Fixed rate ICDs are normal Inter-Corporate Deposits (ICDs) having periodic put/call options exercisable any time after a pre-specified lock-in period.
Put Option is the option on the ICD, which is the right but not the obligation with the Investor, to ask the Issuer of the ICD to redeem the ICD alongwith the accrued interest on the entire face value of the ICD, from the date of placement of the ICD till the date of settlement of the put option of the ICD.
Call Option is the option on the ICD, which is the right but not the obligation with the Issuer of the ICD, to ask the Investor of the ICD to accept redemption of the ICD alongwith the accrued interest on the entire face value of the ICD, from the date of placement of the ICD till the date of settlement of the call option of the ICD.
The put/call option dates can be specified for a particular period i.e. A company issues an ICD for 90 days which has a put/call option which can be exercised only for a period between 75th and 89th day OR can be any day till the maturity of the ICD i.e. A company issues an ICD for 90 days which has a put/call option that can be exercised any day till the maturity. There can also be a lock in period, before which, the put / call options cannot be exercised, i.e. a company issues an ICD for 90 days with a daily put / call option, with a lock in period of 7 days.
Why ICDs with Put/Call make sense?
For the Investor:
If the short term interest rates go up, it makes sense for the Investor to exercise the put option, i.e. ask the Issuer of the ICD to repay the principal alongwith the accrued interest till the number of days the ICD is held. The Investor can then invest the amount received in higher yielding short term issues.
For the Corporate:
If the short term interest rates go down, it makes sense for the Issuer to exercise the call option, i.e. cancel the ICD and repay the principal before the original maturity, alongwith the accrued interest till the number of days the ICD is held. The corporate can then borrow the amount again at lower short term interest rates
ICDs With Put/Call Options in India:
ICDs with daily put/call options (i.e. options can be exercised any days till the maturity of the ICD, by giving a 1 day’s notice) were very popular with institutions that lent in the ICD and were locked in for the ICD period. Put/Call options gave them flexibility. For the corporate also, it made sense, as they could use this point to bargain on a relatively lower interest rate. The concept of ICDs with daily put/call got popular with the short term unsecured debentures with daily put/call options being raised by companies. ICDs were seen as something similar to it.
Pricing
The interest rates applicable on the ICDs with put/call options are generally the same as the ICD without the options. This means that the put option is actually sold and call option is bought by the company, free of cost. The pricing is mutually decided between the issuer and the investor, and the following factors affect the rates charged on the ICD:
Short Term Interest Rates:
It depends on other short term interest rates prevailing in the banking system, like CPs, short term foreign currency loans, call rates, Rupee-Dollar forward rates, etc.
Credit Perception of the Issuer:
Corporates borrowing through ICDs are often not rated for their other short term & long issuance or are corporates that do not generally borrow through the formal debt capital markets. In either case, it is the credit perception of the borrower that plays a larger part in fixing the interest rates on the ICDs.
Counterparty limits:
Investors have limits on how much ICDs can be invested into a single company and collectively into group companies. Hence, if the issuer is more regular, then its counterparty limits would be hit very often, which means that the demand for its ICDs will be relatively lesser than the other companies. This would impact the fixing of the interest rates for all the additional marginal borrowing that the company does.
Lock In Period before the Options:
ICDs with daily put/call options are also generally issued with a minimum lock in for a short period, say 7 days, before which the call / put options cannot be exercised by either parties. The issues are also priced to the put/call option date, rather than the final maturity date. For e.g. if a company issues an ICD for 90 days with daily put/call option, and a minimum lock in period of 7 days before which the put/call option cannot be exercised, then the ICDs can also be priced as a 7 day ICD rather than a 90 day ICD, or an interest rate falling in between both the tenors.
Advantages
Benefits to the Investors:
It will help in improving the yields on liquid funds without sacrificing liquidity.
It helps the investors take advantage of the increase in interest rates, by exercising the put option.
It increases the yield on the investment, as the ICDs are unsecured and unrated, hence the investor can demand a higher interest rate. However, as the nature of the instrument is as short as the investor and the corporate would like, based on the corporate credit quality, the safety of the instrument is well covered, to the extent that the investor has done a basic due diligence on the borrower.
As compared to competing short term investment avenues like call money, CPs, short term secured debentures, etc. these instruments offer a relatively better yield for the same corporate for similar tenors, while imparting more liquidity to the investor.
Benefits to Corporates:
The corporates could use this instrument to meet their requirement for short maturity funds at competitive rates.
The corporates would retain the flexibility of retiring these liabilities as per their requirements because of the periodic put/call options.
The corporate can take advantage of any decline in the interest rates, by exercising the call option.
The corporates can raise money at a very short notice through this instrument, as the instrument is unrated and unsecured and the corporate does not have to undertake any necessary formalities before borrowing the money. All the documentation that is exchanged is a confirmation letter and post dated cheques, if required.
Risks
Liquidity risk
ICDs with periodic put/call have a very short maturity and they also have periodic put/call options. On account of a temporary liquidity shortage, the corporates may face a temporary back stop liquidity facility. This could translate into a liquidity risk for the corporates.
Interest Rate Risk
If the interest rates rise, and the ICDs are put by the investor, then the re-funding of the liability would have to be done at a higher interest rate for the remaining tenor. However, the converse is also true for the investor, i.e. if the interest rates fall and the corporate calls the ICD, then the investor would then have to deploy the funds at a lower interest rate for the balance tenor. However, seen practically, the investors are generally deploying surplus short term funds rather than actually trading on interest rates, and hence, on rise of interest rates, only if there is another borrower at higher rates, will the investor put the ICD and redeploy the funds elsewhere. On the contrary, if the interest rates fall down, the corporate will always get funding from alternative sources at lower rates, and hence is in a better interest rate position than the investor.
perational Risk
The investor and the corporate needs to keep a track of all the call and put options, and from which time onwards, if there is a minimum lock in period. This could become a operational issue and the settlement on the exercise of either options, if exercised. For this, a detailed procedure with specific responsibilities for exercise of call and put options has to be laid down by both the issuer and the investor of the ICD, at the time of the transaction.
A Typical Term Sheet for ICDs with Periodic Put / Call Options
DISCLAIMER
The above views are based on the latest available information. Though the information sources are believed to be reliable, the information is not guaranteed for accuracy. While the views are proffered with the best of intentions, neither the author, nor the firm are liable for any losses that may occur as a result of any action based on the above. The financial markets, and especially the Indian money markets, are illiquid and inherently risky and it is assumed that those who trade these markets are fully aware of the risk of real loss involved.
Unauthorized copying, distribution or sale of this publication is strictly prohibited.
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