Inscribed Stock):

Stock certificate, also known as Inscribed Stock, is a debt held in the form of stock. The owner is given a certificate inserting his name after registering in the books of PDO of RBI. The execution of transfer deed is necessary for its transfer. Since liquidity is affected, these are not much favoured by investors. One will have to wait till maturity to get it encashed.

3. Bearer Bonds:

A bearer bond is an instrument issued by government, certifying that the bearer is entitled to a specified amount on the specified date. Bearer bonds are transferable by mere delivery. Interest Coupons are attached to these bonds. When the periodical interest falls due, the holder clips off the relevant coupon and presents it to the concerned authority for payment of interest.

4. Dated Securities:

They are long term Government securities or bonds with fixed maturity and fixed coupon rates paid on the face value. These are called dated securities because these are identified by their date of maturity and the coupon, e.g., 12.60% GOI BOND 2018 is a Central Government security maturing in 2018, which was issued on 23.11.1998 bearing security coupon 400095 with a coupon of 12.06 % payable half yearly. At present, there are Central Government dated securities with tenure up to 30 years in the market. Dated securities are sold through auctions. They are issued and redeemed at par.

5. Zero Coupon Bonds:

These bonds are issued at discount to face value and to be redeemed at par. As the name suggests there is no coupon/interest payments. These bonds were first issued by the GOI in 1994 and were followed by two subsequent issues in 1995 and 1996 respectively.

6. Partly Paid Stock:

This is a stock where payment of principal amount is made in installments over a given time frame. It meets the needs of investors with regular flow of funds and the needs of Government when it does not need funds immediately. The first issue of such stock of eight year maturity was made on November 15, 1994 for Rs. 2000 crore. Such stocks have been issued a few more times thereafter.

7. Floating Rate Bonds:

These are bonds with variable interest rate, which will be reset at regular intervals (six months). There may be a cap and a floor rate attached, thereby fixing a maximum and minimum interest rate payable on it. Floating rate bonds of four year maturity were first issued on September 29, 1995.

8. Bonds with Call/Put Option:

These are Govt. bonds with the features of options where the Govt. (issuer) has the option to call (buy) back or the investor can have the option to sell the bond (Put option) to the issuer. First time in the history of Government Securities market RBI issued a bond with call and put option in 2001-02. This bond was due for redemption in 2012 and carried a coupon of 6.72%. However the bond had call and put option after five years i.e. in the year 2007. In other words, it means that holder of bond could sell back (put option) bond to Government in 2007 or Government could buy back (call option) bond from holder in 2007.

9. Capital Indexed Bonds:

These are bonds where interest rate is a fixed percentage over the wholesale price index. The principal redemption is linked to an index of inflation (here wholesale price index). These provide investors with an effective hedge against inflation. These bonds were floated on December, 1997 on an on tap basis. They were of five year maturity with a coupon rate of 6 per cent over the wholesale price index.

10. Fixed Rate Bond:

Normally government securities are issued as fixed rate bonds. In this type of bonds the coupon rate is fixed at the time of issue and remains fixed till redemption.

Gold bonds, National Defence bonds, Special Purpose Securities, Rural Development bonds, Relief bonds, Treasury bill etc. are other types of Government securities.

The major investors in G-Secs are banks, life insurance companies, general insurance companies, pension funds and EPFO. Other investors include primary dealer’s mutual funds, foreign institutional investors, high net-worth individuals and retail individual investors.

Most of the secondary market trading in government bonds happens on OTC (Over the Counter), the Negotiated Dealing System and the wholesale debt-market (WDM) segment of the National Stock Exchange.