Debt Market Instruments: Types, Components

  • Post last modified:09/01/2022
  • Reading time:10 mins read

What is debt investment instruments?

A debt instrument represents a contract whereby one party lends money to another on pre-determined terms with regards to rate and periodicity of interest, repayment of principal amount by the borrower to the lender.

In Indian securities markets, the term ‘bond’ is used for debt instruments issued by the Central and State governments and public sector organizations and the term ‘debenture’ is used for instruments issued by the private corporate sector.

Investing in debt instruments is like lending your money to a third party, who utilizes this money to earn more money. Generally, periodically part of this money is passed on to you as interest. The capital is returned after the stipulated time period.

These instruments beat inflation to some extent; however, taxation may be a concern in many of these instruments. The lock-in period could be short, medium or long term depending on the type of debt instrument chosen. Capital is relatively safe; returns are lower than equity but higher than cash instruments.


Types of Debt Instrument

The various types of debt instruments are seen in the Indian debt market. These instruments are discussed below:

  1. Fixed and Floating Rate Instruments
  2. Debt Instruments with Call and Put Option
  3. Zero Coupon Debt Instruments
  4. Debentures
  5. Non-Convertible v/s Convertible Debt Instruments
  6. Irredeemable and Redeemable Debt Instruments
  7. Secured Debentures v/s Unsecured Debentures

Fixed and Floating Rate Instruments

Debt instruments are issued either at a fixed or floating rate of interest. In the case of fixed-rate debt instruments, the interest rate is fixed and paid periodically (semi-annually or annually). The fixed rate of interest, which is always stated on the annual basis, is called the coupon rate and the payment itself is called the coupon. The coupon rate of the instrument is fixed at the time of issuance which remains constant throughout the tenor of the instrument.

For example, issue of 10 per cent bond by a public company for 10 years. Here 10 per cent interest is fixed and remains the same throughout the tenor of a bond. Such bonds are called as simple or plain vanilla bonds or simply fixed coupon bonds.

The coupon is determined by a number of factors which includes the credit rating of the instrument, tax benefits, the collateral securities offered to secure the issue, overall interest rate scenario in the market and special features offered to the investors.

Debt Instruments with Call and Put Option

Nowadays debt instruments are issued with call and put options. A call option allows the bond issuer to call back the bonds and repay them at a predetermined price before maturity. The issuer exercises the call option when general interest rates are lower than the coupon or interest rate on the existing debt instruments thereby retiring existing expensive debt instruments and refinancing at a lower interest rate.

As against this, the put option allows the bondholder or investor to sell the bonds to the issuer at a predetermined price before the maturity date. The holder of such debt instrument will exercise the put option when prevailing interest rates on the new issues of bonds are higher than the coupon on the existing debt instruments.

Zero Coupon Debt Instruments

Such instruments are issued or sold at their discounted value and accordingly have zero interest rates. The best example is treasury bills which are issued at discounted value. For example, a 91 day Treasury bill with a face value of Rs.100 is issued at Rs.98.50.

Therefore such instruments have no coupons or interest rates at all. The difference between the discounted value and face value of the instrument is the gain or income for the investors. In other words, investors are not entitled to any interest income and thus are entitled to receive only repayment of the face value of the security on the maturity date.

The zero-interest debt instruments are beneficial both to the issuers because of the deferred payment of interest and to the investors because of the lucrative yield and absence of reinvestment risk.

Debentures

The term Debenture is derived from the Latin word ‘debere’ which means ‘to owe a debt. A debenture is an acknowledgement of debt, taken either from the public or a particular source. When borrowed capital is divided into equal parts, then, each part is called as a debenture.

Debenture represents debt. For such debts, the company pays interest at regular intervals. It represents borrowed capital and a debenture holder is the creditor of the company. Debenture holder provides loan to the company and he has nothing to do with the management of the company.

Non-Convertible v/s Convertible Debt Instruments

A debt instrument can be issued either with a non-convertible clause or with a convertible clause. A non-convertible debt instrument is an instrument that cannot be converted into equity at all. This means non-convertible debt instrument remains as a debt instrument throughout its tenor.

The holder of a convertible debt instrument can exercise the right to convert the whole of the debt instrument or its portion into equity. On conversion of a debt instrument into equity, the investors will receive equity shares in place of existing convertible bonds.

Once this is done then the investors will receive dividend income instead of interest Such instruments are issued either as fully convertible or partly convertible debt instruments.

Irredeemable and Redeemable Debt Instruments

Debt instruments can be classified according to its irredeemable and redeemable characteristics. The irredeemable debt instruments are those which can be redeemed only at the time of liquidation of an issuer entity.

The redeemable debt instruments are those which are issued for a specified period and thus are redeemed once that period gets over. The common practice is to issue debt instruments as redeemable debt instruments. Under the company law provisions, companies are not allowed to issue irredeemable debt instruments.

They are allowed to issue debt instruments like debentures as redeemable debt instruments with a maximum period of 10 years. A company engaged in the setting up of infrastructure projects like road, power, etc. is allowed to issue secured debentures for up to thirty years. This means such debentures cannot be issued as irredeemable debentures.

Secured Debentures v/s Unsecured Debentures

The secured debentures are those that are secured by a charge on the fixed assets belonging to the issuing company. In view of this, even if the issuer fails to return money to the debenture holders on maturity, the issuer’s assets on which charge is created can be sold to repay the dues of the debenture holders.

The unsecured debentures are those where if payment is not made to the debenture holders on maturity, then their dues are considered along with other unsecured creditors of the issuing company.


Components of Debt Instruments

The key components of corporate bonds are given as follows:

  1. Maturity
  2. Coupon/Interest
  3. Principal
  4. Issue Price
  5. Face Value (FV)
  6. Coupon Frequency
  7. Call/Put Option Date
  8. Maturity/Redemption Value

Maturity

Maturity of a bond refers to the date, on which the bond matures, which is the date on which the borrower has agreed to repay the principal. Term-to-Maturity refers to the number of years remaining for the bond to mature.

The Term-to-Maturity changes every day, from the date of issue of the bond until its maturity. The term to maturity of a bond can be calculated on any date, as the distance between such a date and the date of maturity. It is also called the term or the tenure of the bond.

Coupon/Interest

Coupon refers to the periodic interest payments that are made by the borrower (who is also the issuer of the bond) to the lender (the subscriber of the bond). The coupon rate is the rate at which interest is paid, and is usually represented as a percentage of the par value of a bond.

Principal

The principal is the amount that has been borrowed and is also called the par value or face value of the bond. The coupon is the product of the principal and the coupon rate.

Issue Price

Issue Price is the price at which the corporate bonds are issued to the investors. The issue price is mostly the same as a face value in the case of a coupon-bearing bond. In the case of non-coupon bearing bond (zero-coupon bond security is generally issued at discount.

Face Value (FV)

Face Value is also known as the par value or principal value. A coupon (interest) is calculated on the face value of the bond. FV is the price of the bond, which is agreed by the issuer to pay to the investor, excluding the interest amount on the maturity date. Sometimes, the issuer can pay a premium above the face value at the time of maturity.

Coupon Frequency

It means how regularly an issuer pays the coupon to the holder. Bonds pay interest monthly, quarterly, semi-annually or annually.

Call/Put Option Date

It is the date on which issuer or investor can exercise their rights to redeem the security.

Maturity/Redemption Value

It is the amount paid by the issuer other than the coupon payment. If the redemption proceeds are more than the face value of the bond/ debentures, the debentures are redeemed at a premium. If one gets less than the face value, then they are redeemed at a discount and if one gets the same as their face value, then they are redeemed at par.


FAQ Related to Debt Market Instruments

What is a convertible instrument?

A debt instrument is issued with a convertible clause. The holder of such an instrument can exercise the right to convert debt instrument either fully or partially into equity. On conversion of a debt instrument into equity, the investors will receive equity shares. Once this is done then the investors will be paid dividends but not interest.

What are the options in debt instruments?

A call option allows the issuer of the debt instrument to call back the bonds and repay them at a predetermined price before the maturity date. The issuer may like to exercise the call option when interest rates in the market are lower than the coupon or interest rate on the existing debt instruments thereby retiring expensive debt instruments and refinancing them at a lower interest rate.

What are fixed instruments?

Fixed-Rate Debt Instrument: In the case of such instrument interest rate or coupon is fixed and remains constant throughout the tenor of the instrument. The principal amount is paid on the maturity date. This is also called as plain vanilla or simple debt instrument or straight bonds.

What is difference between public and private placement?

The primary dealers are wholesale traders in the Government securities market. They are market makers and hence provide liquidity in respect of the Government securities. The primary dealers are active participants in the money and Government securities markets. At present in all there are 21 primary dealers in India. Private Placement: It is a method for issue of securities like debt instruments. Under this method offer is made privately to a small chosen number of investors (say less than fifty investors) to subscribe debt instruments or other securities.

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