Debt Instruments – Overview, Examples, Pros, Cons

Share on whatsapp
WhatsApp
Share on twitter
Twitter
Share on linkedin
LinkedIn
debt instruments

Whether you are an active investor or not, you might be aware that investing in debt instruments is as crucial as equity investment.

 

However, many investors still overlook the significance of debt instruments in India, and how they reduce your portfolio risk while offering a regular source of income.

 

So do you wish to avoid the rookie mistake of directing all your funds into one kind of investment as well as earn a stable rate of return? Then let us introduce you to the various elements of Debt Market and what is a debt instrument, so you can make an informed investment decision. 

 

What is Debt Market? 

Debt market basically refers to the financial market where investors can buy and sell debt instruments of various types and features. These instruments will provide you with regular interest payments at a fixed-rate along with principal repayment at the time of maturity. For instance, if Varun invests Rs. 100 in a debt instrument that offers 10% returns and has a tenure of 1 year, he will get a sum of 110 (principal amount + interest) at the time of maturity. 

 

Now, you may be curious who issues these debt instruments in India? Well, the Reserve Bank of India has allowed the following bodies to issue debt instruments:

  • Central and State Governments
  • Municipal Corporations
  • Government agencies
  • Banks
  • NBFCs
  • Public Sector Units
  • Corporates
  Debt Market
Nature of Trading It is a market place where fixed-income securities are traded.
Risk Involved Less volatile in nature, which makes them less risky than the Equity Market.
Nature of Returns Debt market instruments provide fixed returns to the investors.
Role of Investors Debt holders are creditors of the company and don’t have any voting rights.

 

Debt Instruments- Meaning and Classification

A debt instrument is essentially an asset that allows you (the investor) to earn a fixed interest along with getting the principal back. At the same time, these assets help the issuers (institutional entities) to raise capital.

 

So, are you wondering what makes Debt Market’s instruments safer than Equity Market’s? To ensure a less-risk environment for the lender, debt acts as a ‘legal obligation’ on the issuer’s end to repay the borrowed sum along with interest on a timely basis. On the contrary, equity instruments don’t carry such legal obligations.

 

This low-risk and fixed interest are the reasons that different types of debt instruments are also referred to as fixed-income securities.

 

Let us dive further into the major categories of Debt Instruments:

1. Bonds

In simple terms, a bond is loan from an investor to a borrower which is generally a corporate or government entity. The borrower uses the money to fund its operations and the investor receives a predetermined interest on the investment.

 

Let’s assume that you have decided to invest in a bond, now how do you decide which entity to go ahead with? The answer is simple- analyse your risk appetite. If you’re satisfied with a low 6-7% interest rate and don’t want to worry about the corporation defaulting on its debt, then buy the bonds of an entity with good strength, perhaps a blue chip. However, if you are looking for good returns (10-11%) then you might find smaller companies more suitable to your needs.

2. Certificates of Deposits

A certificate of deposit or CD is a type of debt instrument that holds a fixed amount of money for a fixed period of time. Offered by banks, thrift institutions, and credit unions, CDs are insured instruments that offer fixed interest rate which makes them virtually risk-free.

 

If you buy a Certificate of Deposit and hold it until maturity, you will be eligible to withdraw the sum together with the accrued fixed-interest.

 

An interesting thing to note about CDs is that they can only be issued for a minimum of Rs.1 lakh by a single issuer and in multiples of Rs.1 lakh.

3. Debentures

A debenture is similar to a bond because in both the cases you are paid a guaranteed interest, but the difference lies in security levels. Bonds are more secure than debentures. If a company decides to issue bonds, they have to mandatorily back it up with a collateral. However, when the company is issuing debentures keeping collateral is optional which makes them unsecured.

 

Furthermore, in case of liquidation, bondholders will be paid off before debenture holders.

4. Fixed Deposits

In a fixed deposit account, you can deposit your money for a fixed time-period, thereby earning a predetermined rate of interest  return. Fixed deposits are offered by banks and NBFCs, and allow you to choose a period ranging from 7-14 days to even 10 years.

 

What makes these debt market instruments a safe investment option is that when you open a FD account at a specific interest rate, it is guaranteed for the rate of interest to remain the same, irrespective of any market fluctuations.

5. Government Securities

Government securities (G-secs) are debt securities issued by the Reserve Bank of India and broadly include:

  • Central Government Securities.
  • State Government Securities
  • Treasury bills

These debt instruments in India were recently made accessible to retail investors. Initially, they were available only to banks and the large financial institution. But now you can invest in them as well and take advantage of attractive and guaranteed returns.

 

These type of debt instruments can be for the long term or short term, with Treasury Bills being an ideal example of short-term debt instruments. Long term Government securities include instruments like Dated Securities or Bonds.

Role of credit-rating in Debt Instrument Valuations

In simple terms, Credit Rating is a representation of the creditworthiness and the credentials of a business. For instance, Company A wants to get a loan from a bank to run its operations. Now, before approving Company A’s loan the bank will check its credit rating to ensure that the company has the potential to pay back.

 

But you might be wondering what exactly is indicated by ‘credit rating’? Basically, it will state that if the borrower (Company A in the above example) has defaulted on loan payments before and if it is worth trusting with a new loan.

 

And how is this metric relevant for you as an investor? When you make an investment, whether in equity or debt, you do assess the associated risks. So to boost investor confidence, credit ratings help you to form a view on the likelihood that whether an issuer may repay its debts on time and in full.

 

In Debt Market, credit rating of the issuer plays a very important role as investors rely heavily on these ratings, before investing in debt securities.

Credit Ratings Scale

Credit rating agencies rate corporate bonds, Non-convertible debentures (NCD), company deposits, etc. on a scale of AAA (the highest) to D (the lowest). CRISIL, ICRA, and CARE are among the most prominent credit rating agencies in India.

 

Let’s take a look at the credit rating symbols and what they indicate:

Credit Ratings  Indications
AAA
The highest degree of safety and lowest credit risk
AA
High degree of safety and low credit risk
A
An adequate degree of safety and low credit risk
BBB
A moderate degree of safety and moderate credit risk
BB
Moderate risk of default
B
High risk of default
C
Very high risk of default
D
Instruments are in default or expected to default

How Do Credit Ratings Affect Debt Instrument’s Valuations?

 

Credit Rating of a borrower (Debt Instrument issuer) has an inversely proportional relation to the yield of its debt instruments. To put it simply, when a borrower’s credit rating is higher it will pay lower interest rate.

 

Let us take an example to explain the reason behind this. Your friend Ram is starting a business and is asking you to lend him a capital of Rs. 10,000; simultaneously you are planning to invest the same amount of money in a bank FD. Now, while lending to Ram you will charge a higher interest rate as compared to the interest you are being offered by the fixed deposit. This is because the chances of Ram defaulting on the payment is high when compared to chance of the bank defaulting.

 

The same reasoning applies in the debt instrument market. A company with good balance sheet and fair business prospect will enjoy a high credit rating. Surely, it will offer competitive rate of interest but it has no need to offer greater interest rates to attract investors in its bonds or deposits.

 

To know more about credit ratings issued to NBFCs click here.

Pros of Investing in Debt Instruments

There are many benefits of investing in Debt Instruments in India, with the major reasons being:

1. Return on capital

Firstly, as discussed above debt market securities are a great way to earn a return on your capital. Further, certain debt instruments like corporate bonds are designed to reward you with interest and the repayment of capital at maturity.

2. Stable Returns

Debt Market Securities offer a predictable stream of payments by paying interest and principal at the maturity. These interest payments are guaranteed and promised payments, which will assist you in cash flow needs.

 

Being less sensitive to market fluctuations, they may not generate as high returns as equity instruments but their value also do not fall rapidly.

3. Diversification of Portfolio

Fixed-income instruments enable efficient portfolio diversification. While mutual funds and stocks are ideal contenders for risky yet high-returns’ investments, FDs and bonds are instrumental to counter those risks.

 

Further, the maturity date of Debt Instruments range from short-term to long-term which allows investors to tailor their portfolios to meet future needs. For instance, if the money you’d like to invest is supposed to be your emergency fund or the money you will need in the nearby future for travelling or purchasing a car, it’s highly recommended that you stick with short-term debt instruments.

4. Lowering the risk of your Portfolio

As Debt Market Instruments are independent of market fluctuations, they carry significantly lower risks. Further, bondholders also enjoy a measure of legal protection because if a company goes bankrupt, they are the first ones to get paid.

 

So if you are a conservative investor whose priority is to have a fixed interest income, then you should definitely invest in debt instruments. They act as a hedge against market volatility when equity funds are underperforming.

Cons of Investing in Debt Market Instruments

Contrary to popular opinion, Debt Market also has its own risk. Following are the risks associated with debt securities:

1. Credit Risk

When an issuer of a bond is not able to make timely payment of interest or principal on a debt security or to otherwise comply with the provisions of a bond indenture, it is referred to as Credit Risk or Default Risk.

2. Interest Rate Risk

This risk prevails almost in all debt market securities. For example, Varun invested at a time when there was 7% fixed interest rate, but after a month the market fluctuated and the interest rate rose to 10%. In such a situation, Varun lost on to higher interest rates and will get only the fixed interest rate.

3. Reinvestment Rate Risk

It means that you will be unable to reinvest cash flows received from one debt instrument, at a rate comparable to your current rate of return. Any sort of investment that produces cash flow will expose you to this risk.

4. Liquidity Risk

Liquidity risk occurs when an investor cannot convert an asset into cash, without giving up capital and income. For example, Varun is in need of liquid cash and he wants to sell his home for 5 lacs. However, the market is down and he has to sell it for 4 lacs. After a year, the market might improve but Varun has already lost money in the transaction.

 

Hence, before investing in long-term illiquid assets such as PPF you should consider whether you can convert your short-term debt instruments into cash.

Closing Thoughts

Any investment portfolio should comprise the right mix of safe, moderate and risky investments. While equity instruments are the preferred contenders for moderate and risky investments, Debt Instruments are essential to balance out that risk with steady and low-risk returns.

 

You should never focus either solely on the returns or the risk associated while investing in any asset. Making investments requires a comprehensive approach that analyses opportunities in the context of a portfolio’s broader framework. Hence, you should bring Debt and Equity together as per your investment goals to strike the right balance.

Leave a Reply

Your email address will not be published. Required fields are marked *

Subscribe

Subscribe

Sign up to start investing in high yield debt assets.

Sign up