By Sunil K. Parameswaran
Debt securities may be negotiable or non-negotiable. Many of us trade in equities. Assume that two weeks ago you bought shares of L&T from an unknown party in Ahmedabad, and that today, you have sold it to an unknown party in Hyderabad. These transfers are possible because equity shares are negotiable securities, which can be freely traded in the market.
Principal and interest
However, debt may be negotiable or non-negotiable. Government bonds and corporate bonds may be bought and sold. It is a different issue that many of these securities are illiquid, and consequently we may encounter difficulties while buying or selling. However, take a National Savings Certificate or NSC. At maturity, the original buyer will get back his principal with interest. However, if he requires funds before that, he can pledge the certificate and borrow, but cannot sell it to someone else. Similarly, bank fixed deposits cannot be transferred by the depositor to another party.
Negotiable certificates of deposit or NCDs are nothing but FD receipts that can be traded in the market. What we call a fixed deposit in India, is known as a time deposit or TD, in the US. Normal TD certificates are not tradeable, as is the case in India. However, negotiable CDs are securities which are tradeable in the money market. They are not meant for the small boys, as the minimum ticket size is one million USD in America. There are dealers who make a market in such securities, by quoting bid and ask prices. Buyers and sellers can trade with a dealer of their choice.
The interest rate that is paid by the issuing bank is called the coupon rate. At maturity, the issuer will pay the coupon based on the original term to maturity of the instrument, which is nothing but the term to maturity at the time of issue. For instance, consider an NCD with a principal of one million dollars; a coupon of 4.2% per annum; and an original term to maturity of 162 days.
Assume that the day-count convention is Actual/360, that is, the year is assumed to consist of 360 days, which means that each month is assumed to consist of 30 days. At maturity, the last holder will receive 1,000,000 x[1+ 0.042 x(162÷360)] = 1,018,900. In the US and the EU the day-count convention is Actual/360. In the UK and in India it is Actual/365.
The price of this NCD can be determined prior to maturity by discounting the terminal payoff by the prevailing yield in the market. The discounting is done using the actual or remaining term to maturity. As is the norm in money markets, discounting is done on a simple interest basis. Assume the yield at a point in time is 4.5% per annum, and that the actual term to maturity is 108 days.
The dirty price of the NCD is given by 1,018,900 ÷ [1+0.045x(108÷360)] = 1,005,328. The accrued interest is 1,000,000 x 0.042 x (162-108)÷360 = 6,300. Thus, the clean price of the NCD is 1,005,328 – 6,300 = 999,028. The actual price payable by a buyer is the dirty price and not the clean price.
Term NCDs are also available, which may have multiple years to maturity. These will pay interest usually on a semi-annual basis. This will be the focus of attention of a subsequent article.
The writer is CEO, Tarheel Consultancy Services