Debt Instruments
Welcome to the chapter on Debt Investments.
Today, we look at Debt Instruments available for retail investors.
Before we do so, here are our recommended brokers who can help you invest in mutual funds. We suggest you check each one and try at least 2 of them for a few months before you pick one platform for all your investments.
What are Debt Instruments?
Debt instruments are issued by businesses or institutions that need to raise debt or loans from the public for different reasons such as capital expenditure, marketing or advertising expenses or any other reason.
The instruments are a sort of promise from the company or institution (the issuer) that you (the lender) are entitled to receive interest on the money you have lent and get back the principal amount you have lent on a specific date in the future.
It is classified as a fixed income asset as it allows you to earn a fixed interest and get back the principal while the issuer can use it to raise funds at a cost.
In some ways, a debt instrument is like a loan, except that instead of taking the loan from a bank, the company or institution has taken it from you and other investors.
Both public and private companies, government institutions and even the government can issue different types of debt instruments. They can be offered to the public or to a private group of investors. A debt instrument can be in paper or electronic form.
Types of Debt Instruments
Bonds
These are issued by companies to raise funds from the public. The bulk of the investors are financial institutions and mutual funds. You can buy these bonds directly from the company or through a brokerage company.
Bonds usually have a fixed interest rate and are issued for a specific period, though there are bonds with floating rates also. An example of floating rate bonds is the Floating Rate Savings Bonds, 2020 issued by the Government of India. The interest rate is reset every 6 months.
Bonds usually have a maturity period of 5 to 7 years and may have the option for redemption before the maturity date or even for conversion of the bonds into shares. Most corporate bonds can be bought and sold in the secondary market until they are redeemed.
Bonds in the strictest sense are secured by the assets of the company. Sometimes they may be secured by the assets that are purchased with the money collected.
Debentures
In the strictest sense, debentures are unsecured bonds. However, the word is sometimes used interchangeably in India with bonds
Like bonds, these are issued by companies to raise funds from the public with the maximum investors being financial institutions and mutual funds. Like bonds, you can buy denatures directly from the company or through a brokerage company.
They also have a fixed or a floating interest rate and are issued for a specific period. The maturity period is usually 5 to 7 years and you may be offered the option to redeem your investment before the maturity date or even get it converted into shares. Like corporate bonds, debentures can be bought and sold in the secondary market.
Government Securities (G-Secs)
These are bonds issued by the government to finance its expenses. For example, the Government may issue these securities when its revenues (usually from taxes) falls short of its expenses. G-Secs usually earn a fixed rate of interest and are favoured as they are one of the safest ways to earn interest income. These can be usually bought from banks or select brokerage houses.
Treasury Bills
Treasury bills are a type of promissory notes or money market instruments issued by the Government. They are issued at a discount to their face value and you and other investors get the face value at the time of redemption. Treasury bills are a form of short-term debt and issued for different periods from 14 days to 364 days.
The RBI also issues treasury bills from time to time to regulate the money flow in the economy.
They come with guaranteed repayment at a later date and like G-Secs favoured as they are one of the safest ways to earn interest income.
They can be bought from banks which are also depository participants or other registered primary dealers. The minimum investment is Rs. 25,000 and further investments are in multiples of the same amount.
Commercial Papers (CPs)
Commercial Papers are unsecured money market instruments issued as promissory notes. First introduced in 1990, they allow highly rated companies, primary dealers and financial institutions to diversify their sources of short-term borrowings and provide an additional investment option to buyers.
A corporation can only issue CPs when their tangible net worth is at least Rs. 4 crore and it meets certain other requirements as mandated by the RBI including getting a credit rating for issue of Commercial Papers from designated credit rating agencies.
The CPs can be issued for a maturity period of 7 days to one year and the minimum investment limit is Rs. 5 lakh with further investments in multiples of the same. They are issued at a discount to their face value and redeemed at face value like Treasury Bills.
Commercial Papers can be issued only through a scheduled bank.
The Importance of Credit Ratings
Checking the credit ratings is critical if you want to buy any debt instrument issued by a company. Most credit rating agencies rate a company’s debt instruments that are issued to the public.
There is a catch here if you notice. The companies with the highest rating usually do not offer the best returns while those that rank lower on the ratings usually have better returns.
If you are going for corporate bonds that cannot be traded on the secondary market, it is better to go with the higher rated companies as your investments will be safer. But if your instruments can be traded on the secondary market, you may go with lower rated bonds if you can keep an eye on the company’s performance and sell the bonds if you see choppy waters ahead.
Summary
Debt instruments do not offer the same returns as equity investments but are less risky than equity. As such, they can form a part of your portfolio if you are more interested in keeping your money safe and secure instead of growing it. Also, if you are looking for steady returns then this investment avenue is a good one.