Types of fixed income instruments in the debt market!
Updated: Sep 20, 2020
The menu that the fixed income market offers up is almost as long and varied as a yummy Gujarati thali. The issuer of the bond, that is the borrower of the money, the tenure (or tenor in market talk) which is the length of time till repayment of the money, manner of interest payment and repayment of principal are all variants of the bond features that are considered in the market deciding the pricing, or minimum desired returns on the bond.
While fixed income instruments are safer than almost any other financial instrument, such safety is relative. The safety of a paper, based on the ability of the borrower to repay is mostly analyzed by a credit rating agency. Borrowers are rated the highest of AAA, denoting extremely low risk of default in repayment of capital and interest, with AA+, AA, AA- going down to B, C, and lower in a graded increase of risk. A paper rated D is one that has defaulted.
On the domestic or local debt of a government however, there is no credit rating. There is no need for a rating. It is assumed as the highest rated in the land. The safest of all borrowers is the government. This is absolutely true of a government’s domestic borrowings. (There is a rating for the international borrowings of a government, but that does not matter to us at this time). The government is in this unique position because in the territory of which it is sovereign, or ruler, it alone can collect taxes, charge customs duties, or print money to pay for its expenditure, including the repayment of its loans and payment of interest.
Government borrowings are of 2 kinds – short-term and long-term. Short term borrowings are by way of instruments called Treasury Bills (or T-Bills). The long term borrowings are by way of Government Securities (or G-Secs or Gilts*). Each has standard features. At the time of issue, or sale of the instruments a T-Bill always has less than one year to maturity or repayment. It always has a face value of Rs. 1,000 and is issued at a discount, that is at a value lower than Rs. 1,000 and the final maturity value paid out is Rs. 1,000, which is the face value.
G-Secs are long maturity, or longer “dated” securities, to be repaid more than 1 year from the issue date. The borrowing on a G-Sec can be for as long as 40 years. A G-Sec will always have the face value of Rs. 100 and will pay interest every 6 months.
Corporates borrow for the short term through Commercial Paper (CP) and long term through debentures or bonds. Banks also issue tradable deposits called ‘Certificate of Deposit’, or CD. Debentures could be secure against assets owned by the corporate earmarked for repayment in the event of default, or unsecure. In practice, it is the capacity and character of the borrower that is more important than the security because of the possible erosion of the value of the security or the difficulty in selling it at the valuer’s price at the time of liquidation.
Willingness to repay is more important than “security”.
Interest income is taxable. There is an exception where the government permits certain essential corporations in the government sector (PSUs) to borrow through tax-free bonds. Here the interest being tax-free incentivizes investors to invest in projects critical to the nation, with infrastructure being an important beneficiary.
Interest payment could be by way of regular coupon payments, monthly, quarterly, half-yearly, or annually. They might also be cumulative, which means that the entire interest and principal will be repaid only at maturity, which means that the bond has been issued at zero-coupon, or deep-discount, there is a fine distinction between them.
*The term Gilt is traced back to the British, when the paper certificates for the debt securities issued by the Bank of England on behalf of His/Her Majesty's Treasury, had a gilt (golden) edge to suggest that they were as good as gold. Hence, they are known as gilt-edged securities, or gilts for short.
Different types of bond that are traded and available for investment are Corporate Bonds, Government (Sovereign) Bonds, SDL (State Development Loan) Bonds, Tax-Free Bonds - Issued by PSUs, RBI (Savings) Bonds, 54 EC Bonds, Sovereign Gold Bonds, Bank Bonds - Private & Pubic (PSU) Banks, Public Sector Enterprises (PSUs) Bonds.