Debt and Fixed Income Products – NISM Series XA Short Notes (Part 6)
Welcome to Part 6 of the PassNISM short notes series for NISM Series XA – Investment Adviser (Level 1). Debt instruments are a cornerstone of balanced portfolios. The NISM XA exam tests concepts such as bond pricing, yield to maturity, duration, credit ratings, and the inverse relationship between price and yield. This post covers everything clearly with examples.
← Back to Part 5: Equity Products
What are Debt Instruments?
A debt instrument is a contract where the issuer (borrower) receives money from the investor (lender) and promises to pay a fixed or variable interest (coupon) along with repayment of the principal at maturity. Debt investors are creditors, not owners, and have a prior claim over equity holders in the event of liquidation.
Debt instruments offer capital preservation with regular income, making them suitable for conservative investors and for the debt portion of any diversified portfolio.
Key Terminology
| Term | Meaning |
|---|---|
| Face Value (Par Value) | The nominal value of the bond; typically ₹1,000 or ₹100 |
| Coupon Rate | Annual interest rate stated on the bond, applied to face value |
| Coupon Payment | Coupon Rate × Face Value; paid annually or semi-annually |
| Maturity Date | Date when principal is repaid to the bondholder |
| Market Price | Current trading price; may be above (premium) or below (discount) face value |
| Yield to Maturity (YTM) | Total annualised return if held to maturity; most important bond metric |
| Accrued Interest | Interest earned but not yet paid; buyer pays this to seller on purchase |
Types of Debt Instruments Government Securities (G-Secs)
Issued by the Government of India through the Reserve Bank of India. Considered sovereign/risk-free — zero credit/default risk. Traded in the G-Sec market.
- Treasury Bills (T-Bills) – Short-term; maturities of 91, 182, and 364 days; issued at a discount to face value; no coupon; return is the discount itself
- Dated Government Securities (G-Bonds) – Long-term (2–40 years); pay semi-annual coupon; most commonly traded sovereign bonds
- State Development Loans (SDLs) – Issued by state governments; slightly higher yield than Central G-Secs due to marginally higher credit risk
- Inflation-Indexed Bonds (IIBs) – Principal and/or interest linked to inflation (CPI); protect against purchasing power erosion
- Sovereign Gold Bonds (SGBs) – RBI-issued; linked to gold price; pay 2.5% annual interest; capital gains exempt on maturity
Corporate Bonds and Debentures
Issued by companies to raise debt capital. Carry credit risk and offer higher yields than G-Secs as compensation. Types:
- Secured Debentures – Backed by specific assets as collateral; lower risk for investors
- Unsecured Debentures – Not backed by any collateral; higher risk, higher coupon
- Fully Convertible Debentures (FCDs) – Entirely converted to equity at a future date
- Partly Convertible Debentures (PCDs) – Part converts to equity; rest redeemed as debt
- Non-Convertible Debentures (NCDs) – Cannot be converted; redeemed at maturity; may be listed on exchange
PSU Bonds
Issued by government-owned enterprises (NHAI, REC, PFC, HUDCO). Considered quasi-sovereign. Slightly higher yield than G-Secs.
Commercial Paper (CP)
Short-term unsecured promissory note issued by large, creditworthy companies. Minimum denomination ₹5 lakh. Maturity: 7 days to 1 year. Used for short-term working capital needs.
Certificate of Deposit (CD)
Short-term deposit instrument issued by banks (not companies). Negotiable and tradable in the secondary market. Maturity: 7 days to 1 year (for banks); 1–3 years (for financial institutions).
The Inverse Relationship Between Price and Yield
This is the most tested concept in the debt module of NISM XA:
When market interest rates rise → Bond prices fall
When market interest rates fall → Bond prices rise
Why? A bond locked in at an old lower coupon becomes less attractive when new bonds offer higher rates, so its price must fall to offer a competitive yield. Conversely, when rates fall, older higher-coupon bonds become more valuable.
| Market Rate vs Coupon | Bond Price vs Par | Bond Type | YTM vs Coupon |
|---|---|---|---|
| Market Rate > Coupon | Price < Par | Discount Bond | YTM > Coupon |
| Market Rate < Coupon | Price > Par | Premium Bond | YTM < Coupon |
| Market Rate = Coupon | Price = Par | Par Bond | YTM = Coupon |
Duration and Modified Duration Macaulay Duration
Macaulay Duration is the weighted average time (in years) it takes to receive all the bond's cash flows (coupons + principal). It represents the payback period of a bond.
- A zero-coupon bond's Macaulay Duration = its time to maturity
- A coupon bond's duration is always < maturity because coupons are received earlier
- Higher coupon rate → shorter duration (more cash received earlier)
- Longer maturity → higher duration
- Higher YTM → shorter duration
Modified Duration
Modified Duration measures the price sensitivity of a bond to a change in interest rates.
Modified Duration = Macaulay Duration / (1 + YTM/m)
Where m = number of coupon payments per year
Price Change Formula:
% Change in Price ≈ – Modified Duration × Change in Yield (in %)
Example: A bond with Modified Duration of 6 will lose approximately 6% in price if the yield rises by 1% (100 basis points).
Convexity
Convexity corrects for the fact that the price-yield relationship is curved (convex), not linear. A bond with higher convexity will lose less in value when rates rise and gain more when rates fall — all else being equal. It is a desirable property.
Credit Ratings in India
Credit ratings assess the likelihood that a bond issuer will default. Ratings are assigned by agencies registered with SEBI:
| Agency | Global Affiliate |
|---|---|
| CRISIL | S&P Global |
| ICRA | Moody's |
| CARE Ratings | Independent |
| India Ratings | Fitch |
| Acuité Ratings | Independent |
Rating Scale (Long-Term – CRISIL)
AAA → AA → A → BBB → BB → B → C → D (Default)
- Investment Grade: BBB and above
- Speculative / Junk Grade: BB and below
- A rating of D means the issuer is already in default
💡 NISM XA Tip: Credit Risk Funds invest at least 65% in AA and below rated instruments to generate higher yields. Investors must understand that higher yield = higher credit risk.
Yield Curve
The yield curve plots the yields of bonds of the same credit quality across different maturities.
- Normal (Upward Sloping) – Long-term yields higher than short-term; reflects healthy economic expectations
- Inverted (Downward Sloping) – Short-term yields higher than long-term; often signals a potential recession
- Flat Yield Curve – Short and long-term yields are similar; signals economic uncertainty
- Humped Yield Curve – Medium-term yields higher than both short and long-term
Numerical Example
Q: A bond with face value ₹1,000 has a coupon rate of 8% (paid annually) and 3 years to maturity. If the market yield is 10%, what is its approximate price?
Price = 80/(1.10) + 80/(1.10)² + 1080/(1.10)³
= 72.73 + 66.12 + 811.42 = ₹950.26 (Discount Bond, since YTM > Coupon)
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