📘 3.1 Features of a Debt Security
📌 Definition
A debt security represents a contract between the issuer (company) and the lender (investor), allowing the issuer to borrow money at pre-determined terms. These terms include the principal amount, coupon (interest rate), and the maturity date of the debt security.
In India, a debt instrument issued by the government or public sector organizations is called a **bond**, while borrowings by private companies are referred to as **debentures**. The terms are often used interchangeably.
🔑 Key Features of Debt Securities
💵 Principal Amount
The principal is the amount borrowed by the issuer. It is the face value of the debt security, which must be repaid at maturity. This is typically ₹100 or ₹1,000 for debentures.
📈 Coupon Rate
The coupon is the interest rate paid by the borrower to the lender. It is expressed as a percentage of the principal (face value). Interest payments can be annual, semi-annual, quarterly, or monthly.
📅 Maturity Date
📆 What is Maturity Date?
The maturity date of a bond is the date on which the borrower is required to repay the principal amount. The maturity can range from short-term (a few months) to long-term (30 years or more).
💡 Features and Combinations
Debt securities have distinct features that may vary, such as different coupon rates, maturities, and repayment terms. These can be tailored to suit the specific needs of both the borrower and the lender.
💡 Distinctions Between Debt and Equity Securities
💸 Debt Holders vs Equity Holders
- Debt holders are lenders, while equity holders are owners.
- Debt securities have a fixed maturity period, whereas equities are perpetual in nature.
- Debt holders receive fixed returns, while equity holders are entitled to residual profit (not guaranteed).
- Debt holders have preference over equity holders in case of company liquidation.
💡 Example:
A company may issue a 10-year debenture with a face value of ₹1,000, paying an annual interest of 8%. The principal is due on the 10th year, and the investor receives interest payments each year until maturity.
📘 3.2 Market Value of a Debt Security
📌 Definition
The face value (or par value) of a debt instrument is the amount borrowed, which is due to be repaid to the investor at maturity. If the debt instrument is traded before its maturity, the price at which the trade is executed is called the market value. This may be higher or lower than the face value, influenced by various market factors.
📊 Factors Affecting Market Value
📈 Supply and Demand
The market value of a debt security can fluctuate based on supply and demand. If more investors want to purchase a particular security, its price tends to rise, and vice versa.
💹 Interest Rates
Interest rate changes have a significant impact on the market value of debt securities. If market interest rates rise, the market value of existing bonds may fall, and vice versa.
📉 Market Value Fluctuations
⚖️ Market Conditions
Changes in broader market conditions, such as investor sentiment and economic forecasts, can influence the demand for debt securities and, consequently, their market value.
📉 Default Risk
If a company or government faces financial trouble, the perceived risk of default increases, which may lead to a decrease in market value of their debt securities.
💡 Example:
If a company’s bond is issued with a face value of ₹1,000, but due to rising interest rates, the bond is sold in the market for ₹950, this is the market value of the bond. It’s lower than the face value because the bond’s fixed coupon rate is less attractive compared to newer issues with higher interest rates.
📘 3.3 Yield from Debt Instruments
📌 Definition
The return to an investor in bonds is known as the yield. It is primarily composed of coupon payments, but if the bond is acquired or sold at a price different from its par value, it generates capital gains or losses. Therefore, the yield can vary from the coupon rate.
The coupon rate of the bond simply indicates the interest paid periodically to the investor. However, it does not represent the total return the investor may receive, as the market price of the bond can fluctuate.
📈 Types of Yield
💵 Current Yield
Current yield compares the coupon of a bond with its market price. The formula is: Current Yield = Coupon / Market Price.
Example: If a bond pays an annual coupon of 12% and is trading at ₹109.50, the current yield is: 12/109.50 = 10.95%.
📊 Yield to Maturity (YTM)
YTM is a more comprehensive measure of a bond’s return. It calculates the rate that equates the present value of all future cash flows (coupon payments and principal repayment) to the bond’s market price.
Example: A bond paying periodic interest of ₹100 annually and a principal of ₹1,000 at maturity may have a YTM that reflects the total return based on its current market price.
💡 Example:
A bond with a face value of ₹1,000, paying a coupon of 12%, is trading at ₹1095. The current yield would be: 12% × ₹1000 / ₹1095 = 10.95%. This yield represents the annual return based on the market price of the bond.
📘 3.4 Types of Debt Securities
📌 Definition
Debt securities can take various forms, each with its own features and benefits. They are issued to raise capital and come with a promise to repay principal along with interest, based on the terms specified in the debt contract.
🔀 Types of Debt Securities
💡 Convertible Debt Securities
Convertible debt securities are hybrid instruments with both debt and equity features. They pay interest like any debt instrument, but on maturity, they are converted into equity shares based on pre-determined terms.
- Suitable for companies with high growth potential
- Provides lower-cost financing for issuers
- Offers potential capital appreciation for investors
📉 Zero Coupon Bonds
Zero coupon bonds don’t pay periodic interest. Instead, they are issued at a steep discount to their face value, and the investor receives the full face value at maturity.
- No regular interest payments
- Issued at a discount to face value
- Common for projects with long gestation periods
💵 Other Types of Debt Securities
📈 Fixed Rate Bonds
Fixed rate bonds pay a predetermined interest (coupon rate) at specified intervals. These are the most common type of debt instruments.
- Fixed coupon rate paid periodically
- Issued at face value or with a small premium/discount
- Principal is repaid at maturity
🔄 Floating Rate Bonds
Floating rate bonds have a variable coupon rate that is periodically adjusted based on a benchmark interest rate (e.g., RBI Repo Rate).
- Interest rate is linked to a benchmark rate
- Coupon rate resets periodically
- Used in markets with fluctuating interest rates
📉 Other Hybrid and Asset-Backed Securities
📊 Inflation-Indexed Bonds
Inflation-indexed bonds (IIBs) are floating-rate bonds where the coupon payments are adjusted for inflation to provide real returns to investors.
- Issued by government or RBI
- Offers protection against inflation
- Common in the Indian markets
🏠 Asset-Backed Securities
Asset-backed securities are bonds created by pooling assets (such as housing loans) and selling them as a security. These are also called mortgage-backed securities.
- Backed by a pool of assets (e.g., housing loans)
- Creates bonds representing claims on asset cash flows
- Ideal for assets with regular cash flow streams
💡 Example:
A company may issue a convertible debenture, which offers a fixed interest rate over 5
📘 3.5 Classification of Debt Market
📌 Definition
The bond market can be segmented in two primary ways: based on the type of borrower and the tenor (time period) of the debt instrument. These segments help investors make decisions based on the issuer and the duration of their investment.
🔑 Classification Based on Borrower Type
🏛 Government Bonds
Government securities comprise bonds issued by central, state, or local governments. These bonds have low credit risk as they are backed by the government. They are considered safe investments with low yields.
🏢 Corporate Bonds
Corporate bonds are issued by private and public companies to raise capital. These bonds come with higher credit risk compared to government bonds but offer higher returns. The risk depends on the creditworthiness of the issuer.
📅 Classification Based on Tenor
⏳ Short-Term Bonds
Short-term bonds typically have a maturity of less than 1 year. They are often issued by governments and corporations for temporary funding needs and offer lower interest rates due to their lower risk.
📆 Medium-Term Bonds
Medium-term bonds have a maturity period between 1 and 10 years. These bonds offer a balance of risk and return and are popular among institutional investors looking for stable income.
📈 Long-Term Bonds
Long-term bonds are issued for more than 10 years. These instruments typically offer higher yields to compensate for the longer-term risk and are suitable for long-term investors.
💡 Example:
A government may issue a 5-year bond to fund infrastructure projects. Similarly, a corporation may issue a 10-year bond with a higher interest rate to fund expansion activities. The choice between these bonds depends on the investor’s time horizon and risk tolerance.
📘 3.6 Credit Rating
📌 Definition
The biggest risk faced by investors in debt securities is the possibility that the borrower may not honor its commitment to pay interest and repay the principal at maturity. Credit risk refers to the risk that the borrower may default on its financial obligations.
Credit risk is assessed by credit rating agencies, which assign ratings to debt instruments based on the borrower’s ability to repay. The credit risk evaluation takes into account both qualitative and quantitative factors that affect the business’s financial health.
💡 Credit Rating Agencies
📊 Role of Rating Agencies
Rating agencies assign ratings to bonds or debt instruments based on the borrower’s creditworthiness. These agencies are registered with SEBI (Securities and Exchange Board of India) and follow the regulations to evaluate and provide credit ratings.
📉 Dynamic Ratings
Credit ratings are not static. They are updated regularly based on the financial condition of the issuer. If a company’s financial health improves or deteriorates, the credit rating may be reassigned.
💳 Types of Credit Ratings
🔹 Long-Term Debt
Ratings for long-term debt instruments (maturity > 1 year) indicate the credit risk associated with the borrower. The ratings range from AAA (highest safety) to D (default).
🔸 Short-Term Debt
Ratings for short-term debt instruments (maturity ≤ 1 year) reflect the issuer’s ability to meet short-term obligations. The rating symbols include A1 (highest safety) to D (default).
💡 Example:
A company with a rating of AAA is considered to have the highest degree of safety regarding the timely servicing of its obligations, while a company with a rating of C or D has a very high risk of default.
📉 Unrated Bonds
🔑 What Are Unrated Bonds?
Unrated bonds do not have a current rating from an external credit rating agency. These bonds typically offer higher yields due to their higher perceived risk and illiquidity.
💡 Risk of Unrated Bonds
Unrated instruments carry more risk, but investors may demand higher returns to compensate for that risk. SEBI has guidelines for mutual funds on investing in unrated debt instruments.
📜 Credit Rating Symbols
The rating symbols for long-term debt range from AAA (lowest credit risk) to D (default). For short-term debt, ratings range from A1 (highest safety) to D (default). These ratings are used by investors to assess the risk level of a particular debt instrument.
📘 3.7 Money Market Instruments
📌 Definition
Money markets refer to markets where short-term instruments, typically with a maturity of less than one year, are issued and traded. These markets facilitate the borrowing and lending of short-term capital, primarily for governments and commercial banks.
The money market is highly liquid, offering instruments like Commercial Papers (CP), Certificates of Deposit (CDs), and Treasury Bills (T-Bills), all of which mature in less than 365 days. It serves as a platform for short-term financing needs for banks and governments.
💡 Key Money Market Instruments
📄 Commercial Papers (CP)
Commercial papers are unsecured short-term debt instruments issued by corporations to finance their short-term operational needs. These are typically issued with maturities ranging from a few days to 270 days.
💳 Certificates of Deposit (CD)
Certificates of Deposit are short-term deposits issued by commercial banks with a fixed maturity and interest rate. The maturity period can range from a few weeks to a year.
📈 Government Securities in the Money Market
💰 Treasury Bills (T-Bills)
Treasury Bills are short-term government securities with maturities ranging from a few days to 12 months. They are sold at a discount and redeemed at face value.
📉 Long-Term Government Debt
In addition to money market instruments, governments also issue longer-term debt securities for longer-term funding needs. However, these are not considered typical money market instruments due to their longer maturity periods.
📊 Characteristics of the Money Market
Money markets are typically used by governments and financial institutions to meet short-term funding needs. The market operates on high liquidity with large volumes of transactions, and instruments are generally low-risk.
