____________________________________________________________________________________________________

1. Learning Outcomes
After studying this module, you shall be able to

Understand the meaning and characteristics of Debt instruments

Describe various types of debt instruments
Identify the types of return associated with Debt Securities
Analyze various types of risks associated with debt investments

2. Introduction

Meaning of Debt Securities

Debt market is the part of financial market in which debt instruments of varying features are
issued and traded among the investors. Debt instruments are considered safer in comparison to
equity and provide regular income to investors. In India, wholesale debt market is quite vibrant
and volume of trading is very high. However, trading volumes are very low in retail debt segment
and there is a need of reforms to make the market more vibrant and liquid for retail investors. In
India, the issuer of the fixed income instruments includes central and state government, banks and
financial institution and corporates.

Debt instruments may be issued with various features to attract the different categories of
investors. These debt instruments may carry fixed coupon stated as 12% pa or floating coupon
quoted as 5 year G-Sec + 1%. Here 5 Year G-Sec rates is the base rate and it will fluctuate as and
when coupon on government securities will change. The 1% is the spread which will be decided
based on strength of issuer and market interest rates at the time of issue. The debt instrument may
have long term or short term maturity and the coupon may be paid on quarterly, semiannual or
annual basis. These bonds may be issued and redeemed at discount, par or premium depending on
the terms of issue. Further bonds may be callable, puttable or convertible as stated at the time of
issue.

Debt instruments represent borrowing on the part of the issuers of such instrument. The issuer of
debt may be government or corporates. Debt instruments is issued by government/public sector
entity, are known as bonds while debt instruments issued by private sector companies are called
debentures. In this module we will use bonds and debentures interchangeably. The debt is issued
for a specific period of time which is known as its tenure. The subscriber of debt instruments
lends the funds to the borrowing entity. The investor receives periodic return in the form of
interest and at the end of tenure he receives maturity proceeds or the principle amount.

The issuer of debt instrument issues the bond/debentures to the subscriber of these securities
against the funds received from them. These instruments represent the borrowing on the part of
issuer from the investor of these fixed income securities. They are safe investment for the
investors as the principal and interest payment is mandatory irrespective of profits or losses of
issuer. The cash flows from these instruments are quite predictable as the investor receives

BUSINESS ECONOMICS PAPER NO. : 9, FINANCIAL INSTITUTIONS & MARKETS

MODULE NO. : 7, MEANING & TYPES OF DEBT INSTRUMENTS
____________________________________________________________________________________________________

periodic interest normally payable on quarterly or semi-annual basis and principal at maturity.

and movable assets are kept as collateral for these fixed income securities and they have first
charge on these assets. In case of non-payment of interest or principal by the issuer, these
securities will be serviced by selling off the fixed and movable assets which are kept as collateral.
Thus they are considered as quite safe investment.

2.1 Characteristics of Debt Instruments

1. Bonds carry a face/par value which is the nominal value of bond used for accounting purpose.
Normally it is Rs 100 or Rs 1000 in India.
2. The debt securities have a fixed maturity and they are issued for a specific time period, which
is called the tenure of debt. Maturity date is the date at which bond will mature and the
principal will be redeemed by the issuer entity. From this date onwards bond will cease to
exist, if all the payment has been made. Term-to-Maturity is a relative tenure and depends
when we are calculating it. On a given date Term to Maturity implies the number of
months/years remaining for the bond to mature. The Term-to-Maturity changes every day,
from date of issue of the bond until its maturity. The term to maturity of a bond can be
calculated on any date, as the period of time between such a date and the date of maturity. It
is also called the term or the tenure of the bond.
3. Bonds are generally secured by some collateral against it. Normally the fixed assets of the
issuer are kept as security. This safeguards the interest of investors. In the event of default in
the payment of interest and principle by the issuer company these fixed assets can be sold out
and proceeds can be used to recover the dues of the investors.
4. As the debt represents borrowing for the issuer of debt instruments, therefore the investor
receives periodic return in the form of interest and at the end of tenure he receives maturity
proceeds or principle amount.
5. Generally the debt securities carry a fixed coupon rate which is applied to face value and
resulting interest amount is paid to investors. The interest may be paid quarterly/semi-
annually or annually.
6. Generally when the firms raise the funds through debt, they have to agree to various
restrictive conditions known as covenants. This may include the restrictions imposed on the
borrower or may require approval of investors, for further borrowing or expansion of
business.

2.2 Issue and Redemption Price

When the companies issue the bonds/debentures, they have various options regarding their issue
price and redemption value. These options are used to enhance the marketability of debt
instruments. Debt instruments may be issued at par, discount or premium. Similarly it may be
redeemed at par, premium or discount. Depending on the financial strength or reputation of the
issuer for raising the fund, there may be various combinations like issued at par and redeemed at
par or issued at par and redeemed at premium etc.

BUSINESS ECONOMICS PAPER NO. : 9, FINANCIAL INSTITUTIONS & MARKETS

MODULE NO. : 7, MEANING & TYPES OF DEBT INSTRUMENTS
____________________________________________________________________________________________________

3. Types of Debt Instruments

There are various types of Debt Securities traded in the market. These securities can be classified
on several basis like on the basis of issuing entity they can be classified as Government and
Corporate Debt securities. On the basis of type of coupon applicable, these securities can be
classified as fixed coupon, zero coupon and floating coupon bonds/debentures. They are also
classified as convertible, non-convertible and partially convertible debentures depending upon the
option to convert them into equity, on maturity. Thus we have numerous variants of debt which
are discussed follows:

3.1 Government and Corporate Debt Securities

In India when the debt securities are issued by Government or Public sector undertaking they are
called bonds while the debt instruments issued by private sector companies are called debentures.
This is the only difference of terminology. Both have similar features. Therefore bonds and
debentures are used interchangeably.

Companies require funds for variety of purposes for example buying land, plant & machinery,
expansion, modernization etc. In order to raise funds they borrow from the general public by
issuing bonds and debentures. The investor of these debt securities lends the money to issuer
entity for the specified tenure of bond/debenture and in return receives the period interest income
at specified coupon rate. This coupon may be a fixed coupon rate or floating coupon rate payable
quarterly, semi-annually or annually. At the maturity the borrower company redeems these
bonds/debentures and the investor receives back his principal amount.

3.2 Fixed Coupon, Floating Coupon and Zero Coupon Bonds

Bonds can be issued with fixed or floating coupon rate. Coupon rate is the rate, which is quoted
on the instrument and calculated on the face value of bond. It is nominal rate of interest payable
periodically to the holder of bond or debenture. For example fixed rate can be expressed at 11%
p.a. payable semi-annually. In this case, bond will pay interest @11% pa to the investor till
maturity irrespective of movements in market interest rates. Floating rate is linked to a base rate
and - -Sec is base rate and
will change whenever there is change in 10 year government bond market interest rate.
Additional 2% is known as spread and depends on goodwill of issuer company and market
interest rates movements at the time of issue. Higher the goodwill of issuer, lower the spread and
vice-versa. In this case coupon rate will continue to move in alignment with changes in the rate
on Government securities. In case of zero coupon bonds no interest is paid during the tenure.
They are issued at a discount and Redeemed at par. The difference between the issue price and
redemption value denotes the amount of interest to investor.

3.3 Fully Convertible Debentures (FCDs), Partially Convertible Debentures (PCDs)

and Non-Convertible Debentures (NCDs)

BUSINESS ECONOMICS PAPER NO. : 9, FINANCIAL INSTITUTIONS & MARKETS

MODULE NO. : 7, MEANING & TYPES OF DEBT INSTRUMENTS
____________________________________________________________________________________________________

Convertible debentures are the ones that can be converted into equity shares at a later date either
fully or partly. This can be done as per the terms specified at the time of issue of debt. This option
is available with the bond holder. Investor will be benefited by getting the stocks at pre-specified
price while the stock actually would have reached the higher value in the market. Non-
Convertible bonds are redeemed at maturity.

3.4 Secured and Unsecured Debentures

Secured bonds are backed by some collateral, normally the fixed assets of the issuer company.
Long term bond are normally the secured bonds. Short term bonds with a maturity of less than
eighteen months are normally issued without any collateral against them and are called unsecured
bonds.

3.5 Redeemable and Irredeemable Debenture

In most cases, debentures and bonds are repaid at their nominal value at the time of maturity.
They are called redeemable debt instruments. There are certain debt securities which do not have
a set maturity date. Such securities are called irredeemable/perpetual securities. Thus If the bonds
are issued with a fixed tenure they are called redeemable debentures while the perpetual
debentures are called irredeemable debentures.

3.6 Long term, Medium Term and Short Term Bonds

Based on the tenure of bond or maturity period, bonds are classified as long term, medium term
and short term bonds.

4. Bond Returns

4.1 Bond Yield

Yield is an important concept to be considered while investing in bond, because it measures the
return of one bond against another. It enables the investor to take informed decisions about which
bond to buy. In essence, yield is the rate of return on bond investment. However, it is not fixed,
like a bond's quoted coupon rate. Bond yield varies depending upon the changes in the market
interest rates and resultant volatility in the existing bond prices. The following example illustrates
how yield works.

You buy a bond say at Rs100 a bond and hold it for a year in a scenario of rising interest
rates and then sell it.
You will receive a lower price for the bond than you paid for it. Because in the market
interest rates have gone up while your bond carries a fixed coupon rate which is less than
the prevailing interest rates. Therefore your bond has lost its value and you will be able to
sell it only if you accept a lower price say Rs95 a bond.

BUSINESS ECONOMICS PAPER NO. : 9, FINANCIAL INSTITUTIONS & MARKETS

MODULE NO. : 7, MEANING & TYPES OF DEBT INSTRUMENTS
____________________________________________________________________________________________________

Although the buyer will receive the same amount of interest as you did and will also have
the same amount of principal returned at maturity, the buyer's yield, or rate of return, will
be higher than yours, because the buyer has paid lower price for the bond.

Yield is commonly measured in two ways, current yield and yield to maturity.

(a) Current yield

The current yield is calculated by dividing the annual coupon amount by the prevailing
bond price. If you buy a bond at par, the current yield equals its stated interest rate. Thus,
the current yield on a par-value bond paying 6% is 6%.
However, if the market price of the bond is more than par value than current yield will be
less than quoted coupon rate and vice-versa. For example, if you buy a Rs. 1,000 bond
with a coupon rate of 6% at Rs. 850, your current yield would be 7.05% (Rs. 1,000 x
.06/Rs.850).

(b) Yield to maturity

The yield to maturity or redemption yield, is a more useful measure of the return of the
bond. It is calculated by using current cash outflows to buy the bond and all the future
cash flows related to bond. This include current market price, and the amount and timing
of all remaining coupon payments and the repayment amount due on maturity.
It indicates the total return an investor will receive if he holds a bond until its maturity. It
also enables the investor to compare bonds with different maturities and coupons. Yield
to maturity includes all the interest payments plus any capital gain the investor will
realize (if investor purchases the bond below par).Alternatively it will take into account
any capital loss investor will suffer (if purchase price of the bond is above par).

For example, a coupon bond which pays interest of 4% annually, has a par value of
Rs1000, matures in 5 years, and is selling today at Rs785. The actual yield to maturity on
this bond is calculated as:

5. Risk in Debt Investment

Generally the debt investment is considered safer instrument because the coupon rate and
principle repayment are assured by the issuer i t is a risk free investment.
An investor in a debt security has also to bear certain types of risks like default risk, interest rate
risk, reinvestment risk etc.

BUSINESS ECONOMICS PAPER NO. : 9, FINANCIAL INSTITUTIONS & MARKETS

MODULE NO. : 7, MEANING & TYPES OF DEBT INSTRUMENTS
____________________________________________________________________________________________________

5.1 Default Risk

Default risk, also known as credit risk is the risk of non-payment of interest and principle by the
issuer of the debt instrument. Probability of non-payment or delayed payment of interest and
principal by the issuer of bond is known as default risk. The default risk may be caused by poor
financial performance or fraudulent intentions of bond issuer. However, sovereign papers i.e.
government securities are risk-free.

Default or Credit risk is measured by a process known as credit rating. Debt instruments are
mandatorily rated by SEBI registered rating agencies. In India various credit rating agencies are
CRISIL, ICRA, CARE etc. They give the ratings to debt instruments which vary from AAA to D.
where AAA is highest rating and implies highest safety and least risk of default while D implies
default. High rating of a debt instrument implies low risk of default and high safety. So a debt
instrument with an AAA rating will offer a better safety and lesser default risk compared to a debt
instrument with AA, A or lower
of debt payment and its present financial situation. However, rating is not an indication of
probable returns of an instrument it is capable of providing in the future and it does not give a
guarantee against future default.

5.2 Interest Rate Risk

Interest rate risk refers to a change in the price of an existing bond due to the change in the
prevailing interest rate. When the interest rate in general rises then the existing bonds which are
paying low coupon, loses their value and their price comes down and vice-versa. Such bond-price
volatility caused by movements in interest rates is termed as interest rate risk.

Thus Bond prices follow an inverse relationship with interest rates. Corporate bonds tend to rise
in value when interest rates fall because their coupon rate is higher in comparison to declined
market interest rates. Similarly existing bonds will lose their value when interest rates rise
because they are offering lower coupon rates in comparison to new increased rates offered in the
market by newly issued instruments.

Bonds with longer maturity have higher interest rate sensitivity and they depict higher price
volatility for a given change in interest rates. An investor who plans to hold the bond till maturity
is less worried for such price volatility because he will receive the redemption amount at maturity

planning to sell the bonds during the tenure of bond is affected by these bond price movements
caused by market interest rate movements.

The inverse association between bonds prices and market interest rates that is, the fact that
bonds lose their value while interest rates rise and vice versa can be explained as follows:

When market interest rate goes up then new bond issues have to offer the investors higher
coupon rate than older securities. Thus existing bonds which have relatively lower
coupon becomes less attractive. Hence prices of these existing bonds go down.

BUSINESS ECONOMICS PAPER NO. : 9, FINANCIAL INSTITUTIONS & MARKETS

MODULE NO. : 7, MEANING & TYPES OF DEBT INSTRUMENTS
____________________________________________________________________________________________________

When general interest rates in the market decline then new bond issues which are floated
in the market, offers lower yields than older securities. Thus existing bonds which are
offering higher coupons becomes more attractive to investors and their value goes up.
Hence they are sold at higher prices above their par value.
As a result, if one sells a bond before maturity, it may be worth more or less than it was
paid for.

Suppose an investor has invested in a debt security with a coupon rate of 8%.
Subsequently, the coupon rate in the market for similar securities rises to 9%. The
security with 8% coupon rate no longer remains an attractive investment. It will therefore
lose its value and will be quoted at a lower price.
Conversely, if the yields in the market go down, the debt security will gain value.
Thus, there is an opposite relationship between yields and value of such debt securities
which offer a fixed rate of interest.

5.3 Reinvestment Risk

Reinvestment risk is a challenge that all investors face when bond yields are falling. It is the risk
that future cash flows either coupons or the final return of principal will need to be reinvested
in lower-yielding securities.

Reinvestment risk can be defined as the likelihood of a fall in the interest rate resulting in a lack
of alternatives to invest the periodic interest and principal amount received at maturity, at higher
rates or at a rate equivalent to coupon rate.

Assume that an investor has invested Rs100, 000 in a bond which gives him 11 percent per year
coupon rate Year-after-Year. The bond is a 5 year bond. Periodically the investor received that 11
percent interest income and he receives principal amount at the end of 5 years. At what rate does
he reinvest these cash proceeds? The rate would be a function of what are the rates on other bonds
or what is the market offering at that point in time, which may have fallen to 7% during this
period. This means that for all the interest income that the investor receives periodically and
principal amount at maturity, the reinvestment rate is uncertain. The bond portfolio of Rs100,
000 which was generating the return of Rs11000 annually may have to be reinvested at a rate of
7% leading to only Rs7000 annual return. This is reinvestment risk.

BUSINESS ECONOMICS PAPER NO. : 9, FINANCIAL INSTITUTIONS & MARKETS

MODULE NO. : 7, MEANING & TYPES OF DEBT INSTRUMENTS
____________________________________________________________________________________________________

6. Summary
Debt instruments represent borrowing for the issuer of debt.
Debt has certain specific features like:
Fixed Maturity
Fixed Coupon Rate
Redemption at maturity
There are various types of debt instruments like:
Fixed & Floating coupon bonds
Long Term & Short term bonds
Non-Convertible or Convertible debentures
Long-Term and Short Term bonds
Redeemable and Irredeemable debentures

Bond returns includes:

Periodic Coupon payment
Current Yield
Yield to Maturity
Bond investments include various types of risk like:
Interest rate Risk
Default Risk
Reinvestment Risk

BUSINESS ECONOMICS PAPER NO. : 9, FINANCIAL INSTITUTIONS & MARKETS

MODULE NO. : 7, MEANING & TYPES OF DEBT INSTRUMENTS