Debt instruments are contracts in which one party lends money to another on pre-determined terms with regard to rate of interest to be paid by the borrower to the lender, the periodicity of such interest payment, and the repayment of principal amount borrowed (either in installments or bullet). In the Indian securities market we generally use the term ‘bond’ for debt instruments issued by the central and state governments and public sector organisation, and the term ‘debentures’ for instruments issued by Private corporate sector.
The principal features of a bond are:
In the bond markets, the terms maturity and term-to-maturity are used quite frequently.
Maturity of a bond refers to the date on which the borrower has agreed to pay (redeem) the principal amount to the lender, the borrowing is extinguished with redemption, and the bond ceases to exist after that date. Term to maturity, on the other hand, refers to the number of years remaining for the bond to mature. Term to maturity of a bond changes everyday from the date of issue of a bond until its maturity. Coupon rate 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) and coupons are stated upfront either directly specifying then number (e.g. 8%) or indirectly tying with a benchmark rate (e.g. MIBOR+0.5%). 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 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 coupon rate. Typical face values in the bond market are Rs.100 though there are bonds with face values of Rs.1000 and Rs.100000 and above. All government bonds have the face value of aRs.100. In many cases, the name of the bond itself conveys the key features of a bond. For example a GS CG2008 11.40%. Since the central government bonds have a face value of Rs.100, and normally pay coupon semi-annually, this bond will pay Rs.5.70 as six-monthly coupon, until maturity when the bond will be redeemed.
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, when the bond will be redeemed. 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 tenor of the bond. For instance on February 17,2004, the term to maturity of the bond maturing on May 23, 2008 will be 4.27 years. The general day count convention in bond market is 30/360, European that assumes total 360 days in a year and 30 days in a month.
There is not rigid classification of bonds on the basis of their term to maturity. Generally bonds with tenor of 1-5 years are called short-term bonds; bonds with tenors ranging 4 to 10 years are medium term bonds and above 10 years are long-term bonds. In India central government has issued upto 30-year bonds.
Bonds can be issued in secured or unsecured form. Normally bonds issued in the form of debentures are secured. Bond issued by Financial Institutions offer attractive returns. Interest under the scheme is paid monthly, quarterly, half yearly, annually and on maturity. Most of the bonds provide flexibility, liquidity and safety. The flexibility can be seen from the range of options provided (i.e.) frequency of return/tenure/tax benefits etc. Bonds provide good liquidity, option to withdraw on pre-specified dates, listing on major stock exchanges, avail loans from banks by pledging bonds/securities.
Bonds can be broadly classified into:
Regular-Income Bonds, as the name suggests, are meant to provide a stable source of income at regular, pre-determined intervals, examples are:
These Bonds carry fixed rate of interest which is declared at the time of issue and remains same till maturity.
These Bonds carry interest rate which is linked to independent reference rates, independent index, commodities etc. and the rate is fixed for next period at the beginning of the period itself.
This bond is issued at a discount to the face value. The face value is paid at the maturity. These bonds are also know as Zero coupon bonds or "Zeros".
These bonds are medium and long term obligations issued by public sector companies where the Government shareholding is 51% and more. Most of PSU bonds are in form of promissory notes transferable by endorsement and delivery. No stamp duty or transfer deed is required at the time of transfer of bonds transferable by endorsement.
These are bonds for which the coupon payment in a particular period is linked to the inflation rate at that time – the base coupon rate is fixed with the inflation rate (consumer price index-CPI) being added to it to arrive at the total coupon rate. Investors are often loath to invest in longer dated securities due to uncertainty of future interest rates. The idea behind these bonds is to make them attractive to investors by removing the uncertainty of future inflation rates, thereby maintaining the real value of their invested capital.
Apart from public sector undertakings, Financial Institutions are also allowed to issue bonds, that too in much higher quantum. They issue bonds in 2 ways – through public issues targeted at retail investors and trusts and also through private placements to large institutional investors. Usually, transfers of the former type of bonds are exempt from stamp duty while only part of the bonds issued privately have this facility. On an incremental basis, bonds of PFIs are second only to GOISECs in value of issuance.
Retail bond issues of PFI bonds have become a big rage with investors in the last three years. PFIs have also been offering bonds with different features to meet differing needs of investors eg monthly return bonds (which pay monthly coupons), cumulative interest bonds, step up coupon bonds etc