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Bonds

debenture

1. What is it?

Debenture (also known as Bond) is a private and fixed rate bond, whose primary objective is to raise new resources (borrow money) either to finance companies’ investment projects or to extend its debt profile. Debentures can only be issued by anonymous society companies (S/A), listed or not, although only those listed could actually make public offerings of debentures. Also, financial institutions are not allowed to issue debentures (banks, brokers, etc). Property rental companies and mortgage managers can also issue debentures. In other words, while investing in debentures, you lend money to a particular company, which in exchange ‘promise’ to pay the invested value plus interests, after an amount of time. Be aware that if you acquire a debenture, you are not eligible to access any stake on a company’s control or profits.

Just like governments raise money from issuing bonds, companies also rely on such strategy, incurring in much lower interest taxes than those practiced by banks and financial institutions. Debentures are considered one of the most important fundraising tools in the medium or long term for companies, which means by investing in debentures, you are looking for results within the medium to the long term.

The possibility of the issuer to determine the flux of ammortizations and the ways of pay is the appeal of the debentures. Such flexibility allows the ammortization installments and paying conditions to be in line with the company’s cash flow, with the project that the company is financing – if it’s the case – and with market conditions during the issue.

Until very recently, debenture emmissions were exclusively focusing large investors (qualified and institutional), due to the large nominal value for those investiments, around BRL 20,000, which was an obstacle to small investors. By 2009, there was a change in this scenario. Companies then commenced to offer smaller batches, with a minimal value of BRL 1,000, making it accessible to small investors. Lately, a sanctioned law has been stimulating issuing debentures, particularly the so-called ‘infrastructure debenture’, whose primaraly looks for stimulate the country’s infrastructure, and having the advantage of being exempt of income taxes for individual investors, foreign investors and having a tax rate of only 15% for institutional investors.

Debentures do not have any pattern, meaning that each company can issue debentures with different characteristics. Its issue conditions are deliberated in a general assembly and can happen in ‘series’ (in order to follow the company’s needs of cash flow) or according to the market demand. However, new types of debenture have been appearing lately, looking for developing a more dynamic market, giving investors a note that allows them to understand all complex contractual clauses and sophisticated calculations involved in the negotiations. It’s expected that the creation of standards for those clauses can reduce the period of time spent by investors and mediators in reading and understanding terms and conditions.

The main characteristics of a debenture are:

  • They can have any expiration or due date or deadline;
  • Payment can be made annually, in a 6-month basis, quarterly, monthly or even sporadically, in a percentage determined by the company;
  • Payment can be linked to currency corrections or interest taxes, as well as to the issuer’s profits or income;
  • There are debentures that follow the inflation indexes (payments are linked to the IPCA or IGP-M);
  • By its expiration date, if possible, debentures can be converted to shares. In other words, by the expiration date, if debentures are convertible notes, you can choose between having the cash back or receiving some of the company’s shares;
  • They have several types of guarantees;
  • They have a number of characteristics, such as possibilities of redemption or repayment before the expiration date, etc;
  • Debentures are not covered by the state guaranty fund.

All those characteristics are present in the emmission note, which is simply a document where all clauses and conditions for the debenture issue are described, as well as rights and duties of the issuer, ammount of notes and their value, etc.

A debenture issue is decided during a general assembly or a meeting of the issuer’s board, both with the power to establish all conditions of the emmission. For such, the company must choose a financial institution (broker or investment bank) in order to organize and coordinate the whole process, a so-called ‘lead coordinator’. By rule, companies issuing debentures cannot make it by exceeding their own capital. That means, if the company is valuated in BRL 1m, it cannot issue debentures that exceed this value.

The primary market is where the first debenture offer takes place, through a negotiation pool. Moreover, if you need to redeem some cash before the expiration date, it is possible to trade debentures within the secondary market, inside the SND – Sistema Nacional de Debêntures – managed by CETIP. However, the value paid is likely to be different that the one paid in the primary market. In the primary market, notes are firstly offered by issuers, through an entering pool, allowing them to raise resources to meet their financial needs. In the secondary market, debentures are just traded between investors.

Fiduaciary agents

A fiduciary agent is no more than a person or company, or a bank’s credit department that takes care of debenturist interests and rights. It is a third part involved in a debenture contract, and it makes sure that debenture issuers are following clauses, and rights and interests of investors are protected and assured. A fiduciary has a permanent duty and a trust relationship with a third part whose assets it is managing, apart from issuers or any other interest part in the debentures. The fiduciary agent cannot have any conflict of duties with the investors whose debentures he is managing or taking care.

The appointment of a fiduciary is mandatory, in the light of the S/A companies law. Debenturists are just like a ‘condo’, and they need a fiduciary agent to manage the whole process. They can appoint and hire an agent, fire him and use to pay a fixed fee for his services. Besides, the fiduciary is legally responsible for any damage or losses caused to the investors that is direct result of his services or functions.

One of the main tasks of a fiduciary, apart from protecting the investors, is to alert buyers about whether the issuer is correctly paying or not, if there are financial outstandings, etc. For that, the fiduciary is allowed to use any action or instrument to defend and protect the investor interests, for instance:

  • To give notice to the investor about any lack of payment of the issuer related to duties described in the emmission note;
  • To declare the anticipation of the expiration of a debenture;
  • To execute guarantees;
  • To request for notice and bankruptcy of the issuer as well as representing debenturists if the issuer goes into administration or legal liquidation proceedings;
  • Take any necessary actions for debenturists to realize and receive their credits;
  • To resign on his functions, in case of conflict of interests or being unable to develop his functions;
  • To check whether the information written in the issued documents is truthful;
  • To check regularity of the actual, fluctuant and personal guarantees, as well as the value of the assets offered as guarantee;
  • Build a report and making it public, annually, to debenturists, at the company’s headquarters, at his office, at CVM (equivalent to US’ SEC) and at the stock exchange.

To know more about fiduciary agents and all of their functions and characteristics, please find further information within the following CVM instructions:

- Instrução CVM nº 28/83

- Nota Explicativa CVM nº 27/83

Issuing bank

This is the bank responsible for confirming (financially speaking) all payments and operations made by the debentures issuer, and such role can only be performed by commercial or multiple banks. It is also responsible for the existance, authenticity, validity and regularity of the emitted notes. Finally, it is the loyal depositary for the debenture certificates, if they exist.

The issuing bank acts as treasurer for all operations, dealing with physic and financial liquidations between the parts involved and the custodian institution (CETIP/SND, for instance).

To access the complete list of issuing banks, click on the link below:

http://www.debentures.com.br/exploreosnd/consultaadados/participantes/bancosmandatarios_f.asp


2. Profitability

The ways of payment can vary from debenture to debenture, according to the characteristics of each one. They can pay fixed or variable interest rates, equity and/or rewards, redemption on expiration dates only, etc.

Finally, the paying wages will change depending on the contract signed while emitting the notes. Currently, most debentures issued to capital investors use the IGP-M as index (General  Market Price Index) or the CDI variation (depositary certificates) or even the IPCA index (Broad  Consumer Price Index), in addition to a fixed annual rate.

Usually, debentures provide a better profitability than savings accounts, certificates of deposit or sometimes better than government bonds. The profitability margin is directly associated to the risks, meaning that an institution with larger risk will need to be offering notes with higher profitability margins, making their debentures more attractive.

We can only acknowledge how profitable a debenture is by knowing its characteristics. By an example, let’s see the paying terms for some debentures:

  • 104,1% of CDI (Certificates of Deposit)
  • CDI + 0,85% per year
  • 100% of IPCA + 5,70% spread
  • IGPM + 10,65% per year
  • 13,15% per year
  • TJLP + 3,63%
  • 1% per month

There are cases in which rates can be rediscussed. In these situations, the issuer establish new conditions to a next period. If debenture holders do not accept those conditions, the issuer will need to repay all notes. The company, though, could re-issue the repaid debentures to another investor, but only under the conditions that haven’t been accept by the original holder. Another important condition says the issuer can also recover the notes before the expiration dates, but only if it repays all debentures issued at a time.

There are other characteristics of debentures determined by the Central Bank and the CVM that are important to have in mind:

  • For debentures with pre-fixed interest rates there is no minimal expiration date;
  • When the wages are linked to the TJLP (long term interest rates) or the TR (referential index), the minimal expiration or rediscussing period is one month;
  • For debentures with variable rates of payment, they can be readjusted in regular periods of time, if such operations have expiration dates equal or larger than 180 days, unless the Central Bank establish lower periods to make adjustments;
  • Debentures with payments based on coeficcients used to adjust public debts or based on exchange rates, there is no minimal expiration periods;
  • For debentures with clauses of currency correction based on market price indexes (such as IGP-M or IPCA), the minimal expiration period is fixed in one year.

3. Risks

The main risk that debentures are exposed to is the risk of credit, which comprises the possibility of the issuer to not honor the payments. Moreover, all companies that issue debentures are evaluated and ranked according to their risk. Such “rating” is basically an opinion about the ability of a country or company to pay and honor its future commitments. The main institutions doing ratings like that are STANDARD & POOR’S, FITCH RATINGS and some others, so we can see the rating within the debenture prospects.


4. Taxation

Taxes incident on a debenture are similar to those for government bonds. While redeeming a debenture, we incur on income taxes. Tax is automatically paid by the institution where you acquired the notes in a first place.

The income tax rate can change depending on expiration dates for the debenture:

  • Expiration date within 180 days or less: 22,5% (just over profits)
  • Expiration date within 181 to 360 days: 20% (just over profits)
  • Expiration date within 361 to 720 days: 17,5% (just over profits)
  • Expiration date within 720 days: 15% (just over profits)

Debentures are also subject to IOF tax, but only if the redemption happens BEFORE 30 days of investment. There is a table that shows IOF rates, according to a redemption happening during the first 30 days of investment:

Days passed from the investment date Taxable stake of profits (%)
1 96
2 93
3 90
4 86
5 83
6 80
7 76
8 73
9 70
10 66
11 63
12 60
13 56
14 53
15 50
16 46
17 43
18 40
19 36
20 33
21 30
22 26
23 23
24 20
25 16
26 13
27 10
28 6
29 3
30 0

In addition to the income tax and the IOF (if existent), there are other three different taxes and charges that must be considered while investing in debentures:

1. A negotiation tax rate of 0.10% over the total amount. All debentures are subject to this charge. However, it has a maximum value of BRL 40.00. Thus, if you are investing BRL 40,000.00 or more, the tax remains at BRL 40.00. This charge has been discontinuated in January 2013.

2. Another incident tax over debentures is a charge made by CBLC, in order to hold and keep your notes, and make information and balance sheets available. That charge can change depending on the type of the debenture. Some notes generate a charge equivalent to 0.30% of their value per year, some others generate a fixed charge of BRL 6.90 each six months. Again, that will depend on the note characteristics to know which are the taxes and rates incident over the debentures.

3. For investing in debentures, it is necessary to have an account in a specific broker, a custodian. They usually charge a small service fees, set up once you open an account with them. So, always do a research about the fees of a broker to be investing in public notes, because if they charge 1% or more, maybe it is not worth to invest.


5. How it works

When a company needs to raise capital for investing or equalizing its cash flow, it may rely on the debenture issuing for raising the money. The process happens this way: once the green light is given after a general assembly or a board’s meeting, the company releases a document called Debentures Trust Deed. Such document must be notarized and sets out all terms on which debentures are being
issued. That includes rights of potential buyers, duties of the issuer and all other characteristics, such as payment of interests, specific clauses and more. Also, the company needs to appoint a financial institution (investment bank, broker or similar) to be managing and coordinating the whole process. The institution, known as lead coordinator, is to be responsible for the following topics:

  • Issue modelling;
  • Converting the company in an open society, getting all necessary documents and licenses, if necessary;
  • Preparing all documents required by CVM for issuing the notes;
  • Creating the distribution consortium;
  • Organizing road shows;
  • Assessment of bookbuilding, if the case;
  • Positioning notes to investors.

The coordinator is also responsible for proceeding a due dilligence about all information given by the issuer to be disclosed and used within the debentures prospect. They also make a bookbuilding, a previous hearing from the market, in order to define the pay levels for the debentures, and/or its paid interests. That reflects what investors want to be purchasing. After having all characteristics, clauses and contracts written and checked, an underwriting takes place: in other words, a primary distribution of debentures; or the first sell of notes after the issuing. Such process is led by the hired financial institution.


6. Types

Each debenture brings specific characteristics. Some of them are common between the several types, like the guarantee character, if the note is conversible or not, etc. Well, some characteristics shared by all debentures include:

As to the guarantees:

Actual

This is the type of guarantee that protects the investor the most. It is supported by assets (either properties or goods) held or mortgaged by the issuer or related third parties. The volume of notes issued under actual guarantees is limited to 80% of the value of the assets held by the issuer, if the amount of debentures surpass the company’s social capital. When a company chooses an actual guarantee, the assets used for issuing notes cannot be dealt, sold or negotiated before the repayment of all debentures. The fiduciary is responsible for executing actual guarantees when necessary.

Floating

This guarantee assures the investors a privileged position on the issuer’s assets, in case of bankrupcy. However, it doesn’t prevent those assets to be traded, sold or negotiated without noticing debenturists. Debentures with this kind of guarantee have a payment preference over previous debentures issued and other specific and outstanding credits with actual guarantees. The amount of debentures to be issued is limited to 70% of the company’s active on balance sheets, minus the debts backed by actual guarantees.

Chirographic

Chirographic guarantees can also be named “no-preference” guarantees. They do not have the advantages of the previous types, giving no privileges over the issuer’s assets. Thus, investors are equal to all other non-privileged creditors. Chirographic emissions cannot exceed the company’s social capital.

Subordinated

No guaratees taken. In case of a company’s liquidation, debenturists have some preference only over the shareholders. However, for this type of debentures there is no limits for the amount to be issued.

As to receiving conditions:

Simple

For this type, investors are to receive their capital back in cash, plus interests and gains.

Conversible

In the expire date, it is possible to convert the note in company’s shares, at the investor discretion, by predetermined conditions and deadlines.

Exchangeable

In this particular case, it is possible to convert the notes in shares of a company other than the issuer, or even “transform” the notes in assets, like bonds or certificates (however, it is not common in Brazil). Mostly, the shares that are the object of the conversion belong to a subsidiary or another company in the same conglomerate of the issuer.

As to the scrip:

Nomimative

A nominative debenture has a book-entered certificate with the owner’s name, and it is facultative to the issuer the hiring of book-keeping procedures for the emission and transferences.

Bookkept

A bookkept debenture is also nominative, but has no certificates emitted, and to which hiring a financial institution is mandatory. In other words, these debentures are those whose custody is taken by an authorized financial institution, like banks or brokers.

As to the regimen:

Firm Guarantee

In the firm guarantee regimen, the lead financial institution (bank or broker) makes sure the issue to happen a previously determined pricing, taken the future risks. If the notes are not completely accepted by the market, the financial mediator writes the rest of the notes down. The leading wages, in this case, include commissions for coordination, issuing and guarantees.

Best efforts

In the best efforts regimen, the lead coordinator is committed to make its best in reaching the market acceptance, getting the best conditions and capital raising as possible to the issuer before the limit date. It does not take, however, any guarantee that the market will be accepting the offer. In this regimen, the leading wages include just commisions on the coordination and issuing.

Stand-By

The issuer itself writes the non-accepted notes down after a period of.


7. Advantages

  • Attractive profitability margin;
  • Notes linked to inflation rates assure the currency value to your investments;
  • Fiduciary agents help investors during the whole process;
  • Low risk profile if debentures belong to a solid company;
  • They can be traded in the secondary market;
  • Help companies to finance projects and the market growth;
  • They have guarantee to protect investors.

8. Disadvantages

  • They retain taxes on the income, which grabs part of the profits;
  • You must seek lower custodian rates, because anything above 1% can compromise the profitability;
  • Charges on purchase and custody by CBLC;
  • Debentures are not covered by the guaranty fund (FGC);
  • Any redemption before 30 days implies on taxes over financial operations (IOF).

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