TAMIL NADU NATIONAL LAW SCHOOL

CORPORATE LAW I PROJECT

CORPORATE BONDS: A SECURED INVESTMENT

SUBMITTED IN THE PARTIAL FULFILLMENT OF B.COM. L.L.B (Hons.), FIFTH SEMESTER

Submitted to: Asst. Prof. M. L. Shankar Karmughilan

Submitted by: Bhagwat Sharma

Registration no: BCO140019

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 TABLE OF CONTENTS

CHAPTER 1...04
INTRODUCTION

CHAPTER 2. .07
DEBT SECURITIES: GENERAL OVERVIEW

CHAPTER 3...08
CORPORATE BONDS

CHAPTER 4...09
PROTECTION OF CREDITORS

CHAPTER 5...11
SEBI: PRTECTECTION OF INVESTORS INTEREST

CHAPTER 6...12
CREDIT RATING OF DEBT INSTRUMENTS

CHAPTER 7...13
ADVANTAGES AND RISKS INVOLVED IN CORPORATE BONDS

CHAPTER 8...17
VARIETY OF BONDS

CHAPTER 9...19
CONCLUSION

CHAPTER 10.....20
BIBLIOGRAPHY

LIST OF ABBREVIATIONS

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Govt. - Government
SEBI - Securities Exchange board of India
RBI Reserve Bank of India
CRISIL - Credit rating and information services of India limited
ICRP - Investment Information and Credit Rating Agency of India Limited
CARL - Credit Analysis and Research Limited
DCR - Duff and Phelps Credit Rating India Private Limited

CORPORATE BONDS: A SECURED INVESTMENT

CHAPTER 1

INTRODUCTION

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Bonds are instruments of finance that are used to gather huge sums of money by both
governmental and corporate bodies. Government needs funds for infrastructure projects to social
programmes and companies need money to expand their business since the requirement of
money cannot be met by banks. Therefore, money is raised by issuing bonds in public markets.
Interest are paid by the borrower of the bond to the investor at fixed rate, this interest rate is
called coupon. Bonds have a maturity date on which the issuer pays the borrowed amount to the
investor. This maturity rate can vary from 1 day to 40 years.

A person holding bonds is a creditor to the company, he does not enjoy any voting rights as in
the case of stocks, he has no share in the profits of the company but enjoys a fixed interest rate
(coupon), in case of a bankruptcy he will be given preference over the shareholder. Bonds are
preferred over stocks because in stock a huge amount of risk is involved. A retired person cannot
think to invest his money in risky ventures as now he does not have a fixed income. There are
different types of bonds like government bonds which are issues by the central government,
municipal bonds issued by the city municipalities, corporate bonds in which a company can issue
bonds just like it issues shares, though these bonds carry higher risks than bonds issued by the
government but this is compensated by the higher coupon rates offered by corporate to attract the
investors, zero coupon bonds in which no interest is paid. These bonds are issued on discount
and redeemed at par.

It is concluded that bonds are both a secured and an unsecured form of investment it all
depends on the type of bond that an investor goes for and from which issuer. The interest on
bond depends on whether the economy is going through an inflation phase or not. The rate of
interest is also dependent on the maturity period of the bond.1

DEBT V. EQUITY
The interest rate paid on debt security is tax deductible unlike the dividends paid on the equity
shares this makes debt cheaper option than equity.2

1 Available at, http://www.investopedia.com/university/bonds/bonds4.asp , Last

accessed on 27th Oct. 2016

2 Hayne E. Leland, Corporate debt value, bond covenants, and optimal capital structure, THE JOURNAL
OF FINANCE, 12131252(1994), last accessed on 30th Oct. 2016

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Debt securities are traded in secondary market and are listed on stock market though most of the
trading takes place over the counter (OTC). A owner of equity share has a stake in the company and
shares both profits and losses of the company on the contrary a debt owner is a creditor to the
Company and has no share in the profits but as a creditor he ranks above shareholders in case of
insolvency.

Debt financing provides a wide range of options as compared to equity financing option( for
equity there is only issue of shares that to preference and normal) on the contrary debt financing
provides more variety that helps in selection of the most apt option in the given circumstances.
Other difference is the control in equity the shareholders have significant role they exert control
over the directors in relation to issuing of new shares but debt financing is an overall corporate
decision taken by the directors solely.

STATEMENT OF PROBLEM

It is often said that bonds are a secured form of investment and there are no risks in bonds but it
is not so. The present paper analyses and discusses whether corporate bonds are a secured form
of investment or not. Investors have the notion that interest paid on bonds are less in comparison
to stocks and once money is invested in bonds it can only be redeemed after the bonds get
matured, the paper also discusses about what protection does a creditor requires when he
advances the loan and the various aspects of bonds that are not known to investors like the
regulators in the market and the role played by them.

SCOPE, OBJECTIVE AND SIGNIFICANCE

The following Project aims to study different aspects of bonds. The present study has condensed
the topic into why are bonds considered as secured investment option by the investor, the study
further discusses what bonds are and the risks associated with it and the protection of the

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 creditors with a comparative analysis between Debt and equity along with the advantages and
disadvantages of bonds and credit rating of debt instruments.

RESEARCH QUESTIONS

1. What do you mean by Corporate Bonds?

(i) Why are corporate bonds considered as secured investment or a better investment
option?
(ii) What are the various advantages and risks involved in corporate bonds?
(iii) How are bonds classified and their various types?
2. How are creditors protected?

(i) How SEBI protects the investments of investors in securities?

3. What do you mean by credit rating of debt instruments?

RESEARCH METHODOLOGY

In this project, we have adopted Doctrinal type of research. Doctrinal research is essentially a
library-based study, which means that the materials needed by a researcher may be available in
libraries, archives and other data-bases. Various books were used to get the adequate materials
essential for this project. Our research methodology requires gathering relevant data from the
specified documents and compiling databases in order to analyze the material and arrive at a
more complete understanding and historical reconstruction.

CHAPTER 2

DEBT SECURITIES: GENERAL OVERVIEW

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These are tradable instruments issued by the companies to raise money from the lenders. These
lenders are usually high in numbers and these securities are mostly issued in the primary market
with limited number of investors, after issuing they can be traded in the secondary market
however all debt securities are not traded a few are kept with the original owner till maturity (eg.
Loan notes).3

A large number of debt securities are issued by the government these are highly rated (although it
too depends on the credit rating of the government) long term debt securities are known as bonds
or notes however notes have floating interest rates.

When securities are issued two sides are considered namely investors and the issuer. Investors
are not in a position to negotiate so it is the lead manager that decides what sort of bonds the
investors would buy at what rates keeping in mind the level of covenants and purpose of
financing (whether the issue fulfills the requirement), adjustability/flexibility of term (call
options with the company) and what features should be kept for the benefit of investors and for
the protection of creditors.

Debt securities attract investors as they provide them with steady income and they are tradable in
recognized markets i.e. without waiting for the bonds to mature they can be traded thus the risk
of default is transferred to someone else.4

CHAPTER 3

CORPORATE BONDS

Bonds are securities that represent a debt owned by the issuer to the investor. Bonds obligate the

3 Available at, https://www.lexisnexis.com/uk/lexispsl/bankingandfinance/document/391289/57DN-

7YJ1-F185-X3YY-00000-00/Types%20of%20debt%20securities%E2%80%94overview, last accessed on
29th Oct. 2016

4 Ibid.

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issuer to pay a specified amount at a given date, generally with periodic interest payments. The
par, face, or maturity value of the bond is the amount that the issuer must pay at maturity.5

Every financial advisor advises its investor to invest in diverse investments to be on a safer side,
bonds provide income semiannually or annually at fixed rates this provides for a security for its
investors like retirees whose major source of income now is the fixed interest rate had he
invested in stocks then this income would have been unpredictable and there would have been no
security for him.6

In every market there is a risk of rise and fall in prices of shares hence it is better to diversify
ones option, it is a general observation in the market that bond prices and stock prices tend to
move in contrary directions i.e. when stock market doesnt perform well then bond prices are
rising and vice a versa. Hence it is better to have a cushion in form of bonds to help investors in
time of crises.

The return on bonds investment is influenced by two factors mainly: rate of interest offered on
bonds and the rate of inflation. The cost of a commodity (it can be a financial instrument like
bond) increases over a period of time this is known as erosion of purchasing power.7

5 Dr. G K Kapoor & Sanjay Dhamija, Company Law, ( 18th edn, Taxmann Publication
Pvt Ltd 2015)

6 Ibid.

7 Available at, https://www.sec.gov/investor/alerts/ib_corporatebonds.pdf , Last accessed on 25th Oct.

2016

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CHAPTER 4

PROTECTION OF CREDITORS

CONTRACTUAL AND PROPRIETARY

In credit the most important factor that the creditor sees is his protection, before moving on to the
topic we need to discuss about a few aspects like: what protection does a creditor requires when
he advances is loan and how does this affect the transaction. When a creditor lends credit the
most important factor that he sees is his protection or the credit risk. This risk is moderated by
obtaining rights either contractual or proprietary with agreement to borrower. The distinction
between the two rights can be seen in situation of insolvency where a creditor having proprietary
rights has a priority over general unsecured creditors and creditors with contractual rights will
come under the latter category.

Proprietary rights are further divided into absolute and security interest, a creditor with absolute
interest becomes the absolute owner of the asset. In security interest there is an obligation to
repay the borrower with surplus in the value of asset further charges could be fixed or floating. In
case of a fixed charge the borrower cannot dispose of the asset charged without his consent
whereas in case of floating charge the borrower can dispose of the asset without the consent.

Contractual rights- They are divided into rights against borrowers and rights against third
parties. Rights offered against third party are more valuable in case of insolvency where the
borrower is hardly in a condition to repay examples of these rights are insurances, guarantees and
credit default swap.

PROTECTION BY MEANS OF REGULATION

Creditors are protected by way of regulations laid down by the statues that impose fulfillment of
certain conditions before a transaction is entered into this limiting the transactions between
creditors and borrowers.

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Some areas of debt financing are highly regulated due to the amount of risk they involve the
creditor into and further the market hence debt securities are regulated like the equity securities
thus insuring accurate and exact information to the creditors.

In India the regulators of the debt market are Reserve bank of India (RBI) and the Securities
Exchange board of India (SEBI). The RBI looks after debt securities and determines the
guidelines as to how a commercial bank can raise money from general public whereas SEBI in
involved in regulation of secondary role and determining the guideline for raining money
through public issues.8

There are various legislations introduced by the government to regulate debt securities like:

Government securities act, 2006

Government securities and regulation act, 2007

SEBI (Disclosure and Investor Protection) guideline, 2000

SEBI (Issue and listing of debt securities) regulations, 2008

SEBI ICDR Regulations, 2009

As in case of covered bonds which are backed by assets belonging to the issuer, so in case of
insolvency the payment on bonds would be made from those assets in priority to other creditors.

GOVERNMENT SECURITIES ACT, 2006

These were introduced to offer safety, liquidity and attractive returns to the investors with these
act govt. securities (saving and relief bonds) have become investor friendly. According to the act
government securities (G-sec) are those which are issued by the govt. for the purpose of raising a
public loan or any other purpose as notified in the gazette. The various forms of securities are
govt. promissory note, bearer bond.9

8 Avtar Singh, Company Law, ( 16th edn, Eastern Book Company 2015 )

9 Dr. G K Kapoor & Sanjay Dhamija, Company Law and Practice, ( 20th edn, Taxmann Publication Pvt
Ltd 2015)

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CHAPTER 5

SEBI: PROTECTION OF INVESTORS INTEREST

It is the duty of SEBI to protect the investment of investors in securities, promote develop and
regulate secondary market. In order to carry on these functions it has been vested with the
following powers:

a. Regulation of business in stock exchanges and other securities.

b. Registering and regulating working of stock brokers, investment advisors, portfolio
managers and all other people who are associated with the security market.
c. Registering and regulation of collective investment scheme.
d. Prohibition of fraudulent trade practices associated with securities market.
e. Prohibiting insider trading.
f. Regulating substantial acquisition of shares and mergers of companies.
g. Calling information, undertaking inspection, conducting inquiries and audits of stock
exchanges and self-regulatory organizations in security market.
h. Performing functions that may be prescribed.10

SEBI introduced effective and strong measures against violations by intermediaries. The stock
exchanges were asked to implement uniform norms for imposition of circuit breakers and trading
suspensions in cases where price manipulation was suspected. A trading database has been
created within the SEBI for trades on NSE and BSE. Where price manipulations are detected,
auction proceeds are frozen and impounded so that they do not accrue to manipulators.11

10 Ibid.

11 Ibid.

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CHAPTER 6

CREDIT RATING OF DEBT INSTRUMENTS

Security rating or credit rating in India is mandatory for issuance of debt instruments. These
security ratings are judgments about firms financial and business prospects. It is defined as

A process by which a statistical service prepares various rating identified by symbols which are
indicators of the investment quality of securities rated 12 the securities can be either debt or
equity.

In case of debt rating is given while in case of shares, grading is done. This is done to help
investors know the financial position of the instrument.

The rating industry in India was ushered in 1998 with the setting up of credit rating and
information services of India limited (CRISIL) followed by three more the latest devoted to
rating entirely

NBFCS. These credit rating agencies are regulated by SEBI since 1999. These agencies can be
promoted by a financial institution or a co. with net worth more than Rs. 100 crore. Credit rating
agencies should have minimum net worth of Rs. 5 cr. they are prohibited from rating instruments
of their promoters.

In India there are four credit rating agencies namely:

i. Credit rating and information services of India limited (CRISIL) set up by ICICI and UTI
in 1998.
ii. Investment Information and Credit Rating Agency of India Limited (ICRA) set up by FCI
in 1991.
iii. Credit Analysis and Research Limited (CARL) promoted by IDBI in 1993 in association

12 Supra Note 6.

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 with financial institution.
iv. Duff and Phelps Credit Rating India Private Limited (DCR India) for rating non banking
financial companies for fixed deposits.13

CHAPTER 7

ADVANTAGES AND RISKS INVOLVED IN CORPORATE BONDS

In laymans terms bonds are considered more secure than other forms of financing due to the
following reasons:

1. Bonds are less volatile in comparison to shares, the day to day volatility of bonds is lesser
than stocks and interest payments of bonds are at times higher than general dividends.

2. Bonds are easy to sell as they are liquid it is possible for bondholders to sell bonds
without much a difference in its prices as compared to equity, bonds provide a steady
income to its holders as the interest rate is fixed.

3. Bonds enjoy legal protection if a company goes insolvent they will be preferred over the
stock holders and bonds too comes with covenants that specifies the duties of issuer and
the rights of bondholders. These limit the amount of interest the firm can pay and ability
of the firm to issue additional debt so as to conserve cash for payment of interest to
bondholders. More the restrictions are put the interest rates would be lower as the
investment would be a safer one for the investor.

4. Interest rate risk: longer the time until the bond matures greater will be the change in
price, this does not however cause any harm to those that do not sell their securities

13 Available at, http://www.sebi.gov.in/investor/addcra.html , Last accessed on 26th

Oct. 2016

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 before maturity.14

Although bonds are considered as a secure form of investment yet there are risks that are
associated with it such as:

1. Inflation risk are associated with long term bonds as bonds interest rates are fixed their
value can erode with rising inflation thus reducing the real interest rate value of bonds in
the long run.15

An example to illustrate the above risk would be:

A company offers for sale its securities to the general public, the prices of the security are
fixed at 4,000 Rs. At the time of offer under the terms the co. promises to pay 10,000 Rs.
to the owners of the securities after 7 years and no intermediate interest are paid. An
investor will definitely think about the opportunity cost of investment whether he should
part away with 4,000 right now to earn 10,000 in the future. Although it appears that one
gets 2.5 times the investment but what would the erosion in purchasing power of rupee
after 7 years? One has to evaluate the present value of 10,000 Rs. receivable after 7 years.
This will help in arising the actual return on investment that one has earned.

2. Interest rate risk is another type of risk associated with bonds in this type usually if new
bonds are sold at higher interest rates by the company then the old bonds prices fall as
older, lower yielding bonds are less attractive to the investors and vice a versa.16

14 Supra Note 6.

15 Paul Conley, The Risk of bond Investing: understanding dangers in fixed income investing,
http://bonds.about.com/od/bonds101/a/bondrisk.htm , Last accessed on 28th Oct. 2016

16 Bond investing Risk, CNN Money,

th
http://money.cnn.com/magazines/moneymag/money101/lesson7/index5.htm , Last accessed on 25 Oct. 2016

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 3. Call risk are associated with corporate and municipal bonds where the issuer of the bonds
has an option to call back or redeem the bonds before its maturity and they are paid at
par this usually happens when the rates fall below the interest rates payable on bonds the
issuer issues new bonds with low interest rates.17

A second reason for firms to issue bonds that include call provision is that firm may have
to retire a bond issue if the covenants restrict the firm from carrying on activities that are
in the interest of the shareholders. Suppose a firm may need additional funds for
introducing a storage facility. If the bonds carry a restriction on adding debt then the firm
has to retire its existing bonds before introducing new bonds.

Credit risk: Not all bondholders are able to make payments on time this depends on their
credit rating and their financial health, there are financial institutions like Standard &
Poor's and Moody's that evaluate the credit worthiness of corporations and governments
and then provide them with credit rating (AAA rating is provided to strongest issuer with
high credit worthiness)18

5. Bonds also suffer from the market risks of supply and demand, popular the bond more is
its value (we could see it in the recent economic meltdown of Asian and Russian markets
how the prices of US Treasury bond rose up).

6. Even bonds like municipal are not default free. A study by Fitch rating report 0.63%
default in municipal bonds. These default rates are higher during weak economic periods,
local governments unlike federal governments are not able to print money and further
there are limits on taxes imposed by them. This point out that even government bonds are

17 Supra Note 14.

18 Supra Note 16.

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 a risky option at times.19

7. Price risk: The extent to which price changes every day is price risk. It is a combination
of a). Default risk and b). Interest rate risk

a. DEFAULT RISK: It arise when issuer is not able to satisfy the terms and conditions of
the obligation with respect to the timely payment of interest and repayment of the
principal amount borrowed. If default occurs then the investor does not loses the
entire amount but only a certain part. The part that is recovered is known as recovery
rate.

b. INTEREST RISK: It is known that the price of a bond changes in opposite direction
with a change in interest rate i.e. when interest rate raises then a bonds price will fall;
and when interest rate will fall then the bond price will rise. Since the price of bond
fluctuates with the market interest rate hence the risk that an investor faces is that the
price of the bond held in portfolio will decline in market interest rate rises. This risk is
the interest rate risk and is the major risk faced by investors in the bond market.

19 Supra Note 3.

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CHAPTER 8

VARIETY OF BONDS

Bonds are available in large varieties raging from vanilla bonds to zero coupon bonds to euro
bonds so it depends on the investor to choose from the available bonds the best suitable to him. A
vanilla bond is a promise by the issuer to pay both the interest and principal debt on the maturity
of the bond. The documentation involves interest rate payable, details of payment, redemption,
administrative and covenant to protect the investors and maximize the profits of the issuers.

A zero coupon bond are issued at discount there are no interest paid on it, it is redeemed at its
face value (the amount paid on its maturity) hence the interest payments are paid in the end,
when the bond matures, it used to have tax advantage as the income was seen as a capital gain
rather than income but now many jurisdictions have changed their tax legislation so that it is seen
as interest.20

ABS (asset backed securities) bonds are issued on the basis of repayment that comes from
income producing assets such as receivables; these types of bonds are not issued by the original
owners of the receivables but by a special purpose vehicle (SPV) which has brought the
receivables from the original owner. The original owner gets cash in return of future debts ( and
acts as a service provider for the SPV, collects in the receivable and pays out proceeds to
bondholders, thus receiving fees for it). This form of financing is securitization and is a form of
alternative for the owner of the receivables, to some form of sale of receivables to a financier or
to taking a loan from a bank secured on receivable.

Deep discount bonds: these are issued at high discount rates at the face value, and the face value

20 Supra Note 6.

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is paid at the time of maturity IDBI bank have issued bonds of such nature of face value 1 lack
rupees at Rs. 2700 with a maturity period of 25 years.21

Convertible bonds: These bonds give an option to the investor to convert their bonds into equity
at a fixed determined rate whereas in case of dual convertible bonds they have an option to
convert into equity or debentures.

Easy exit bonds: These bonds provide liquidity and easy to exit route to investors by way of
redemption by which investors have the option of encashment of their bonds before maturity
period. In floating rate bound the interest rates are not fixed and they are allowed to change
according to the market conditions this is helpful for the investors as it saves them from volatile
market conditions.

Commodity bonds: These bonds are issued to share the risks and profits of future price of
commodities with the investors e.g. Petrol bonds, silver bonds.

Secured bonds: These are bonds that have collateral attached to them. For example mortgage
bonds used to finance a specific project, a building may be collateral for bonds issued for its
construction. In event the firm fails to pay the bondholders they have a right to liquidate the
property and be paid. These bonds are more secure than unsecured bonds as they have collateral
attached to them.22

21 Available at, http://money.cnn.com/pf/money-essentials-bond-types/ , Last

accessed on 28th Oct. 2016

22 Supra Note 21.

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CHAPTER 9

CONCLUSION

It is concluded that Bonds are both a secured and a unsecured form of investment it all depends
on the type of bond that an investor goes for and from which issuer, a US Treasury bill is far
more secured than a Treasury bill of a third world country, but still even the bonds of high rated
countries are never safe there are risks attached with it too. The interest on bond depends on the
market conditions whether the economy is going through an inflation phase or not or whether
their interest rate provided by the current debt securities are more or less than the purchased
bonds rate of interest are dependent on the type of bond also whether it is a deep coupon bond or
a zero coupon bond (one with no interest rate) or an index bond (one that is inflation protected)
or a junk bond (which has huge risks attached with it). The rate of interest is also dependent on
the maturity period of the bond. During the past couple of years the transactions in bonds have
grown a couple of times in India however it is the government securities that are more traded
into then the private corporate institutions the people are still hesitant to invest into the securities
of the private sector given the large amount of risk involved. Over the years numerous stringent
legislations have been made in India by SEBI, whose job is to safeguard and protect the interest
of the investors, these have helped in securing and protecting the investors. A lot of things have
been done on bonds but a lot needs to be done, it is the present and the future for corporations
and governments who seek funds for financing of projects.23

23 Available at,
http://www.mondaq.com/india/x/227488/debt+capital+markets/Corporate+Bonds+I
n+India , Last accessed 28th Oct. 2016

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CHAPTER 10

BIBLIOGRAPHY

PRIMARY SOURCES:
The SEBI Act, 1992

The Government Securities Act, 2006

SECONDARY SOURCES

ARTICLES REFERRED:

Hayne E. Leland, Corporate debt value, bond covenants, and optimal capital structure,
THE JOURNAL OF FINANCE, 12131252(1994), last accessed on 30th Oct. 2016
http://www.investopedia.com/university/bonds/bonds4.asp , Last accessed on 27th Oct.
2016
https://www.lexisnexis.com/uk/lexispsl/bankingandfinance/document/391289/57DN-
7YJ1-F185-X3YY-00000-00/Types%20of%20debt%20securities%E2%80%94overview,
last accessed on 29th Oct. 2016
https://www.sec.gov/investor/alerts/ib_corporatebonds.pdf , Last accessed on 25th Oct.
2016
http://scholarship.law.georgetown.edu/cgi/viewcontent.cgi?article=1575&context=facpub
, Last accessed on 29th Oct. 2016
http://www.sebi.gov.in/investor/addcra.html , Last accessed on 26th Oct. 2016
Paul Conley, The Risk of bond Investing: understanding dangers in fixed income
investing, http://bonds.about.com/od/bonds101/a/bondrisk.htm , Last accessed on 28th
Oct. 2016

20 | P a g e
 Bond investing Risk, CNN Money,
http://money.cnn.com/magazines/moneymag/money101/lesson7/index5.htm , Last
accessed on 25th Oct. 2016
http://money.cnn.com/pf/money-essentials-bond-types/ , Last accessed on 28th Oct. 2016
http://www.mondaq.com/india/x/227488/debt+capital+markets/Corporate+Bonds+In+Ind
ia , Last accessed 28th Oct. 2016

BOOKS REFFERED:
Dr. G K Kapoor & Sanjay Dhamija, Company Law, ( 18th edn, Taxmann Publication Pvt
Ltd 2015)
Avtar Singh, Company Law, ( 16th edn, Eastern Book Company 2015 )
Dr. G K Kapoor & Sanjay Dhamija, Company Law and Practice, ( 20th edn, Taxmann
Publication Pvt Ltd 2015)

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