Most investors are familiar with equity markets. There are talking heads discussing stocks on television, there is a lot of media coverage about stock markets, and success stories of investors multiplying their capital from share markets. Then there are brokers running advertising campaigns, there is minute by minute coverage of Sensex and Nifty; besides now it’s become easier now than ever for anyone to directly invest in stocks or equity mutual funds.
But that is not the case with fixed income. We don’t see much being talked about this asset class as the issuances and subscription is primarily meant for institutional investors. As a result, investors understand what a share is and how investment in a share will benefit them, but when it comes to fixed income securities/debt securities, they are usually blank.
However, what investors fail to understand is the risk associated with equity investments, the volatility and sometimes a long spell of bear markets, which at times lead to unpleasant investing experience.
Fixed income securities, as the title says, are intended to give the investor a fixed income. Through this article we intend to provide an introduction to different types of fixed income/debt securities.
What is a debt security? A debt security provides regular cash flows to investors at pre-determined rates and intervals. The rates can be fixed or floating. Also, the principal is returned to investors at maturity. The interest accrued on debt instruments will be received before maturity unlike a Fixed Deposit where investor gets both principal and interest at the end. Typically, companies prefer to raise their capital through these securities rather than issue equity shares as cost of debt is cheaper compared to cost of equity for them.
Traditionally, debt is assumed to be a safe asset class with stable return expectations and is usually the cushion part of the portfolio. However, this comes at the cost of lower returns compared to equities in the long term.
Types of debt Instruments/ Securities:
These are issued by government of India with a promise of repayment on maturity. Government bond having 10-year maturity is considered as a benchmark for all other corporate bonds.
Certificate of Deposit (CDs)
CDs are short-term borrowings having a maturity of not less than 15 days up to a maximum of one year. They are like bank term deposits accounts. Unlike traditional time deposits, these are freely negotiable instruments and are often referred to as Negotiable Certificate of Deposits. All scheduled banks (except Regional Rural Banks and Co-operative banks) are eligible to issue CDs to individuals, corporations, trusts, funds and associations. They are issued at a discount rate freely determined by the issuer and the market/investors.
Commercial Paper (CPs)
Commercial Papers are unsecured short term borrowings by Corporates, FIs, Primary Dealers, from money market with a maturity period of 15 days to 1 year.
Borrowing or lending for one day upto 14 days, in the interbank market is known as call money. Entry into this segment of the market is restricted to notified participants which include scheduled commercial banks, primary dealers and satellite dealers, development financial institutions and mutual funds
Treasury Bills are short term GOI Securities. They are issued for different maturities viz. 91 days, 182 days and 364 days. Banks, Primary Dealers, State Governments, Provident Funds, Financial Institutions, Insurance Companies, NBFCs, Mutual funds, FIIs (as per prescribed norms), NRIs & OCBs can invest in T-Bills.
A debenture is a debt security issued by a company (called the Issuer), which offers to pay interest in lieu of the money borrowed for a certain period. In essence, it represents a loan taken by the issuer who pays an agreed rate of interest during the lifetime of the instrument and repays the principal normally, unless otherwise agreed, on maturity. These are long-term debt instruments issued by private sector companies. Unlike other fixed income instruments such as Fixed Deposits, Bank Deposits they can be transferred from one party to another. Debentures can be secured or unsecured.
Zero Coupon Bond
In such a bond, no coupons are paid. The bond is instead issued at a discount to its face value, at which it will be redeemed. There are no intermittent payments of interest. When such a bond is issued for a very long tenor, the issue price is at a steep discount to the redemption value and hence is also referred to as a deep discount bond. The effective interest earned by the buyer is the difference between the face value and the discounted price at which the bond is bought. There are also instances of zero coupon bonds being issued at par, and redeemed with interest at a premium. The essential feature of this type of bonds is the absence of intermittent cash flows.
Floating Rate Bonds
Instead of a pre-determined rate at which coupons are paid, it is possible to structure bonds, where the rate of interest is re-set periodically, based on a benchmark rate. Such bonds whose coupon rate is not fixed, but reset with reference to a benchmark rate, are called floating rate bond.
Any fixed income fund is made of these securities. Fund’s risk profile and return prospects depend upon the weightage of different type of securities. We suggest investors to take more informed investment decisions. Allocating a portion of one’s portfolio towards debt scheme will provide protection in adverse situations.