DEBT & MONEY MARKETS

SYBFM SEM III 2025-26

MODULE I DEBT MARKETS – DRAFT 1

FINANCIAL MARKET

A financial market refers to the institutional arrangement for dealing in financial assets and
credit instruments of different types, such as currency cheques, bank deposit bills, etc.

It is a system through which funds are transferred from surplus sector to the deficit sector.
Channelizing funds from savers to spenders

Financial market is a market where financial instruments are exchanged or traded and helps in
determining the prices of the assets that are traded in and is also called the price discovery
process.

Organizations that facilitate the trade in financial products. For e.g. Stock exchanges (NYSE,
Nasdaq) facilitate the trade in stocks, bonds and warrants.

Coming together of buyer and sellers at a common platform to trade financial products is
termed as financial markets, i.e. stocks and shares are traded between buyers and sellers in a
number of ways including: the use of stock exchanges; directly between buyers and sellers etc.

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This is a market for financial assets which have a long or indefinite maturity. Capital market is
a market for long-term debt and equity shares. In this market, the capital funds comprising of
both equity and debt are issued and traded. This also includes private placement sources of debt
and equity as well as organized markets like stock exchanges.
Industrial Securities : It is a market for industrial securities like equity shares or
ordinary shares, preference shares and debentures or bonds. It is a market where
companies raise their capital or debt by issuing appropriate instruments. Industrial
Securities Market is further sub-divided into two types

Primary Market / New Issue Market : Primary market is a market for new issues
or new financial claims. It deals with those securities which are issued to the
public for the 1st time. Borrowers issue / exchange new financial securities for
long-term funds in this market. This facilitates capital formation. The primary
market provides the channel for sale of new securities. Primary market provides
opportunity to issuers of securities; Government as well as corporates, to raise
resources to meet their requirements of investment and / or discharge some
obligation.
They may issue the securities at face value, or at a discount / premium and these
securities may take a variety of forms such as equity, debt etc. They may issue
the securities in domestic market and / or international market.
There are mainly three ways to raise capital : Public Issue, Rights Issue, Private
Placement.
IPO - An Initial Public Offer (IPO) is the selling of securities to the public in
the primary market. It is when an unlisted company makes either a fresh issue
of securities or an offer for sale of its existing securities or
both for the first time to the public. This paves way for listing and trading of the issuer’s
securities. The sale of securities can be either through book building or through normal public
issue.
Secondary Market / Stock Exchange : It is a market for secondary sale of
securities i.e., securities which have already passed through the new issue
market are traded here. It consists of stock exchanges recognised by the
Government of India. Generally, securities quoted in the Stock Exchange
provide continuous and regular market for buying and selling of securities.
Secondary market refers to a market where securities are traded after being
initially offered to the public in the primary market and
/ or listed on the Stock Exchange. Majority of the trading is done in the
secondary market. Secondary market comprises of equity markets and the debt
markets.
Long Term Loans : Development banks and commercial banks play a significant
role in this market by supplying long term loans to corporate. This market can be
further classified as :

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 Term Loan : it is the market that provides debt that is paid off over an
extended time frame that exceeds one year in duration. It may or may not
have collateral security attached.
Mortgage Loan : it is a market for a mortgage which is a debt instrument,
secured by the collateral of specified real estate property, that the borrower is
obliged to pay back with a predetermined set of payments.
Financial Guarantees : Financial guarantees are used when a supplier faces a
risk that a debtor may go into default. A contract of guarantee is a contract
involving three parties, a guarantor, a debtor, and a creditor.
Government Securities / Gilt-edged Securities : They are long term & short- term
Government Securities. Long Term securities are traded in this market whereas
Short Term in the money market. Major participants in this market are the
commercial banks because they hold a great portion of these securities to meet
their SLR requirements. Government Securities are sold through the Public Debt
Office of the RBI while Treasury bills are sold through auctions.

Financial markets may be classified on the basis of

• types of claims – debt and equity markets
• maturity – money market and capital market
• trade – spot market and delivery market
• deals in financial claims – primary market and secondary market
Indian Financial Market consists of the following markets:
• Capital Market/ Securities Market
o Primary capital market o Secondary capital market
• Money Market
• Debt Market

FUNCTIONS OF FINANCIAL MARKETS

 Capital Formation:
Financial markets in India facilitate the mobilization of savings from individuals and
institutions. These funds are then channeled to businesses, government, and other
entities for productive purposes, leading to capital formation and economic
development.
 Resource Allocation:
Financial markets help in the efficient allocation of resources by directing funds from savers
(investors) to entities in need of capital (borrowers). This process ensures that
resources are allocated to the most productive and promising investment opportunities.
 Price Discovery:
The financial markets provide a platform for the determination of prices for various
financial instruments, including stocks, bonds, commodities, and currencies. This price
discovery mechanism is crucial for investors to make informed decisions.
 Liquidity Provision:
Liquidity is essential for the smooth functioning of financial markets. Markets provide a
platform for buying and selling financial instruments, ensuring that investors can
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 easily convert their assets into cash when needed.
 Risk Management:
Financial markets offer a range of instruments, such as derivatives and insurance products,
that allow market participants to manage and transfer risks. This is important for both
investors and businesses to protect themselves from adverse market movements.
 Facilitating Monetary Policy:
Financial markets play a role in transmitting monetary policy signals. The central bank, in
India's case, the Reserve Bank of India (RBI), uses various instruments in the financial
markets to implement and control monetary policy.
 Facilitating Foreign Exchange Transactions:
India has a foreign exchange market where currencies are bought and sold. This market is
crucial for facilitating international trade and investment and managing exchange rate
risks.
 Market Regulation and Surveillance:
Regulatory bodies, such as the Securities and Exchange Board of India (SEBI), oversee and
regulate the functioning of financial markets. They enforce rules and regulations to
ensure fair and transparent trading practices.

PRODUCTS AVAILABLE IN CAPITAL MARKET

1. Equity (instrument of ownership) Equity shares are instruments issued by companies to

raise capital and it represents the title to the ownership of a company. You become an
owner of a company by subscribing to its equity capital (whereby you will be allotted
shares) or by buying its shares from its existing owner(s).

As a shareholder, you bear the entrepreneurial risk of the business venture and are entitled to
benefits of ownership like share in the distributed profit (dividend) etc. The returns earned in
equity depend upon the profits made by the company. company’s future growth etc.
2. Debt (loan instruments)
a. Corporate debt Debentures are instrument issued by companies to raise debt capital. As an
investor, you lend your money to the company, in return for its promise to pay you interest at a
fixed rate (usually payable half yearly on specific dates) and to repay the loan amount on a
specified maturity date say after 5/7/10 years (redemption). Normally specific asset(s) of the
company are held (secured) in favour of debenture holders. This can be liquidated, if the
company is unable to pay the interest or principal amount. Unlike loans, you can buy or sell
these instruments in the market.
Types of debentures that are offered are as follows:
o Non convertible debentures (NCD) – Total amount is redeemed by the issuer
o Partially convertible debentures (PCD) – Part of it is redeemed and the remaining is converted
to equity shares as per the specified terms
o Fully convertible debentures (FCD) – Whole value is converted into equity at a specified
price
Bonds are broadly similar to debentures. They are issued by companies, financial institutions,
municipalities or government companies and are normally not secured by any assets of the
company (unsecured).

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Types of bonds:
Regular Income Bonds provide a stable source of income at regular, pre determined intervals.
Tax-Saving Bonds offer tax exemption up to a specified amount of investment, depending on
the scheme and the Government notification. Examples are: • Infrastructure Bonds under
Section 88 of the Income Tax Act, 1961 • NABARD (National Bank for Agriculture & Rural
Devp.)/ NHAI (National Highway authority of India)/REC (ural electrification) Bonds under
Section 54EC of the Income Tax Act, 1961 • RBI Tax Relief Bonds
Government debt: Government securities (G-Secs) are instruments issued by Government of
India to raise money. G Secs pays interest at fixed rate on specific dates on half-yearly basis.
It is available in wide range of maturity, from short dated (one year) to long dated (up to thirty
years). Since it is sovereign borrowing, it is free from risk of default (credit risk). You can
subscribe to these bonds through RBI or buy it in stock exchange.
Money Market instruments (loan instruments up to one year tenure) • Treasury Bills (T-bills)
are short term instruments issued by the Government for its cash management. It is issued at
discount to face value and has maturity ranging from 14 to 365 days. Illustratively, a T-bill
issued at Rs. 98.50 matures to Rs. 100 in 91 days, offering an yield of 6.25% p.a.
• Commercial Papers (CPs) are short term unsecured instruments issued by the companies for
their cash management. It is issued at discount to face value and has maturity ranging from 90
to 365 days.
• Certificate of Deposits (CDs) are short term unsecured instruments issued by the banks for
their cash management. It is issued at discount to face value and has maturity ranging from 90
to 365 days.
Hybrid instruments (combination of ownership and loan instruments)
• Preferred Stock / Preference shares entitle you to receive dividend at a fixed rate. Importantly,
this dividend had to be paid to you before dividend can be paid to equity shareholders. In the
event of liquidation of the company, your claim to the company’s surplus will be higher than
that of the equity holders, but however, below the claims of the company’s creditors,
bondholders / debenture holders.
Mutual Funds They collect money from many investors and invest this corpus in equity, debt or
a combination of both, in a professional and transparent manner. In return for your investment,
you receive units of mutual funds which entitle you to the benefit of the collective return earned
by the fund, after reduction of management fees.
Mutual funds offer different schemes to cater to the needs of the investor are regulated by
securities and Exchange board of India (SEBI) Types of Mutual Funds
At the fundamental level, there are three types of mutual funds:
o Equity funds (stocks)
o Fixed-income funds (bonds)
o Money market funds
a. By structure

• Open-ended Funds - An open-ended fund does not have a maturity date.

• Closed-end Funds - Closed-end funds run for a specific period.
b. By investment objective
• Growth Funds - A mutual fund scheme investing in equity
• Bond / Income Funds - A mutual fund scheme investing primarily in government and
corporate debt to provide income on a steady basis.
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 • Balanced Funds - A mutual fund scheme investing in a mix of equity and debt.
• Money Market Funds - A mutual fund scheme investing in money market instruments.
Others
• Tax savings schemes - (Equity Linked Saving SchemeELSS) Equity funds along with tax
benefits to the investors and has a lock in period of three years.
• Sector funds - They target at the specific sectors of the economy such as financial, technology,
health, etc.
• Index Funds - This type of mutual fund replicates the performance of a broad market index
such as the SENSEX or NIFTY.

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 Definition of debt instruments

Companies and governments both need money to fulfill their requirements. A company needs
funds to expand into new markets, while governments need money for everything from
infrastructure to social programs. Many a time‟s large corporations need much more money than
what the average bank can provide. For this purpose corporates raise money by issuing bonds to
a public market.

Thousands of investors then each lend a portion of the capital needed. A bond is a kind of loan
for which the investors are the lenders. The organization that sells a bond is known as the issuer.

The issuer of a bond must pay the investor something for using his or her money. This payment
comes in the form of interest payments, which are made at a predetermined rate and schedule.
The interest rate is often referred to as the coupon. The date on which the issuer has to repay the
amount borrowed (known as face value) is called the maturity date. Bonds are known as fixed-
income securities because the investor knows the exact amount of cash he or she will get back if
they hold the security until maturity.

For example, an investor buys a bond with a face value of Rs.1,000, a coupon of 10%, and a
maturity of 10 years. This means the investor will receive a total of Rs.100 (Rs.1,000*10%) of
interest per year for the next 10 years. If bonds pay interest semi-annually, investor receives two
payments of Rs.50 a year for 10 years. When the bond matures after a decade, investor will get
Rs.1, 000 back.

1.2 Debt versus Equity

Bonds are debt, whereas stocks are equity. This is the important distinction between the
two securities.

By purchasing equity (stock) an investor becomes an owner in a corporation. Ownership comes

with voting rights and the right to share in any future profits. By purchasing debt (bonds) an
investor becomes a creditor to the corporation (or government).

The primary advantage of being a creditor is that investor has a higher claim on assets than
shareholders.That is, in the case of bankruptcy, a bondholder will get paid before a shareholder.
However, the bondholder does not share in the profits if a company does well the investor is
entitled only to the principal plus interest.

In simple terms, there is generally less risk in owning bonds than in owning stocks, but this
comes at the cost of a lower return.

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 Importance and Role of Fixed Income Securities in Indian Financial System.

The Debt Market holds a pivotal role in the development of any expanding economy that
requires substantial capital and resources to achieve desired industrial and financial growth. In
the case of the Indian economy, which has sustained a growth rate of over 7% annually and is
poised for double-digit growth, a robust and dynamic debt market is essential to meet its resource
demands.

The Government Securities market, also known as the „G-Sec‟ market, is the oldest and largest
segment of the Indian debt market, considering market capitalization, outstanding securities, and
trading volumes. This market plays a crucial role in the Indian economy by establishing the
benchmark for determining interest rates through yields on government securities, recognized as
the risk-free rate of return in any economy.

In addition to the G-Sec market, India also boasts an active market for corporate debt
instruments. This includes the trade of short-term instruments like commercial papers and
certificates of deposit, as well as long-term instruments such as debentures, bonds, and zero
coupon bonds.

The Indian bond market is a cornerstone of the country's financial landscape, offering investors
diverse investment opportunities and serving as a vital funding source for government and
corporate entities.

As of September 2023, the Indian bond market boasts remarkable figures, with a total value
reaching a staggering ₹205.3 lakh crore, approximately equivalent to $2.5 trillion. This
substantial market size underscores the significance of bonds as a crucial asset class within
India's financial ecosystem.

Government bonds command a significant market share, accounting for approximately 78% of
the total market share. These bonds, issued by the government, are perceived as low-risk
investments and enjoy a high level of investor trust, reflecting confidence in sovereign debt.

On the other hand, corporate bonds contribute around 22% to the market share, representing the
participation of private enterprises in the bond market. Corporate bonds serve as a means for
companies to raise capital for various purposes, including expansion projects, infrastructure
development, and working capital requirements.

The Indian bond market has experienced remarkable growth in recent years, witnessing a
staggering 77% increase in value over the past five years. This robust growth trajectory reflects
investors' growing appetite for fixed-income securities and the increasing demand for capital by
government and corporate issuers.

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 Factors Driving Growth:

Several factors have contributed to the growth and development of the Indian bond market:

1. Economic Expansion: India's sustained economic growth has created a conducive

environment for bond market development, with rising incomes and increasing investor
participation driving demand for fixed-income investments.

2. Policy Reforms: Regulatory initiatives aimed at deepening the bond market, such as
introducing electronic trading platforms and measures to enhance market transparency, have
bolstered investor confidence and facilitated market growth.

3. Infrastructure Investment: The government's focus on infrastructure development has

spurred demand for infrastructure bonds, providing investors with opportunities to invest in
projects critical to India's economic progress.

4. Investor Awareness: Growing investor awareness about the benefits of diversification and
the role of bonds in a balanced investment portfolio has contributed to increased bond market
activity.

Investor Implications:

For investors, India's burgeoning bond market presents a myriad of opportunities and
considerations:

1. Diversification: Bonds offer investors a valuable tool for diversifying their investment
portfolios, providing exposure to fixed-income assets with different risk profiles and maturities.

2. Income Generation: Bonds provide a reliable source of income through periodic interest
payments, making them particularly attractive for income-seeking investors.

3. Risk Management: With their low credit risk, government bonds can hedge against market
volatility and stabilize investment portfolios.

4. Capital Preservation: Bonds offer capital preservation benefits, with the assurance of
principal repayment at maturity, making them suitable for investors focusing on wealth
preservation.

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 Participants in Debt Market

1. Central Governments, raising money through bond issuances, to fund budgetary deficits
and other short and long term funding requirements.
2. Reserve Bank of India, as investment banker to the government, raises funds for the
government through bond and t-bill issues, and also participates in the market through
open-market operations, in the course of conduct of monetary policy. The RBI regulates
the bank rates and repo rates and uses these rates as tools of its monetary policy. Changes
in these benchmark rates directly impact debt markets and all participants in the market.
3. Primary Dealers, who are market intermediaries appointed by the Reserve Bank of India
who underwrite and make market in government securities, and have access to the call
markets and repo markets for funds.
4. State Governments, municipalities and local bodies, which issue securities in the debt
markets to fund their developmental projects, as well as to finance their budgetary
deficits.
5. Public Sector Units are large issuers of debt securities, for raising funds to meet the long
term and working capital needs. These corporations are also investors in bonds issued in
the debt markets.
6. Corporate treasuries issue short and long term paper to meet the financial requirements
of the corporate sector. They are also investors in debt securities issued in the debt
market.
7. Public Sector Financial Institutions regularly access debt markets with bonds for
funding their financing requirements and working capital needs. They also invest in
bonds issued by other entities in the debt markets.

8. Banks are the largest investors in the debt markets, particularly the treasury bond and bill
markets. They have a statutory requirement to hold a certain percentage of their deposits
(currently the mandatory requirement is 25% of deposits) in approved securities (all
government bonds qualify) to satisfy the statutory liquidity requirements. Banks are very
large participants in the call money and overnight markets. They are arrangers of
commercial paper issues of corporates. They are also active in the inter-bank term
markets and repo markets for their short term funding requirements. Banks also issue
CDs and bonds in the debt markets.

9. Mutual Funds have emerged as another important player in the debt markets, owing
primarily to the growing number of bond funds that have mobilised significant amounts
from the investors. Most mutual funds also have specialised bond funds such as gilt funds
and liquid funds.

Mutual Funds are not permitted to borrow funds, except for very short-term liquidity
requirements. Therefore, they participate in the debt markets pre-dominantly as
investors, and trade on their portfolios quite regularly.

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 10. Foreign Institutional Investors FIIs can invest in Government Securities upto US $ 5
billion and in Coporate Debt upto US $ 15 billion.

11. Provident Funds are large investors in the bond markets, as the prudential regulations
governing the deployment of the funds they mobilise, mandate investments pre-
dominantly in treasury and PSU bonds. They are, however, not very active traders in their
portfolio, as they are not permitted to sell their holdings, unless they have a funding
requirement that cannot be met through regular accruals and contributions.

12. Charitable Institutions, Trusts and Societies are also large investors in the debt
markets. They are, however, governed by their rules and byelaws with respect to the kind
of bonds they can buy and the manner in which they can trade on their debt portfolios.

13. Insurance companies: Insurance companies invest in international bonds mainly to

manage various kind of risk associated with insurance. Investment in international bonds also
helps insurance companies in ALM process.

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 Characteristics of a Bond

Bonds have a number of characteristics of which we need to be aware of. All of these factors
play a role in determining the value of a bond and the extent to which it fits in investor‟s
portfolio.

1.3.1 Face Value/Par Value

The face value (also known as the par value or principal) is the amount of money a holder will
get back once a bond matures. A newly issued bond usually sells at the par value. Corporate
bonds normally have a par value of Rs.1,000, but this amount can be much greater for
government bonds.

However the par value is not the price of the bond. A bond's price fluctuates throughout its life in
response to a number of factors. When a bond trades at a price above the facevalue, it is said to
be selling at a premium. When a bond sells belowfacevalue, it is said to be selling at a discount.

1.3.2 Coupon (The Interest Rate)

The coupon is the amount the bondholder will receive as interest payments. It's called a "coupon"
because in past there were physical coupons on the bond that investor needed to tear off and
redeem for interest. Nowadays, records are more likely to be kept electronically.

Most bonds pay interest every six months, but it's possible for them to pay monthly, quarterly or
annually. The coupon is expressed as a percentage of the par value. If a bond pays a coupon of
10% and its par value is Rs.1,000, then it will pay Rs.100 of interest a year.

A rate that stays as a fixed percentage of the par value like this is a fixed-rate bond. Another
possibility is an adjustable interest payment, known as a floating-rate bond. In this case the
interest rate is tied to market rates through an index, such as the rate on Treasury bills/MIBOR.

Investors will more likely pay more for a high coupon than for a low coupon.

1.3.3 Maturity

The maturity date is the date in the future on which the investor's principal will be repaid.
Maturities can range from as little as one day to as long as 30 years (though terms of 100 years
have been issued).

A bond that matures in one year is much more predictable and thus less risky than a bond that

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 matures in 30 years. Therefore, in general, the longer the time to maturity, the higher the interest
rate. Also, all things being equal, a longer-term bond will fluctuate more than a shorter-term
bond.

1.3.4 Issuer

The issuer of a bond is a crucial factor to consider, as the issuer's stability is investor‟s main
assurance of getting paid back. For example, the government security is considered far more
secure than any corporation. Its default risk (the chance of the debt not being paid back) is
extremely small - so small that government securities are known as risk-free assets. The reason
behind this is that a government will always be able to bring in future revenue through taxation.

A company, on the other hand, must continue to make profits, which is far from guaranteed. This
added risk means corporate bonds must offer a higher yield in order to attract investors.

1. Government Sector - The government sector can include either sovereign nation governments
or government related entities, supranational entities are government related organizations that
operate globally. The World Bank and the International Monetary Fund have been known to be
active bond issuers to fund their programs. Several sovereign nation governments issue bonds to
fund some of their budget, a prime example is U.S. Treasury bonds. But many sovereign nations
like Singapore issue sovereign bonds to investors. Non sovereign governments are government
entities that are not national governments, examples of such entities include the state of
California or the city of Toronto. Quasi government entities are government related
organizations that secure their own funding outside of government budget. A good example is
the Federal National Mortgage Association in the US, better known as Fannie Mae.

2. Corporate bonds are issued by the private sector. They're commonly divided into those issued
by financial companies such as banks and insurance companies and those issued by non-financial
companies.

3. Structured Finance Sector: The structured finance sector mainly comprises special legal
entities that securitize assets to create a special class of bonds known as asset backed securities.

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 Classification of Debt Market Securities

TYPES OF BONDS
1. Based on issuer
Government : Issued by the government, these bonds are considered among the safest investments
because they are backed by the government's credit. Public sector undertaking : Issued by government-
owned corporations or entities, these bonds carry varying levels of credit risk depending on the issuer.
Corporates : Issued by private companies, corporate bonds range from highly-rated (lower risk) to
lower-rated (higher risk) based on the issuer's creditworthiness. Banks & financial institutions : Issued
by banks and financial institutions, these bonds may offer a relatively higher yield compared to
government or corporate bonds.
2. Based on maturity period
Short term : These bonds have a relatively short maturity period, typically less than one year. Medium
term : These bonds have a moderate maturity period, generally ranging from one to ten years. Long term
: These bonds have an extended maturity period, often exceeding ten years. Perpetual : Perpetual bonds,
also known as perpetuities, have no fixed maturity date and pay periodic interest indefinitely.
3. Based on coupon
Fixed rate : These bonds have a fixed interest rate, and bondholders receive periodic interest payments at
the specified coupon rate. Module 3 - DEM 3 Floating rate : The interest rate on floating-rate bonds is
not fixed; it adjusts periodically based on a reference interest rate or benchmark. Zero coupon : These
bonds do not pay regular interest but are issued at a discount to their face value and provide a lump-sum
payment at maturity. Deep discount : Similar to zero-coupon bonds, deep discount bonds are issued at a
significant discount to their face value and do not pay periodic interest
4. Based on convertibility
Partially convertible : These bonds allow the bondholder to convert a portion of the bond into equity
shares of the issuing company. Fully convertible : Fully convertible bonds permit the bondholder to
convert the entire bond into equity shares of the issuing company
5. Based on Redemption
Single redemption : These bonds have a single maturity date at which the principal is repaid to
bondholders Amortizing bonds : Amortizing bonds repay the principal in installments over the bond's
life, in addition to periodic interest payments

CORPORATE BONDS
These are bonds issued by private or public sector companies in order to borrow funds from the market.
The companies acts makes no distinction between debentures & bonds. Corporate bonds are a good
source to raise long term funds with lower borrowing cost as compared to bank loans.
TYPES
 Bearer and Registered bonds
Bearer bonds are unregistered and can be transferred by physical possession, while registered

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 bonds are recorded in the owner's name, providing greater security and preventing unauthorized
transfer.
 Revenue bonds and General Obligation bonds

Revenue bonds are backed by the revenue generated from a specific project, while general
obligation bonds are secured by the issuer's full faith and credit, including taxation powers.
 Treasury/Government bonds
These bonds are issued by governments (usually national) and are considered among the safest
investments, backed by the government's credit
 Convertible bonds

Convertible bonds allow bondholders to convert their bonds into a predetermined number of
company shares, providing potential for capital appreciation
 Fixed rate bonds

Fixed-rate bonds offer a fixed interest rate for the bond's entire term, providing predictable
income to investors.
 Floating Rate bonds

The interest rate on floating-rate bonds is variable and adjusts periodically based on a reference
interest rate or benchmark.
 Zero coupon bonds/ STRIP bonds

Zero coupon bonds do not pay periodic interest but are issued at a discount to face value and
provide a lump-sum payment at maturity. STRIP bonds are created by separating the interest and
principal components of a bond.
 Capital Indexed bonds

These bonds are designed to protect investors against inflation by adjusting the principal and/or
interest payments based on changes in a specific inflation index.
 Bonds with call/put option

Bonds with a call option allow the issuer to redeem the bonds before maturity, while bonds with
a put option give bondholders the right to sell the bonds back to the issuer before maturity.

Basic classification of bonds can be considered based on the following criteria:

1) Based on issuers;
2) Based on maturity;
3) Based on coupon;
4) Based on currencies;
5) Based on embedded options;
6) Based on priority of claims;
7) Based on purpose of issue;
8) Based on underlying;

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 9) Based on taxation.

2.1 Classification of fixed income securities based on the Type of Issuer

The borrowers of funds who borrowed by the way of issuing of bonds are called Issuers. Bonds
are usually gauged for their riskiness based on the issuer‟s profile. The value of the bond mainly
depends on the ability of the borrower to service the debt obligations as per the bond indenture.

2.1.1 Government Bonds / Sovereign Bonds / Gilt edged Bonds

A sovereign bond is issued by the government and is typically denominated in the domestic
currency to support planned and unplanned expenditures. Government bonds are also known as
“sovereign debt” and are generally issued via auctions and traded in the secondary market.
Government bonds issued in local currency are considered risk free as the Government, being a
sovereign entity, can print the currency to repay its obligation to bond holders. However, as
demonstrated during the European debt crisis (2008-2012), Governments may also default in
debt payments in case of an emergency situation. Because of their relative low risk, government
bonds typically pay lower interest rates than the bonds issued by other issuers in the country.
In India, government bonds constitute the largest segment of the fixed income market. This also
includes the securities issued by the various State Governments and Union Territories, which are
known as State Development Loans (SDLs).
Indian Government Securities market (G-sec) also includes the special securities issued by the
central and state governments in India. Special securities are issued by the Government for
providing various subsidies like oil, fertilizer, bank recapitalization, etc.

2.1.2 Municipal Bonds

Local authorities may also issue bonds to fund projects such as infrastructure, libraries, or parks.
These are known as “municipal bonds”, and often carry certain tax advantages for investors.
Municipal bonds are also known as "muni bonds" or "muni". A municipal bond is categorized
based on the source of its interest payments and principal repayments. For example, a general
obligation bond (GO) is issued by governmental entities and is not backed by revenue from a
specific project but rather by the credit and taxing power of the issuing jurisdiction. GO bonds
are primarily used to subsidize the development of public projects. On the other hand, a revenue
bond is a category of municipal bonds supported by the revenue from a specific project, such as a
toll bridge, a highway or a local stadium. Revenue bonds that finance income-producing projects
are thus secured by a specified revenue source. In India, while very few local authorities or
municipal authorities have

Compiled by Asst. Prof. Bhoomi Rathod

 issued such bonds, the market is gradually picking up. The Ahmedabad Municipal
Corporation was the first municipal corporation in Southeast Asia to raise money through public
issuance, when it had raised ₹100 crore through this route in 1998.

2.1.3 Corporate Bonds

A corporate bond is issued by a corporate to raise capital. The performance of the bond during its
life depends on future revenues and profitability of the corporate. Debt is typically cheaper
source of financing for corporates and, unlike issuance of more equity, their ownership structure
is not diluted. In some cases, the corporate‟s physical assets may be used as collateral. Corporate
bonds carry higher risk vis-a-vis government bonds and hence the bond holders expect higher
interest rates to compensate for the additional risk they take while investing in the bond.
Corporates issue short term papers like Commercial papers (CPs) to fund their short-term
requirement or for their working capital funding. The corporate papers are issued either through
public issuance or private placements. The creditworthiness of the issuer (i.e., issuer‟s ability to
discharge its financial obligations) is to be assessed periodically by one or more of credit rating
agencies. The bond‟s credit rating,
and ultimately the company's credit rating, impacts the market price of the bond in both primary
and secondary markets. The Credit Rating Agencies (CRAs) assign ratings through letter grades
for their common and global understanding. The highest quality (and safest) bonds are given
“AAA”, while the high risk bonds are known as "junk" or “high-yield bonds”. The difference
between the yields on corporate bonds and government bonds is called the credit spread.

2.1.4 Securitized Debt

Securitization is the process of monetizing illiquid loan assets of a lender such as a bank, into a
liquid pool of tradable assets. Securitization is achieved by creation of a Special Purpose Vehicle
(SPV) and structuring the pool of loans into tradable bonds. Securitized (or assetbacked)
securities transfer ownership of assets (i.e., loans and receivables) to the SPV.

2.2 Classification of fixed income securities based on Maturity

Bonds are issued for various maturities depending on the requirement of funds as well as the
demand from the investors. Long term bonds are generally costlier than short term loans as the
funds are locked in for a longer period of time while investors may suffer from illiquidity. Bonds
may be classified in terms of maturities like ultra-short term, short term, medium term and long
term. Short term borrowings are typically made for working capital requirement where as long
term funds are used for project, capital and infrastructure funding. Collective investment
schemes also create debt oriented funds using such maturities. The returns on bonds by similar
rating class of issuers also vary according to the maturity, which forms the basis of yield curve
theories.

2.2.1 Overnight Debt / Borrowings

Typically, banks borrow overnight funds from the money market as well as from the RBI. These
borrowings can be collateralized or clean. Collateralized borrowings cost less vis-à-vis clean
borrowings. The RBI plays a very important role in this market through absorption or supplying
liquidity through banks and Primary Dealers.

Compiled by Asst. Prof. Bhoomi Rathod

 2.2.2 Ultra Short Term Debt (Money Market)
Short term borrowings up to one year are covered under this category. Mostly, money market
instruments like Commercial Papers (CP), Certificate of Deposits (CD), Treasury Bills (TB),
Cash Management Bills (CMB), etc. belong to this category.
2.2.3 Short Term Debt
Bonds with maturity spanning from 1 to 5 years are referred to short term bonds. Bonds maturing
within a year are classified under money market instruments as discussed above.
2.2.4 Medium Term Debt
These are bonds maturing in 5 to 12 years. These are also referred to as intermediate bonds.
Generally, the bulk of debt issuances take place in this segment.
2.2.5 Long Term Debt
These are bonds with maturity beyond 12 years. Mostly Government of India bonds are of long
term maturity.

2.3 Classification of fixed income securities based on Coupon

The promised interest as per the indenture of the bond is referred to as the coupon. The coupon
payments on bonds have a pre-determined payment frequency and may be paid annually, semi-
annually, quarterly or monthly. Bonds are classified on basis of coupons as these are returns on
the investment made by the holders.
2.3.1 Plain Vanilla Bonds
A plain vanilla bond is the simplest form of a bond with a fixed coupon and defined maturity and
is usually issued and redeemed at the face value. It is also known as a straight bond or a bullet
bond. These bonds have intermittent cash flows in the form of coupons received as well as the
final cash flow of the face value of the bond on maturity.
2.3.2 Zero-Coupon Bonds
A zero coupon bond (ZCB) is a discounted instrument which does not pay any interest and are
redeemed at the Face Value of the Bond at the time of maturity. These bonds are issued at a
discount and redeemed at the face value with the difference amounting to the return earned by
the investor. ZCBs have a single cash flow at maturity which is equal to the face value of the
bond. Common examples of ZCBs in India include Treasury Bills and Cash Management Bills
and STRIPS created by separating and trading independently (in other words “stripping off”) the
coupons from the final principal payment of normal bonds. ZCBs are highly sensitive to changes
in the interest rate as they do not have intervening cash flows and are generally used by long
term fixed income investors such as pension funds and
insurance companies to gauge and offset the interest rate risk of these firms‟ long-term liabilities.
2.3.3 Floating Rate Bonds
Floating rate bonds (FRBs) do not pay any pre-fixed coupons but are linked to a benchmark
interest rate (generally a short-term rate like the 182-day Treasury bill rate in India). The coupon
rate is reset on each coupon payment date. When the general interest rate rises in the market, the
benchmark interest rises and hence does the coupon on the FRBs. The same situation reverses
when the interest rate falls. FRBs typically trade very close to their face value as interest resets
happen at regular intervals. These instruments are generally immune to interest rate risk and are
considered conservative investments.
2.3.4 Caps and Floor
Most FRB issuers may issue bonds which will cap their interest payment obligation if the interest
rate rises. These instruments may also provide for a floor beyond which the interest rate will not

Compiled by Asst. Prof. Bhoomi Rathod

 fall in order to protect the interest of the investors. If an FRB has both a cap to protect the issuer
and a floor to protect the investor, it is called a “Collar”.
2.3.5 Inverse Floater
These types of bonds are similar to FRBs in that the coupon is related to the benchmark linked to
the bond (but it is inversely related in case of Inverse Floaters). If the benchmark increases, the
Coupon falls and vice versa. For example, in India generally the interest rate on such bonds is
linked to a negative spread over the fixed coupon rate. The spread is usually few percentage
points over the benchmark MIBOR rate. If the interest rates go up, corporates end up paying less
as the coupon will be a few percentage point lower than the original coupon rate. This has mostly
been used by NBFCs to raise funds while mutual funds are the primary investors.
2.3.6 Inflation Indexed Bonds
These are a type of FRBs which protect investors from the adverse effects of rising prices by
being indexed to an inflation measure like the WPI or CPI in India. Only the face/par value or
both par value and coupons may be indexed against the inflation measure.
2.3.7 Step Up/Down Bonds
These bonds are designed to pay lower coupon in the initial years of the bond and higher coupon
towards maturity. These bonds are preferred by issuers like start-ups who expect their cash flows
to balloon after some time and hence would like to service the bonds with lower cash flows at the
beginning. The investors of these bonds also take higher risk as higher cash flows are expected
after some time and hence expect higher interest rate to make the investment attractive. These
bonds are generally risky.
Step down bonds are the exact opposite of step up bonds. These bonds pay high interest at the
beginning of the bond and as the time moves towards maturity, the coupon drops. Such bonds are
usually issued by companies where revenues/profits are expected to decline in a phased manner;
this may be due to wear and tear of the assets or machinery as in the case of leasing.
The step up and step down bonds are used for better cash flow planning of both issuers and
investors.
2.3.8 Deferred Coupon Bonds
This is a mixture of coupon paying bond and a ZCB. In the initial years, these bonds do not pay
any interest but these bonds pay very high interest after a few years and typically few years
before the maturity. The corporates having high gestation period typically prefer this kind of
arrangement.
2.3.9 Deep Discount Bonds
When a zero coupon bond is issued at a high discount to the Face Value, it is generally referred
to as a Deep Discount bond. Normally, a discount of 20% or more with relatively longer maturity
is the main characteristics of the Deep Discount Bond. Typically, infrastructure companies issue
such kind of bonds as their gestation period is very long. These bonds carry high risk. Junk
bonds are examples of deep-discount bonds.
2.4 Classification of fixed income securities based on Currencies
With increased globalization of financial markets, often investments are spread across continents
yielding cash flows in different currencies. Hence, bonds can also be classified on the basis of
currencies.
2.4.1 Foreign currency Denominated Bonds
Many Governments as well as corporates issue bonds in overseas market in foreign currency
denominations. For example, Indian companies typically issue US Dollar denominated bonds to
raise cheaper funds from international markets. However, these bonds carry foreign currency risk

Compiled by Asst. Prof. Bhoomi Rathod

 as any devaluation of the domestic currency would increase the cost for the issuers as its
repayment would be done by acquiring foreign currency from the market at higher exchange
rate. Generally, bonds are named after the country of the currency in which the bond is issued,
e.g. Yankee bonds, Samurai bonds, etc. A Yankee bond is a U.S. dollar denominated bond that is
issued in the USA by a non-US issuer. A Samurai bond is a yen denominated bond that is issued
in Japan by a non-Japanese issuer. A dual currency bond is issued with coupon being payable in
one currency while principal would be paid in another currency.
2.4.2 Masala Bonds
Masala bonds are the debt securities issued by Indian corporates to raise money outside India but
the debt is denominated in Indian Rupees. Masala as a word is recognized the world-over for
Indian spices and was thus used by the World Bank- backed International Finance Corporation
(IFC) for global bonds of Indian corporates. Unlike dollar bonds, where the borrower takes the
currency risk, in case of the masala bonds, the investors bear the currency risk. The first masala
bond was issued by the IFC in November 2014 when it raised a ₹1,000 crore to fund
infrastructure projects in India. Later in August 2015, IFC for the first time issued green masala
bonds and raised ₹3,150 crore to be used for private sector investments that address climate
change in India. In July 2016, HDFC became the first Indian company to issue Masala bonds to
raise funds.

2.5 Classification of fixed income securities based on Embedded Options

An embedded option bond is an instrument with a provision of callability by the issuer and
puttability by the investor. The optionality influences the price of the bond as the risk is higher
for these bonds. The “Call” feature incorporates the right of the issuer to call back /repay the
bond on a specific date. The same way, the “Put” provision of the bond gives the right to seek
redemption of the bond by the investor on a particular date. A bond having call provision is
likely to be called when the cost of refinancing the bond is low due to fall in interest rates. A
bond having “Put” option may encourage the investors to submit the bond for redemption when
interest rate rises. The bonds with embedded options are valued using option premia.
2.5.1 Straight Bonds
A straight bond is a bond that pays interest at regular pre-determined intervals and at maturity
pays back the principal that was originally invested. A straight bond is also called a plain vanilla
bond or a bullet bond. These bonds pay regular coupon which is typically fixed at the beginning
or at the issuance time. It is the most basic form of debt investments.
2.5.2 Bond with a Call Option
A bond with a Call provision gives the right to the bond issuer to call back the bond and pay the
borrowed funds to investors before the original maturity date but at the pre-fixed call date. The
issuer invokes this right only when the market interest rate is lower than the interest in the
callable bond. However, the callable bonds generally require premium to be paid at the time of
redemption when called.
2.5.3 Bond with a Put Option
A bond with a Put provision gives the right to the bond investor to seek redemption of the bond
from the issuer before maturity date but at the pre-fixed Put date. The investor invokes this right
only when the market interest rate is higher than the interest in the puttable bond. However, these
bonds generally require discount at the time of redemption when the investor chooses to redeem
the same before maturity.
2.5.4 Convertible Bonds (including FCCB)

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 Convertible bonds are the bonds issued by corporates and such bonds get converted to equity
shares at a specified time at a pre-fixed conversion price. The bondholder has the right to convert
the said bonds to equity shares and issuing company cannot refuse the conversion as it is agreed
at the time of the issuance. These bonds are preferred by foreign investors who would like to test
the company for some time before talking an exposure to the equity shares of that company. This
is a hybrid security as the price of the bond depends on market interest rate, equity share prices
and the rating of the issue.

2.5.5 Warrants
A warrant is a bond with option rights. For a limited time, it confers the right to buy equity
securities, such as shares, of the bond issuer at a predetermined price (exercise price). Warrants
are derivative instruments like options that give the right but not the obligation to the investor to
buy an equity stock at a certain price before expiration. As these are option contracts, it will have
strike or exercise price.
2.6 Classification of fixed income securities based on Security
All bonds are in essence fungible loans for which returns ultimately depend on the servicing
ability of the issuer. Bonds can be secured or unsecured. These can be senior or junior types
depending on their claim in the company‟s asset at the time of liquidation.
2.6.1 Secured debt
The debt payout at the time of liquidation is made according to the seniority of bonds. Junior
bonds are typically subordinate to senior bonds. The senior bonds are put at the top of the
hierarchy in the structure as the “secured” debt. Otherwise, the age of the debt determines which
has seniority if bonds are not secured. Secured bonds have collateral ranking and they would be
paid first out of the assigned assets which have been collateralized against such debt. This makes
it more secure with higher recovery rate vis-àvis lower level unsecured junior bonds in the event
the company defaults. Secured debt holders are paid out first in case of liquidation.
2.6.2 Unsecured debt
Unsecured debt instruments are issud by companies without any specific collaterals allocated
against these issuances. Companies issue such unsecured debt using their name and reputation in
the market. These bonds are paid out last, if any bankruptcy happens. But senior unsecured debt
is paid out first and then the junior unsecured debt is paid out.
2.6.3 Subordinated debt
Subordinated bonds are issued by companies that pay higher coupon but are more risky as these
bonds are paid out just before the equity holders at the time of liquidation. In India, banks issue
subordinate bonds to shore up their Tier II capital as per the capital adequacy requirement.
2.6.4 Credit enhanced bonds
Credit enhancement is a strategy to show the investors that the company would be able to pay
back the borrowings as there is some kind of guarantee system in place to support the
borrowings. It is a method whereby a borrower or a bond issuer attempts to improve the credit
worthiness of its debt offering. Through credit enhancement, the lender or bond holder is
provided with reassurance that the borrower will meet its repayment through an additional
collateral, insurance, or a third party guarantee. A company lowers its cost of borrowing using
credit enhancement. The credit enhancement also leads to better rating grade for the bond and
reduces the risk for investors.

Compiled by Asst. Prof. Bhoomi Rathod

 2.7 Other fixed income securities in India
Apart from the basic categories of bonds described above, there are several other types of fixed
income securities which attract investors with specific investment requirements. Some of these
instruments are discussed below.

2.7.1 Sovereign Gold Bonds

Sovereign Gold Bonds (SGB) are government securities denominated in grams of gold. These
are considered as substitute for physical gold. SGBs are issued by RBI on behalf of Government
of India in order to reduce the import of gold into the country. These are paid out in domestic
currency but the value is determined using the price of gold at the time of issue and redemption.
These are held in demat form and remove the risk of physical gold holding and are free from
issues like making charges and purity in the case of gold held in jewelry form. Minimum
investment is one gram with a maximum limit of subscription of 4 kg for individuals, 4 kg for
Hindu Undivided Family (HUF) and 20 kg for trusts and similar entities notified by the
government from time to time per fiscal year (April-March). SGBs bear interest at the rate of
2.50 per cent (fixed rate) per annum on the amount of initial investment.
2.7.2 Perpetual Bonds
Perpetual bonds do not have specified maturity but the bond issuer pays interest on the bond to
the investor till the issuing entity exists. The yield offered by these bonds is significantly higher
due to the associated high risks such as:
a. Perpetual bonds are lower in order of liquidation and they are considered as
subordinate to senior level bonds.
b. The perpetual bonds are non-cumulative in nature and the interest is not guaranteed in case of
loss made in a year.
c. Perpetual bonds have “Call” provision which can be used by the issuer to call back
the bond.
d. Perpetual bonds have very low liquidity and it is extremely difficult to sell such bonds in the
market.
In India, banks and non-banking finance companies (NBFCs) have been major issuers of
perpetual bonds to meet the Basel III norms (also known as AT-1 instruments).
2.7.3 AT1 Bonds
As per Basel III norms, Indian banks have to maintain capital at a minimum ratio of 11.50
percent of their risk-weighted assets. Out of these, 9.50 per cent needs to be in Tier-1 capital and
only 2 per cent in Tier-2 capital. Tier-1 capital can include perpetual bonds without any expiry
date. These instruments are often treated as quasi-equity. RBI is the regulator for these bonds in
India.
AT1 bonds carry a face value of ₹10 lakh per bond and are complex hybrid products. These
bonds pay higher rate of interest compared to similar, non-perpetual bonds. However, the issuing
bank has no obligation to pay back the principal to the investors. Banks issuing AT1 bonds can
skip interest payouts for a particular year or even reduce the bonds‟ face value without
consulting their investors. These thresholds are specified in their offer terms. Moreover, for a
bank on the brink of collapse, RBI can direct the bank to cancel its outstanding AT1 bonds
without consulting its investors.
2.7.4 Tier-2 Bonds
Tier-2 bonds are components of Tier-2 capital and these are subordinate to Tier-1 capital and
further divided into upper and lower Tier-2 capital.

Compiled by Asst. Prof. Bhoomi Rathod

 Features of Tier-2 bonds issued by banks in India are:

-2 instrument can be issued in foreign currency upto 25% of unimpaired

Tier-1 capital. Lower Tier-2 instrument can be issued in foreign currency after taking
approval of RBI on case-by-case basis.

are subordinated bonds.

2.7.5 Savings Bonds
Also known as RBI savings bonds, these bonds (with tenure of seven years with half-yearly
compounding and cumulative and non-cumulative options) provide retail investors a safe fixed
income investment option with reasonable returns. These bonds are issued with a lock-in period
of seven years. These bonds are generally illiquid and cannot be used as collateral for loans.
2.7.6 High-Yield Bonds
High-yield bonds are bonds that pay very high interest rates because they have lower credit
ratings than investment-grade bonds. These bonds are more likely to default and hence they must
pay a higher coupon or yield than investment-grade bonds to compensate investors.
2.7.7 Green Bonds
Green bonds are a type of bond designed to raise funds to invest in environmental or climate
change mitigation projects. Green bonds are issued by financial, non-financial or public entities
where the proceeds are used to finance 100 per cent green projects and assets. Green bonds are
also a barometer for the impacts of climate change on the financial system. The development of
vibrant green bond markets allow countries and organizations to mobilize traditional debt
investments into projects that can have positive environmental impacts for society. Green bonds
also give investors an opportunity to meet their environmental, social and governance (ESG)
objectives by creating low-carbon investments.
2.7.8 REITs and InvITs
Real estate investment trusts (REITs) and infrastructure investment trusts (InvITs) are innovative
vehicles that allow developers to monetize revenue-generating real estate and infrastructure
assets, while enabling investors or unit holders to invest in these assets without actually owning
them.
2.7.9 Tax-Free Bonds
Tax-free bonds are issued by approved government enterprises to raise funds for a
particular purpose with no tax liability on the coupon income and/or on the capital gains. One
example of these bonds is the municipal bonds. Many public sector undertakings in India have
issued tax-free bonds. Default possibility for these bonds is low. However, these bonds typically
tend to have very low liquidity in the market.
2.7.10 Asset-Linked Bonds
An asset-backed security (ABS) is an investment security which is collateralized by a pool of
assets, such as loans, leases, credit card debt, royalties, or receivables. Asset-backed securities
allow issuers to monetize the receivables. ABS allow issuers to generate cash, which can be used
for more lending, while giving investors in the ABS the opportunity to participate in a wide
variety of income-generating assets.

2.7.11 Equity-Linked Note

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 An equity-linked note (ELN) is an instrument that combines a debt with additional potential
returns that are linked to the performance of certain equities while protecting their capital. This is
a type of structured product appealing to risk-averse investors who nevertheless have a bullish
outlook on the market.
2.7.12 Participatory Bonds
A participatory bond is a bond whereby the issuer promises a fixed rate of interest but the
coupon may increase or decrease depending on the performance of the company in terms of
profit generation. It helps the investor to participate in the revenues/income.
2.7.13 Income Bonds
Income bonds are similar to participatory bonds. However, these bonds do not have a reduction
in interest payments when the revenues/income reduces.
2.7.14 Payment in Kind Bonds
These types of bonds pay interest/coupon, not in terms of cash payouts but in the form of
additional bonds.
2.7.15 Extendable Bonds
Extendable bonds are bonds that allow the holder to enjoy the right to extend the maturity of the
bond.
2.7.16 Extendable Reset Bonds
These are types of bonds which allow the issuer and the bondholders to extend the maturity with
a reset in the coupon rate based on the then prevailing market scenario. These bonds have very
long maturity periods.

Compiled by Asst. Prof. Bhoomi Rathod

 Role of Credit Rating Agencies

Credit risk is the risk of default on a debt that arises from the borrower failing to make
required payments. Sovereign domestic currency based debt instruments are regarded as
safe sovereign investment and perceived to be “credit risk free”. Pricing and returns for non-
government debt instruments are dictated by their issuers‟ creditworthiness i.e., the
continuing ability of the issuer / borrower to service the debt payments. Any deterioration
in financial capability of the borrowing firm may result in delinquency, either in part or in
full. Debt investments are generally long term investments and are illiquid. Hence, investors
must have full information about the issuer as well as the issue, through regulatory and
voluntary disclosures. The voluminous information about the issuer as well as the issue are
required to be standardized and summarized through a well-qualified and unbiased agency
that can provide the independent view about the possible future performance of the debt.
This particular role of providing risk information about the possible future performance of
the issue is typically performed by a Credit Rating Agency in the debt market. As per the
extant SEBI regulations in force in the capital markets, it is necessary for an issuer to obtain
a rating from any of the major credit rating agencies. In India, the Rating Agencies are
regulated by SEBI under SEBI (Credit Rating Agencies) Regulations, 1999.

A Credit Rating Agency (CRA) is a company that provides information about the riskiness of a
debt instrument or a company in terms of its promised performance of a debt instrument.
They are regulated by SEBI and have to follow governance standards while giving the Rating
on a debt instrument. They issue letter grades to instruments: “AAA” for highest safety, “D”
for a Default and many other grades in between. The CRAs may rate government and
corporate bonds, CDs, CPs, municipal bonds, preferred stock, mortgage-backed securities
and collateralized debt obligations, etc. Investors typically see the rating before they invest
in a debt instrument.

Credit rating started in 1909 in the USA with Moody‟s rating of corporate and railroad bonds
as these bonds promised future performance. In the current times, credit rating has become
an integral part of debt market around the globe. Credit Rating and Investor Services of
India Ltd (CRISIL) started functioning in India in 1988 to rate corporate papers. SEBI
mandates disclosure of at least one Credit Rating while issuing debt instrument. The credit
rating represents a CRA‟s evaluation of the qualitative and quantitative information
pertaining to the prospective debtor, including information provided by the prospective
debtor and other non-public information obtained by the credit rating agency‟s analysts.
Ratings are the probability of default on repayment of principal or interest on relative scale
i.e., an issuer‟s likelihood to default and its likelihood to default compared to another similar
issuer. Ratings assigned by the rating agencies are taken as a key indicator of the relative
riskiness of the bonds and to determine the credit spread to be charged for these
instruments. It must be noted that the CRAs always qualify the rating provided for an entity
or instrument and encourage investors to look for other possible publicly available
information on the companies along with the Rating information. Often bonds are rated by
more than one rating agency but the issuer is not bound to publish all the ratings.
For ease of understanding by investors, CRAs generally assign letter grades for their view of
the instruments. The highest quality (safest, lower yielding) bonds are commonly referred to

Compiled by Asst. Prof. Bhoomi Rathod

 as “AAA”, while the least creditworthy are termed as "junk".

Common Scale of Ratings:

-: Investment Grade
-: Non-investment or Junk Grade

Ratings may also be issued for an issuer or a country‟s sovereign. Issuer rating is called
Issuer Default Rating (IDR) which refers to the probability of issuer defaulting.

Advantages of Credit Rating:

issuer and they take into

account the private as well as pubic information about the Company and its
management along with its financial position to give a simplified riskiness rating.
CRAs take complex data and general information and transform the same into an
easily understandable form for the investor. The rating information is available to
the investors freely on the website of the rating agency, if the rating is accepted by
the issuer. For the investor, seeking such information from the websites of Rating
Agencies is costless.

guides the market about any rating downgrade or upgrade at regular intervals. A
consolidated history of rating migration of corporate entities may be used for
understanding the possible probability of default level in the country vis-a-vis other
countries.

can easily understand and interpret the risk of investment in a debt instrument.

an instrument is important for investors. However, as the issuers pay for the ratings,
an inherent conflict of interest is built into the system.

many high rated instruments would be regarded as a preferred investment

destination by many investors, including the collective investment schemes like
Mutual Funds.

investments with regards to: risk identification, issuer credibility, independent

opinion and view about the potential risk, wider choice, saving in time and resources
for understanding riskiness of the instrument and benefits of intensive surveillance
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 by the rating agency.

Compiled by Asst. Prof. Bhoomi Rathod

 easy to sell debt, lowers cost of borrowing, opens up a wider market, facilitates
image building for the company and are particularly beneficial to new and unknown
corporate firms.

For corporate bonds, default risk gauges the possible capacity of the bond issuers to make
payment of the contractual interest and principal on agreed dates. Default Risk is the
qualitative representation by the credit rating of the issue and the possibility of default
increases, if the rating is downgraded by the rating agency during the life of the instrument.
It is quantified as Probability of Default (PD) associated with the bond rating category. PD is
measured using historical, annual default rates of bonds in different rating categories.
Rating Migration is the possible change of rating (both upgrade and downgrade) of an
instrument before its maturity.

A credit rating downgrade of the bond issuer impacts the spread over the risk-free yield
curve at which the corporate bond is valued and thus translates into potential mark-to-market
losses on a long bond position. A credit rating upgrade can similarly lead to potential
mark-to-market losses on a short bond position. Rating Migration Risk is quantified by
Rating Transition Probabilities released by CRAs. Each CRA has its own methodology for
these matrices which are used for valuation of the instruments. Accurate and reliable
default and transition/migration rates are important for all debt-market participants as they
are critical inputs for valuation and pricing of debt instruments and loan exposures. They
allow investors and lenders to quantify credit risk in their debt exposures and decide on the
pricing. These are also critical inputs for credit risk assessment models.
The top global CRAs are Moody‟s, Standard and Poor‟s (S&P) and Fitch Ratings. Some of the
prominent CRAs in India are:
a) The Credit Rating Information Services of India Ltd. (CRISIL)
b) ICRA Ltd.
c) Credit Analysis & Research Ltd. (CARE)
d) Fitch Ratings India Pvt. Ltd.
e) Brickwork Ratings India Pvt. Ltd.
f) Acuite Ratings & Research Ltd.
g) Infomerics Valuation and Rating Pvt. Ltd. (IVRPL)

CREDIT RISK
All corporate bonds are exposed to credit risk, which includes credit default risk
and credit-spread risk.
Measuring Credit Default Risk
Any bond investment carries with it the uncertainty as to whether the issuer will make timely
payments of interest and principal as prescribed by the bond‟s indenture. This risk is termed
credit default risk and is the risk that a bond issuer will be unable to meet its financial
obligations. Institutional investors have developed tools for analyzing information about both
Compiled by Asst. Prof. Bhoomi Rathod
 issuers and bond issues that assist them in accessing credit default risk. However, most
individual bond investors and some institutional bond investors do not perform any elaborate
credit analysis. Instead, they rely largely on bond ratings published by the major rating agencies
that perform the credit analysis and publish their conclusions in the form of ratings. The three
major nationally recognized statistical rating organizations (NRSROs) in the United States are
Fitch Ratings, Moody‟s, and Standard & Poor‟s. These ratings are used by market participants as
a factor in the valuation of securities on account of their independent and unbiased nature.
The ratings systems use similar symbols, as shown in Exhibit 10-1. In addition
to the generic rating category, Moody‟s employs a numerical modifier of 1, 2, or 3 to indicate the
relative standing of a particular issue within a rating category. This modifier is called a notch.
Both Standard & Poor‟s and Fitch use a plus (+) and a minus (-) to convey the same information.
Bonds rated triple B or higher are referred to as investment-grade bonds. Bonds rated below
triple B are referred to as non-investment-grade bonds or, more popularly, high-yield bonds
or junk bonds.

Credit ratings can and do change over time. A rating transition table, also called a rating
migration table, is a table that shows how ratings change over some specified time period.
Exhibit 10-2 presents a hypothetical rating transition table for a one-year time horizon. The
ratings beside each of the rows are the ratings at the start of the year. The ratings at the head of
each column are the ratings at the end of the year. Accordingly, the first cell in the table tells that
93.20% of the issues that were rated AAA at the beginning of the year still had that rating at
the end. These tables are published periodically by the three rating agencies and can be used to
access changes in credit default risk.

Measuring Credit-Spread Risk

The credit-spread is the difference between a corporate bond‟s yield and the yield on a
comparable-maturity benchmark Treasury security or the swap rate. Credit spreads are so named
because the presumption is that the difference in yields is due primarily to the corporate bond‟s
exposure to credit risk. This is misleading. however, because the risk profile of corporate bonds
differs from Treasuries on other dimensions; namely, corporate bonds are less liquid and often
have embedded options.
Credit-spread risk is the risk of financial loss or the underperformance of a portfolio resulting
from changes in the level of credit spreads used in the marking to market of a fixed income
product. Credit spreads are driven by both macroeconomic forces and issue-specific factors.
Macro-economic forces include such things as the level and slope of the Treasury yield curve,
the business cycle, and consumer confidence. Correspondingly, the issue-specific factors include
such things as the corporation‟s financial position and the future prospects of the firm and its
industry.

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Compiled by Asst. Prof. Bhoomi Rathod
 Types of Interest Rates (Fixed and Floating)

Fixed rate bonds are a type of debt instrument that guarantees a certain amount of money. These
bonds have a fixed maturity date and interest rate for the duration of the bond. As a result, fixed-
rate bonds provide investors with a consistent stream of income, referred to as coupon payments.
On the other hand, floating-rate bonds have a variable coupon rate that depends on the
benchmark rate (repo rate or reverse repo rate). Thus, the coupon rates are reset at regular
intervals. This article covers, in detail, the difference between fixed vs floating bonds.

Difference Between Fixed Vs Floating Bonds

Basis of
Fixed Rate Bonds Floating Rate Bonds
Difference

For floating rate bonds, the interest

Fixed rate bonds have a fixed interest rate
Meaning rate fluctuates during the bond
throughout the bond tenure.
tenure.

Fixed-rate bonds are issued for a fixed tenure. Floating rate bonds have floating
Furthermore, the bond issuer fixed the coupon coupons that move in line with the
How Do rate. Bondholders will receive interest market rates. As a result, if interest
They annually, semi-annually, or monthly after the rates rise, the coupon rates also rise,
Work? fixed-rate bonds are issued. The bondholder but the bond prices remain the same.
will get the face value when the bond matures As a result, the bondholder receives
(principal amount). higher returns.

Throughout the bond tenure, you

receive a variable coupon rate. In
You will get a predetermined coupon
Coupon other words, when the interest rate
payment throughout the bond tenure, either
Payments rises, so do the coupon rates, and
monthly, half-yearly, or yearly.
vice versa. Hence the coupon
payments vary.

Bondholders are well aware of the maturity

amount. In other words, before purchasing the Due to the changing interest rates, it
Maturity
bond, you will know the amount you will be is difficult for you to predict the final
Amount
receiving at the end of the bond tenure and maturity amount.
also the coupon payments.

Floating rate bonds are not as

Fixed-rate bonds are extremely vulnerable to
Risk sensitive as fixed-rate bonds to
interest rate movements.
interest rates movements.

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 Fixed rate bonds are suitable for investors
Floating rate bonds are suitable for
who wish to know how much they receive at
investors who wish to take advantage
Suitability the end of the bond tenure. Furthermore, the
of the changing interest rate
regular fixed coupon payments help them
movements.
plan their financial goals in a better way.

Asset-Backed Securities (ABS): Detailed Explanation

1. Introduction to Asset-Backed Securities (ABS)

Asset-Backed Securities (ABS) are financial instruments that derive their value from a pool of
underlying assets, such as loans, leases, or receivables. These securities are created through a process
called securitization, where illiquid assets are converted into tradable securities.

ABS are a type of fixed-income security, similar to bonds, but instead of being backed by a corporation
or government, they are backed by cash flows from the underlying assets.

2. Key Features of ABS

 Underlying Assets: ABS are backed by assets like auto loans, credit card receivables, home loans
(Mortgage-Backed Securities - MBS), student loans, etc.
 Cash Flow Driven: Investors receive payments from the cash flows generated by the underlying assets.
 Tranching: ABS are often divided into different tranches (layers) with varying risk and return profiles.
 Credit Enhancement: Techniques like over-collateralization, insurance, or senior-subordinate
structures are used to reduce risk.

3. How ABS Work? (Securitization Process)

1. Origination: A bank or financial institution (originator) lends money (e.g., auto loans, mortgages).
2. Pooling: Multiple loans with similar characteristics are bundled into a single pool.
3. Transfer to SPV: The pool is sold to a Special Purpose Vehicle (SPV), a bankruptcy-remote entity.

What is a Bankruptcy-Remote Entity?

A bankruptcy-remote entity is one that is legally structured to protect its assets from the
bankruptcy or financial distress of its parent company.

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  This means that even if the originator (bank) goes bankrupt, the assets (pooled loans) in the
SPV are protected and cannot be claimed by the originator’s creditors.
 The SPV is not consolidated on the balance sheet of the originator.
 It ensures investors' money is safe from risks related to the original lender’s insolvency.

Example:

Let’s say HDFC Bank has issued thousands of home loans.

1. These home loans are pooled together.

2. HDFC creates an SPV named "HDFC Home Loan Trust 2025".
3. HDFC sells the pool of loans to this SPV.
4. The SPV now owns the loans and receives the EMIs from borrowers.
5. The SPV issues securities (like pass-through certificates) to investors backed by these EMIs.

Even if HDFC Bank goes bankrupt, the investors still receive payments from the SPV, because the
SPV is bankruptcy-remote.

This setup is crucial for investor confidence, especially in the securitization market, because it
reduces counterparty risk. Investors are lending against the cash flows from the assets, not the
creditworthiness of the originating bank.

What is an SPV?

🟢 SPV = Special Purpose Vehicle

A legal mini-company created just to hold and manage the loans.

It is:

 Independent from the bank

 Holds only the pooled loans
 Used to protect investors from risk

What does Bankruptcy-Remote Mean?

A bankruptcy-remote entity means:

If the original bank goes bankrupt, the SPV is not affected, and the assets (loans) inside it are safe.

So investors will still get paid — because the money comes from the SPV, not from the original bank
anymore.

Who buys PTCs?

Pass-Through Certificates (PTCs) are typically bought by:

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  Mutual Funds
 Insurance Companies
 Pension Funds
 Banks & Financial Institutions
 High Net-Worth Individuals (HNIs)

They invest in PTCs to earn income from loan repayments, without originating the loans themselves.

How do investors benefit from buying PTCs?

1. Regular Income:

 Investors who buy PTCs receive periodic payments (usually monthly or quarterly).
 These payments come from the EMIs paid by borrowers in the underlying loan pool.
 Each EMI has two parts: principal + interest, and the investor receives both as per their share.

2. Attractive Returns:

 SME or microfinance PTCs often offer higher yields than traditional debt instruments (like
bonds or FDs), due to slightly higher risk.
 Typical returns may range from 8% to 12% annually, depending on the pool quality and tranche
level.

3. Diversification:

 By investing in a pool of loans, the investor's risk is spread across multiple borrowers,
reducing the impact of any one default.

4. Priority in Payments (for Senior Tranche Investors):

 If the PTC structure is tranched (senior, mezzanine, junior), the senior tranche investors are
paid first.
 This offers lower risk and more stable cash flows.

5. Capital Efficiency (for Banks):

 If a bank buys PTCs, it doesn’t need to originate new loans itself, but can still earn interest
income.
 It’s a way to deploy capital efficiently and manage asset-liability mismatches.

🔹 What are their earnings? (Example)

Let’s say:
Compiled by Asst. Prof. Bhoomi Rathod
  An investor buys PTCs worth ₹1 crore from a pool of SME loans.
 The pool yields 10% interest per annum.
 Monthly EMI collections are passed through to PTC holders.

🔹 Earnings:

 Monthly payment = ₹1,00,00,000 × 10% ÷ 12 = ₹83,333 (approx.)

 Over a year: ₹10,00,000 total (before tax)

This income may be taxed as interest income, depending on the investor type.

Risks to be aware of:

 Prepayment Risk: Borrowers may repay early, reducing total interest earned.
 Default Risk: If borrowers don’t repay, income may be affected.
 Servicer Risk: If the originator fails to service the loans properly.

But credit enhancements (like guarantees, reserves) help mitigate these risks

Types of Asset-Backed Securities

A. Mortgage-Backed Securities (MBS)

 Backed by residential or commercial mortgages.

 Example: Housing Development Finance Corporation (HDFC) issues MBS in India.

B. Non-Mortgage ABS

1. Auto Loan ABS – Securitized car loans (e.g., Maruti Suzuki, Mahindra Finance).
2. Credit Card Receivables ABS – Future payments from credit card users.
3. Loan Against Property (LAP) ABS – Secured by real estate collateral.
4. Microfinance ABS – Bundled loans given to small borrowers.

Benefits of ABS

For Originators (Banks/NBFCs)

 Liquidity: Converts illiquid loans into cash.

 Risk Transfer: Shifts credit risk to investors.
 Regulatory Capital Relief: Reduces capital requirements under Basel norms.

For Investors

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 Diversification: Exposure to different asset classes.
 Higher Yields: Often offer better returns than government bonds.
 Structured Risk: Tranches allow choice based on risk appetite.

Risks in ABS

 Credit Risk: Borrowers may default on underlying loans.

 Prepayment Risk: Early loan repayments can disrupt cash flows.
 Interest Rate Risk: Changes in rates affect ABS pricing.
 Liquidity Risk: Some ABS may be hard to sell in secondary markets.

ABS Market in India

 Regulated by SEBI (Securities and Exchange Board of India) under the SEBI (Public Offer and
Listing of Securitized Debt Instruments) Regulations, 2008.
 Key Players:

o Originators: HDFC, ICICI Bank, Bajaj Finance.

o Investors: Mutual funds, pension funds, insurance companies.

Compiled by Asst. Prof. Bhoomi Rathod