People make investments with the intention to fulfil their long-term and short-term financial goals. And to help people meet these goals, India’s financial market offers a wide range of investment products.
These products are generally categorised into various types, with one major distinction being- equity vs debt investments. You can choose to invest in an equity or a debt product, depending on your risk appetite & returns expectations. But what is the difference between the two?
When you buy equity in a company, you become a part owner of that company; debt represents a loan you expect to get back, along with interest. Debt represents a legal obligation of the “borrower” to repay the borrowed amount with interest to the lender on time. The following article will discuss debt instruments in India and their types in detail.
What is Debt Market?
The 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 about 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
- Public Sector Units
What are Debt Instruments?
Your investment in a company or a government body through a debt instrument is a debt investment. Now you may ask- what is a debt instrument? Basically, a debt instrument is an asset that provides the lender (investor), a fixed income on the asset from the borrower. The lender receives the principal back in due course along with interest payments.
Simply put, these investments are the money you lend to an organisation or government entity against fixed-income instruments for a specific duration. Organisations use these instruments to raise capital for growth, expansion, or running operations.
For instance, you invest Rs 5,00,000 in a bond issued by ABC company for ten years at 5% interest and a quarterly payout. You will be entitled to receive Rs 6,250 as a quarterly payout for the next ten years (unless you choose to make a premature withdrawal).
Debt instruments carry low risk as compared to their equity counterparts. This is because the returns of debt instruments have priority over the returns of equity, in case of liquidation.
Also Read: Equity Funds vs Debt Mutual Funds
Let us dive further into the Common Debt Instruments Examples:
Types of Debt Instruments in India
The debt market in India—one of the largest in Asia—broadly consists of government securities (G-Secs), including central and state government securities and bonds issued by corporations.
Debt products available include bonds, Certificates of Deposit, Commercial Papers, Debentures, National Savings Certificates, Government Securities, Fixed Deposits, and more. Here’s a detailed description of some of them:
1. Government Bonds
Government Bonds are a popular category of debt instruments issued by the central or state government. These bonds act as a loan wherein the government borrows money from investors at a predetermined interest rate for a specific time period. The investors receive the principal and interest as per the clauses mentioned in the bond.
Government bonds fall under the broad category of government securities (G-secs) and are issued under the supervision of the Reserve Bank of India. The interest rate offered on the government bond, also known as the coupon rate, can be either fixed or floating.
- You can buy a government bond through the NSEGoBID Platform or RBI Retail Direct.
- Government Bonds are a safe investment choice for retail investors as they carry sovereign guarantee.
Companies issue debentures to raise funds by borrowing money from the public. The company thus promises to pay fixed interest to the investors. These debt instruments may or may not be backed by any specific security or collateral. Hence, the investors have to rely on the credit ratings of the issuing company as security.
While the interest payment and principal repayment depend on the issuing company’s creditworthiness, the payment of debt instruments is prioritised over stock dividend payments to shareholders.
- Check the credit rating of the issuing company before you invest in debentures.
- Debentures, though a debt instrument, do carry some inherent risk.
- Suitable for long-term investment.
3. Fixed deposits
Fixed deposits (FDs) are one of the most popular investment products as they are versatile and flexible. Banks, certain Non-Banking Finance Companies (NBFCs), and even post offices issue fixed deposits.
They score over many other debt instruments in India due to their ease of investment, liquidity (except in tax-saving FDs), and uncomplicated nature. You can arrange a fixed deposit in your neighbourhood bank branch or at a post office for a term ranging from 7 days to 10 years.
Banks offer cumulative and non-cumulative FDs. Cumulative option deposits pay you interest on maturity. For non-cumulative deposits, you receive the interest monthly, quarterly, or annually and the principal on maturity. You can also invest in Tax-saving FDs that have a tenure of 5 years, to help you save tax under Section 80C of the IT Act.
- Premature withdrawals are allowed, although the bank may charge a penalty fee.
- Suitable for those who want liquidity and flexibility.
- You can take a loan against an FD.
- Each depositor in a bank is insured up to a maximum of Rs. 5,00,000 for both principal and interest amounts.
Also Read: How to check PPF account statement
4. Debt mutual funds
Another way to invest in debt instruments in India is through a mutual fund (MF). Debt Mutual funds invest the pooled money in fixed-income products like government securities, corporate bonds, and some part in money market instruments.
Also Read: Debt Funds: Best Debt Mutual Funds to Invest in 2023
Debt funds, also known as fixed income funds, are considered less volatile compared to equity funds as they invest in fixed-income products. They also have a low-cost structure. You can choose from a variety of mutual fund types based on your requirements.
- They are suitable for those looking for relatively stable returns.
- They offer steady returns with low volatility
- Debt mutual funds are of various types and suit different requirements; a few types are:
- Overnight funds
- Liquid funds
- Ultra-short duration funds
- Medium to long-duration funds
- Dynamic bond funds
- Corporate bond funds
Read More: Liquid Mutual Funds – What Are Liquid Funds | Risk, Returns & Benefits
5. Certificates of deposit
Certificates of Deposit (CDs), introduced in India in 1989, are short-term debt instruments. Banks and Financial Institutions issue CDs in dematerialised form against the funds that an investor deposits for a specific term. The Reserve Bank of India lays down guidelines from time to time for their issue and operation.
Banks must maintain the cash reserve ratio (CRR) and statutory liquidity ratio (SLR) on the price of CDs. Cash Reserve Ratio (CRR) is the minimum deposit amount that a bank has to hold as reserves with the Reserve Bank of India. On the other hand, SLR is a minimum percentage of deposits that a commercial bank has to maintain in the form of liquid cash, gold or other securities. SLR is not reserved with the RBI, but with the bank itself.
All individual residents in India are eligible to buy certificates of deposit. The minimum duration of a CD issued by a bank is seven days and goes up to one year. For CDs issued by Financial Institutions, the minimum tenure is one year and the maximum is three years. The interest rate may be fixed or floating for a CD. In the case of the latter, the interest rate is reset periodically in accordance with a predetermined formula.
- You can deposit a minimum of Rs 5 lakh and multiples thereof in CDs.
- You get interested on them at a fixed or floating rate.
- No loan facility is available against it.
Also Read: Equity Markets vs Debt Markets
6. The public provident fund
The Public Provident Fund (PPF) scheme is a popular long-term investment product. PPFs have been around since 1968. In this investment option, you put aside a small sum of money regularly to create wealth in the long term.
You can invest a minimum of Rs 500 and a maximum of Rs 1,50,000 per year in PPFs. The returns are guaranteed by the government of India, making it one of the safest products for investment purposes.
- The PPF scheme has a 15-year maturity period.
- Interest is fixed by the government every quarter.
- It helps with tax saving under Section 80C of the Income Tax Act, 1961.
Table Comparing Different Debt Instruments
|Government Bonds||Debentures||Fixed Deposit||Debt Mutual Fund||Certificate of Deposit||PPF|
|They are issued for a fixed term and can be redeemed only on maturity.||Debentures cannot be withdrawn, but as they are listed, they can be traded.||Except for tax FDs, you can withdraw funds, sometimes with some restrictions.||Open-ended debt mutual funds are liquid.||CDs can be redeemed only after maturity, so they have limited liquidity.||15 years tenure, loan available from the 3rd and 5th year, partial withdrawals after the 7th year|
|Issued for the long term.||Issued for the short to long term.||The term varies as per your choice, from days to months.||Different funds are suitable for different time horizons.||CDs are short-term investments; there is no flexibility in the term.||They create corpus over the long term|
|Generally offer fixed payouts at fixed intervals.||Pay a regular or coupon rate to investors, susceptible to market and business risk.||The interest rate is fixed; you can get periodic payments or the entire amount on maturity. Risk is minimal||Returns vary; you get the market value when you redeem.||Rates are fixed and quarterly, with minimal risk.||Interest rates are fixed by government quarterly. You can redeem the corpus at maturity.|
|Interest is fully taxable.||Interest is fully taxable.||Interest is fully taxable. No tax is deducted if the interest income from all FDs with a bank is less than Rs. 40000 in a year.||Taxation rules depend on the holding period.||Interest is fully taxable.||Investment and returns are tax-exempt.|
Role of credit-rating in Debt Instrument Valuations
In simple terms, a 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 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 an issuer may repay its debts on time and in full.
In Debt Market, the credit rating of the issuer plays a very important role as investors rely heavily on these ratings, before investing in debt securities.
Read More: Dynamic Bond Funds: Definition, Benefits, Risk and Things to Consider
Credit Rating 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:
The highest degree of safety and lowest credit risk
The high degree of safety and low credit risk
An adequate degree of safety and low credit risk
A moderate degree of safety and moderate credit risk
Moderate risk of default
High risk of default
Very high risk of default
Instruments are in default or expected to default
How Do Credit Ratings Affect Debt Instrument Valuations?
The 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 a 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 the chance of the bank defaulting.
The same reasoning applies to the debt instrument market. A company with a good balance sheet and fair business prospects will enjoy a high credit rating. Surely, it will offer a 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.
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 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 in India 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.
Also Read: Equity Markets vs Debt Markets
Cons of Investing in Debt Market Instruments
Contrary to popular opinion, Debt Market Instruments also has its own risk. The 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.
Also Read: The Structure of Financial Markets in India
Choosing the Right Debt Instrument
The above discussion focuses on debt Instrument meaning, understanding each product and helping you pick the right one. A combination of factors dictates your choice of product for investment. Let us look at a few of them:
- The investment horizon is an important aspect when choosing the right product. For a very short term like 3 to 6 months, liquid mutual funds can be a good option. CDs are also an excellent short-term money market investment option.
- If your investment horizon is one to two years, you can add corporate bonds to your options. Short-term debt funds could also be a good option.
- For an investment horizon of more than three years, consider debt funds. The gains are treated as long-term capital gains and are taxed at 20% after indexation. PPFs are also a good option for the long term.
- While debt instruments in India are less risky than equity, the risk varies depending on the type of debt investment.
- FDs are insured by the government with deposit insurance coverage of Rs 5 lakh per depositor per bank; you have additional security to some extent.
- CDs are the least risky, as they are issued against funds deposited in a bank.
- PPF investments also carry negligible risk.
A well-balanced portfolio has products from different class categories and sectors. You could create a portfolio tilted towards equity or debt, depending on your risk appetite. When you choose debt products, it is not always one option versus another. You can pick a combination depending on the time frame you have in mind.
Read More: Balanced Hybrid Mutual Funds: Meaning, Types, Benefits, Return and Taxation
Your investment goal and careful research are two aspects that are crucial to investment decisions. Before you invest, understand the product features well and see if they match your investment objective. Debt investments offer a low-risk approach to saving and can help you meet your financial goals. Wint Wealth is a comprehensive wealth-management and education platform that can help you make highly informed investment decisions. So, invest well and safely!
Are there other debt instruments available in India?
The above article discusses a few debt instruments available for investment. Many other options are also available. Some of them are Sukanya Samriddhi Yojana, National Savings Certificate, and Senior Citizen’s Safety Scheme.
Do I have to pay tax on debt funds?
You pay tax on debt funds depending on their holding period. If the holding period is less than three years, you pay taxes on short-term gains. The profits are added to your taxable income and you pay tax at the applicable tax slab. When the holding period is more than 36 months, you pay tax at a flat rate of 20% after indexation.
Is a DEMAT account mandatory for investing in debt instruments?
A Demat account makes investing in all types of instruments more convenient. Some investments, like CDs, are available only in electronic (Demat) format. Fixed deposits, bonds, and mutual funds are also available in electronic and physical forms. Holding securities electronically helps keep them safe and increases the ease of trading.
What is the role of credit ratings in debt investment?
Rating agencies like CRISIL, CARE, and ICRA rate debt instruments in India like debentures, bonds, etc. The highest rating they provide is AAA (the safest), and D is the lowest (the least safe). Credit ratings can help you choose a suitable investment based on the rating.
Are all debt products 100% safe?
Debt products range from moderately safe to very safe; all are not equal in terms of safety. Your FDs may be susceptible to risk due to bank operations failing. Debentures are prone to business risk and debt funds to market ups and downs, even though minor.