Types of Fixed Income Instruments

Just like selecting a savings account, a fixed deposit, or a long-term bond, each instrument comes with its own risk, return, and time horizon, which makes choosing between different types of fixed income investments to park your money a tough job. Understanding the types of fixed income instruments available is key to building a diversified portfolio and aligning your investments with your financial goals.

What Are Fixed Income Instruments?

Fixed income instruments are debt securities that pay a fixed rate of return (interest) over a specified period. The investor is essentially lending money to the issuer — whether a government, a corporation, or another entity — in exchange for regular interest payments and the return of the principal amount at the end of the term. These instruments offer a predictable income stream and can be used to balance a portfolio of more volatile assets like equities.

Common Types of Fixed Income Instruments:

1. Bonds:

Bonds are the most common type of fixed income instrument. When you purchase a bond, you’re essentially lending money to the issuer for a fixed period of time. In return, the issuer agrees to pay you a fixed interest rate (coupon) periodically and return the principal amount (face value) at maturity.

• Government Bonds: Bonds issued by national governments. In India, these are typically government securities (G-secs) issued by the Reserve Bank of India (RBI).
  Example : A 10-year Government of India Bond might offer a 6% annual coupon, paid every year, with the face value of ₹1,000 being paid back to the investor at maturity.

• Corporate Bonds: These are bonds issued by companies to raise capital. They typically offer higher interest rates than government bonds because of the additional risk involved.
  Example: A bond issued by a company like Reliance Industries could offer an 8% coupon rate, but it may also carry a higher risk of default compared to a government bond.

2. Treasury Bills (T-Bills):

Treasury Bills are short-term debt instruments issued by the government, typically with maturities ranging from a few days to a year. These bills are sold at a discount to their face value, and the investor is paid the full face value at maturity. The difference between the purchase price and the maturity value is the interest earned.

Example: A ₹1,00,000 T-Bill may be issued at ₹98,000. At maturity, the investor receives ₹1,00,000, earning ₹2,000 as the interest.

3. Fixed Deposits (FDs):

Fixed Deposits are popular in India, where investors deposit a lump sum amount with banks or financial institutions for a fixed tenure at an agreed interest rate. Interest is paid periodically, and the principal is returned at the end of the tenure.
Example: A ₹5,00,000 FD with a State Bank of India (SBI) might offer an interest rate of 6.5% annually. At maturity, the investor receives the ₹5,00,000 principal plus the accumulated interest.

4. Municipal Bonds:

These are bonds issued by local governments or municipalities to fund public projects such as schools, hospitals, and infrastructure. In India, these are less common but are becoming an important tool for funding urban development.
Example : Municipal bonds in Mumbai might fund the construction of new roads, with returns typically coming in the form of tax-free interest income for investors.

5. Commercial Paper (CP):

Commercial Paper is a short-term debt instrument issued by corporations to meet short-term funding requirements. These typically have maturities ranging from a few days to 270 days. Since they are unsecured, they carry a higher risk compared to other fixed-income instruments.
Example: A company like Tata Motors might issue a commercial paper for ₹50 crore at an interest rate of 7% for a period of 6 months to fund working capital requirements.

6. Inflation-Linked Bonds:

These bonds are linked to inflation and are designed to protect investors from the eroding effects of inflation. The interest rate is adjusted according to inflation, ensuring that the real return is maintained.
Example: Government of India Inflation-Linked Bonds are tied to the inflation rate measured by the Consumer Price Index (CPI). If inflation rises, the returns on these bonds increase, providing protection against rising prices.

7. Zero-Coupon Bonds:

Zero-Coupon Bonds are bonds that do not make periodic interest payments. Instead, they are issued at a deep discount to their face value, and the investor receives the full face value at maturity.
Example: A ₹1,000 Zero-Coupon Bond may be issued for ₹600. The investor doesn’t receive any interest payments, but at maturity, they will receive the full ₹1,000, earning ₹400 in interest.

8. Convertible Bonds:

These are hybrid securities that give the bondholder the option to convert the bond into a predetermined number of shares of the issuing company. These bonds offer the potential for capital appreciation in addition to regular interest income.
Example: Bharti Airtel might issue convertible bonds that can be converted into its shares at a set price, offering bondholders the potential to benefit from future stock price appreciation.

9. Callable and Putable Bonds:

• Callable Bonds can be redeemed by the issuer before the maturity date, typically when interest rates fall. This gives the issuer flexibility but limits the investor’s potential interest income.

• Putable Bonds give the bondholder the right to sell the bond back to the issuer at a predetermined price, often when interest rates rise.
  Example: A callable bond issued by Reliance Power might allow the company to redeem the bond early if market conditions become favourable.

Why These Instruments Matter:

1. Diversification: Each type of fixed income instrument offers different risk and return profiles. By holding a mix of these instruments, investors can diversify their portfolios, balancing risk and reward.

2. Income Generation: Investors seeking a predictable income stream, especially retirees and conservative investors, primarily use fixed income instruments, especially bonds and fixed deposits.

3. Risk Management: By choosing the right fixed income instrument, investors can protect themselves from market volatility. For example, inflation-linked bonds can protect against rising prices, while municipal bonds offer tax-free income.

The world of fixed income securities is vast, with various instruments catering to different investor needs. From government bonds to corporate debt and municipal bonds, each type serves a unique purpose in a well-diversified portfolio. In the next chapter, we will dive into Bond Pricing and Valuation, where we will explore how the value of these fixed income instruments is determined in the market.