Debt Instruments: India has a sizable financial market with a wide range of assets and instruments available for investment. The market can be essentially divided into two categories: the money market and the capital market, the latter of which is primarily composed of the equities and debt markets.
Fixed-income assets in the debt market offer guaranteed interest rates at much lower risk levels than the fluctuating and somewhat riskier products found in the equity market.
For guaranteed returns, investors seeking to diversify their investment portfolios or risk aversion can consider investing in the debt market.
What is the Debt Market?
The financial market where investors can purchase and sell different kinds and characteristics of debt instruments is referred to as the debt market. You will get principal repayment at maturity and with regular interest payments at a set rate from these securities. For example, if Varun puts Rs. 100 in a debt instrument with a one-year maturity period and a 10% return, he will receive Rs. 110 at maturity (principal amount plus interest).
You could wonder who in India issuing these debt instruments. The following organizations are now able to issue debt instruments thanks to permission from the Reserve Bank of India:
- Central and State Governments
- Municipal Corporations
- Government agencies
- Banks
- NBFCs
- Public Sector Units
- Corporates
What are Debt Instruments?
Debt instruments are fixed-income investments that offer investors low-risk & fixed return investing options. Additionally, they meet the government’s or the organization’s financial demands after raising the cash. Debentures, bonds, certificates of deposit, fixed deposits, and so on are examples of the various kinds of debt instruments.
Now let’s examine some more examples of common debt instruments:
Types of Debt Instruments in India
One of the biggest debt markets in Asia, India’s debt market is mostly made up of government securities (G-Secs), which include bonds issued by corporations and securities issued by the federal and state governments.
Bonds, Commercial Papers, Debentures, Certificates of Deposit, National Savings Certificates, Government Securities, Fixed Deposits, and more are examples of debt products that are offered. Here’s a thorough explanation of a few of them:
Government Bonds
One common class of debt instruments issued by the federal or state governments is government bonds. With the use of these bonds, the government effectively lends money to investors for a set amount of time at a fixed interest rate. Following the bond’s provisions, the investors get their principal and interest.
Under the Reserve Bank of India’s supervision, government bonds are issued and classified as government securities (G-secs). The coupon rate, which is the interest rate offered on a government bond, may be fixed or variable.
Key aspects
- NSEGoBID Platform or RBI Retail Direct are the two options available to purchase government bonds.
- Because government bonds are backed by a governmental guarantee, they are a secure option for individual investors.
Read also: What is Equity Fund? – Return, Types, Pros-Cons, How to
Debentures
Businesses borrow money from the general public by issuing debentures to raise capital. As a result, the business guarantees the investors will receive fixed interest. These debt instruments might or might not be supported by particular collateral or security. As a result, investors must rely on the issuing company’s credit ratings as security.
Debt instrument payments are made before stock dividends to shareholders, even though principal and interest repayments are contingent on the creditworthiness of the issuing business.
Key aspects
- Before investing in debentures, find out the issuing company’s credit rating.
- Despite being a financial product, debentures do have some inherent risks.
- Fit for a long-term financial commitment.
Fixed Deposits
The flexibility and versatility of fixed deposits (FDs) make them one of the most popular financial options. Fixed deposits are issued by banks, certain Non-Banking Finance Companies (NBFCs), and even post offices.
Their simplicity, liquidity (apart from tax-saving FDs), and ease of investment make them superior to many other debt securities in India. A fixed deposit can be set up for a duration of one week to ten years at a post office or a bank branch in your community.
Cumulative and non-cumulative FDs are offered by banks. You get interest from cumulative option deposits when they mature. You get the principal at maturity along with the interest on non-cumulative deposits on a monthly, quarterly, or annual basis. To benefit from tax savings under Section 80C of the IT Act, you can also invest in tax-saving FDs with a five-year term.
Key aspects
- Although there can be a penalty fee associated with early withdrawals, they are permitted.
- Ideal for people who desire flexibility and liquidity.
- A loan against an FD is available to you.
- A bank’s insurance coverage for each depositor is limited to Rs. 5,00,000, which includes both principal and interest amounts.
Read also: What is the Hybrid Fund? – Return, Types, Pros-Cons
Debt Mutual Funds
Investing in debt instruments in India can also be done via mutual funds (MF). Debt mutual funds allocate a portion of their pooled assets to money market instruments and other fixed-income securities such as corporate bonds and government securities.
Because they invest in fixed-income products, debt funds—also referred to as fixed-income funds—are thought to be less volatile than equities funds. They have an inexpensive structure as well. Depending on your needs, a range of mutual fund kinds are available for selection.
Key aspects
- They are appropriate for people seeking comparatively steady profits.
- They provide low consistent volatility returns.
- Debt mutual funds come in a variety of forms and fit a range of needs. Some examples of them include:
- Overnight funds
- Liquid funds
- Ultra-short duration funds
- Medium to long-duration funds
- Dynamic bond funds
- Corporate bond funds
Certificates of Deposit
Introduced in India in 1989, Certificates of Deposit (CDs) are short-term debt instruments. Dematerialized CDs are issued by banks and other financial institutions in exchange for an investor’s deposited funds for a predetermined period of time. Periodically, the Reserve Bank of India issues rules for its issuance and functioning.
On the price of CDs, banks are required to maintain the statutory liquidity ratio (SLR) and cash reserve ratio (CRR). The minimum deposit amount that a bank must maintain as reserves with the Reserve Bank of India is known as the Cash Reserve Ratio (CRR). Conversely, SLR is the minimal proportion of deposits that a commercial bank must hold in gold, cash, or other securities. Reservations for SLR are held by the bank, not the RBI.
The ability to purchase certificates of deposit is available to all individual Indian residents. A bank-issued CD has a minimum term of seven days and a maximum term of one year. The minimum and maximum terms for CDs issued by financial institutions are one year and three years, respectively. For a CD, the interest rate could be floating or fixed. For the latter, an established formula is used to determine how often the interest rate is reset.
Key aspects
- A minimum of Rs 5 lakh and multiples of that amount can be deposited in CDs.
- You can choose to pay a fixed or variable interest rate for them.
- It is not eligible for any financing facilities.
The Public Provident Fund
One well-liked long-term investing option is the Public Provident Fund (PPF) scheme. PPFs were first introduced in 1968. With this investing choice, you set away a small amount of money on a regular basis with the goal of building wealth over time.
A minimum of Rs 500 and a maximum of Rs 1,50,000 can be invested in PPFs annually. It’s one of the safest items to invest in because the Indian government guarantees the returns.
Key aspects
- 15 years is the PPF scheme’s maturity period.
- The government sets interest rates once every three months.
- Under Section 80C of the Income Tax Act of 1961, it assists with tax savings.
What Are the Benefits of Investing in Debt Instruments?
The following are some of the main advantages of investing in debt instruments in India:
- Return on Capital
First off, debt market securities are a fantastic way to get a return on your investment, as was previously explained. Furthermore, you will receive interest and capital payback upon maturity from some debt products, such as corporate bonds.
- Stable Returns
Debt market securities pay interest and principal at maturity, providing a steady flow of income. These interest payments are promised and guaranteed, which will help you meet your cash flow requirements. They might not yield the same returns as stock instruments due to their lower sensitivity to market swings, but their value also does not decline quickly.
- Diversification of Portfolio
Effective portfolio diversification is made possible by fixed-income products. Bonds and FDs are essential to mitigate the risks associated with investing in equities and mutual funds, which are excellent options for riskier but highly profitable ventures.
Additionally, debt instruments in India include a variety of maturity dates, from short-term to long-term, allowing investors to customize their portfolios to suit changing demands. For example, it is strongly advised that you stick with short-term debt instruments if the money you would like to invest is intended to be your emergency fund or the money you will need for travel or the purchase of a car soon.
- Lowering the risk of your Portfolio
Debt market instruments have far lower risks because they are not affected by changes in the market. Bondholders also benefit from some legal protection because they are the first to be paid in the event that a firm files for bankruptcy.
Therefore, you should absolutely invest in debt instruments if you are a conservative investor whose top aim is to have a fixed-interest income. When equity funds are not performing as expected, they serve as a hedge against market volatility.
Read also: Best SIP Plan for 1000 per Month
Cons of Investing in Debt Market Instruments
Debt market instruments do carry some risk, despite common belief. The risks connected to debt securities are as follows:
- Credit Risk
Credit risk, also known as default risk, arises when an issuer of a bond is unable to comply with the terms of the bond indenture, including failing to pay interest or principal on time or on a debt security.
- Interest Rate Risk
Almost all debt market securities carry this risk. Varun, for instance, made an investment at a fixed interest rate of 7%, but the market moved and the rate increased to 10% after a month. Varun will only receive the fixed interest rate in such a scenario since he lost out on higher interest rates.
- Reinvestment Rate Risk
This indicates that you won’t be able to reinvest cash flows from a single debt instrument at a rate that matches your existing rate of return. This risk applies to every investment that generates cash flow.
- Liquidity Risk
When an investor is unable to turn an asset into cash without forfeiting capital and income, liquidity risk arises. Varun, for instance, needs to sell his house for five lacs and needs the money immediately. But because of the low market, he must sell it for four lacs. The market may improve in a year, but Varun has already suffered financial loss on the deal.
Hence, you should think about your ability to convert your short-term debt instruments into cash before investing in long-term illiquid assets like PPF.
Credit rating’s function in debt instrument valuations
To put it simply, a credit rating is an indicator of a company’s qualifications and creditworthiness. For example, Company A is seeking a bank loan in order to finance its activities. The bank will now verify that Company A has the ability to repay the loan before authorizing it by looking up the company’s credit rating.
However, you may be asking yourself what the term “credit rating” actually means. In essence, it will indicate whether or not the borrower—Company A in the example above—has a history of missed loan payments and whether or not it is a reliable source for a new loan.
In what way does this metric matter to you as an investor? You do consider the risks involved when you make an investment, whether it be in debt or stock. In order to increase investor trust, credit ratings enable you to assess the possibility that an issuer will be able to repay its debts in whole and on schedule.
When investing in debt instruments, investors greatly rely on the issuer’s credit rating, which is why it matters so much in the debt market.
Credit Rating Scale
Corporate bonds, firm deposits, and non-convertible debentures (NCD) are rated by credit rating agencies on a scale from AAA (the highest) to D (the lowest). Among the most well-known credit rating organizations in India are CARE, CRISIL, and ICRA.
Let’s examine the credit rating symbols and their meanings:
| Credit Ratings | Indications |
| AAA | The lowest credit risk and the highest level of safety |
| AA | The minimal credit risk and high level of safety |
| A | A sufficient level of security and minimal credit risk |
| BBB | modest credit risk and a modest level of safety |
| BB | mediocre default risk |
| B | high default risk |
| C | Extremely high default risk |
| D | Instruments are either expected to default or are currently in default. |
How Do Credit Ratings Impact the Valuation of Debt Instruments?
The yield of a borrower’s debt instruments is negatively correlated with its credit rating (the issuer of the debt instruments). In other words, a borrower will pay a lower interest rate if their credit rating is greater.
To illustrate why this is the case, let’s look at an example. Your friend Ajay is requesting a 10,000 rupee loan to launch his business, and you intend to invest the same sum of money in a bank savings account. Now, the interest rate you charge on the loan to Ajay will be more than the interest the fixed deposit is providing for you. This is because there is a greater likelihood of Ajay missing the payment than there is of the bank missing it.
The debt instrument market follows the same logic. A business will have a high credit rating if its balance sheet is sound and its business prospects are reasonable. It will undoubtedly provide a competitive interest rate, but it doesn’t need to do so to draw people to its bonds or deposits.
How to Choose the Right Debt Instrument
The explanation of debt instruments above aims to help you choose the best product by helping you comprehend each one. Your selection of goods for investment is determined by a number of criteria. Let’s examine a handful of them:
- When selecting the appropriate product, the investment horizon is a crucial consideration. Liquid mutual funds can be a viable choice for very short terms, such as three to six months. Another great alternative for short-term money market investments is CDs.
- You can expand your investing horizon to include corporate bonds if it’s one to two years. Funds for short-term debt may also be a wise choice.
- If you plan to invest for more than three years, you should think about debt funds. The gains are subject to 20% post-indexation taxation and are regarded as long-term capital gains. PPFs are a wise choice in the long run as well.
- Even though debt instruments carry a lower risk than equities in India, the risk varies according to the kind of debt investment.
- You have some extra security because government-backed FDs are covered up to Rs 5 lakh per depositor per bank through deposit insurance coverage.
- Because CDs are issued against money deposited in a bank, they are the least dangerous option.
- Investing in PPFs likewise carries very little risk.
A well-balanced portfolio includes investments from many industries and class groups. Depending on your risk tolerance, you may build a portfolio that is more heavily weighted towards debt than equities. Selecting debt products is not always a matter of picking one over the other. A combination might be chosen based on the time frame that you have in mind.
Conclusion
Two factors that are essential to making wise investing decisions are your investment aim and thorough research. Make sure the product features align with your investment goal before making an investment. Debt investments can assist you in reaching your financial objectives and provide a low-risk way to save. With the aid of Wint Wealth, an extensive platform for wealth management and education, you may make extremely well-informed financial choices. So,Invest wisely and securely.
Debt Instruments – FAQs
Are there other debt instruments available in India?
ANS. A few debt instruments that are accessible for investment are covered in the article above. There are plenty additional alternatives as well. The Senior Citizen Safety Scheme, National Savings Certificate, and Sukanya Samriddhi Yojana are a few among them.
Do I have to pay tax on debt funds?
ANS. Depending on how long the money are held, you must pay tax on them. You are required to pay taxes on short-term gains if the holding period is shorter than three years. You pay tax at the appropriate tax slab on the gains once they are deducted from your taxable income. After indexation, you pay tax at a flat rate of 20% when the holding term exceeds 36 months.
Is a DEMAT account mandatory for investing in debt instruments?
ANS. Investing in a variety of instruments is more convenient with a Demat account. Certain assets, such as CDs, can only be purchased electronically (Demat). Mutual funds, bonds, and fixed deposits are offered both physically and electronically. Electronically storing securities facilitates trade and contributes to their safety.
What is the role of credit ratings in debt investment?
ANS. Debt instruments such as bonds and debentures are rated in India by rating agencies like CRISIL, CARE, and ICRA. They offer two ratings: D is the lowest (the least safe) and AAA, the highest (the safest). Based on the rating, credit ratings can assist you in selecting an appropriate investment.
Are all debt products 100% safe?
ANS. Debt products differ in terms of safety; some are quite safe, while others are only somewhat safe. Should bank operations go awry, your FDs might be at risk. Even with slight fluctuations in the market, debentures are susceptible to business risk and debt funds fluctuations.
What are the examples of debt instruments?
ANS. Corporate bonds, debt mutual funds, certificates of deposit, fixed deposits, etc. are a few types of debt instruments.
What is the most common debt instrument?
ANS. Bonds are the most common debt instrument. Bonds are created through a contract known as a bond indenture.
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