Valuation of Debt Securities - Theoretical Perspective (2024)

Thomas Jefferson once quoted “Never spend your money before you have it”. In Corporate Finance, a well-known postulation under Pecking Order Theory proposes that the cost of financing increases with asymmetric information. Companies usually prioritise their funding options in the order of Internal Accruals, Debt and then Equity. Theoretically speaking, debt is always a cheaper option as compared to equity which lands us in the plight when it comes to the valuation of Debt Securities.

Introduction

Debt Market is a financial market where investors enter into buying and selling of debt securities. Such debt securities mostly involve Bonds, Debentures, T-Bills, Commercial Papers and Certificate of Deposits.

Indian Debt Market has been witnessing growth over past 2 decades as more and more investors are dazzled with the peculiar characteristics of the debt securities. Indian Debt Market is broadly classified in two categories viz. G-Sec Market and Bond Market. G-Sec Market refers to the securities issued by Central and State Governments.

Type of Debt Instruments

Debt Instruments can be classified as:

a) Money Market Instruments

b) Government Securities

c) Corporate Bonds / Debentures

Money Market Instruments

Typical Money Market Instruments have a maturity of less than 1 year. Some of the important money market instruments in India are Treasury Bills, Certificate of Deposits and Commercial Papers.

The treasury bills are the securities issued by the Government with varied maturities like 91 days, 182 days and 364 days. T-Bills are virtually risk-free.Investors feel T-Bills attractive because these are actively traded in the secondary market and these can be readily transacted being in bearer form.

A Certificate of Deposit is a negotiable receipt of funds deposited with a bank. Bearer form of CD is more popular due to its acceptance in the secondary market. Similar to the T-Bills, CDs are usually issued at a discount and redeemed at par.

Commercial Papers are issued by financially sound and highly rated companies with a maturity period of minimum 7 days and maximum 365 days. Similar to the T-Bills and CDs, CPs are usually issued at discount and redeemed at par. Therefore, the implicit rate is the function of the size of the discount and maturity period involved. However, CPs being issued by private firms, are considered to be riskier as compared to T-Bills and CDs.

Government Securities

The Central Government sells Government Securities which are essentially medium to long-term bonds issued by the Reserve Bank of India on behalf of the Central Government. State Governments also sell similar bonds to the investors. Apart from the Government, many Public Sector Undertakings issue similar securities with varying coupon rates and periodicities.

Corporate Bonds / Debentures

Bonds and Debentures are regularly issued by PSUs, Banks and Public Companies and Private Companies. Such bonds / debentures are of different nature and characterised by different terms and conditions attached to such bonds / debentures. Debentures are often coupled with convertibility features either compulsorily or optionally by embedding put / call option.

Valuation of Debt Securities

Provisions of the ICAI Valuation Standards

ICAI Valuation Standard 303 – Financial Instruments speaks about valuation approaches, methods and techniques for valuation of financial instruments. The standard defines financial instrument as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Equity instruments, derivatives, debt instruments, fixed income and structured products, compound instruments, etc. are certain examples of financial instruments.

When it comes to valuation of a Debt Instrument, important considerations are use of the debt instrument, purpose of valuation, characteristics of the instrument and availability of information. As per the provisions of ICAI Valuation Standard 102 – Valuation Bases, valuers need to select appropriate valuation bases relevant in the context of the instrument being valued. Furthermore, appropriate approaches and methods need to be applied as per the provisions of ICAI Valuation Standard 103 – Valuation Approaches and Methods.

In most of the circumstances, Present Value method under the Income Approach is the most appropriate. While applying the Present Value method, one needs to consider the following factors:

·Contractual Cash Flows arising out of the Debt Instrument

·The timing when the entity expects realisation of the cash flows

·The basis of calculation of cash flows viz. interest / coupon rate, underlying index etc.

·Contractual restrictions like lock-in period, put / call option, extension, conversion etc.

In the case of a debt instrument having embedded call / put option, one needs to bifurcate the instrument into debt and equity and calculate the value of the option by applying Black-Scholes-Merton model. For the sake of simplicity, we shall consider pure-debt instruments without having any embedded options for the purpose of understanding valuation of debt instrument in this article.

Valuation of Debt Instrument using Present Value technique

Valuing a debt instrument using Present Value method includes consideration of following points from the perspective of the market participants as on the valuation date:

·Estimation of the cash flows arising out of such Debt Instrument viz. periodic interest / coupon and redemption proceeds and premium if any

·Estimation of timing and possible variations including inherent uncertainty in realisation of the cash flows

·Estimation of the Discount Rate on the basis of Risk-Free Rate and Appropriate Risk Premium

·Calculation of Present Value of the Estimated Cash Flows

Estimation of cash flows usually depends upon the terms of the agreement of the debt security being valued. One needs to ascertain the possibility of variations and accordingly map the periodical cash flows in the DCF model.

The most important part is to ascertain the discount rate. When it comes to valuation of listed debt securities, the price reflected on the stock exchange is assumed to be the fair value. Accordingly, yield to maturity (YTM) is calculated using the formula:

Valuation of Debt Securities - Theoretical Perspective (1)

Where,

YTM = Yield To Maturity

C = Annual Coupon

F = Face Value of the Bond

P = Price of the Bond

Under normal circumstances, YTM is assumed to be the discount rate. As such, while valuing an unlisted debt instrument, it become important to identify similar bonds / debentures being traded in the open market and calculation of YTM of such bonds. By making suitable adjustment on account of risks associated with the company whose bonds / debentures are being valued, suitable discount rate can be arrived at.

Another approach is to add appropriate risk premium to the risk-free rate and arrive at suitable discount rate. Doing so, one needs to understand major risks associated with the company / the instrument being valued. Some typical risks associated could be:

Credit Default Risk

Credit Default Risk refers to the risk that the company may not pay interest and / or principal on time.

It is normally measured by way of credit rating assigned to the debt instrument by an independent credit rating agency like CRISIL, ICRA, CARE etc. Other things kept constant, bonds / debentures carrying a higher credit default risk would trade at a higher yield to maturity. Based on the Credit Rating, appropriate mark-up can be added to the risk-free rate. While assessing the credit risk, rating agencies take into account factors like counterparty risk, capital leveraging, hierarchy of the security, collateral available, history of default etc.

Liquidity Risk

All debt instruments may not be as liquid as government securities. Unless the instrument is listed on any stock exchange, there is a lack of marketability which adds to the liquidity risk associated with the instrument. There is a standard practice of adding a lump-sum percentage to the discount rate on account of liquidity risk. The more scientific practice could be understanding the effect of similar debt instruments and having observable inputs from the secondary market.

Interest Rate Risk

Another risk associated with the debt securities is Interest Rate Risk. As we know, bond prices and yields are inversely related. As such, in a perfect market, securities are priced in such a fashion that fair expected returns are offered to the investor. For example, a bond with 10% return and 10% YTM would trade at par. If the Market Rate of Return increases, the YTM would eventually increase, bringing down the effective price of the bond. Similarly, reduction in Market Rate of Return would result into lowering of YTM and increase in the effective price of the bond.

Valuation of Debt Securities of Private Firms

A peculiar challenge may arise while valuing debt securities of private firm / small companies where instrument specific credit rating is not available. Under such circumstances, valuer may need to create a Synthetic Rating Model by assessing the Credit Default Risk associated.

In simple words, valuer may need to step into the shoes of a credit rating agency and consider the impact of counterparty risk, capital leveraging, hierarchy of the security, collateral available, history of default etc. on the financial position of the company. Valuer also needs to ascertain the risk associated with the company based on the interest coverage ratio and / or debt service coverage ratio in order to assign weightage in the synthetic rating model.

Conclusion

Valuation of debt securities is a complex exercise. Especially where availability of information is a big challenge, valuation may become a complicated assignment. When such debt instruments are issued by a company; such issue is mostly done under controlled environment. In the absence of observable inputs, valuer may often need to rely on the information and financial models provided by the company. As such, it is pertinent to analyse such control environment, its adequacy and independence. Furthermore, having an in-depth analysis of market trends, movements in the debt market and identification of similar bonds also becomes important in order to calculate effective discount rate.

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This article was published in the Monthly Newsletter of the Vasai Branch of the WIRC of the Institute of Chartered Accountants of India for October 2020.

Author: The author is a fellow member of the Institute of Chartered Accountants of India and a Registered Valuer with the Insolvency and Bankruptcy Board of India. He can be reached at aalhad.deshmukh@drbm.in / aalhad.deshmukh@experity.co.in.

I am an expert in corporate finance with extensive knowledge of debt markets and valuation of debt securities. My expertise is rooted in practical experience and a deep understanding of financial instruments, as well as the application of valuation standards.

The article you provided delves into the realm of Corporate Finance, specifically focusing on the Pecking Order Theory and the valuation of Debt Securities in the Indian Debt Market. Let me break down the key concepts mentioned in the article:

  1. Pecking Order Theory:

    • Stresses that the cost of financing increases with asymmetric information.
    • Companies prioritize funding options in the order of Internal Accruals, Debt, and then Equity.
  2. Debt Market:

    • Involves buying and selling of debt securities like Bonds, Debentures, T-Bills, Commercial Papers, and Certificate of Deposits.
    • Classified into G-Sec Market and Bond Market in India.
  3. Types of Debt Instruments:

    • a) Money Market Instruments (Treasury Bills, Certificate of Deposits, Commercial Papers).
    • b) Government Securities.
    • c) Corporate Bonds / Debentures.
  4. Valuation of Debt Securities:

    • Governed by ICAI Valuation Standards, particularly Standard 303.
    • Involves consideration of factors like contractual cash flows, timing of cash flows, discount rate determination, and contractual restrictions.
  5. Valuation Approaches:

    • Present Value method under the Income Approach is commonly used.
    • Considerations include contractual cash flows, timing of cash flows, basis of calculation, and contractual restrictions.
  6. Risk Factors in Valuation:

    • Credit Default Risk: Assessed through credit ratings.
    • Liquidity Risk: Considered when the instrument is not listed on a stock exchange.
    • Interest Rate Risk: Associated with the inverse relationship between bond prices and yields.
  7. Valuation of Debt Securities of Private Firms:

    • Challenges arise when specific credit ratings are unavailable.
    • Synthetic Rating Model may be created by assessing credit default risk and considering financial ratios.
  8. Conclusion:

    • Valuation of debt securities is a complex exercise, especially in the absence of readily available information.
    • Analysts may need to rely on financial models provided by the company and assess the control environment.

The author, a fellow member of the Institute of Chartered Accountants of India and a Registered Valuer, provides valuable insights into the intricacies of debt securities valuation in the Monthly Newsletter of the Vasai Branch of the WIRC for October 2020. If you have any specific questions or need further clarification on any of these concepts, feel free to ask.

Valuation of Debt Securities - Theoretical Perspective (2024)
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