What are Debt Instruments?

Debt instruments are legally obligated contracts issued to repay the borrowed principal amount with interest within the specified time to the investor. These bonds have fixed or variable rates of returns, and the variable-rate instrument is connected to market rates. A few examples of debt instruments are debentures, bonds, certificates of deposits, notes, and commercial paper.  

Investors usually invest in these, expecting a return of the principal amount with interest. The amount and the interest duration, however, vary on the type of instrument.

Who Issues Debt Instruments in India?

In India Debt instruments, often also known as fixed-income securities, are issued by Government, Government Entities and statutory corporations or bodies, corporate bodies, and financial institutions.

Type of Debt Instruments

Listed below are the different types of debt instruments you can find in India:

#1. Bonds

These are the most common and are created through bond indenture. The investor buys corporate or government bonds for a fixed return. Bonds are backed by collateral and physical assets. Generally they have a maturity range of 5 to 40 years. They are appreciated when the market rate is low. Governments, corporations, and local governments all issue bonds. 

Corporate bonds, government securities bonds, convertible bonds, RBI bonds, sovereign gold bonds, inflation-linked bonds, and zero-coupon bonds are among the several bond categories in India that you can invest in.

#2. Debentures

They are similar to bonds, but their securitisation differs as they are unsecured and rely on the issuer’s creditworthiness. They are not backed by any collateral and physical assets. Major corporations and the government issue them to raise funds. Since it hardly creates any claim on the assets, it is a significant advantage to the issuer. Hence leaving them available for future funding. They appear on the balance sheet and are included in share capital. 

#3. T-Bills

The government and RBI issue T-bills, or treasury bills, which are money market instruments. It is a liability to the Indian government and is paid within a fixed time. With a maximum maturity of up to 364 days, it carries no risk and may be quickly turned into cash in an emergency.

These bills are auctioned weekly by non-competitive bidding, creating a higher cash flow to the capital market. The tenure structure of these bills determines their discount rates and face value. These are subject to fluctuations based on financing requirements, reserve bank policies, and the total number of bids received.  

#4. Certificates of Deposits

CDs or certificates of deposits are time-specific deposits and are provided by banks. They are equivalent to conventional bank savings accounts. They are risk-free, insurance-covered, and cannot be issued for less than one year or more than three years. CDs have fixed interest rates mostly and differ from savings as they have a set term period.

#5. Commercial Papers

CPs are issued when organisations have to raise capital over one year, hence short-term instruments. These are unprotected instruments issued as promissory notes with a minimum of seven days and a maximum one-year maturity period from the issue date. They are available for INR 5 lakh or in their multiples and are issued by financial institutions to help companies raise money. 

#6. Mortgages

A mortgage is a type of loan backed by real estate. People usually use these loans to purchase homes, commercial buildings, land, and other real estate. They are annualised over time, allowing borrowers to pay until the debt is paid. On the other hand, the lenders receive interest until it is paid. If the borrower defaults, the lender seizes and sells the assets to get its funds.

#7. Government Securities

These are issued on behalf of the government by RBI and include State and Central government securities and treasury bills. To cover its budgetary shortfalls, the Central government takes out loans. The issuance of dated securities and 364-day treasury bills, either by loan floatation or auction, increases the government's market borrowing. 

In addition, 91-day treasury notes are created to help the government easily handle short-term cash imbalances. There is no default risk since government securities are issued at face value and are backed by a sovereign guarantee. Interest payments are provided on a half-yearly basis at face value.  

The investor has the option to sell the asset on the secondary market. Investors can redeem the securities at face value at maturity, and tax is not withheld at the source. Two to thirty years is the maturity range.

What is the Difference Between Convertible and Non-Convertible Security?

What are the Instruments that are Normally Traded in the Debt Market?

A few examples of debt instruments traded in the debt market are debentures, bonds, certificates of deposits, notes, and commercial paper.  

What are the Different Types of Bonds?

The different types of bonds are listed below:

• Fixed-rate bonds - They pay consistent interest amounts until they mature, regardless of the market conditions.
• Floating-rate bonds - They do not pay a fixed rate of return, and the interest depends on the benchmark for that tenure.
• Zero-coupon bonds - These bonds do not pay periodic payments over their term. However, when issued, they have a discount and must be repaid at par.
• Perpetual bonds have no maturity, and the issuer does not repay the principal amount. They only pay steady coupon payments to the bondholders until perpetuity.
• Inflation-linked bonds - They are designed to reduce the effect of inflation on face value and coupon payments. To account for inflation, the principal is updated, and coupon payments are made using the adjusted principal.
• Convertible bonds - The holder of these bonds gets the right to convert them into the company’s equity shares at a specific time in the term. If they don’t exchange, they can opt to get the principal amount repaid on maturity.
• Callable bonds are high coupon paying, giving issuers the option to call back the bonds at a pre-agreed date and price.
• Puttable bonds - The investors can return the bonds at a pre-agreed price and date and ask for principal repayment. 

How do Credit Ratings Affect Debt Instruments?

Investors look for debt instruments with lower default probability. Thus, the riskier debt instruments must compensate their investors for significant default probability. Credit rankings help rank these debtors in their default probability order. Irrespective of whether it's a business, a country, or an individual, everyone has a credit rating.

These ratings are directly related to the entity’s ability to get debt financing. If there is an increase in the debt instruments rating, it will increase its price and offer more returns.

Credit Rating Scale

The table below will tell the credit rating symbol and what it means:

Advantages of Debt Instruments

Listed below are some of the advantages of investing in debt instruments:

• Return on Capital

Debt instruments offer a great way of earning a return on capital. Some debt instruments, such as corporate bonds, reward the investors with repayment and interest at maturity.

• Lower Portfolio Risk

Debt instruments are significantly lower in risks as they are independent of market fluctuations. Bondholders also benefit from some legal protection because they are the first to be paid if a firm files for bankruptcy. 

• Stable Returns

Debt market securities pay principal and interest at maturity, providing a steady flow of income. These interest payments are promised and guaranteed, which will help you meet your cash flow requirements. They might yield different returns than stock instruments due to their lower sensitivity to market swings, but their value will stay high.

• Portfolio Diversification

Debt instruments are an excellent portfolio diversification option. Investors can combine stocks and mutual funds that yield high risk and add bonds and FDs with low risk to manage their portfolios. Moreover, the maturity dates vary between short and long-term, allowing investors to create a portfolio per their needs.

Disadvantages of Debt Instruments

Below are some disadvantages of debt instruments:

• Credit Risk

Credit risk, also known as default risk, arises when an issuer of a bond cannot comply with the terms of the bond indenture. It also includes failing to pay interest or principal on time or a debt instrument.

• Liquidity Risk

When an investor cannot convert an asset into cash without giving up income and capital, it is known as liquidity risk. Hence, investors should consider their ability to convert short-term debt instruments into money before investing in long-term illiquid assets like PPF.

• Interest Rate Risk

It is a risk that is involved in every debt market security. It is a problem in cases where the interest rate remains fixed till maturity. In such cases, if the investor agrees on an interest rate and increases during the tenure, the investor will not benefit from the increment.

• Reinvestment Rate Risk

This indicates that investors won't be able to reinvest cash flows from a single loan instrument at a rate that matches their existing rate of return. This risk applies to every investment that generates cash flow.

What are Various Risks Associated with Investing in Bonds?

Here are some risks associated with investing in bonds:

• The bond prices rise when the interest rate falls.
• If investors want to reinvest, they may have to proceed at a lower rate than the bond previously made.
• Bonds may have a negative rate of return if the inflation increases significantly.
• Corporate bonds primarily depend on the issuer's debt-repaying capabilities. Hence, there is always a default possibility.
• If the corporate credit rating is low, it will result in higher loan interest rates, impacting the bondholders.
• There can be price volatility because of low liquidity in some bonds.

How to Choose the Right Debt Instrument

Many factors must be considered before choosing the right debt instrument for yourself. The same are listed below:

• You can select CDs or liquid mutual funds if your investment horizon is small, between 3-6 months.
• Corporate bonds and short-term debt funds are an excellent choice for one to two years of investment horizon.
• Debt funds and PPFs can be opted if you invest more than three years. The gains will be treated as long-term capital gains, and if they exceed INR 1 lakh, they will be taxed at 20%  post-indexation. However, starting from 1st April 2023, the finance bill introduced a new amendment that scraps the indexation benefits on debt mutual funds for LTGC. Now, debt funds are taxed at the investor’s applicable slab rates. 
• Even though debt instruments have a lower risk than equities in India, the risk varies according to the kind of debt investment. Some examples:
  • You have some extra protection because government-backed FDs are covered up to INR 5 lakh per depositor per bank under deposit insurance coverage. 
  • Since CDs are issued against money deposited in a bank, they are the least dangerous option.
  • Investing in PPFs likewise carries minimal risk. 

Debt vs Equity