Debt Instruments

A debt instrument is a debt security issued by the government, public sector or private sector entity to raise funds for various purposes. This is typically characterized by a fixed rate of interest paid out at regular intervals, and repayment of principal amount at maturity. The return flow from these securities is fixed and predictable, and not affected by market rates if held till maturity. However, that does not mean that the value of the security does not change over a period of time. If the holder of the debt instrument wishes to sell it before maturity he will have to sell it at the market price which is dependent on the prevailing interest rates and yields.

Some of the Debt Securities are given below:

 

  1. Government issued
  2. Treasury Bills: These are short-term money market securities issued by the government to fund their short-term credit requirement. They have maturities of 3 months, 6 months and 12 months. They are offered at a discount on their face value, and redeemable at face value on maturity. They are issued in primary market through RBI auction, and traded in secondary market through institutional players like money market mutual funds.
  3. Government Securities (G-sec): G-secs are long-term sovereign securities issued by the Central and State Governments to finance government expenditure. G-Secs are the oldest and largest element of the Indian debt market in terms of value and volumes. The yield on G-sec is considered as a benchmark for the risk-free rate of return on the Indian economy. G-secs are long term instruments with maturities of up to 30 years. The different types of G-secs include:
    • Fixed rate bonds: These have a fixed coupon rate which does not change with the market rates. In this case, the price of the G-sec would change to accommodate market yields.
    • Floating rate bonds: These have a variable interest rate, which is linked to the market rates. For example, the G-sec rate could be based on MIBOR (Mumbai Inter Bank Offered Rate).
    • Special Securities: These are untradeable, and are issued for specific purposes only.

 

  1. Banks and Financial Institutions’ (FIs) issued
  2. Certificates of Deposit: These are issued by Banks and Financial Institutions (FIs) as an acknowledgement of deposits held with them. They have a fixed rate of interest payable at maturity. Maturities of bank CDs range between 7 days to one year, while of other financial institutions can range from one to three years. They are virtually risk-free, just like a bank deposit. But unlike FDs, they can be traded in the secondary market physically and through demat. They can be issued by all scheduled commercial banks, except regional rural banks and local area banks. Some of the All -India FIs are also permitted to raise CDs short term funds. They can be issued to all individuals, HUFs, funds, trusts, companies, associations, etc. They can also be issued to NRIs, but on non-repatriable basis.

 

  1. Companies issued
  2. Commercial Paper: CPs are unsecured instruments issued as promissory notes. CPs are issued by Companies, Primary Dealers and other FIs to raise funds for current account like inventories and other operational expenses. They are issued in multiples of ₹ 5 lacs. They have maturities ranging from 15 days to one year. They have to adhere to the RBI guidelines, and can only be purchased through primary market. They can only be issued by corporates who have an investment grade rating given by a standard credit rating agency. They are issued at a discount to face value and redeemed at par, similar to a zero-coupon bond. CPs are mainly bought by banks. Other investors include Corporate and Non-corporate bodies, Non-Resident Indians (NRIs), and Foreign Institutional Investors (FIIs) as per limits set by Securities and Exchange Board of India (SEBI).
  3. Bonds: These are issued by companies and financial institutions to raise money in the form of debt from the purchaser. They have a predetermined interest rate and a fixed frequency of pay-outs. Maturity of a bonds range from 5 to 7 years, and they could also come with call options (redeem before maturity) or conversion options (convert to shares). Bonds could be secured against the company assets, or it could be unsecured. The investor must keep in mind the credit rating of a bond before investing in it. Credit rating of the bond gives an idea of the financial health of the issuer company, and its ability to repay the principal amount along with interest. Bonds with lower credit rating could have a history of defaulting on payments, so one should be wary of investing I them. Bonds are one of the riskiest debt instruments.

Types of bonds include:

  • Fixed rate bonds: These carry a fixed rate of interest which does not change till maturity
  • Floating rate bonds: These bonds have interest rates which are flexible and dependent on the market interest rates, e.g. MIBOR (Mumbai Inter Bank Offered Rate).
  • Zero Coupon bonds: These are issued at a discount and redeemed at face value.

Bonds can be bought and sold in the secondary market. Hence, they are subject to interest rate risk. This means that the price of the existing fixed rate bonds will be affected by the change in the prevailing interest rates. This risk is higher for long term bonds. Liquidity of bonds is a concern in the Indian Debt Markets, as these are not listed instruments, and one has to find a buyer in the secondary market to liquidate the bond. Many-a-times, bonds have to be sold at a sharp discount from its intrinsic value, in case the holder is desperate to sell.

Some bonds have a call and put option. In case of a call option, the company can recall the bonds after a certain specified time frame, and prepay its debt. In case of a put option, the investor can approach the issuing company and sell the bond back to them. Put option can be useful to the investor in case he wants to sell in a high-yield scenario.

 

FAQs

  1. Why should I invest in Debt Instruments?

There are many advantages of investing in Debt Instruments.

  • They are less volatile that other asset classes. Hence, they provide stable returns.
  • They fetch higher returns than Bank FDs and other traditional schemes.
  • They help to diversify the portfolio and mitigate risk, as they generally fetch higher returns when equity markets slump.

 

  1. How can I invest in Debt Instruments?

It is difficult for a retail investor to invest in Debt Instruments in the Primary market due to reasons relating to high investment requirement, illiquidity, inaccessible markets and difficulty in risk evaluation. Hence, a more feasible way to gain exposure in debt assets is through Debt Mutual Funds. There are many types of Debt Funds depending on the market they operate in, like Money Market Funds, Gilt funds, MIPs, etc.

 

  1. What are the limitations of Debt Instruments?

There are a few cautions to bear in mind while investing in Debt Securities:

  • Lack of liquidity: The instruments have to be held till maturity, unless they are traded in the secondary market.
  • Underrated investments: Lack of retail buyers leads to under-pricing of the asset, reducing the probability of capital gains.
  • Easily affected by market rates: Changes in the market interest rates affect the yields on debt securities held by the investor.

 

  1. What is the meaning of yield on a security?

Yield on a security refers to the returns generated by it over its lifetime, given its current market price. Market price and yield of a security are inversely related. For example, if a ₹100 bond fetches an interest rate of 10%, i.e. ₹10 in a year, and if the market interest rates fall, the price of this bond will rise, lets say, to ₹120. In this case, the bond yield will be 8.33%, i.e. ₹10 interest on ₹120 bond. On the contrary, if the market rates rise, then this bond fetching 10% interest will become cheaper, at ₹90, increasing the bond yield to 11.11% (₹10 interest on ₹90 bond).

 

  1. How is the credit quality of a debt instrument determined?

Credit quality of a security indicates the ability of its issuer to pay back his debt. The credit quality of fixed-income securities is generally assessed by independent credit rating agencies like CRISIL & ICRA in India. Apart from these, large financial institutions also have their own credit rating systems. A credit rating of BBB and above is generally considered ‘investment grade’ and a rating below that is considered ‘non-investment grade’

  1. What are floating rate securities? What is the benchmark rate used for such securities in India?

Floating rate securities are those securities where the interest rates are reset at predetermined intervals of time as per a predetermined benchmark. The benchmark generally used in India is the MIBOR, i.e. Mumbai Inter Bank Offered rate. This is the rate at which one bank charges another bank interest for short term loans. Floating rate securities have interest rates in formats, for example, MIBOR + 2 basis points. Thus, the returns on floating rate securities are dependent on MIBOR.

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