Fixed Income Products

Fixed-income investments are more appealing to risk-averse investors. The basic principle of Fixed Income Security is repayment of principal at maturity. Investors are repaid the amount of money they originally invested at the end of the agreed period. Companies, governments, or other entities often need to take loans. Instruments that they issue against the loan are called fixed-income securities because they provide periodic income payments at a predetermined fixed interest rate.

LEARNING OUTCOMES

At the end of this course, you will be able to understand the following:-

• Fixed Income Products.
• Features of Fixed Income Products.
• Types of Fixed Income Products.
• Government Securities.
• Non-Government Products.
• Tax Benefits in Fixed Income Products.

What is a Fixed Income Product?

The Fixed Income Securities Market was the earliest of all the securities markets in the world and has been the forerunner in the emergence of the financial markets as the engine of economic growth across the globe. The Fixed Income Securities Market, also known as the Debt Market or Bond Market, is the largest of all the financial markets in the world today.

The Debt Markets have a very prominent role to play in the efficient functioning of the world financial system and in catalyzing the economic growth of nations across the globe.

In many countries, the debt market (both sovereign and corporate) is more significant than equity markets. In fact, in matured economies, the debt market is three to four times the size of the equity market. Equity investment is riskier; a particular class of investors chooses to invest in debt based on their risk appetite and liquidity requirements.

Most investors like to spread their investments into equity, debt, and other asset classes for optimal return, liquidity, and safety combinations. A vibrant debt market enables investors to shuffle and reshuffle their portfolios depending upon the expected changes. The debt market, in particular, provides financial resources for developing infrastructure. Hence, a well-functioning debt market is important for all market participants.

Features of a Fixed-Income Product

Fixed-income securities are one of the most innovative and dynamic instruments that have evolved in the financial system ever since the inception of money. As they are based on the concept of interest and the time value of money, fixed-income securities personify the essence of innovation and transformation, which have fueled the explosive growth of the financial markets over the past few centuries.

Fixed-income securities offer one of the most attractive investment opportunities about the following:-

• Safety of investments.
• Adequate liquidity and flexibility in structuring a portfolio.
• Easier monitoring.
• Long-term reliability.
• Decent returns.

They are an essential component of any portfolio of financial assets, whether in pure interest-bearing bonds, innovative and varied types of debt instruments, or asset-backed mortgages and securitized instruments.

Classification of Fixed Income Products

Classification of Fixed Income instruments is done based on the following:

• Tradability.
• Investors.

Tradability

The following are the investment avenues available for investors in ‘Fixed Income’ securities classified based on their credibility.

Tradable

• Government Securities.
• Corporate Bonds/Debentures.

Non-Tradeable

• RBI Relief Bonds.
• Bank Deposits.
• Post Office/Monthly Income Schemes/NSC.
• Provident Fund.
• Company Deposits.

Investors

Based on volume, transaction size, minimum qualifying amount, and other norms, the market of fixed-income products could be classified into the following two categories:

• Retail Debt Market – for individuals.
• Wholesale Debt Market – for others, which include:
  • Institutional investors.
  • Government.
  • Corporate.

Benefits of Fixed Income Product

Fixed income instruments in India typically include company bonds, fixed deposits, and government schemes. The reasons for investing in fixed-income products are mentioned below:

• Low-risk tolerance.
• Need for returns in the short-term.
• Predictable versus uncertain returns.

Low-risk Tolerance

One of the key benefits of fixed-income instruments is low risk, that is, the relative safety of the principal and a predictable rate of return (yield). If one’s risk tolerance level is low, fixed-income investments might suit the investment needs better. But it should be remembered that these still have risks associated and are explained later.

Need for Returns in the Short-Term

Investment in equity shares is recommended only for that portion of the investor’s wealth for which the investor is unlikely to need in the short-term, at least five years. Consequently, the money that the investor is likely to invest in the short term (for capital or other expenses), should be invested in fixed-income instruments.

Predictable Vs. Uncertain Returns

Returns from fixed-income instruments are predictable; they offer a fixed rate of return. In comparison, returns from shares are uncertain. Fixed-income instruments are recommended if one needs a specific, predictable stream of income.

Before deciding to invest in fixed-income instruments, one should evaluate their needs from three key perspectives:

• Risk.
• Returns.
• Liquidity.

The investor should also match the investment options with their financial needs.

Long Term Fixed Income Products

Long-term debt instruments have a maturity of more than a year. The following instruments come under the purview of long-term debt instruments.

Government of India Securities

Government of India securities are securities issued by the Government of India to meet its financial requirements for long-term investments. They have maturity ranging from 1 to 30 years. These securities are also issued on a French auction basis. The Government of India issues these securities to finance its investments in infrastructure and industry, which is relatively long-term.

PSU Bonds

PSU bonds are long-term debt instruments issued by the Public Sector Units. They have maturity ranging from 5 to 10 years. Generally, these bonds are privately placed with select individuals to reduce the issue cost. PSUs issue these bonds to meet their long-term financial requirements, such as an expansion or acquisition of an asset, etc. They carry high liquidity because these instruments are issued by Blue-chip PSUs and guaranteed by the Government of India.

Bonds of Development Finance Institutions (DFIs)

These are the long-term debt instruments issued by the DFIs. These DFIs issue bonds in two ways. Through a public issue for the retail investors and a private placement route to confident selected investors. They issue these bonds to finance the long-term credit they provide to the commercial sector. They have maturity ranging from 5 to 10 years and, in some cases, even more than that.

Long-Term Debentures

Long-term debentures are long-term debt instruments issued by Corporates. Corporations issue these debentures to finance their long-term fund requirement having a maturity of generally 5-7 years.

Government Securities

Government securities, also termed sovereign securities, are issued by the Reserve Bank of India on behalf of the Government of India.

The term Government Securities includes the following:

• Central Government Securities.
• State Government Securities.
• Treasury Bills.

The Central Government borrows funds to finance its ‘fiscal deficit’. The market borrowing of the Central Government is raised through the issue of dated securities and 364 days treasury bills either by auction or by floatation of loans.

In addition to the above, treasury bills of 91 days are issued for managing the temporary cash mismatches of the Government. These do not form part of the borrowing program of the Central Government.

Types of Government Securities

Government Securities are of the following types:

• Dated Securities.
• Zero-Coupon Bonds.
• Partly Paid Stock.
• Floating Rate Bonds.
• Bonds with Call/Put Option.
• Capital Indexed Bonds.

Dated Securities

Dated securities are generally fixed maturity and fixed coupon securities, usually carrying semi-annual coupons. These are called dated securities because these are identified by their date of maturity and the coupon; for example, 5.85% Government of India 2030 is a Central Government security maturing in 2030, which carries a coupon of 5.85% payable half yearly.

The key features of these securities are as follows:

• They are issued at face value.
• The coupon or interest rate is fixed at the issuance time and remains constant until the security redemption.
• The tenor of the security is also fixed.
• Interest (also known as a coupon) payment is made on a half-yearly basis on its face value.
• The security is redeemed at par (face value) on its maturity date.

Zero-Coupon Bonds

Zero coupon bonds are issued at a discount to face value and redeemed at par. These were first issued on January 19, 1994, followed by the subsequent issues in 1994-95 and 1995-96, respectively. The key features of these securities are as follows:

• They are issued at a discount to face value.
• The tenor of the security is fixed.
• The securities do not carry any coupon or interest rate. The difference between the issue price (discounted price) and face value is the return on this security.
• The security is redeemed at par (face value) on its maturity date.

Partly Paid Stock

Partly paid stock is stock where the principal amount is paid in installments over a given time frame. It meets the need of investors with a regular flow of funds and the need of the Government when it does not need funds immediately. The first issue of such stock of eight years maturity was made on November 15, 1994, for Rs 2000 crore. Such stocks have been issued a few more times thereafter. The key features of these securities are:

• They are issued at face value, but this amount is paid in installments over a specified period.
• The coupon or interest rate is fixed at the issuance time and remains constant until the security redemption.
• The tenor of the security is also fixed.
• Interest/coupon payment is made on a half-yearly basis at its face value.
• The security is redeemed at par (face value) on its maturity date.

Floating Rate Bonds

Floating rate bonds are bonds with variable interest rates with a fixed percentage over a benchmark rate. A cap and floor rate may be attached, thereby fixing a maximum and minimum interest rate payable on it. The floating rate bonds of four years maturity were first issued on September 29, 1995, followed by another issue on December 5, 1995. The coupon in floating rate bonds is usually reset every six months. The key features of these securities are:

• They are issued at face value.
• A coupon or interest rate is fixed as a percentage over a predefined benchmark rate at the time of issuance.
• The benchmark rate may be the treasury bill, bank, etc. Though the benchmark does not change, the rate of interest may vary according to the change in the benchmark rate till the redemption of the security.
• The tenor of the security is also fixed.
• Interest/coupon payment is made on a half-yearly basis at its face value.
• The security is redeemed at par (face value) on its maturity date.

Bonds with Call/Put Option

First time in the history of the Government Securities market, RBI issued a bond with a call-and-put option. This bond was due for redemption in 2012 and carries a coupon of 6.72%. However, the bond had a call-and-put option after five years, that is, in 2007. In other words, it means that the bondholder could sell the bond back (put option) to the Government in 2007, or the Government could buy back (call option) the bond from the holder in 2007. This bond had been priced in line with 5-year bonds.

Capital Indexed Bonds

Capital-indexed bonds are bonds where the interest rate is a fixed percentage over the wholesale price index. These provide investors with an effective hedge against inflation. These bonds were floated on December 29, 1997, on a tap basis. They were of five years maturity with a coupon rate of 6% over the wholesale price index. The principal redemption is linked to the Wholesale Price Index. The key features of these securities are as listed below:

• They are issued at face value.
• The coupon or interest rate is fixed as a percentage of the wholesale price index at the time of issuance. Therefore, the actual amount of interest paid varies according to the change in the Wholesale Price Index.
• The tenor of the security is fixed.
• Interest/coupon payment is made on a half-yearly basis at its face value.
• The principal redemption is linked to the Wholesale Price Index.

Debenture

A Debenture is a debt security issued by a company (called the Issuer), which offers to pay interest instead of the money borrowed for a specific period. In essence, it represents a loan taken by the issuer who pays an agreed rate of interest during the lifetime of the instrument and repays the principal typically, unless otherwise agreed, on maturity.

These are long-term debt instruments issued by private-sector companies. These are issued in denominations as low as Rs 1,000 and have a maturity between one and ten years. Long-maturity debentures are rarely issued, as investors are uncomfortable with such maturities.

Debentures enable investors to reap the dual benefits of adequate security and good returns. Debentures are normally issued in physical form. However, corporates/PSUs have started issuing debentures in Demat form also.

Generally, debentures are less liquid as compared to PSU bonds, and their liquidity is inversely proportional to the residual maturity. Debentures can be secured or unsecured. The fundamental difference between debentures and bonds is that the former is usually secured, whereas the latter is not. Hence in general, bonds are issued at a higher interest rate than debentures.

Countries have different interpretations of the terms ‘corporate bonds’ and ‘debentures.’ The terms ‘corporate bonds’ and ‘debentures’ are interchangeably used in India.

As per Companies Act Section 2(12), “Debenture” includes debenture stock bonds and any other company securities, whether constituting a charge on the company’s assets or not.

Thus, the Companies Act of 1956 identifies both as the same.

Convertibility Debenture

Debentures could be classified based on convertibility into:

Non-Convertible Debentures

This type of security retains all the characteristics of a debt instrument and cannot be converted into any other form of security (mainly equity).

Partly Convertible Debentures

A part of this instrument can be converted into equity shares in the future at the instance of the issuer. The issuer decides the ratio of the conversion at the time of subscription.

Fully Convertible Debentures

These instruments are fully convertible into equity shares at the issuer’s notice. The issuer decides the ratio of conversion. Upon conversion, the investors enjoy the same status as ordinary shareholders of the company.

Optionally Convertible Debentures

The investor can convert these debentures into shares at a price decided by the issuer/agreed upon at the time of issue.

Debenture Security

Based on Security, debentures are classified as follows:-

Secured Debentures

A charge on the fixed assets of the issuing company secures these instruments. So, if the issuer fails the pay the principal or interest amount, the issuing company’s assets could be sold to repay the liability to the investors. This is usually in the form of a first mortgage or charge on the company’s fixed assets on a pari passu basis with other first charge holders such as financial institutions, etc. Sometimes, the charge can also be a second charge instead of a first charge. Most of the time, the charge is created on behalf of the entire pool of debenture holders by a trustee appointed explicitly for the purpose.

Unsecured Debentures

These instruments are unsecured because if the issuer defaults on payment of the interest or principal amount, then during the process of liquidation of the company, principal repayment to an investor would come in the category of unsecured creditors of the company.

Bonds

Corporate Bonds

Bonds typically pay interest periodically at the pre-specified rate of interest. The annual rate at which the interest is paid is known as the coupon rate or simply the coupon. Interest is usually paid every half-yearly though some bonds pay interest monthly, quarterly, annually, or at some other frequency. The dates on which the interest payments are made are known as the coupon due dates.

Zero-Coupon Bonds

A plain bond is offered at its face value. It earns a stream of interest till redemption and is redeemed with or without a maturity premium. A zero coupon bond is issued at a discount to its face value with no periodic interest and is redeemed at face value on maturity.

Derived Instruments

Derived instruments are not direct debt instruments. Instead, they derive value from other debt instruments. Mortgage bonds, Pass through Certificates, etc., fall under this category.

Mortgage Bonds

Mortgage-backed bond is a collateralized term-debt offering. Pledged collateral backs every issue of such bonds. Eligible collateral will be a property that can be pledged as a security. The bonds are secured by a first charge on the pledged collateral and delivered to the issue’s trustee. This ensures that a smooth liquidation takes place in the event of default on the part of the issuer of bonds. The terms of these bonds are like any other bonds in the market, with semi-annual or quarterly payments of interest and a final bullet payment of principal.

Pass-Through Certificates (PTCs)

Pass-through securities are created when mortgages are pooled together and undivided interest in the pool is sold. The term ‘undivided’ in this context means that each security holder has a proportionate interest in each cash flow generated in the pool. The pass-through securities promise that the cash flow from the underlying mortgages would be passed through to the holders of the securities in the form of monthly payments of interest and principal.

Bank Deposits

Bank Deposits serve as a medium of saving and as a means of payment and are a significant variable in the national economy. A bank has the following types of deposits:-

Saving Account

Saving deposits are deposits maintained continuously on which the bank offers a particular interest. There is a specific limit on the number of withdrawals from the account using a cheque on this account. Interest is allowed on minimum monthly balances and not daily.

Current Account

A current account is a running account. This account does not provide any interest; hence, the account provides no limit on the number of withdrawals from this account. The deposits offered by NBFCs are not insured, whereas the deposits accepted by most banks are insured up to a maximum of Rs 5 lakhs.

Time Deposits

Time deposits are those funds that savers deposit based on obtaining the same on the maturity of a specific period. They are also termed Fixed Deposits. Fixed Deposits are sums accepted by most NBFCs, corporates, and banks. The amount of deposits NBFCs and corporates may raise is linked to their net worth and rating. However, the interest rate offered by an NBFC and corporate is regulated.

Tax Benefit U/s 80 C

Under Section 80C, the Government of India allows taxpayers to reduce their taxable income and save on taxes. At present, taxpayers can invest up to Rs. 1.5 Lakh on eligible tax-saving schemes for claiming deduction under this section.

Some Fixed-Income Investment Options u/s 80C are:

• Public Provident Fund (PPF)
• Sukanya Samriddhi Yojana (SSY)
• Senior Citizens’ Saving Scheme (SCSS)
• Tax-saving Bank Fixed Deposits
• National Saving Certificate (NSC)

Tax-Saving Investments: Safety and Growth

The fixed-income investments mentioned above are bankable and stable tax-saving options under Section 80C of the Income Tax Act in India. These instruments provide an excellent alternative to having a disciplined investment without taking any risks in the market.

Further, these instruments could be used to make an informed decision to build a long-term corpus to realize financial goals and save tax under Section 80C.

Tax-Free Bonds