Asset Class Part - III : Introduction to Fixed income or Debt Instruments

In order for a business to grow it needs money to buy plant and machinery or invest in new product development. Business has two options to get this money – generate it internally or get it from from external sources. In order to raise money from external sources they again have two options – either bring in fresh equity, or raise debt (bonds or bank loans). Fixed Income or debt instruments are created when the company chooses to raise debt from external sources.

Fixed income securities or debt instruments are contracts in which one party lends money to another on pre-determined terms – with regards to –  rate of interest to be paid, periodicity (monthly, quarterly, half-yearly or annual) of interest payment, and method of repayment of principal amount (either in installments or in bullet). 

Some of the key terms used to define debt market instruments are –

1. 1. Principal is the amount that has been borrowed. This entire principal is subdivided into several bonds have uniform value. This uniform value is called face value of bond. The face value of each bond is fixed by the borrower (issuer of bond). Typical face value of bond is INR 1000.
   2. Interest or coupon rate is the rate of interest used to make periodic interest payment by the borrower to lender (subscriber of bond). Coupon rates are stated upfront (e.g. 8% PA of INR 1000). Interest payments are typically made every six months.
   3. Date of Maturity is the date on which borrower has agreed to pay the entire principal back to the lender. Once the entire principal is repaid the debt instrument ceases to exist.

Let us take an example of a Central Government bond – GS CG2025 10.50% bond. This refers to Central government bond maturing in Year 2025 having coupon rate of 10.5% paid every six months. This means central government will make approximate interest payment of INR 52.5 every six months on face value of INR 1000.

In India, the term “bond” is used for debt instruments issued by government and public sector organizations; while the term “debentures” is used for debt instruments issued by private sector organizations.

Most fixed income securities or debt instruments are classified according to their term to maturity. They are generally segregated into three buckets –

• • Short-term bonds having maturity within 1 to 3 years.
  • Medium-term bonds having maturity within 3 to 10 years.
  • Long-term bonds having maturity after 10 years or more.

Who are part of debt markets?

In India, debt markets is quite concentrated having only small number of players. They are banks, financial institutions, mutual funds, provident funds, insurance companies and corporates. Thus it is a wholesale market where most of the new debt issues are privately placed or auctioned to these participants. And secondary market dealings are mostly negotiated over telephone.

Most of the time, retail investments (or investments by citizens of India) into debt market happen indirectly through various banks, insurance companies, public provident funds and other financial institutions. Mutual funds comprising of liquid funds, bond funds and gilt funds is the most recent way for retail investors to invest into debt markets.

What are different debt market products?

In India, some of the most common debt market instruments are –

1. 1. T-Bills or Treasury Bills are short term debt raised by the central government with maturity duration ranging from 91 days to 1 Year. These are sold at a discount to their face value and do not involve any interest payments.
   2. Bonds are the most common debt instrument issued by public sector units with maturity duration between 5-10 years from the date of issue. These are sold at face value and pay regular interest every six months.
   3. Dated Securities are long term securities issued by the government with maturity duration between 2-30 years from the date of issue. These carry a fixed or floating interest rate to be paid every six months. The Public Debt Office (PDO) of the RBI acts as the registry / depository of Government securities and deals with the issue, interest payment and repayment of principal at maturity.
   4. Fixed Deposits is a product offered by banks and non-banking financial companies (NBFC) (eg. HDFC or Bajaj Finance) where the customer agrees to leave a lump-sum deposit untouched for a predetermined period of time in return for regular interest payments made at fixed time intervals. These are also known as time deposits or term deposits.
   5. Commercial Paper are unsecured short term debt issued by private sector companies to meet their short term money requirements with maturity duration less than a year. These too like T-Bills are issued at a discount from face value to reflect the prevailing interest rates in the market.
   6. Debentures are issued by private sector organizations with maturity duration between 1-12 years from the date of issue. These are sold at face value and make regular interest payments at predefined dates. These interest payments can be made on quarterly, semi-annual and annual basis depending in lenders choice.
   7. Structured Obligations are modified way to raise funds from the markets. Organizations create Special purpose vehicle (SPV) (usually a trust) by committing their assets to it. It then creates special ownership rights and sell them to prospective lenders. These are then rated by credit rating agencies. The investors buy them based on their risk taking ability thus providing funds to the organization for future use. Banks, financial institutions, infrastructure companies use this method to raise money.

Matrix of issuer, investors, debt market instruments and their maturity is presented below –

Why people buy debt products?

People buying debt products (or fixed-income securities) generally have low-risk taking ability or are looking for safe and predictable returns on their investment. For example, financial requirement of a retired person will be to receive regular payments at pre-defined intervals to meet their expenses, without consuming the principal. One of the safest way to meet this requirement is by buying fixed income securities. Thus, this retired person can buy fixed income securities using principle amount, and meet monthly expenses from the interest received. And on date of maturity, the retired person will get back their principle amount.

Factors impacting debt market products?

Debt market products are not risk free, they too have risks associated with them. Let us discuss some of them here –

1. 1. Inflation risk – Inflation reduces the purchasing power of money. Inflation also causes the price of various products to increase. Thus over a period of time the purchasing power of your principal and interest received will decrease while your expenses will increase. However your income from debt products remains constant with time.
   2. Interest rate risk – Any reduction in interest rates will cause losses to the borrower as they end up paying higher than prevailing interest to lenders for the remaining duration of debt security. Similarly an increase in interest rates will cause losses to lenders as they end up getting less interest than prevailing the interest rates for the remaining duration of debt security.
   3. Reinvestment risk – Reinvestment risk occurs when the buyer of debt products (or lender) is not be able to purchase another debt product generating similar returns on maturity of existing debt instrument. In case the interest rates increase (or goes up) then the buyer will benefit by purchasing new debt securities as they will generate additional income. However when the interest rates are reduced then the buyer needs to buy more debt securities to get same amount of interest.
   4. Default risk – Default risk materializes when the issuer of debt securities (or borrower) is unable to make interest or principal payment due to any reason.
   5. Liquidity risk – Let’s assume the buyer (or lender) of debt securities urgently needs their principal amount before maturity, however they are be unable to exchange the security for cash without incurring a loss due to lack of buyers. This is liquidity risk.
   6. External risk – There are certain external factors like governmental actions, or fluctuation in foreign exchange rates that cause change in value of the debt instruments. These factors are called external risks and are beyond the control of both buyer and seller of debt instrument.

Conclusion

In this article, we have provided you information about Fixed Income securities, different types of securities, and why people buy them. And we have also explained about factors which impact them. For more information please feel free to reach out to us via email at – enquiry@taptoprosperity.com or by phone – 91-9515475381.

Next Article – Asset Allocation Part – IV : Introduction to Commodities

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