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What are the different types of debt instruments available in India?

    IndianMoney.com Research Team | Monday, June 29,2009, 10:14 PM
 

Debt Instruments are obligation of issuer of such instrument as regards certain future cash flow representing Interest & Principal, which the issuer would pay to the legal owner of the Instrument. Debt Instruments are of different types like Bonds, Debentures, Commercial Papers, Certificates of Deposit, Government Securities (G - Secs) etc. The Government Securities (G-Secs) market is the oldest and the largest element of the Indian debt market in terms of market capitalization, trading volumes and outstanding securities. The G-Secs market plays a very important role in the Indian economy as it provides the benchmark for determining the level of interest rates in the country through the yields on the government securities which are treated as the risk-free rate of return in any economy.

The reserve Bank of India has allowed Primary Dealers, Banks and Financial Institutions in India to do transactions in debt instruments among themselves or with non-bank clients. Debt instruments provide fixed return known as coupon rate. Retail investors would have a natural preference for fixed income returns and especially so in the present situation of increasing volatility in the financial markets. Now, retail investors are also showing keen interest in Debt Instruments particularly in the Central Government Securities (G-secs).For an individual investor G-secs are one of the best investment options as there is zero default risk and lower volatility.

There are different kinds of Debt Instruments available in India such as;
Below given are the important debt instruments available in india

  • Bonds
  • Certificates of Deposit
  • Commercial Papers
  • Debentures
  • FD
  • G - Secs (Government Securities)
  • National savings Certificate (NSC)

Bonds

A Bond is simply an 'IOU' in which an investor agrees to lend money to a company or government in exchange for a predetermined interest rate. If a business wants to expand, one of its options is to borrow money from individual investors. The company issues bonds at different interest rates and sells them to the public. Investors purchase them with the understanding that the company will pay back their original principal with some interest that is due by a set date (this is known as the "maturity"). The interest a bondholder earns depends on the strength of the corporation.

For example, a blue chip is more stable and has a lower risk of defaulting on its debt. Sometimes some big companies issue bonds and they may only pay 7% interest, but some other small companies may pay you 10%. A general rule of thumb when investing in bonds is that "the higher the interest rate, the riskier the bond."

Following are allowed to issue bonds
-     Governments
-     Municipalities
-     Variety of institutions
-     Corporations

There are many types of bonds, each having diverse features and characteristics. Bonds and stocks are both securities, but the major difference between the two is that stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely.

Returns in Bonds
Returns is depends on the nature of the bonds that have been purchased by the investor. Bonds may be secured or unsecured. Firstly, always check up the credit rating of the issuing company before purchasing the bond. This gives you a working knowledge of the company's financial health and an idea about the risk considerations of the instrument itself. Interest payments depend on the health and credit rating of the issuer. Therefore, it is essential to check the credit rating and financial health of the issuer before loosening up the bond. If you do invest in bonds issued by the top-rated Corporates, there is no guarantee that you will receive your payments on time.

Risks in Bonds
In certain cases, the issuer has a call option mentioned in the prospectus. This means that after a certain period, the issuer has the choice of redeeming the bonds before their maturity. In that case, while you will receive your principal and the interest accrued till that date, you might lose out on the interest that would have accrued on your sum in the future had the bond not been redeemed. Always remember that if interest rates go up, bond prices go down and vice-versa.

Buying and Holding of Bonds
Investors can subscribe to primary issues of Corporates and Financial Institutions (FIs). It is common practice for FIs and corporates to raise funds for asset financing or capital expenditure through primary bond issues. Some bonds are also available in the secondary market. The minimum investment for bonds can either be Rs 5,000 or Rs 10,000. However, this amount varies from issue to issue. There is no prescribed upper limit to your investment. The duration of a bond issue usually varies between 5 and 7 years.

Selling of Bonds
Selling bonds in the secondary market has its own drawbacks. First, there is a liquidity problem which means that it is a tough job to find a buyer. Second, even if you find a buyer, the prices may be at a sharp discount to its intrinsic value. Third, you are subject to market forces and, hence, market risk. If interest rates are running high, bond prices will be down and you may well end up incurring losses. On the other hand, Debentures are always secured.

Liquidity of a Bond: Selling in the debt market is an obvious option. Some issues also offer Put and Call option.

  • In Put option, the investor has the option to approach the issuing entity after a specified period (say, three years), and sell back the bond to the issuer.
  • In Call option, the company has the right to recall its debt obligation after a particular time frame.

Debenture

A debenture is similar to a bond except the securitization conditions are different. A debenture is generally unsecured in the sense that there are no liens or pledges on specific assets. It is defined as a certificate of agreement of loans which is given under the company's stamp and carries an undertaking that the debenture holder will get a fixed return (fixed on the basis of interest rates) and the principal amount whenever the debenture matures.

In finance, a debenture is a long-term debt instrument used by governments and large companies to obtain funds. The advantage of debentures to the issuer is they leave specific assets burden free, and thereby leave them open for subsequent financing. Debentures are generally freely transferrable by the debenture holder. Debenture holders have no voting rights and the interest given to them is a charge against profit.

Debentures vs. Bonds

Debentures and bonds are similar except for one difference bonds are more secure than debentures. In case of both, you are paid a guaranteed interest that does not change in value irrespective of the fortunes of the company. However, bonds are more secure than debentures, but carry a lower interest rate. The company provides collateral for the loan. Moreover, in case of liquidation, bondholders will be paid off before debenture holders.

A debenture is more secure than a stock, but not as secure as a bond. In case of bankruptcy, you have no collateral you can claim from the company. To compensate for this, companies pay higher interest rates to debenture holders. All investment, including stocks bonds or debentures carry an element of risk.

Commercial Papers

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. It was introduced in India in 1990 with a view to enable highly rated corporate borrowers/ to diversify their sources of short-term borrowings and to provide an additional instrument to investors. Subsequently, primary dealers and satellite dealers were also permitted to issue CP to enable them to meet their short-term funding requirements for their operations. CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by a single investor should not be less than Rs.5 lakh (face value). It will be issued foe a duration of 30/45/60/90/120/180/270/364 days. Only a scheduled bank can act as an Issuing and Paying Agent IPA for issuance of CP.

Features of Commercial Papers

Following are the important features of commercial papers

  • They are unsecured debts of corporates and are issued in the form of promissory notes, redeemable at par to the holder at maturity.
  • Only corporates who get an investment grade rating can issue CPs, as per RBI rules.
  • It is issued at a discount to face value
  • Attracts issuance stamp duty in primary issue
  • Has to be mandatorily rated by one of the credit rating agencies
  • It is issued as per RBI guidelines
  • It is held in Demat form
  • CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by a single investor should not be less than Rs.5 lakh (face value).
  • Issued at discount to face value as may be determined by the issuer.
  • Bank and FI’s are prohibited from issuance and underwriting of CP’s.
  • Can be issued for a maturity for a minimum of 15 days and a maximum upto one year from the date of issue.

Who can Issue Commercial Papers?

  • Corporates and primary dealers (PDs)
  • All-India financial institutions (FIs)

Maturity

CP can be issued for maturities between a minimum of 7 days and a maximum up to one year from the date of issue.

Investment in CP

CP may be issued to and held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by FIIs would be within the limits set for their investments by Securities and Exchange Board of India. Banks still continue to be a major player in the CP market.

Mode of Issuance

CP can be issued either in the form of a promissory note or in a dematerialized form through any of the depositories approved by and registered with SEBI. CP will be issued at a discount to face value as may be determined by the issuer. No issuer shall have the issue of CP underwritten or co-accepted.

CP Issue Expenses

Stamp duty

0.2% - If placed through banks
1.0% - If placed through merchant bankers

Rating fees*

0.10% (subject to a minimum of Rs.100,000)
(for a rating from CARE)

Issuing and paying agent fee

0.1%

(All charges are on per annum basis and are subject to changes from time to time)

CP is issued at a discount to the face value. The following costs are involved in the issue of CP:

*CARE charges a rating fee of 0.10% of the amount of issue subject to a minimum of Rs.100,000 and a maximum of Rs.30,00,000. For issues above Rs.500 crore, the maximum fee would be Rs.40 lakh

Certificate of Deposit

A certificate of deposit or CD is a time deposit, a financial product commonly offered to consumers by banks, thrift institutions, and credit unions. CDs are similar to savings accounts in that they are insured and thus virtually risk-free; they are "money in the bank". They are different from savings accounts in that the CD has a specific, fixed term (often 3 months, 6 months, or 1 to 5 years), and, usually, a fixed interest rate. It is intended that the CD be held until maturity, at which time the money may be withdrawn together with the accrued interest.

Eligibility to issue CD

  • Scheduled commercial banks excluding Regional Rural Banks (RRBs) andLocal Area Banks
  • All-India Financial Institutions that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI.

Who can subscribe
CDs can be issued to individuals, corporations, companies, trusts, funds, associations, etc. Non- Resident Indians (NRIs) may also subscribe to CDs, but only on non-repatriable basis which should be clearly stated on the Certificate. Such CDs cannot be endorsed to another NRI in the secondary market.

Maturity

  • The maturity period of CDs issued by banks should be not less than 7 days and not more than one year.
  • The FIs can issue CDs for a period not less than 1 year and not exceeding 3 years from the date of issue.

Discount/ Coupon Rate

CDs may be issued at a discount on face value. Banks/FIs are also allowed to issue CDs on floating rate basis provided the methodology of compiling the floating rate is objective, transparent and market-based. The issuing bank/FI is free to determine the discount/coupon rate. The interest rate on floating rate CDs would have to be reset periodically in accordance with a pre-determined formula that indicates the spread over a transparent benchmark.

Reserve Requirements

Banks have to maintain the appropriate reserve requirements, i.e., cash reserve ratio (CRR) and statutory liquidity ratio (SLR), on the issue price of the CDs.

Transferability

Physical CDs are freely transferable by endorsement and delivery. Dematted CDs can be transferred as per the procedure applicable to other demat securities. There is no lock-in period for the CDs.

Loans/Buy-backs

Banks/FIs cannot grant loans against CDs. Furthermore, they cannot buy-back their own CDs before maturity.

In the next series of this article we will cover Fixed Deposits and Government Securities. Also read about our article on Debt Mutual Funds.

IndianMoney.com Research Team

The research team at IndianMoney.com comprises of certified and experienced professionals who share the company's vision to make every Indian financially literate by equipping every Indian with right and unbiased advice. IndianMoney.com research team provides newsletters, articles, videos and FAQs on various financial products and concepts only to help you make wise financial decisions.

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