Debt Instruments – Overview, Examples, Advantages & Disadvantages

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Whether you are an active investor or not, you are probably aware that investing in debt instruments is just as important as investing in stock.

However, many investors in India continue to overlook the importance of debt instruments and how they can decrease portfolio risk while providing a consistent source of income.

So, do you want to avoid the beginner mistake of directing all of your cash into one type of investment while also earning a consistent rate of return? Then, so you can make an informed investing decision, let us introduce you to the main aspects of the Debt Market and what a debt instrument is.

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What is Debt Market? 

Debt Instruments- Meaning and Classification

Role of credit-rating in Debt Instrument Valuations

Advantages of Investing in Debt Instruments

Disadvantages of Investing in Debt Market Instruments

Closing Thoughts

What is Debt Market? 

The debt market is a financial market where investors can purchase and sell various types and features of debt instruments. These securities will provide you with fixed-rate interest payments as well as principle repayment at maturity. For example, if Varun invests Rs. 100 in a debt instrument with a 10% return and a one-year term, he will receive Rs. 110 (principal amount + interest) at maturity.

You may be wondering who issues these loan instruments in India. The Reserve Bank of India, on the other hand, has authorised the following entities to issue debt instruments:

  • Central and State Governments
  • Municipal Corporations
  • Government agencies
  • Banks
  • NBFCs
  • Public Sector Units
  • Corporates
 Debt Market
Nature of TradingIt is a market place where fixed-income securities are traded.
Risk InvolvedLess volatile in nature, which makes them less risky than the Equity Market.
Nature of ReturnsDebt market instruments provide fixed returns to the investors.
Role of InvestorsDebt holders are creditors of the company and don’t have any voting rights.

Debt Instruments- Meaning and Classification

A debt instrument is essentially an asset that allows you (the investor) to receive a fixed interest rate while also receiving your investment back. Simultaneously, these assets assist issuers (institutional entities) in raising cash.

So, what makes debt market products safer than equity market instruments? To create a lower-risk environment for the lender, debt operates as a “legal duty” on the issuer’s end to repay the borrowed amount plus interest on time. Equity instruments, on the other hand, do not bear such legal duties.

Because of their low risk and fixed interest, many types of debt instruments are also referred to as fixed-income securities.

1. Bonds:

A bond is a debt made by an investor to a borrower, who is typically a corporation or government organisation. The borrower uses the funds to fund company activities, while the investor earns a fixed rate of return on the investment.

Assume you have decided to invest in a bond; how do you determine which entity to go with? The solution is straightforward: assess your risk tolerance. If you’re content with a low 6-7% interest rate and don’t mind the firm failing on its debt, buy bonds from a strong entity, such as a blue chip. However, if you are looking for strong returns (10-11%), smaller companies may be more suitable for your needs.

2. Certificates of Deposits:

A certificate of deposit, sometimes known as a CD, is a type of debt instrument that retains a set amount of money for a set length of time. CDs are insured products with fixed interest rates that are offered by banks, thrift institutions, and credit unions, making them essentially risk-free.

If you purchase a Certificate of Deposit and retain it until maturity, you will be able to retrieve the principal amount as well as the accrued fixed-interest.

CDs are unique in that they can only be issued by a single issuer for a minimum of Rs.1 lakh and in multiples of Rs.1 lakh.

3. Debentures:

A debenture is similar to a bond because in both the cases you are paid a guaranteed interest, but the difference lies in security levels. Bonds are more secure than debentures. If a company decides to issue bonds, they have to mandatorily back it up with a collateral. However, when the company is issuing debentures keeping collateral is optional which makes them unsecured.

Furthermore, in case of liquidation, bondholders will be paid off before debenture holders.

4. Fixed Deposits:

In a fixed deposit account, you can deposit your money for a fixed time-period, thereby earning a predetermined rate of interest return. Fixed deposits are offered by banks and NBFCs, and allow you to choose a period ranging from 7-14 days to even 10 years.

What makes these debt market instruments a safe investment option is that when you open a FD account at a specific interest rate, it is guaranteed for the rate of interest to remain the same, irrespective of any market fluctuations.

5. Government Securities:

Government securities (G-secs) are debt securities issued by the Reserve Bank of India and broadly include:

  • Central Government Securities.
  • State Government Securities
  • Treasury bills

These debt instruments in India were recently made accessible to retail investors. Initially, they were available only to banks and the large financial institution. But now you can invest in them as well and take advantage of attractive and guaranteed returns.

These type of debt instruments can be for the long term or short term, with Treasury Bills being an ideal example of short-term debt instruments. Long term Government securities include instruments like Dated Securities or Bonds.

Role of credit-rating in Debt Instrument Valuations

In layman’s terms, a credit rating is a representation of a company’s creditworthiness and qualifications. For example, Company A want to obtain a bank loan in order to continue operations. Before granting Company A’s loan, the bank will assess its credit rating to confirm the company’s ability to repay.

But you might be wondering what the term “credit rating” means. Essentially, it will tell whether the borrower (Company A in the preceding example) has previously defaulted on loan payments and whether 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 whether an issuer may repay its debts on time and in full.

In the debt market, the issuer’s credit rating is particularly essential because investors rely heavily on these ratings before investing in debt instruments.

Credit Ratings Scale

Credit rating agencies assign ratings to corporate bonds, non-convertible debentures (NCD), firm deposits, and other financial instruments on a scale of AAA (the highest) to D (the lowest) (the lowest). CRISIL, ICRA, and CARE are three of India’s most renowned credit rating agencies.

Let’s take a look at the credit rating symbols and what they indicate:

Credit Ratings Indications
AAAThe highest degree of safety and lowest credit risk
AAHigh degree of safety and low credit risk
AAn adequate degree of safety and low credit risk
BBBA moderate degree of safety and moderate credit risk
BBModerate risk of default
BHigh risk of default
CVery high risk of default
DInstruments are in default or expected to default

How Do Credit Ratings Affect Debt Instrument’s Valuations?

A borrower’s (Debt Instrument issuer’s) credit rating is inversely related to the yield on its debt instruments. Simply expressed, a borrower with a higher credit rating will pay a lower interest rate.

Let me use an example to demonstrate why this is so. Your friend Ram is beginning a business and wants you to finance him Rs. 10,000; at the same time, you intend to invest the same amount in a bank FD. Now, when lending to Ram, you will charge a greater interest rate than the interest rate offered by the fixed deposit. This is because the chances of Ram defaulting on the payment is high when compared to chance of the bank defaulting.

The same reasoning applies in the debt instrument market. A company with good balance sheet and fair business prospect will enjoy a high credit rating. Surely, it will offer competitive rate of interest but it has no need to offer greater interest rates to attract investors in its bonds or deposits.

Advantages of Investing in Debt Instruments

There are numerous advantages to investing in debt instruments in India, the most important of which are:

1. Return on capital:

To begin, as previously said, debt market securities are an excellent way to make a return on your investment. Furthermore, certain debt products, such as corporate bonds, are designed to reward you with interest and capital payback at maturity.

2. Consistent Returns:

Debt market securities provide a consistent stream of payments by paying both interest and principal at maturity. These interest payments are assured and promised, which will help you with your cash flow demands.

They may not provide as high returns as stock instruments since they are less vulnerable to market changes, but their value does not decline as quickly.

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 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.

Disadvantages of Investing in Debt Market Instruments

Contrary to popular opinion, Debt Market also has its own risk. 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.

Closing Thoughts

Any investment portfolio should comprise the right mix of safe, moderate and risky investments. While equity instruments are the preferred contenders for moderate and risky investments, Debt Instruments are essential to balance out that risk with steady and low-risk returns.

You should never focus either solely on the returns or the risk associated while investing in any asset. Making investments requires a comprehensive approach that analyses opportunities in the context of a portfolio’s broader framework. Hence, you should bring Debt and Equity together as per your investment goals to strike the right balance.

Also read: Unicorns: To invest or not to invest?

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