Term Finance Certificates (TFC)

There is an urgent and growing need for corporate debt instruments in Pakistan. That need is driven by three major policy shifts:

• The restriction imposed on institutional investment in the National Saving Schemes (NSS) in March 2000;
  
  
• The linkage of NSS returns with yields on government bonds from January 2001;
  
  
• The sharp decline in yields on government debt instruments from July 2001.

In particular, employee benefit funds and insurance company funds face an acute problem: Unless maturing assets, and new inflows, are (re) invested in alternative high yield investments, those funds face the risk of becoming under-funded (present value of funds less than present value of liabilities).

Corporate Term Finance Certificates (TFC’s) offer institutional investors, in particular provident funds, pension funds and insurance companies, with a viable high yield alternative to the NSS and bank deposits. They are also an essential complement to risk free, lower yielding government bonds such as PIB’s. As a result, the demand for TFC’s is growing steadily, and will gather increasing momentum in the future.

Being a relatively new instrument in the Pakistan capital market, corporate bonds in general and TFCs in particular, are not well understood by the average investor. To address that problem, Taurus Securities (TSL), in collaboration with National Discount Service Ltd. (NDSL), has prepared a booklet that answers questions most frequently asked by investors: What is a TFC? Which ones should I buy? How can I buy and sell them? etc. The booklet is not exhaustive, it is only meant to set investors off on the road to a better understanding of the instrument. We hope you find it useful.

Market making service

To help create a liquid secondary market for TFCs, NDSL and TSL have also launched a TFC market-making service. The term market-making means NDSL will quote daily bid (buy) and offer (sell) prices for a range of TFCs on the Karachi Stock Exchange trading system through TSL. Buyers and sellers wishing to trade TFCs at those prices, may contact TSL to execute their orders. The service provides a means by which investors can buy TFCs when they require, and find a ready buyer when they wish to sell.

Should you be interested in availing of the above service, as a buyer or seller of TFCs, please do not hesitate to contact us. We would also welcome any queries that you might have, on TFCs in general, and our service in particular.

We look forward to being of service to you.

For TFC information and execution services contact:

• For research/information: Abid Naqvi at Phone: 111-828787 Ext. 205; Direct: 5683728 
  Email: abid@taurus-sec.com.pk 

• For execution: Zain Hussain at Phone: 111-828787 Ext. 208; Direct: 5662818 
  Email: zain@taurus-sec.com.pk

Frequently Asked Questions on Term Finance Certificates

An introduction to fixed income securities (FIS)

What is a FIS?
How is the price of a bond determined?
How is the yield of a bond determined?
What are the benefits of investing in fixed income securities?
What are the risks associated with investing in fixed income securities?
How can I manage those risks?

An introduction to Term Finance Certificates (TFC)

What is a TFC?
Who is eligible to invest in TFCs?
How is a TFC’s cashflow structured?
Are TFCs secured?
Who safeguards my interests as a TFC investor?
What happens if the issuer defaults on coupon, or redemption payments?
What taxes are applicable on TFCs?
How are listed TFCs traded in the secondary market?
How can I buy/sell TFCs through Taurus Securities?
Does Taurus provide research/advisory services

What is a FIS?

Definition: A fixed income security (FIS) is an investment vehicle that provides a return in the form of fixed periodic payments and return of principal.

A ‘bond’ is a generic type of fixed income security. The key features of a bond are:

• Coupon payment – periodic interest payment made to bond holders during the term of the bond.
  
  
• Principal payment – the face value of the bond repaid at maturity.
  
  
• Term to maturity – number of years remaining in the life of the bond.

Types of fixed income securities: There are several types of FIS depending upon who the issuer is, and what type of risk / return characteristics the instrument offers.

Types of issuers

• Governments (e.g. PIBs, NSS)
  
  
• Government agencies (e.g. WAPDA)
  
  
• Financial Institutions (e.g. COIs)
  
  
• Corporates (e.g. TFCs, preferred stock)

Types of returns

• Fixed rate bond – carries a fixed coupon rate (as a percentage of par value).
  
  
• Floating rate bond – carries a floating, i.e. variable, coupon rate, based on a benchmark rate (usually the SBP discount rate in Pakistan) plus/minus a premium/discount that reflects the risks of the bond. The coupon rate is reset on specified dates.
  
  
• Caps/Floors – applicable on floating rate securities. Caps and floors impose limits on the maximum and minimum coupon rate respectively.

Embedded Options

Some FIS also have embedded options that give certain rights to the issuer or bondholder. There are two basic options:

• Call option – this option gives the issuer the right to redeem the outstanding bond issue at specified dates, and at a specified price, prior to maturity.
  
  
•  Put option - this option gives the bondholder the right to sell the bond back to the issuer at specified dates, and at a specified price, prior to maturity.
  

How is the price of a bond determined?

A bond’s price equals the sum of the present values (PV) of all future cash flows (coupon + principal) associated with the bond, discounted at the required yield. The required yield is the yield that an investor wants from investing in a bond.

Illustration - pricing a basic bond

Type: Fixed rate coupon, option free bond

Face value – Rs10,000
Term to maturity – 5 years
Coupon rate – 10%pa fixed = Rs1,000
Coupon payment - annual
Required yield (discount rate) – 12%pa

= Price of bond today  = Rs9,279

Relationship between required yield and price at a given time

The price and yield of a bond move in opposite directions - i.e.they are inversely related.  Thus, as the required yield rises, the price of the bond falls, and vice versa. This key relationship is derived from the method by which the price of a bond is calculated: since the price is the present value of future cashflows from the bond discounted at the required yield, the higher (lower) that yield, the lower (higher) the price of the bond. This so called inverse relationship between the price and yield of a bond is the basis for understanding, valuing and managing bonds.

Inverse price/yield relationship

Price

• The coupon rate and term to maturity of a bond are fixed at a given point in time – therefore, yield changes have to be reflected by changes in the price of the bond. Hence,
  
  
• When the coupon rate = the required yield price = par value.
  
  
• When the coupon rate < the required yield price < par value.
  
  
• When the coupon rate > the required yield price > par value.
  
  For a bond not trading at par, the price will converge towards its par value as the bond moves towards maturity. Hence,
  
  
• At maturity price = par value.

Bond pricing between coupon periods

When a bond is sold, the seller, in return for receiving the price of the bond, transfers the ownership of all future cashflows from the bond to the buyer, from the settlement date onwards i.e. the date on which the seller gives delivery of the bond to the buyer. If the bond is sold between coupon payment dates, the buyer will receive the whole of the next coupon payment, even though the seller would have held the bond for a part of the coupon period.

In a liquid, secondary bond market, trading takes place continuously. It is likely, therefore, that most trades will take place between coupon payment dates, given the time length between those dates. In such cases, the price of the bond has to be adjusted for that part of the next coupon payment that belongs to the seller, for having held the bond for the period between the last coupon payment date, and the trade settlement date. This is called Accrued Interest, and it is computed as follows:    

• Number of days from last coupon payment date to settlement date  x  Coupon payment
  Number of days in coupon period
  
  Bond prices in the secondary market are, therefore, quoted on the following bases:
  
  
• Cum-interest price : (a.k.a. full or dirty price) includes the accrued interest that belongs to the seller. The buyer pays only the quoted price to the seller.
  
  
• Ex-interest price : (a.k.a. clean price) does not include the accrued interest i.e. the buyer would have to pay the seller the quoted price plus the accrued interest.

Be sure to check which of the two price types is being quoted to you.

How is the yield of a bond determined?

The underlying yield of a bond can be determined by using the bond’s price, and its cashflows. There are three sources of potential cashflow from holding a bond:

• The coupon payments.
  
  
• Capital gain / (loss) from the difference between the purchase and sale (redemption) price when the bond is sold (redeemed).
  
  
• Income from reinvestment of coupon payments.

Common yield measures

Current yield : Considers only coupon payments  Annual coupon payment (in Rs)
                                                                                      Price 

Yield to maturity (YTM) : Considers coupon payments, capital gain/(loss) and reinvestment of coupons. The YTM is the discount rate that equates the present value of future cashflows to the current price; in other words, it is the Internal Rate of Return (IRR) of the investment, a concept familiar to financial analysts.

The YTM is an expected return, which means that it will only be realised under certain conditions. The investor will only realize the YTM if:

• The bond is held to maturity.
  
  
• Coupon payments can be reinvested at the YTM.

If either of these conditions is not met, the actual return to the investor may be different (higher or lower) from the YTM.

Total return : Considers coupon payments, capital gain/(loss) and reinvestment of coupons. Total return is the discount rate that equates the present value of future cashflows to the current price under certain assumptions:

• A holding period based on the investors’ investment horizon.
  
  
• An expected coupon reinvestment rate over the holding period
  
  
• An expected selling price for the bond at the end of the holding period

What are the benefits of investing in fixed income securities?

•  FIS provide regular income under varying combinations of risk and return.
  
  
• The return from investing in fixed income securities is best illustrated through a comparison of historical returns from various financial instruments.
  
  
• The fixed, periodic nature of cashflows allows the investor to better match future payment liabilities. This feature is especially useful for institutions such as insurance companies and provident/pension funds. 

What are the risks associated with investing in fixed income securities?

There are a number of potential risks that fixed income securities may be exposed to. The major ones are:

• Interest rate risk: This risk arises from the inverse relationship between price and yield. If market interest rates rise, increasing the required yield on bonds, the price of the bond will fall, resulting in a capital loss to the investor. Conversely, if interest rates fall, the required yield on a bond will also decrease, and the price of the bond will rise, resulting in a capital gain to the investor.
  
  
• A common measure used to quantify interest rate risk is duration, which measures what the approximate percentage change in price would be (hence the capital gain/loss to the investor), if interest rates changed by one percentage point from current levels. Thus, duration is a measure of bond price sensitivity to interest rate changes.
  
  
• The duration measure observes the following general relationships, holding other factors constant:
  
  
  • The longer a bond’s term to maturity, the higher its duration
  • The lower a bond’s coupon payments, the higher its duration
  • The lower a bond’s initial required yield, the higher its duration
    
    

• The above relationships suggest the following bond trading strategy: If bond yields are expected to rise (prices fall), then invest in bonds with shorter durations (lower price sensitivity), i.e. in bonds with shorter terms to maturity, higher coupons and higher yields.  The opposite strategy would apply if bond yields are expected to fall.

• Reinvestment rate risk: This risk refers to the possibility that coupons may not be reinvested at the calculated YTM due to changes in market interest rates over the life of the bond. Thus, the investor’s realised YTM may differ from the calculated YTM. However, this risk moves in the opposite direction to interest rate risk i.e. rising interest rates increase interest rate risk, but reduce reinvestment rate risk, and vice versa.
  
  
• Call risk: Specific to bonds with call options, this is the risk investors face of the issuer exercising his call option and redeeming the bonds before the maturity date. Issuers with call options usually redeem issues at an earlier date if interest rates fall below the coupon rate, thus reducing their financing costs.  
  
  
•  Credit risk: This is the risk of default by the issuer e.g. inability to make coupon payments on the specified date, or redeem the bond at maturity.
  
  
• Unexpected inflation risk: The risk that the real (after inflation) value of cash flows received during the life of a bond may vary from the expected real value due to unanticipated changes in inflation.  Inflation that is anticipated, however, is built into the required nominal yield to provide a required real yield.
  
  
• Liquidity risk : The risk that the bond may be sold below its true value due to a lack of market trading.
  

How can I manage those risks?

To minimize specific FIS risks, the following strategies are recommended:

What is a TFC?

A Term Finance Certificate (TFC) is a corporate debt instrument issued by companies in Pakistan to generate short and medium-term funds. 

Types of TFCs

• The TFCs issued to date include both fixed and floating rate instruments, although issuers have lately tended to favour the floating rate variant.
  
  
• The coupon rate on floating rate TFCs is set at a risk-free benchmark rate plus a risk spread to reflect the relative risk of the instrument. The risk-free benchmark is typically the SBP’s discount rate, or the auction yield on the Pakistan Investment Bond (PIB) of equivalent maturity. 
  
  
• Floating rate TFCs may impose caps and floors on the coupon payments.
  
  
• Some TFCs may have embedded call and put options.

Parties to a TFC

There are three contractually related parties involved in a TFC issue: the issuer (the borrower), the investors (the lenders), and the trustee. The trustee, typically a financial institution, is appointed by the issuer to protect the contractual rights and interests of investors at all times.

Listing

• The issuer has the option of listing the TFC on any one or all of the stock exchanges in Pakistan.
  
  
• The TFC remains listed for the entire tenor of the issue and is automatically delisted at maturity.
  
  
• A listed TFCs is tradable at the exchange where it is listed. In fact, legally, a listed TFC can only be traded on the exchange at which it is listed, through a licensed member of that exchange.
  
  
• Unlisted TFCs are not tradable on an exchange, but may be traded through negotiation directly between buyers and sellers. Unlisted TFCs may, therefore, be less liquid than listed ones, in which case they would offer a liquidity risk spread over comparable listed TFCs.

Rating

All TFCs must be rated before they are issued. The rating is conducted by a rating agency, which conducts a comprehensive analysis of the credit outlook of the issuer, and the structure of the TFC, before conferring a rating on the TFC. The rating reflects, in the opinion of the rating agency, the credit risk of the TFC, i.e. the issuer’s ability and commitment to repay scheduled TFC payments. PACRA and JCR-VIS are the two rating agencies presently operating in Pakistan.

Who is eligible to invest in TFCs?

Investment and commercial banks, non-banking financial institutions, leasing companies, insurance companies, pension and provident funds, corporates and individuals can all invest in TFCs.   However, insurance companies and provident/pension funds can only invest in listed TFCs.  In addition, provident/pension funds may only invest in TFCs rated ‘BBB’ and above, i.e. in investment grade TFCs only.

How is a TFC’s cashflow structured?

Like bonds, TFCs are structured to provide regular income in the form of coupons, which are typically paid semi-annually. However, unlike a generic bond, where the principal is repaid in lump sum at maturity, a TFC’s principal is gradually redeemed over the tenor of the instrument.

Typically, TFC principal redemptions start 2 to 3 years after issue, in equal semi-annual installments, with the last installment paid at maturity. Thus, TFC cashflows are recovered faster than those from a generic bond.  Other things being equal, accelerated cashflow recovery reduces the risk of a TFC versus a generic bond of equivalent maturity.

A typical TFC cashflow structure would be as follows:

Typical TFC Structure

Are TFCs secured?

A TFC may, or may not, be backed by collateral security. Secured TFCs would be backed by different types of security, including corporate guarantees and fixed and floating charges on assets. The ranking (first, second etc.) of the charge on assets, relative to other secured creditors, may also vary.

Unsecured TFCs offer no specific asset charge to holders, or payment guarantee. In the event of a default, the trustee may initiate recovery proceedings, but unsecured TFC holders’ claim on the proceeds from the liquidation of the issuers’ assets would be subordinate to all secured creditors and rank senior to equity investors only.

The security features of a TFC would be reflected in its credit rating, and hence in its required yield. Other things being equal, a TFC with superior security features should trade at a lower yield than a TFC with inferior security features.

Who safeguards my interests as a TFC investor?

A trustee is appointed jointly by the issuer and arranger (financial institution handling the initial sale of TFCs on the issuer’s behalf) to safeguard the interests of investors. The trustee’s functions, described in the Trust Deed executed between the trustee and issuer, include:

•  Monitoring the performance of the issuing company.
  
  
• Keeping a check on the possibility of default on coupon/redemption payments to investors.
  
  
• Acting as a custodian of security on the investors’ behalf.
  
  
• In case of default, enforcing contractual provisions for the recovery of investors’ dues.
  

What happens if the issuer defaults on coupon, or redemption payments?

Being corporate debt instruments, TFCs are risky assets, in the sense that they carry varying degrees of default risk. On the other hand, government debt obligations – T-Bills, PIBs, NSS – are defined as risk free assets, although, strictly speaking, even government bonds carry some level of sovereign default risk. To compensate investors for the higher default risk compared to government debt, corporate bonds offer a higher yield (risk spread) over comparable government bonds.

The Trust Deed would specify the actions that the trustee, on behalf of investors, may take in the event of a default in the payment of coupons and/or principal (or any other event of default covered in the Trust Deed). Unless the default is remedied by negotiation to the investors’ satisfaction, in the last resort, the trustee can initiate legal action to enforce the security held by it. The proceeds of the enforcement (sale) are distributed amongst the TFC holders in proportion to their holdings at the time.

What taxes are applicable on TFCs?

• TFCs are exempt from capital gains tax.
  
  
• Coupon payments are subject to income tax on the following basis:

 
Note: The levy of these taxes may be subject to change under the IT Ordinance 2001 that will be implemented in July 2002.

To trade listed TFCs you would need to approach a broker licensed to deal on the exchange on which the TFC is listed. The basic features of secondary trading are as follows:

• Trading : Bid (buying) and offer (selling) prices for TFCs listed on the KSE may be found on the Karachi Automated Trading System (KATS). Quotes for TFCs listed on the Lahore Stock Exchange (LSE) may be found on the trading system of the LSE. Licensed members of the exchange place those bids and offers in the market on behalf of their clients. Prices are quoted for specific quantities, known as trading lots.
  
  
• Trading lot: The trading lot for a TFC is one unit and multiples thereof.  Typically, one unit has a face value of Rs,5000.
  
  
• Delivery : TFCs may be traded in both physical (paper) and electronic form. Like shares, physical TFCs are delivered with attached transfer deeds, properly signed and verified. Alternatively, TFCs may also be delivered in electronic form through the Central Depositary System (CDS). The CDS is an electronic share/certificate register operated by the Central Depositary Company (CDC).
  
  
• The CDS eliminates the need for physical movement of shares/certificates. It has also solved investor problems related to handling of paper shares/certificates on the settlement date, registration of shares/certificates, and exercise of corporate action benefits. You may open your own account with the CDC for secure custody of your TFC holdings, and for receiving/delivering TFCs against purchases/sales. (For details, contact the CDC at: 92-21-111-111-900). Alternatively, you can leave your TFCs in the custody of your broker in a sub-account in your name. Ask your broker for details.
  
  
• Transaction costs : The transaction costs for a TFC would normally consist only of the following:
  
  
  • Brokerage commission : The commission your broker would charge for execution services. Since there are no prescribed commissions for TFC transactions, these may vary from broker to broker. Get, and agree to, a commission rate before you place an order with your broker.
    
    
  • CDS cost: The CDC will charge you for each inward and outward movement of certificates through your account against purchases and sales. Currently the CDC charges Rs.0.00375 per unit of TFC received in, or delivered from, the account. However, charges may vary over time, so keep a check on the charges by contacting the CDC. 

Taurus Securities is a leading corporate member of the Karachi Stock Exchange (KSE). Through us, you can buy and sell TFCs listed and traded on the KSE. In addition, through our affiliates in Lahore, we can provide you with access to TFCs listed and traded on the Lahore Stock Exchange.

You can buy/sell TFCs through Taurus Securities via the following simple process.

• You contact our TFC dealing desk, specify your requirements (buy or sell), and ask for current market quotes.
  
  
• The dealer checks the available market quotes for your specified TFC(s), and communicates the available bid/offer prices and quantities to you.
  
  
• You ask the dealer what the broking commission for the transaction would be.
  
  
• Should you find an available price that matches your requirement, and the commission rate is acceptable, you ask the dealer to execute your order at that price specifying the quantity in units (units are defined above in ‘Trading Lot’).
  
  
• If the available quotes do not match your requirement, you ask the dealer to place your order in the market through the trading system, specifying price, quantity and validity period (e.g. ‘good for the day only’, ‘good till done’, etc.).
  
  
• In either of the above cases, you will receive a verbal confirmation via phone as soon as your order is executed, followed by a printed contract the next day, containing the gross price, commission, net price, quantity, net value of payment due to (sale)/from (purchase) you and the settlement date.
  
  
• If you have bought TFCs, you will need to send us the net purchase amount at least one day prior to the settlement date for us to pay that amount to the counter-party early on the settlement day. Please note the funds should be credited to our bank account at least one day prior to the settlement day.
  
  
• If you have sold TFCs, you will need to deliver the TFCs to us at least one day prior to the settlement date, in order that we may deliver them onward to the counter-party early on the settlement day. Your proceeds will be paid to you the day after the settlement day.
  
  
• If the TFCs are traded in electronic form, depending on your delivery instructions, purchased TFC’s may be delivered to your CDS account (for CDS definition see above under ‘How are listed TFCs traded in the secondary market?’), or kept in custody by us in your CDS sub-account.
  
  
• If the TFCs are in paper form, they will be delivered to you along with signed, verified transfer deeds.
  
  
• The entire settlement cycle is normally completed in three days from the trade date.

Does Taurus provide research/advisory services?

Apart from execution services, we can also provide you with advice, guidance and research on TFCs and their issuers. Our advice is research driven, and is based on our outlook on future interest rates (and hence price direction), and view on the likely future financial condition of companies issuing and/or backing TFCs. Our advisory service is strictly non-discretionary, that is you make the final decision on buying/selling.