3.3 Debt Securities & Interest Rates

What a Bond Is

A debt security (bond or debenture) is essentially a loan from the investor to the issuer. In exchange for the money lent, the issuer promises to:

1. Pay periodic interest (the coupon),
2. Repay the borrowed amount (the face value or principal) on a stated date (maturity).

Unlike equity, a bondholder is a creditor — not an owner. Bondholders have a prior claim on the issuer's cash flows, ahead of all equity holders, which makes debt less risky than equity for the same issuer.

Key Bond Terms

Issuer Types in India

India's debt market has three broad issuer categories:

• Government Securities (G-Secs): Long-term debt issued by the Government of India through RBI (as the government's debt manager). G-Secs carry sovereign credit risk (effectively risk-free) and are the benchmark for the risk-free rate. Typical tenors range from 5 to 40 years.
• Treasury Bills (T-Bills): Short-term government debt with tenors of 91, 182, and 364 days. Issued at a discount to face value and redeemed at par — the discount is the investor's return. They are zero-coupon instruments.
• Corporate Bonds / Debentures: Debt issued by companies. Secured debentures are backed by assets; unsecured ones are not. Coupon and rating vary with the issuer's credit quality.
• Commercial Paper (CP): Short-term unsecured promissory notes issued by corporates. Under the RBI's Commercial Paper and Non-Convertible Debentures Directions, 2024 (in force from April 1, 2024), CP is issued for a tenor of 7 days to 1 year, held in dematerialised form, in a minimum denomination of ₹5 lakh and multiples of ₹5 lakh, and sold at a discount to face value.

Regulator note: G-Secs and T-Bills fall under RBI's purview (RBI conducts the auctions); corporate bonds listed on exchanges are regulated by SEBI.

The Inverse Price–Yield Relationship

This is the single most tested concept in debt. When market interest rates rise, the price of an existing bond falls, and vice versa. The intuition: a bond paying a 7% coupon becomes less attractive when new bonds offer 9%, so its market price must fall until its effective yield matches 9%.

Worked Example

Consider a bond with:

• Face value: ₹1,000
• Coupon: 7% (₹70/year)
• Remaining maturity: 1 year

Scenario A — market rate stays at 7%: Bond price ≈ (₹70 coupon + ₹1,000 principal) / 1.07 ≈ ₹1,000 (trades at par).

Scenario B — market rate rises to 9%: Bond price ≈ (₹70 + ₹1,000) / 1.09 ≈ ₹981.65 (trades at a discount).

Scenario C — market rate falls to 5%: Bond price ≈ (₹70 + ₹1,000) / 1.05 ≈ ₹1,019.05 (trades at a premium).

The longer the maturity and the lower the coupon, the greater the price sensitivity to a given rate change (this sensitivity is measured by duration).

YTM vs Coupon Rate

Two yields are commonly confused:

• Coupon rate: Fixed at issuance, expressed as a percentage of face value. It never changes for a fixed-rate bond.
• YTM: The current annualised total return to maturity, based on the market price. YTM changes constantly with price.

Memory hook: Discount → YTM higher than coupon (you buy cheap, so your return exceeds the coupon). Premium → YTM lower than coupon (you paid up, so your return is less than the coupon).

Credit Risk and Credit Ratings

Credit risk is the risk that the issuer defaults on coupon or principal. Indian credit rating agencies — CRISIL, ICRA, and CARE — follow a SEBI-standardised alphanumeric scale. Long-term instruments are rated from AAA (highest safety) down to D (default).

Investment grade = BBB- and above. Below BBB- is non-investment grade (high-yield / junk). The three agencies use the same scale, prefixed by their own name: CRISIL AAA, [ICRA]AAA, CARE AAA. Plus/minus modifiers (e.g., AA+, AA-) indicate relative standing within a category.

Two Key Risks for Bondholders

• Interest-rate risk: The risk that a bond's price falls because market interest rates rise. Longer-maturity and lower-coupon bonds carry higher interest-rate risk.
• Reinvestment risk: The risk that coupons must be reinvested at lower rates than the original YTM, reducing the realised return. Higher-coupon and callable bonds carry higher reinvestment risk.

Inverse relationship: When rates rise, price falls (interest-rate risk bites) but reinvestment improves (reinvestment risk falls). When rates fall, price rises but reinvestment risk rises. The two risks move in opposite directions.

Banking Products — the Other Half of the Fixed-Income Shelf

The official syllabus pairs debt instruments with banking products, because for most Indian households the fixed-income allocation is held at a bank, not on an exchange. A PAIA must be able to describe each accurately.

Deposit insurance — the number to know

Bank deposits are insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC), an RBI subsidiary. Cover is ₹5 lakh per depositor per bank, counting principal and interest together, and aggregated across all branches and all deposit types held in the same right and capacity. Two accounts at the same bank do not double the cover; accounts at two different banks do.

Risks in fixed income and banking products

Candidates often assume "debt equals safe". The syllabus expects the opposite instinct — name the risk, then judge it.

• Credit / default risk — the issuer or bank fails to pay. Highest in low-rated corporate paper and in co-operative banks; effectively absent in G-Secs; capped by DICGC cover at ₹5 lakh in a bank.
• Interest-rate risk — the price of an existing bond falls when market rates rise. A fixed deposit does not re-price, so it carries no mark-to-market risk, but it carries the mirror-image opportunity cost: your money is locked at yesterday's rate.
• Reinvestment risk — coupons or a maturing deposit must be redeployed at a lower rate than before. This is the dominant risk for an FD ladder in a falling-rate cycle, which is where the repo rate now sits at 5.25%.
• Liquidity risk — a thinly traded corporate bond may not be sellable at a fair price; a tax-saving FD cannot be broken at all.
• Inflation / purchasing-power risk — the most under-appreciated. A 7% FD when inflation is 4.38% delivers a real return of roughly 2.5% before tax, and materially less after slab-rate tax.
• Taxation drag — FD and recurring-deposit interest is taxed at the depositor's slab rate every year on an accrual basis, with TDS deducted by the bank once interest crosses the prescribed threshold. Bond capital gains are taxed only on sale, which is why post-tax outcomes can differ from headline rates.

What a PAIA should say and not say: explaining that a 5-year tax-saving FD cannot be broken, or that DICGC cover is ₹5 lakh per depositor per bank, is a factual disclosure and entirely within the non-core role. Saying "put your emergency fund in a 5-year FD instead" is a recommendation, and belongs to the registered adviser.