Debt Capital Markets puzzles, solved step by step

Principal of about Rs 115.76 and a year 3 coupon of about Rs 2.32. The principal is lifted by inflation each year and compounds: 100 times 1.05 cubed is Rs 115.7625. The 2% real coupon is paid on that indexed principal, so the year 3 coupon is Rs 2.315. Both the coupon and the principal keep their buying power, which is what the investor is paying for.

What exactly is being indexed?

Think of a rent agreement where the rent rises with inflation every year and the deposit is topped up by the same percentage. On an indexed bond the principal is scaled up by inflation, and the fixed real coupon rate is then applied to that scaled principal, so both the income and the repayment keep pace with prices. After one year of 5% inflation the principal is Rs 105 and the coupon is 2% of 105, Rs 2.10, not Rs 2.

Why does the principal compound instead of adding 5 a year?

Because the index is a price level, and price levels compound: 5% in year 2 is 5% of the already higher year 1 prices. The indexed principal is the original principal times the ratio of today's index to the index at issue, which after three years of 5% is 1.05 cubed. Adding 5 a year gives 115, off by Rs 0.76, small here but large over a 10 or 20 year bond.

What does that mean for the yield an investor sees?

Bought at Rs 100, the cash flows 2.10, 2.205 and 118.08 give a money return of about 7.1% a year, which is 1.02 times 1.05 minus 1: the real 2% plus inflation plus a small cross term. The investor has locked in a real return of 2% whatever inflation turns out to be, and that certainty is the product. Say the limits: actual indexed bonds use a lagged index, some protect principal from falling below par, and the tax treatment of the uplift varies, so check the specific bond's terms.

Pre-funding costs about Rs 13 crore of negative carry, before tax. The issuer pays 8.2% on the new bond while earning 6.9% on the parked cash, a 1.3% gap on Rs 1,000 crore for twelve months. In return it removes refinancing risk: it no longer needs the market to be open, spreads to hold and its rating to survive the final year. On a five-year deal, waiting would have to cost more than about 26 basis points a year for pre-funding to lose.

What exactly does pre-funding cost?

A family renting a flat signs a new lease a year before the old one ends because rents are rising and good flats are scarce. For twelve months they pay a little extra holding the new flat, but they are not searching in a panic the week the old lease ends. Pre-funding costs the gap between what the new money costs and what the parked cash earns, for as long as both exist: the negative carryThe cost of holding a position whose income is lower than its funding cost, here cash earning less than the bond that raised it.. Here 8.2% less 6.9% is 1.3%, on Rs 1,000 crore for a year, Rs 13 crore, about Rs 1.08 crore a month.

What does that Rs 13 crore buy?

Certainty. Without pre-funding, the issuer must refinance in a narrow window before maturity, and if markets are shut, spreads have widened or its rating has slipped in that window, it either pays far more or cannot repay. Pre-funding is insurance with a known premium. A useful breakeven: spread over a five-year replacement bond, Rs 13 crore is about 26 basis points a year before discounting and about 33 after. If waiting risked a rise larger than that, or a missed maturity, the premium was cheap.

Say the refinements. Interest paid is usually tax deductible and interest earned is taxable, so at an assumed 25% rate on both the after-tax carry is about Rs 9.75 crore. The issuer also carries a bigger balance sheet for a year, gross debt rises before the old bond goes, which can briefly worsen reported leverage. And the parked cash must be invested safely and kept liquid; reaching for yield on it defeats the purpose of paying for certainty.