Fixed Income Securities

Unit-3
Fixed-Income Securities

A fixed-income security is an investment that provides a return

through fixed periodic interest payments and the eventual return of
principal at maturity. Fixed-Income securities are debt instruments
that pay a fixed amount of interest, in the form of coupon payments, to
investors. The interest payments are commonly distributed semi
annually, and the principal is returned to the investor at maturity.
Features of Fixed Income Securities
• The following are the key features of fixed income instruments –
• Fixed income instruments generate regular or fixed returns through
interest payments.
• These instruments involve lower risk. Hence they are ideal for investors
with a low-risk tolerance level.
• The predictability of returns makes fixed income instruments safer than
equity because of the rate of interest and payment structure, which the
investors know in advance.
• They offer higher rates of interest in comparison to saving accounts.
• Instruments such as PPF, 5-year Fixed Deposits, and Post Office Deposits
are exempt from tax under Section 80C of the Income Tax Act,1961.
• The taxation of fixed income instruments is similar to debt funds. The short
term capital gains are taxable as per your income tax rate. The long term
capital gains are taxable at 20% with indexation benefit.
Debt Instrument
A debt instrument is a type of financial tool that can get used to
help raise capital. Basically, it’s a fixed-income asset where a debtor
provides interest and principal payments to a lender. The debt
instrument used is a documented and binding obligation that gives
funds to an entity, which will pay back the funds based on the terms of
a contract.
The debt instrument contract will have various provisions that
will include things such as the rate of interest, collateral involved, the
timeframe to maturity, and the schedule for interest payments.
Features of Debt Instrument
1. Issue date and issue price
Debt securities will always come with an issue date and an issue price at
which investors buy the securities when first issued.
2. Coupon rate
Issuers are also required to pay an interest rate, also referred to as the
coupon rate. The coupon rate may be fixed throughout the life of the security or
vary with inflation and economic situations.
3. Maturity date
Maturity date refers to when the issuer must repay the principal at face
value and remaining interest. The maturity date determines the term that
categorizes debt securities.
4. Yield-to-Maturity (YTM)
Yield-to-maturity (YTM) measures the annual rate of return an investor is
expected to earn if the debt is held to maturity. It is used to compare securities
with similar maturity dates and considers the bond’s coupon payments,
purchasing price, and face value.
Types of Debt Instruments
1. Government Bonds:
Government Bonds are a popular category of debt instruments issued by the central or state
government. These bonds act as a loan wherein the government borrows money from investors at a
predetermined interest rate for a specific time period. The investors receive the principal and
interest as per the clauses mentioned in the bond.
2. Debentures:
Companies issue debentures to raise funds by borrowing money from the public. The company thus
promises to pay fixed interest to the investors. These debt instruments may or may not be backed
by any specific security or collateral. Hence, the investors have to rely on the credit ratings of the
issuing company as security.
3. Fixed Deposits:
Fixed deposits (FDs) are one of the most popular investment products as they are versatile and
flexible. Banks, certain Non-Banking Finance Companies (NBFCs), and even post offices issue fixed
deposits. They score over many other debt instruments in India due to their ease of investment,
liquidity (except in tax-saving FDs), and uncomplicated nature. Banks offer cumulative and non-
cumulative FDs. Cumulative option deposits pay interest on maturity. For non-cumulative deposits,
receive the interest monthly, quarterly, or annually and the principal on maturity. The investor can
also invest in Tax-saving FDs that have a tenure of 5 years, to help you save tax under Section 80C of
the IT Act.
4. Debt Mutual Funds
Debt Mutual funds invest the pooled money in fixed-income products like government securities,
corporate bonds, and some part in money market instruments. Debt mutual funds offer low-risk
and predictable returns to their investors over the investment period. With Debt MFs, you can earn
returns in two ways- firstly through interest payments from the bond holdings and secondly the
capital gain that results from price change of underlying instruments.
5. Certificates of Deposit
Certificates of Deposit (CDs), introduced in India in 1989, are short-term debt instruments. Banks
and Financial Institutions issue CDs in dematerialised form against the funds that an investor
deposits for a specific term. The Reserve Bank of India lays down guidelines from time to time for
their issue and operation. CDs differ from savings accounts in that they have a set term (typically 3
months, 6 months, or 1 to 5 years) and, in most cases, a fixed interest rate. CDs can be issued for a
duration of not less than one year and not more than three years from the date of release.
6. The Public Provident Fund
The Public Provident Fund (PPF) scheme is a popular long-term investment product. PPFs
have been around since 1968. In this investment option, you put aside a small sum of
money regularly to create wealth in the long term. The investors can invest a minimum of
Rs 500 and a maximum of Rs 1,50,000 per year in PPFs. The returns are guaranteed by the
government of India, making it one of the safest products for investment purposes.
7.Commercial Papers (CP)
Commercial paper, often known as CP, is a short-term financial instrument used by businesses to
raise capital over a one-year period. It is an unprotected form of debt instrument that is issued as a
promissory note and was first launched in India in 1990. CPs have a seven-day minimum maturity
period of time and a maximum maturity period of one year from the date of issue. The maturity
date of the debt instrument, on the other hand, should normally not exceed the date up to which
the borrower's credit rating is applicable. They are available in amounts of Rs 5 lakh or multiples of
that value.
8.Mortgage
A mortgage is a loan secured by a piece of real estate. These debt instruments are used to fund the
acquisition of real estates, such as a plot of land, a house, or a commercial building. Mortgages are
annualized over time, allowing the borrower to make payments until the debt is paid off. Lenders
are paid interest during the life of the loan.
Advantage of Investing in Debt Instruments
1. Return on capital
Debt market securities are a great way to earn a return on your capital. Further,
certain debt instruments like corporate bonds are designed to reward you with interest
and the repayment of capital at maturity.
2. Stable Returns
Debt Market Securities offer a predictable stream of payments by paying interest
and principal at maturity. These interest payments are guaranteed and promised
payments, which will assist you in cash flow needs.
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.
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.
Disadvantage of Investing in Debt Instruments
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.
Bonds
• “A Bond is a fixed income instrument that represents a loan made by
an investor to a borrower.” In simpler words, bond acts as a contract
between the investor and the borrower. Mostly companies and
government issue bonds and investors buy those bonds as a savings
and security option.
• These bonds have a maturity date and when once that is attained, the
issuing company needs to pay back the amount to the investor along
with a part of the profit. This kind of dealing with bonds between the
issuer and the investor is done by brokers.
Characteristics of Bonds
• Face Value
Face value implies the price of a single unit of a bond issued by an enterprise. Principal,
nominal, or par value is used alternatively to refer to the price of bonds. Issuers are under a
legal obligation to return this value to the investor after a stipulated period.
• Interest or Coupon Rate
Bonds accrue fixed or floating rates of interest across their tenure, payable periodically
to creditors. Bond interest rates are also called coupon rates as per the tradition of claiming
interests on paper bonds in the form of coupons.
• Tenure of Bonds
Tenure or term refers to the period after which bonds mature. These are financial debt
contracts between issuers and investors. Financial and legal obligations of an issuer to the
investor or creditor are valid only until the tenure’s end.
• Credit Quality
The credit quality of a bond refers to the creditors’ consensus on the performance of a
company’s assets in the long-term. It is determined by the degree of confidence that
investors have in an organisation’s bonds. Credit rating agencies classify bonds based on the
risk of a company defaulting on debt repayment.
• Tradable Bonds:
Bonds are tradable in the secondary market. The ownership can thus
shift among various investors within a given tenure. These creditors often
sell their bonds to other entities when market prices exceed the nominal
values as they have an option to secure bonds with high yield and
appropriate credit ratings.
• Taxation:
Looks for bonds which exempt tax. Few corporate bonds levy tax on
their bonds and bonds issued by Government, municipality bonds and few
other do not impose a tax on the profit earned.
• Date of Maturity:
Ensure that you check the maturity period of the bond and invest in
something where you can earn more with a shorter time duration
• Coupon Rate:
The rate of interest at which a bond is issued and the Company is
liable to pay the Investor is called the coupon rate. Research and look for
Bond options which offer high coupon rate
Types of Bonds
1. Treasury Bonds:
The central government issues treasury bonds. Hence, it is the safest type of bond
because there is no credit risk. These bonds have a maturity period of ten to thirty years
and pay a fixed interest rate, which is a factor in the prevailing market conditions.
2. Municipal Bonds:
Local and state governments use these to gather funds for development projects
such as schools, highways, and hospitals. Municipal Bonds are exempted from tax. They are
available in both short-term and long-term maturities.
3. Corporate Bonds:
Companies or business conglomerates issue corporate bonds to raise capital for
their business operations. They are riskier than treasury bonds because the
creditworthiness of the issuing company backs them. Corporate bonds can have varying
maturities and interest rates, depending on the issuer's creditworthiness and market
conditions.
4. High-yield Bonds:
Companies issue high-yield bonds with lower credit ratings and are riskier than
investment-grade bonds. They offer a higher yield to compensate for the higher risk. High-
yield bonds are also known as junk bonds.
5. Mortgage-Backed Securities:
Real estate companies create mortgage-backed securities by pooling many
mortgages and issuing bonds against the underlying mortgage pool. The cash flow from the
mortgages backs these securities, so they are safer than corporate bonds because they
carry less credit risk.
6. Floating Rate Bonds:
Floating rate bonds have an interest rate adjusted periodically based on a
reference rate, such as the Reserve Bank of India's repo rate. It protects investors from
interest rate risk because the rates move with prevailing market rates. The interest rate of
these bonds is subject to market fluctuations and macroeconomic parameters.
7. Zero-Coupon Bonds:
Zero-coupon bonds are issued at a discount to their face value and do not pay
periodic interest. Instead, they offer a fixed return at maturity, i.e., the difference between
the issue price and face value. They are ideal for investors who want to lock in a fixed
return for a specific period.
8. Callable Bonds:
The issuer can redeem callable bonds before maturity, usually at a premium price.
They offer the issuer flexibility in managing their debt obligations but carry reinvestment
risk for the investor.
9. Convertible Bonds:
The issuing company can convert these bonds into shares of the issuing company's
stock at a pre-determined conversion ratio. They offer the investor the potential for capital
appreciation and fixed income.
10. Inflation-Protected Bonds:
The government issues inflation-protected bonds intending to protect investors
from inflation. They pay a fixed interest rate, which is adjusted periodically to reflect
changes in the Consumer Price Index.
Bond Indenture
Bond indentures are important, legally binding documents that
can be referenced by bond issuers and bondholders if some part of the
agreement becomes disputed. They describe what may happen if one
of the parties fails to uphold its responsibilities and criteria. If both
parties maintain their individual responsibilities and the bond issuer
pays investors on time, then a bond indenture may not need to be re-
read. It is important that all parties read the bond indenture before
entering into an agreement with other entities to understand the terms
of the contract.
Bond Yield
A bond yield is the return an investor realizes on a bond. Put
simply, a bond yield is the return on the capital invested by an investor.
Bond yields are different from bond prices—both of which share an
inverse relationship. The yield matches the bond's coupon rate when
the bond is issued. Bond yields can be derived in different ways,
including the coupon yield and current yield.
Factors affecting Bond Yield
• Interest rate risk:
One of the risks of bonds is that if plan to sell a bond before it matures, then they need to
consider interest rates. In general, when interest rates rise, bond prices fall. When interest rates fall,
bond prices rise. Bonds have an inverse relationship with general interest rates. If the rate on the
bond is higher than general interest rates, then the bond is still likely to be attractive to investors.
But if you need to sell a bond before its maturity date — while interest rates are high — you may
end up selling it for less than you paid for it.
• Inflation risk:
Inflation risk is the risk that the return you earn on your investment doesn’t keep
pace with inflation. This kind of risk affects many kinds of investments, but it is particularly
relevant for bonds. In general, when inflation is on the rise, bond prices fall. When inflation
is decreasing, bond prices rise. In other words, when your bond matures, the return you’ve
earned on your investment will be worth less in today’s dollars. That’s because rising
inflation erodes the purchasing power of what you’ll earn on your investment.
• Market risk:
This is the risk that the entire bond market declines. If this happens, the price of
your bond investments will likely fall regardless of the quality or type of bonds you hold. If
you need to sell a bond before its maturity date, you may end up selling it for less than you
paid for it. Because of market risk, it’s important to consider your time horizon when
purchasing a bond or any other type of investment. If there’s a chance you might need the
money sooner, then consider a shorter time horizon. All other things being equal, longer-
term bonds tend to have higher returns and higher risk than shorter-term bonds.
• Credit risk:
Credit rating agencies assign ratings to bond issuers and to specific bonds. A credit
rating can provide information about an issuer’s ability to make interest payments and
repay the principal on a bond. In general, the higher the credit rating, the agency considers
the issuer more likely to meet its payment obligations. If an issuer’s rating goes up, the
price of its bonds will rise. If the rating goes down, the price will drop. An issuer’s credit
rating can change over time.
Current Yield
The current yield of a bond is calculated by dividing the annual coupon
payment by the bond's current market value. Because this formula is based on
the purchase price rather than the par value of a bond, it more accurately reflects
the profitability of a bond, relative to other bonds on the market. The current yield
calculation helps investors drill down on bonds that generate the greatest returns
on investment each year. This is especially helpful for short-term investments.

Current Yield= Annual Coupon Payment​​

Current market Price
Holding Period Return
Holding period return is the total return received from holding an asset
or portfolio of assets over a period of time, known as the holding period. It is
generally expressed as a percentage and is particularly useful for comparing returns
on investments purchased at different periods in time. Holding period return is
calculated on the basis of total returns from the asset or portfolio. It is particularly
useful for comparing returns between investments held for different periods of
time.

Holding period return = Coupon Interest+ Price Change

Price at the beginning of
the holding period
Yield to Maturity
The term yield to maturity (YTM) refers to the total return anticipated on a
bond if the bond is held until it matures. Yield to maturity is considered a long-
term bond yield but is expressed as an annual rate. In other words, it is the internal
rate of return (IRR) of an investment in a bond if the investor holds the bond until
maturity, with all payments made as scheduled and reinvested at the same rate.
YTM accounts for the present value of a bond's future coupon payments. In
other words, it factors in the time value of money, whereas a simple current yield
calculation does not. As such, it is often considered a more thorough means of
calculating the return from a bond.
𝑪𝒐𝒖𝒑𝒐𝒏𝟏 𝑪𝒐𝒖𝒑𝒐𝒏𝟐 𝑭𝒂𝒄𝒆 𝑽𝒂𝒍𝒖𝒆
Present value = 𝟏 + + +
𝟏+𝒚 (𝟏+𝒚)𝟐 ……… (𝟏+𝒚)𝒏
Approximate Yield to Maturity
The yield to maturity formula is used to calculate the yield on a bond
based on its current price on the market. The yield to maturity formula looks
at the effective yield of a bond based on compounding as opposed to the
simple yield which is found using the dividend yield formula.
(𝑷 −𝑷 )
𝑪+[ 𝒏 𝒏 𝒐 ]
AYTM = 𝑷𝒏 +𝑷𝒐
𝟐
C=Coupon amount, Pn = Face value, Po =Market value, n= Maturity period

The formula shown is used to calculate the approximate yield to maturity. To

calculate the actual yield to maturity requires trial and error by putting rates
into the present value of a bond formula until P, or Price, matches the actual
price of the bond.
Yield To Call
Yield to call (YTC) is a financial term that refers to the return a
bondholder receives if the bond is held until the call date, which occurs
sometime before it reaches maturity. Yield to call applies to callable
bonds, which are debt instruments that let bond investors redeem the
bonds—or the bond issuer to repurchase them—on what is known as
the call date, at a price known as the call price. By definition, the call
date of a bond chronologically occurs before the maturity date.

𝒏 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑹𝒆𝒅𝒆𝒎𝒑𝒕𝒊𝒐𝒏 𝑽𝒂𝒍𝒖𝒆

P= σ𝒊=𝟎 +
(𝟏+𝒀𝑻𝑪)𝒊 (𝟏+𝒀𝑻𝑪)𝒏