Various Debt instruments

Various Debt instruments

Subject: Economy

Context:

Should retail investors park their money in debt instruments and funds for the medium term, or should they wait for rates to peak?

Details:

• Returns on debt funds and instruments like non-convertible debentures (NCDs) are showing signs of improvement due to rise in repo rate, reverse repo rate and Standing Deposit Facility.
  • The yield on the benchmark 10-year government bonds is also rising.
• Optimal options amidst uncertain interest rate changes-Floating rate funds and low-maturity funds are likely to be sound investments.
  • As fixed income yields have improved significantly and are likely to rise further, one can look at funds with maturities up to 3 years, which invest in high-quality papers like government bonds, PSU and bank bonds, AAA rated corporate bonds, credit risk funds, gilt fund and Dynamic bond funds.

Concept:

• A debt fund is a mutual fund scheme that invests in fixed income instruments, such as Corporate and Government Bonds, corporate debt securities, and money market instruments etc. that offer capital appreciation.
  • Debt funds are also referred to as Income Funds or Bond Funds.
• Credit risk funds are debt funds that lend at least 65% of their money to not-so-highly rated companies. The borrowers pay higher interest charges as a way to compensate for their lower credit rating, which translates into a higher risk for the lender due to an increased possibility of default. Although these funds lend mostly for short duration, they are still one of the riskiest in the category.
• Gilt funds are debt funds that invest primarily in government securities. These funds have no risk of non-payment of interest or principal amount but get affected by interest rate movements as the Government borrowing typically happens to be for a longer duration.
• Dynamic bond funds are debt funds which invest in debt and money market instruments like Government Securities, corporate bonds etc of different durations. These funds are constructed in a way that allows fund managers to use interest rates movements in the economy as an opportunity to generate higher returns.
  • If the fund manager expects interest rates to go down in the future, he / she will invest in longer term (longer duration) bonds with a view to earning profits from price appreciation.
  •  If the fund manager expects interest rates to go up in the future, he / she will invest in shorter term bonds to reduce interest rate risks and also re-invest maturity proceeds of the bonds at higher interest rates in the future.
• Debentures are long-term financial instruments which acknowledge a debt obligation towards the issuer. Some debentures have a feature of convertibility into shares after a certain point of time at the discretion of the owner. The debentures which can’t be converted into shares or equities are called non-convertible debentures (or NCDs).
  • Non-convertible debentures are used as tools to raise long-term funds by companies through a public issue. To compensate for this drawback of non-convertibility, lenders are usually given a higher rate of return compared to convertible debentures.
  • An NCD can either be secured or unsecured.
    • A secured NCD is backed by the issuing company’s assets. This means that the company has to fulfill its debt obligation whatsoever. However, that’s not the case for unsecured NCDs. This makes secured NCDs safer since they have a lower default risk.
• Public Sector Undertaking Bonds (PSU Bonds) are the bonds in which the government shareholding is generally more than 51%.
  •  It is a medium and long-term debt instrument issued by public sector companies.
  • PSU Banks, power sector companies, railways, and other organisations issue PSU bonds as they have 51% of the government shareholding with them. These entities could be held by the central or state government.
  • PSU Bonds are considered a secure option for investment.
• A government bond is a debt instrument issued by the country’s central and state governments to finance their needs while also regulating the money supply.
  • At the bond’s maturity date, the government will repay the principal and interest in accordance with the terms of the bond. The Reserve Bank of India supervises the issuance of government bonds.
  • Types:
    • Treasury Bills: Treasury bills (also known as T-bills) are short-term government bonds. They are issued with a one-year maturity date. These bonds are issued by the government in three categories: 91 days, 182 days, and 364 days. The difference between the face value and the discounted value is the profit for the investors.
    • Cash Management Bills: These are short-term bonds with a high degree of flexibility. They are issued in response to the government’s funding requirements. They must usually be less than 91 days. It’s similar to treasury bills.
    • Dated Government Securities: This type of bond has variable interest rates. Dated Government securities are so-called because they have a predetermined maturity date. These bonds are auctioned off by the Reserve Bank of India.
    • Fixed-Rate Bonds: These government bonds have a fixed coupon rate for the duration of the bond. In other words, regardless of market rates, the interest rate remains constant for the duration of the investment.
    • Floating Rate Bonds: The interest rate on these bonds fluctuates throughout the investment period. Interest rates are changed at predetermined intervals before the bond is issued.
    • Zero-Coupon Bonds: Bonds with no coupon payments are known as zero-coupon bonds. Profits from these bonds are generated by the difference between the issue price and the redemption value.
    • Capital Index Bonds: These are bonds in which the principal amount is linked to an accepted inflation index. This bond is issued to protect investors’ principal from inflation.
    • Inflation-Indexed Bonds: Inflation-Indexed Bonds (IIBs) are bonds in which the principal and interest payments are linked to an inflation index. The Consumer Price Index (CPI) or the Wholesale Price Index (WPI) may be used to calculate inflation (WPI).
    • Bonds with a Call or Put Option: These bonds have an option that allows the issuer to buy back the bond (call option).
    • Sovereign Gold Bonds (SGBs): The prices of Sovereign Gold Bonds are linked to the price of gold (commodity price). The bond’s nominal value is based on the previous week’s simple average closing price of 99.99% purity gold.