Debt Capital Markets puzzles, solved step by step

Rs 4 crore a year. Two notches below AA, from AA to AA- to A+, trigger two steps of 25 basis points, so the coupon rises from 8.00% to 8.50%. Half a per cent of Rs 800 crore is Rs 4 crore, taking annual interest from Rs 64 crore to Rs 68 crore for as long as the rating stays there. A step-up turns a downgrade into a cash cost.

How do you convert basis points into rupees quickly?

Anchor on one basis point. One basis point of Rs 800 crore is Rs 8 lakh, so 50 basis points is 50 times Rs 8 lakh, Rs 4 crore. It works like a fuel surcharge on a bus ticket: a small percentage, but on a large base and paid every trip. Say the conversion out loud; desks talk in basis points and issuers pay in rupees, and the interviewer wants to hear that you can move between the two instantly.

Why would an issuer agree to a step-up at all?

To get a lower coupon today. Investors worried about a downgrade will accept a tighter starting coupon if they are compensated when that fear comes true. A step-up couponA coupon that rises by a set amount if a trigger is hit, most often a downgrade of the issuer rating below a stated level. shifts rating risk back to the issuer: cheap while the credit holds, costlier exactly when the credit weakens. That timing is the catch, and it is what a good answer names next.

What is the hidden danger in the structure?

It adds cost at the worst moment. A downgrade usually follows weaker cash flow, and the step-up then raises interest, which weakens coverage further and can invite another downgrade. On this bond, Rs 4 crore is small against Rs 64 crore of interest, but many issues carrying the same clause, or a larger step, can turn one downgrade into a spiral. Close with that, and add the limit: the terms of real step-ups vary, some step back down on an upgrade and some cap the total, so read the clause.

About Rs 490.2 crore of face value, recorded initially at the Rs 500 crore received. At 102, every Rs 100 of face raises Rs 102, so 500 divided by 1.02 is Rs 490.20 crore. The issuer carries the debt at the cash received and amortises the Rs 9.8 crore premium down to face over the remaining life, so its interest expense sits below the Rs 39.22 crore coupon.

Why does a premium mean less face, not more?

Think of selling gift vouchers with a face value of Rs 100 that are so popular buyers pay Rs 102 for each. To collect Rs 50,000 you need to hand out fewer vouchers than 500. When a bond trades above par, each unit of face value brings in more than its face in cash, so the issuer creates less face than the cash it raises. The bond trades at 102 because its 8% coupon is above the yield investors now demand; the extra Rs 2 is them paying today for that above-market coupon.

What goes on the balance sheet?

Under amortised cost accounting, which Ind AS and IFRS use for most issued bonds, the debt starts at the cash received, Rs 500 crore before issue costs, not at the face value. The premium is then released over the bond's remaining life, so the carrying amount falls to Rs 490.2 crore by maturity and the interest expense is the effective yield on the carrying amount, below the cash coupon. Covenants that test debt may use face value instead, so check which number the documents count; the accounting details belong to the issuer's auditors.

What else must you check on a tap?

Three practical points. Taps usually settle between coupon dates, so buyers also pay accrued interest, which is cash in hand but not new debt, and it should not be counted in the Rs 500 crore. Face is issued in set denominations, so Rs 490.2 crore rounds to what the minimum lot allows. And the issuer should compare the tap with a fresh issue: tapping an existing line at 102 adds liquidity to one bond, which investors often value, while a new bond with a lower coupon might price differently.

The ask is about 2.5 basis points above the issuer's fair level, a small concession. Interpolating between 8.10% at 3 years and 8.40% at 5 years puts 4.5 years at 8.325%. Paying 8.35% costs the issuer 2.5 basis points on Rs 300 crore, about Rs 7.5 lakh a year and Rs 33.75 lakh over the life, which is often less than a public deal would need to clear.

What do you compare a reverse enquiry against?

A buyer walks into a tailor and asks for a jacket in a size the shop never stocks. The tailor prices it from the sizes either side, not from a different shop's rate card. A reverse enquiry, where an investor asks the issuer for a tailored bond, is judged against the issuer's own curve at that exact tenor. The issuer's 3-year and 5-year yields bracket the request, so the fair yield at 4.5 years comes from reading between them.

Is 2.5 basis points a lot?

Put it in rupees. One basis point on Rs 300 crore is Rs 3 lakh a year, so 2.5 basis points is Rs 7.5 lakh a year, about Rs 33.75 lakh over 4.5 years before discounting. Against that, a reverse enquiry saves the issuer the cost of a public deal: no roadshow, no marketing, and no new issue concessionThe extra yield a new bond usually offers over the issuer existing bonds so that investors take it up.. If a public 4.5-year deal would need a concession wider than 2.5 basis points to clear, the enquiry is the cheaper route.

Say the assumption and its limit. Linear interpolation treats the curve as a straight line between 3 and 5 years. Real curves usually bend, flattening as tenor lengthens, so the true 4.5-year point may sit a fraction above 8.325%, which would shrink the gap. An odd tenor also leaves the issuer with a bond that matches nothing else outstanding and trades less easily, which is one reason investors pay a little for the tailoring and issuers are willing to give a little back.

The make-whole price is about 105.25, and calling to refinance at 7.3% loses the issuer about 0.81 per Rs 100. Discount the remaining 9, 9 and 109 at 6.5% plus 50 basis points, 7.0%, to get 105.25. Valued at the 7.3% refinancing rate, the same payments are worth 104.44, so paying 105.25 to retire them destroys value. Calling only saves money if the issuer can borrow below 7.0%.

What does a make-whole price actually compute?

Suppose you repay a relative's loan early and they say: fine, but pay me today everything I would have earned, discounted at a low rate. That is a make-whole callAn issuer option to repay a bond early at the present value of its remaining payments, discounted at the government yield plus a fixed spread set in the documents.. The call price is the present value of every remaining coupon and the principal, discounted at the government yield plus a small fixed spread, here 6.5% plus 0.5%, which is 7.0%. The low discount rate is what pushes the price above par: the lender is compensated for giving up a 9% coupon.

Why does refinancing at 7.3% not pay?

Compare two ways of carrying the same obligation. Keeping the old bond means payments worth 104.44 at the issuer's 7.3% borrowing rate; calling means paying 105.25 in cash today, raised with new 7.3% debt. The issuer would give up 0.81 per Rs 100, about Rs 81 lakh on every Rs 100 crore, to swap into debt that only looks cheaper. The coupon saving from 9% to 7.3% is real, but the make-whole has already charged for it, valued at 7.0%, a lower rate than 7.3% and therefore a higher price.

That gives a clean rule to say out loud. A make-whole call only saves money if the issuer can refinance below the make-whole discount rate, the government yield plus 50 basis points. Few corporates borrow that tightly, which is why make-wholes are usually exercised for other reasons: to escape a restrictive covenant, to complete a merger, or to tidy the capital structure. The limit: this ignores the fees on the new bond, which make calling worse still.

The issuer paid a new issue premium of about 15 basis points. Its own curve runs from 8.10% at 5 years to 8.40% at 7 years, so a fair 6-year yield, interpolated halfway, is 8.25%. The new bond priced at 8.40%, 15 basis points wide of that. On a Rs 1,000 crore issue that is Rs 1.5 crore a year of extra coupon, about Rs 6.9 crore in today's money over six years.

What is fair value for a bond that does not exist yet?

If flats in one building sell for Rs 80 lakh on the fifth floor and Rs 84 lakh on the seventh, a sixth-floor flat is fairly priced near Rs 82 lakh; asking Rs 84 lakh for it is a premium. A new bond's fair value is read off the issuer's own curve at the new bond's maturity, because that curve already prices this issuer's credit. With points at 5 and 7 years, the 6-year point is the straight-line midpoint: 8.10% plus half of 30 basis points, 8.25%.

Why do issuers pay a premium at all, and what does it cost?

Investors want a small concession for buying a new bond rather than the existing ones: they take size, commit before the bond trades, and often sell other holdings to make room. The syndicate desk's job is to keep that premium as small as the order book allows. Here 15 basis points on Rs 1,000 crore is Rs 1.5 crore of extra coupon a year, about Rs 6.9 crore today over six years at 8.40%, which is why syndicate desks argue over five basis points.

State the assumptions behind the answer. Linear interpolation assumes the curve is straight between 5 and 7 years; a curve that bows would move fair value by a few basis points. The outstanding bonds may also be small or rarely traded, so their yields can carry a liquidity premium of their own. A desk would check the answer against a second yardstick, such as the spread over the government curve, before calling the premium high or low.

About 8.9 basis points, or roughly Rs 4 crore, and yes, 10 basis points looks generous. A 0.40 point rise on a duration of 4.5 is 0.40 / 4.5 = 8.9 basis points of tightening. On Rs 1,000 crore, 0.40 points is Rs 4.0 crore of value that went to investors. Almost all of the premium came back on the first trade, so the book would probably have cleared tighter.

How do you turn a price jump into basis points?

A shop that sells out of a new phone in an hour, and then sees it resold online for more, has learned that it priced too low. A bond's first trades tell the issuer the same thing. Modified durationThe approximate percentage price change for a one point change in yield. is the exchange rate between price and yield: here a 1 basis point move in yield moves the price by about 4.5 hundredths of a point. So a price rise of 0.40 points means the market is valuing the bond about 8.9 basis points tighter than where it was priced.

What does the Rs 4 crore actually cost the issuer?

It is paid through the coupon, not written as a cheque. Pricing about 8.9 basis points too wide costs Rs 0.89 crore a year on Rs 1,000 crore, for five years: Rs 4.4 crore in total, or about Rs 3.6 crore in today's money at an assumed 7.5% yield, the same order as the Rs 4.0 crore jump in the bond's price. The first trade after pricing tells you how much of the premium was needed, because it shows where investors will buy the bond once the allocation is done.

So was 10 basis points too much?

On these numbers, most of it. But say two things before you convict the syndicate desk. First, strip out the market: if benchmark yields fell 3 basis points during the same session, only 5.9 basis points of the move belongs to the deal. Second, some positive performance is deliberate. Investors who were allocated want to see the bond trade well, and a flat or weak break makes the issuer's next deal harder to fill. A generous premium is a cost this time and an investment in the next book; the judgement is whether nearly the whole premium needed to be spent.

The total saving is 0.7% a year, the difference between the fixed gap of 1.2% and the floating gap of 0.5%. A borrows fixed at 7.0%, B borrows floating at benchmark plus 0.8%, and they swap. Split evenly, B pays A 7.05% fixed and A pays B the benchmark: A ends at benchmark minus 0.05% and B at 7.85% fixed, each 0.35% better than going direct.

Why is there a gain when one firm is cheaper at everything?

Picture two flatmates: one cooks and cleans faster than the other, but is much faster at cooking and only slightly faster at cleaning. The household still gets more done if the fast cook cooks and the other one cleans. Borrowing works the same way. What matters is comparative advantage: firm B is 1.2% worse in the fixed market but only 0.5% worse in floating, so B should borrow floating and A fixed, and the gap between those two penalties, 0.7%, is the gain.

How do you check the split adds up?

Follow each firm's cash. A pays its lenders 7.0% fixed, receives 7.05% fixed from B and pays B the benchmark, so its net cost is the benchmark minus 0.05%, against benchmark plus 0.3% going direct. B pays its lenders benchmark plus 0.8%, receives the benchmark from A and pays A 7.05%, so its net cost is 7.85% fixed, against 8.2% direct. 0.35% plus 0.35% is the full 0.7%, which is the check that nothing was lost or invented. On Rs 1,000 crore that is Rs 7 crore a year between them. In practice a bank sits in the middle and keeps a slice, so each firm gets somewhat less.

What is the honest limitation?

The gain is not free money. Part of the gap exists because floating lenders can reprice or refuse to roll a weaker borrower, while fixed lenders are locked in for years; B's floating spread of 0.8% may not hold if its credit slips. Each firm also takes on counterparty risk to the other or to the bank. Say that one sentence and the answer sounds like someone who has watched a swap book.

You can tighten 25 basis points, to 125, and still be 2 times covered. Each 5 basis point step loses 10% of the original demand, which is 0.4x of cover. Going from 4.0x to 2.0x gives up 2.0x, or five steps, so 5 x 5 = 25 basis points. On a Rs 500 crore deal the book falls from Rs 2,000 crore to Rs 1,000 crore, and the issuer saves Rs 1.25 crore a year.

What is actually being traded off?

A shopkeeper with a queue of forty customers for twenty items can raise the price, and some customers will walk away; the question is how high to go before the queue gets too short to be comfortable. Book-building trades cover for price: each step tighter saves the issuer money and costs orders, and cover is the buffer against a weak aftermarket. Here every 5 basis points costs 0.4x, because the loss is 10% of the original book each time.

Would you really go all the way to 125?

Not automatically. The linear rule is a model of the book; real books drop in lumps, because price-sensitive orders carry limits and the orders that leave first are often the highest quality long-term investors. Landing exactly on the 2.0x floor leaves no margin if a few orders drop after the final terms. A syndicate desk might stop one step short, at 130 with 2.4x cover, giving up Rs 0.25 crore a year of saving on Rs 500 crore for a safer book and a better chance of a positive break. The arithmetic sets the limit; the judgement picks the point inside it.