Debt Market: Meaning and Types

In the last few chapters, you have learned all about stocks and related instruments such as indices, ETFs, mutual funds, etc. It is time that we move on to the other major type of investment instrument, i.e. debt. 

Introduction to Debt Meaning

Debt is another word for loan. It involves one party,i.e. the creditor, giving a lump sum of money to another party, i.e. the debtor, and then getting back that money in instalments over time, along with some additional money. This additional money paid to the creditor is called ‘interest’ and it acts as the price paid by the debtor for being able to avail the loan.  Since the interest charged is usually fixed, a debt is also known as a ‘fixed income instrument’.

What Is Debt Market?

A loan can sometimes be bought and sold in the open market, where it becomes known as a ‘bond’. A non-tradeable loan as well as a tradeable bond are both known as ‘debt’. The market where tradeable bonds and other closely resembling debt instruments such as debentures, commercial papers, etc. are bought and sold is known as the debt market.

Working of Debt Market with Example

The debt marke is where government and corporate entities borrow funds by issuing bonds. These bonds are certificates promising the investors who buy them repayment of the principal amount, i.e. the borrowed sum, plus interest over a defined period called the maturity period. Buying and selling these bonds are what make the debt market gain in liquidity for smooth working.

Let us illustrate this with an example:

Meet Rahul, an aspiring investor. Rahul has some savings and wants to earn a steady income stream. He decides to invest in a bond issued by ABC Corporation.

ABC Corporation needs a loan.They want to raise ₹100 million to expand their operations. Instead of approaching a bank, they choose to issue bonds directly to investors like Rahul.

ABC Corporation issues bonds with a face value of ₹1,000 each, an interest rate of 5% per year, and a maturity date of 5 years. This means:

• Rahul can buy one bond for ₹1,000.
• He will receive annual interest payments of ₹50 (5% of ₹1,000) for the next 5 years.
• On the maturity date 5 years from now, Rahul will get back the original ₹1,000 he invested.
• Rahul doesn't have to buy the bond directly from ABC Corporation. He can purchase it on the secondary market, where existing bonds are traded between investors. 

The price of a bond on the secondary market fluctuates based on factors like:

1. Interest rates: Generally, when interest rates rise, the price of existing bonds falls (and vice versa). This is because newer bonds with higher interest rates become more attractive.
2. Creditworthiness of the issuer: If the issuer's financial health deteriorates, the bond price may fall due to increased risk of default.
3. Time to maturity: Bonds closer to maturity generally trade closer to their face value.

Rahul makes his purchase as he sees that ABC Corporation's bonds are currently trading at ₹950 on the secondary market. This means he can buy a ₹1,000 bond for a slightly discounted price. He decides to purchase 10 bonds for a total of ₹9,500.

The outcome for Rahul:

• Annual income: Rahul will receive ₹500 in interest payments per year (10 bonds * ₹50 per bond).
• Capital gain (potential): If interest rates fall in the future, the price of his bonds could rise above ₹950. He could then sell them for a profit.
• Capital loss (potential): If interest rates rise or ABC Corporation's creditworthiness deteriorates, the price of his bonds could fall below ₹950. He would then incur a loss if he sold them before maturity.

This is just a simplified example, but it illustrates the basic mechanics of the debt market and how a bond trade works. Remember, the debt market is a complex and dynamic ecosystem, and it's crucial to do your research and understand the risks before investing in any bond.

Types of Debt

Debt can be a complex and nuanced topic, but understanding the different types can help you make informed financial decisions. Here's a breakdown of some common categories:

1. By Collateral:

• Secured debt:

This type of debt is tied to an asset, like your car or house. If you default on the loan, the lender can seize the asset to recoup their losses. Examples include mortgages, auto loans, and home equity loans.

• Unsecured debt:

This type of debt has no collateral backing it. If you default, the lender has no recourse but to sue you for repayment. Examples include credit cards, personal loans, and student loans.

2. By Repayment:

• Revolving debt:

This type of debt has a credit limit that you can borrow against and repay over time. You're only charged interest on the outstanding balance. Examples include credit cards and lines of credit.

• Instalment debt:

This type of debt is paid back in fixed instalments over a set period. The interest is typically calculated upfront and included in the monthly payments. Examples include mortgages, auto loans, and personal loans.

3. By Type of Borrower:

• Government debt:

This is money owed by a government to its creditors, such as foreign governments, banks, or individuals.

• Corporate debt:

This is money owed by a corporation to its creditors, such as banks, bondholders, or suppliers.

• Overseas Debt:

As the name suggests, Overseas funds are a type of mutual fund that invests in international markets, providing Indian investors exposure to global opportunities and diversification beyond domestic markets.

Types of Debt Instruments

• Bonds:

These are essentially IOUs issued by governments and corporations to raise capital. You, the investor, loan them money and receive regular interest payments in return, plus the original amount (principal) at maturity.

• Zero-coupon bonds:

These are sold at a discount to their face value and don't pay regular interest. The profit comes from the difference between the purchase price and the redemption value.

• Debentures:

Similar to bonds, debentures are unsecured debt instruments issued by companies. However, they lack the collateral backing of secured bonds, making them riskier investments but potentially offering higher returns.

• Commercial paper:

These are short-term (usually less than a year) debt instruments issued by large corporations to meet their ongoing financial needs. They're considered relatively low-risk due to the issuer's creditworthiness and short maturity.

• Certificates of deposit (CDs):

Issued by banks, CDs offer a fixed interest rate for a set period in exchange for your deposit. They're generally considered safe investments but offer lower returns than some other instruments.

• Promissory notes:

These are simple written agreements between two parties where one promises to repay a loan to the other at a specific time and interest rate. They're often used for personal loans or informal borrowing arrangements.

Understanding these different types of debt can help you manage your finances more effectively. 

What Is Bad Debt?

Bad debt refers to debt owed to a lender that is unlikely to be recovered after exhausting reasonable collection efforts. The Reserve Bank of India defines it as a loan overdue for more than 90 days or deemed doubtful even before that. Bad debts affect profitability, necessitate provisioning, and can harm borrower credit ratings.

What Are Debt Mutual Funds?

Think of a debt mutual fund as a basket of fixed-income instruments like bonds, bills, and money market securities. You pool your money with other investors, and a fund manager invests it on your behalf. Here's the gist:

• Stable returns:

Debt funds generally aim for consistent income through regular interest payments and capital appreciation. They're less volatile than stock funds, making them ideal for conservative investors.

• Diversification:

By owning a basket of instruments, you spread your risk and reduce dependency on individual issuers.

• Professional management:

Fund managers handle the research and selection of underlying securities, saving you time and effort.

• Liquidity:

Most debt funds allow you to easily buy and sell units, providing greater flexibility compared to some fixed-income instruments.

Debt-based ETFs: Bonds on Autopilot

Imagine a blend of bond stability and stock market convenience - that's debt-based ETFs. These passively track an index of fixed-income securities, offering:

• Diversification:

Get instant exposure to a basket of bonds, spreading risk and minimising dependence on individual issuers.

• Transparency:

Know exactly what you're invested in, as holdings mirror the underlying index.

• Low fees:

Passively managed ETFs typically boast lower fees than actively managed bond funds.

• Flexibility:

Trade debt-based ETFs like stocks throughout the day, offering easy entry and exit.

Benefits of Debt Investment

• Steady income:

Bond interest and regular coupon payments can be a reliable source of income, ideal for retirees or income-seeking investors.

• Reduced risk:

Compared to stocks, debt instruments tend to be less volatile, providing a smoother ride and safeguarding your capital.

• Portfolio balance:

Debt diversifies your portfolio, cushioning the blows of stock market downturns and creating a stable foundation for growth.

• Inflation protection:

Some debt, like Treasury Inflation-Protected Securities (TIPS), adjusts for inflation, safeguarding your purchasing power.

• Liquidity options:

Many debt instruments, like CDs and ETFs, offer easy exit routes for quick access to your money when needed.

Risks Involved in Debt Investment

• Interest rate fluctuations:

Rising rates can lower bond prices, leading to losses if you sell before maturity.

• Credit risk:

Issuers may default, meaning missed or lost interest payments and potential principal erosion.

• Inflation erosion:

Fixed interest rates may not keep pace with rising inflation, reducing the real value of your returns.

• Liquidity limitations:

Some debt instruments, like long-term bonds, lack the quick buying and selling of stocks, potentially trapping your money.

• Call risk:

Issuers may redeem bonds before maturity, forcing reinvestment at potentially lower rates.

Debt market investments can be a useful tool for achieving your financial goals, such as reducing your risk profile. However, it's important to use debt responsibly and make sure you can afford the repayments.

Final Words

Now that we have comprehensively covered both equity and debt, let us move on to a slightly more complex concept of derivatives. Check out the next chapter to begin your journey into the world of derivatives trading!