Investing in Fixed Income Securities

1The debt market and bond basics

In the debt market, governments and companies borrow by issuing securities, which investors buy in the primary market or the secondary market. Debt is generally safer than equity: it carries fixed obligations and is often secured by assets. If the issuer defaults, though, recovering money can take a long legal process.

India's debt market has three segments:

• government securities: G-secs, T-bills and SDLs;
• PSU and bank bonds;
• private sector paper: bonds, debentures and CPs.

Bond features. A bond is a fixed income security. The issuer promises two things:

• periodic coupons (usually semi-annual, though some pay annually, quarterly or monthly; zero-coupon bonds pay none);
• the face value at maturity. Perpetual bonds never mature.

Maturity classes. Paper of up to one year is money market; over one year is capital market. A long bond becomes money market paper as it nears maturity.

G-secs pay semi-annual coupons, with tenors typically of 5 to 30 years. Maturity is also called tenor.

Price versus face value. Price equals face value only when the coupon equals the market rate.

• Market rate above coupon: the bond trades at a discount.
• Market rate below coupon: the bond trades at a premium.

A company can have many bond issues outstanding at once. Regulation caps new ISINs at 12 maturing per financial year, so companies often re-issue existing ISINs. Terms are set out in the indenture, the legal agreement between issuer and investors.

Bonds with embedded options

• Callable: the issuer may redeem early, typically when rates fall. This favours the issuer and gives the investor reinvestment risk.
• Puttable: the holder may sell the bond back at a preset price on set dates. This favours the investor.
• Convertible: a plain bond plus the right to exchange it for a set number of shares.

Remember

• Market rate above coupon → discount; below coupon → premium.
• The call option is the issuer's; the put option is the investor's.

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2Risks in fixed income

Government bonds are treated as risk-free and yield the least. PSU and bank paper sits in between, and pure corporate paper yields the most. The two broad groups of risk are market risk (interest rates) and credit risk (the borrower).

Remember

• Corporate yield above the G-sec yield = credit spread.
• Masala bonds: the currency risk sits with the foreign investor.

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3Pricing bonds

A bond is valued with the present value model: discount its known cash flows at the market yield, the YTM.

Par value is the face value repaid at maturity, typically ₹100 for G-secs and ₹10,000 for corporate bonds. Coupons are calculated on face value.

• Prices are quoted as a percentage of face value. A bid of 106.35 means 106.35% of par.
• Above par is a premium bond; below par is a discount bond. At maturity every bond is pulled to par.
• T-bills and CPs are always issued at a discount. The investor's return is face value minus the price paid.

Example A 5-year bond with a 10% annual coupon, face ₹100, and a market yield of 8%. The discount factors at 8% sum to 3.9927 (the PVIF), and year-5's factor is 0.6806. Price = 10 × 3.9927 + 100 × 0.6806 ≈ ₹107.99. It sits above par because the coupon is above the yield.

Semi-annual coupons. Pay ₹5 every six months and discount at 4% per half-year over 10 periods: price ≈ ₹108.11. That is slightly more than the annual-pay bond, because of more frequent compounding. Very frequent payments approach continuous compounding.

Sources of return: coupons, capital gain or loss, and reinvestment income. XIRR implicitly assumes coupons are reinvested at the XIRR rate itself.

Zero-coupon (money market) price and yield

• Price = 100 ÷ (1 + r × days ÷ 365)
• YTM = (100 − P) ÷ P × 365 ÷ days × 100

Coupon rate (CR), current yield (CY) and YTM

Clean and dirty price

• Dirty (full or invoice) price = clean price + accrued interest.
• Markets quote and trade on clean price, and yield formulas use it. The buyer pays the seller the clean price plus accrued interest.
• To value a bond between coupon dates: value it as at the last coupon date, roll that value forward to settlement, then deduct accrued interest to get the clean price.

Price–yield relationship

• It is inverse and non-linear (convex).
• Longer maturity means more sensitivity to rate changes.
• Lower coupon means more sensitivity.

Perpetual bond: value = coupon ÷ yield.

Example An 8% perpetual bond on ₹100 face, with a required yield of 6%: 8 ÷ 0.06 = ₹133.33.

Remember

• Discount bond: CR < CY < YTM.
• Lower coupon and longer maturity → more price sensitivity.
• Trades are on clean price.

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4Yield measures

• Coupon yield = coupon ÷ face value. For example, 8.24 ÷ 100 = 8.24%.
• Current yield = annual coupon ÷ market price. For example, 8.24 ÷ 103 = 8%.
• Yield to maturity (YTM) is the discount rate that makes the PV of all future cash flows equal to the price, which is the bond's IRR. It assumes the bond is held to maturity. It is found by trial and error, interpolation, or Excel's YIELD(settlement, maturity, rate, price, redemption, frequency, basis).

Example A 2-year 8% bond with semi-annual coupons, priced at ₹102, has 4 half-yearly payments of ₹4 plus ₹100 at the end. YTM ≈ 6.91%. It is below the coupon because the bond trades at a premium.

Day count conventions

• Indian bond market: 30/360.
• Indian money market (including T-bills): actual/365.

The workbook's Excel example uses basis code 2 even though its text says code 4 for 30/360. Pick the code that matches the convention you need.

• Effective yield is the annual rate that gives the same year-end amount once compounding is included. A 4.20% nominal rate paid monthly works out to about 4.28% effective.
• Yield to call: the return if the bond is held to the first call date.
• Yield to put: the same idea, measured to the first put date.

Remember

• Current yield uses market price; coupon yield uses face value.
• YTM is the bond's IRR.

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5The yield curve

The yield curve plots yield against maturity. Its slope shows the extra premium for lending longer. Expectations of higher inflation push long yields up.

• Sovereign curve: usually flattens after about 5–7 years, because there is no default risk; investors only want a small liquidity premium.
• Corporate curve: keeps rising with maturity, because credit risk grows with time.

Four shapes

1. Normal: upward sloping, long rates above short rates. This is the healthiest shape for an economy.
2. Inverted: short rates above long rates. Causes include high policy rates to cool demand or severe asset-liability mismatches. It often signals recession.
3. Flat: about the same yield at every maturity.
4. Humped: medium-term yields are higher than both short and long yields.

Remember

• Inverted curve → possible recession.

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6Duration

Macaulay duration is the weighted-average time to receive a bond's cash flows in present-value terms, roughly how long it takes the bond to "pay back" its price. It is expressed in years.

How to calculate it

1. Find the PV of each cash flow.
2. Multiply each PV by the time (in years) at which it is received.
3. Add these up and divide by the bond's price.

Key properties

• Duration is always ≤ maturity. It equals maturity only for a zero-coupon bond.
• It rises with maturity but levels off; it does not grow without limit.
• Higher duration means more price volatility when rates change.

Modified duration = Macaulay duration ÷ (1 + periodic yield). It gives the % change in price for a change in yield and is always slightly lower than Macaulay duration.

Convexity measures the curvature of the price–yield relationship.

Formula % price change ≈ − modified duration × change in yield.

Remember

• Zero-coupon bond: duration = maturity.
• Modified duration < Macaulay duration.

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7The money market

The money market covers borrowing and lending from overnight to one year, secured or unsecured. It is the main channel through which the RBI transmits monetary policy, and it is central to financial stability: a freeze in overnight lending helped trigger the 2008 crisis.

Participants: banks of all kinds, FIs, insurers, mutual funds, primary dealers, NBFCs, corporates, PF and pension funds, payments banks and small finance banks.

• Call, notice and term money are unsecured and interbank. Call money is limited to scheduled commercial banks and primary dealers.
• Repo (ready forward): borrowing by selling securities with an agreement to buy them back. The interest is built into the repurchase price. A reverse repo is the lender's side, a collateralised loan. Each deal has two legs.
• Triparty repo uses a triparty agent to handle collateral, settlement and custody. CCIL's CBLO (2003) became TREP in November 2018. Funds borrowed on TREPS are exempt from CRR/SLR computation.
• T-bills: zero-coupon, issued at a discount and redeemed at par. The RBI auctions them weekly in 91, 182 and 364-day tenors. The 14-day T-bill is not offered to the public.
• CMBs: very short T-bills (under 91 days) for temporary government cash mismatches.
• CPs: unsecured, discounted short-term corporate borrowing. Issuers need a strong credit rating (typically at least the second-highest) and a minimum net worth. They are used for working capital.
• CDs: issued by banks for up to 1 year and by FIs for 1–3 years.
• Corporate bond repo was introduced in 2010. Participants cannot borrow against their own or related entities' securities. Triparty repo on corporate bonds started on exchanges in 2017.

Remember

• CBLO became TREP in 2018.
• CPs: minimum ₹5 lakh. CDs: minimum ₹1 lakh.

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8The government debt market

The G-sec market is the most active part of India's fixed income market. It funds the government, sets benchmark rates and transmits monetary policy.

Participants

• Banks, which hold G-secs to meet SLR requirements; SLR has been eased over time.
• Primary dealers, who make markets with two-way quotes.
• Insurers, co-operative banks, mutual funds, corporates, PF and pension funds, FPIs, and the RBI, which is a large holder.

Each security carries a unique ISIN. The Centre issues bills and bonds; states issue only bonds, called SGSs.

Instruments

• T-bills (91, 182 and 364 days, auctioned weekly against a quarterly calendar) and CMBs (under 91 days, launched in 2010; used after demonetisation in 2016 and during the 2013 forex volatility).
• Dated G-secs: maturities of 1–50 years, semi-annual coupons, issued against calendars announced in March (for April–September) and September (for October–March).
  • The RBI's Public Debt Office handles them. The RBI acts as depository, merchant banker and RTA.
  • If a coupon date is a holiday, payment moves to the next working day. If a maturity date is a holiday, redemption moves to the previous working day.
• Fixed-rate bonds: the largest category. For example, 5.77% GS 2030 pays 2.885% of face value every six months. The coupon is usually the auction cut-off rate.
• Floating-rate bonds (since 1995): the coupon resets, mainly linked to the 182-day T-bill. Take-up has been low.
• Zero-coupon bonds (last issued in 1996) and capital-indexed bonds (1997, principal indexed to inflation) found little demand.
• Inflation-indexed bonds: protect both principal and coupon. WPI-linked IIBs were issued in June 2013 and CPI-linked retail IIBs in December 2013. They were later discontinued and largely bought back.
• Bonds with call and put options: the first was 6.72% GS 2012, issued in 2002. None are issued now.
• Special securities (oil, food and fertiliser bonds, bank recapitalisation bonds): issued in lieu of cash subsidies. They are not SLR-eligible, so they pay slightly more.
• STRIPS: each coupon and the principal are separated into individual zero-coupon bonds. They carry zero reinvestment risk, which appeals to retail investors.
• Sovereign Gold Bonds: denominated in grams of gold, with a fixed coupon paid semi-annually. They redeem at the simple average of the IBJA 999 gold closing price for the previous 3 business days. Fresh issues may not continue; existing tranches trade on exchanges.
• Savings (taxable) bonds: for retail investors, from ₹1,000 with no upper limit. Interest is taxable and has been floating since FY21, resetting every 6 months.
• SGSs: state bonds, SLR-eligible and usable for LAF borrowing. UDAY bonds (for power discoms) are not SLR-eligible.

Remember

• STRIPS remove reinvestment risk.
• States issue only bonds (SGSs).
• Special securities are not SLR-eligible.

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9The corporate debt market

Corporate debt is still a small share of issuance in India. Institutions dominate, limited by their regulators' prudential norms. Issuers often prefer bank loans or overseas borrowing. Secondary trading is thin for individuals because the market is mostly wholesale and lacks a guaranteed central counterparty.

Key players

• Issuer: raises money through private placement or a public issue. Public issues must be listed. Privately placed debt may or may not be listed.
• Debenture trustee (DT): registered with SEBI under the SEBI (Debenture Trustees) Regulations, 1993. Banks, insurers, public FIs or companies can act as DTs.
  • The DT holds the secured property for the benefit of debenture holders.
  • It monitors security cover and compliance, and calls for reports.
  • On default it can appoint nominee directors and sell the secured assets.
  • A DT is compulsory for debentures with maturity over 18 months. The issuer pays the DT's fees.
  • Unsecured debentures taken from individuals are treated as deposits.
• QIBs: scheduled commercial banks, IRDAI-registered insurers, mutual funds, state industrial development corporations, development FIs, PF and pension funds with at least ₹25 crore corpus, public FIs, FIIs/FPIs, and SEBI-registered VCFs and FVCIs.
• Retail individual investor: applies for ₹2 lakh or less.
• Designated stock exchange: an exchange with nationwide terminals where the debt is listed.

Instruments

• Company deposits: 1–3 years, at rates above bank FDs depending on the company's strength. They are not securities under SCRA because they are not transferable.
• Bonds and debentures: longer term, often secured. Default risk still matters.
• Infrastructure bonds: 10–20 years; analyse the underlying projects.
• Inflation-indexed bonds: the rate resets with inflation to protect the real return.

Remember

• DT mandatory above 18 months.
• Retail = up to ₹2 lakh.
• Company deposits are not securities.

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10Bank deposits and small savings schemes

Bank fixed deposits

• Tenors range from 7 days to 10 years. The rate is fixed for the term; new rates apply only to fresh deposits. Odd tenors such as 333 or 777 days may carry special rates.
• Senior citizens (over 60) usually get 0.25%–0.75% extra.
• DICGC insures up to ₹5 lakh per depositor per bank, covering principal and interest across all branches.
• Banks may impose a lock-in and premature withdrawal penalties. Loans and overdrafts against FDs are available.
• 5-year tax-saver FDs qualify under Section 80C (limit ₹1.5 lakh, with a 5-year lock-in).

Floating Rate Savings Bonds (GoI, launched July 2020)

• The rate is NSC rate + 0.35%, reset every six months. The first rate was 7.15%.
• Residents only; NRIs are not allowed. Held in demat (bond ledger account) form.
• Interest is taxable as income from other sources.

Small savings schemes carry an implicit government guarantee and are sold through post offices and select banks.

Exam trap The POMIS limits have since been raised, to ₹9 lakh single and ₹15 lakh joint since April 2023. Small savings rates and limits change by government notification, so check current rules before advising. Answer exam questions from the workbook figures.

Remember

• DICGC cover: ₹5 lakh per depositor per bank.
• KVP has no tax benefit.
• SSA: girl up to 10, matures at 21.

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