Chapter 3: Characteristics of Debt Securities

Learning Objectives

After studying this chapter, you should understand:

• Core structural components of debt securities: Issuer, Principal, Coupon, Maturity, and Embedded Options (Put & Call).
• The primary categories of debt instruments in the Indian market: G-Secs, T-Bills, SDLs, Corporate Bonds, Commercial Papers, and Certificates of Deposit.
• Key debt market valuation metrics: Coupon Rate, Current Yield, Yield to Maturity (YTM), and Duration.
• The Clean Price vs. Dirty Price accounting mechanism and accrued interest calculations.
• The risk spectrum in debt investing: Credit Risk, Interest Rate Risk, Reinvestment Risk, Liquidity Risk, and Call Risk.
• The statutory role, legal duties, and regulatory oversight of the Debenture Trustee under the Companies Act, 2013 and SEBI regulations.

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3.1 Structural Components of Debt Securities

A debt security is a contract between the issuer (borrower) and the lender (investor), establishing a fixed legal obligation to service interest and repay principal:

┌─────────────────────────────────────────────────────────────────┐
│                    ANATOMY OF A DEBT SECURITY                   │
├────────────────────┬────────────────────────────────────────────┤
│ 1. Issuer          │ Government, Municipality, Bank, Corporate  │
│ 2. Face Value      │ Nominal value on which coupon is computed  │
│ 3. Coupon Rate     │ Contractual interest rate (Fixed/Floating) │
│ 4. Coupon Frequency│ Annual, Semi-annual, Quarterly, Monthly    │
│ 5. Maturity Date   │ Final redemption date for principal repayment│
│ 6. Embedded Options│ Call Option (Issuer) / Put Option (Investor│
│ 7. Credit Rating   │ Standardized letter grade evaluating risk  │
└────────────────────┴────────────────────────────────────────────┘

Core Features Explained

1. Principal / Face Value: The nominal amount stated on the debt certificate (e.g., ₹1,000 or ₹1,00,000). The coupon is calculated as a percentage of the Face Value.
2. Coupon Structures:
   • Fixed Rate Bonds: Pays a constant percentage of face value throughout its life.
   • Floating Rate Bonds (FRBs): Coupon is tied to a benchmark rate (such as 91-day T-Bill yield or MIBOR) plus a spread; resets periodically.
   • Zero-Coupon Bonds (ZCBs): Issued at a discount to face value and redeemed at par on maturity.
3. Embedded Options:
   • Callable Bonds: Gives the issuer the right to redeem bonds early (exercised when interest rates fall).
   • Puttable Bonds: Gives the bondholder the right to demand early repayment (exercised when interest rates rise).

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3.2 Types of Debt Securities in India

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3.3 Debt Market Terminology, Yield & Duration

1. Current Yield: $$\text{Current Yield} = \frac{\text{Annual Coupon Payment}}{\text{Current Market Price}} \times 100$$
2. Yield to Maturity (YTM): The internal rate of return (IRR) earned by holding a bond to maturity, assuming all cash flows are received on schedule and reinvested at the YTM rate: $$P = \sum_{t=1}^{n} \frac{C}{(1 + \text{YTM})^t} + \frac{M}{(1 + \text{YTM})^n}$$
3. Inverse Price-Yield Relationship: Bond prices and interest rates move in opposite directions: $$\text{Yields Rise } (\uparrow) \implies \text{Bond Prices Fall } (\downarrow)$$ $$\text{Yields Fall } (\downarrow) \implies \text{Bond Prices Rise } (\uparrow)$$
4. Modified Duration: Measures percentage change in bond price for a 1% shift in yield: $$% \Delta P \approx -D_{\text{mod}} \times \Delta Y$$
5. Clean vs. Dirty Price: $$\text{Dirty Price} = \text{Clean Price} + \text{Accrued Interest}$$ Bonds are quoted in market screens at Clean Price.

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3.4 Key Risks in Debt Investing

• Credit / Default Risk: Probability that the issuer fails to pay scheduled coupon or principal.
• Interest Rate Risk: Risk of bond price depreciation when market interest rates rise.
• Reinvestment Risk: Risk that coupons must be reinvested at lower prevailing yields during easing cycles.
• Liquidity Risk: Inability to sell debt securities quickly at fair market value due to low trading volume.
• Call Risk: Risk that the issuer redeems high-coupon bonds early during falling rate regimes.

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3.5 Role of the Debenture Trustee

Under Section 71(5) of the Companies Act, 2013 and SEBI regulations:

• Appointment of a SEBI-registered Debenture Trustee is mandatory for public issues or when debentures are offered to more than 500 persons.
• Debenture Trust Deed (DTD): Must be executed within 3 months from the closure of the issue.
• Asset Cover: Debenture Trustees must verify that company assets provide a minimum 100% asset cover (or specified higher ratio) and monitor this cover continuously.
• Debenture Redemption Fund (DRF): Ensures the issuer invests at least 15% of debentures maturing during the following financial year in approved liquid assets.

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Chapter Summary & Exam Cheat Sheet

• T-Bills: Issued by Central Government in 3 tenors: 91, 182, and 364 days; zero-coupon instruments issued at discount.
• Commercial Paper (CP): Minimum denomination ₹5 Lakhs; tenor 7 days to 1 year; unsecured money market debt.
• Certificate of Deposit (CD): Minimum denomination ₹1 Lakh; tenor 7 days to 1 year; issued by commercial banks.
• Price-Yield Relationship: Strictly inverse; when market yields rise, bond prices fall.
• Clean vs. Dirty Price: $\text{Dirty Price} = \text{Clean Price} + \text{Accrued Interest}$.
• Debenture Trustee Threshold: Mandatory under Section 71 if debenture issue exceeds 500 subscribers or for public issues.
• Debenture Trust Deed Execution: Must be executed within 3 months of issue closure.
• Debenture Redemption Fund (DRF): Issuer must invest at least 15% of debentures maturing within the next financial year into specified liquid assets.