Comprehensive Guide to Types of Fixed Income Securities: NISM Series XXII (Part 1)

Fixed income securities are essential financial instruments used by legal entities to raise capital from the market with a promise to return the principal and provide regular income. This guide provides an authoritative deep-dive into the classifications of these securities based on issuers, maturity, and coupon structures, as outlined in the official NISM Series XXII workbook.

Understanding the Fundamentals of a Bond

A bond is a debt security where the issuer (borrower) agrees to refund the borrowed principal at the end of a contract period (or at intervals) along with a promised interest rate, known as the coupon.

Bonds vs. Loans: Key Differences

2.1 Classification Based on the Type of Issuer

The profile of the issuer is the primary gauge of a bond's riskiness. The value of a bond is dictated by the borrower's ability to service debt obligations as defined in the indenture.

2.1.1 Government/Sovereign Bonds (Gilt-Edged)

These are issued by the national government to fund planned and unplanned expenditures, typically denominated in domestic currency.

• Risk Profile: Considered risk-free in local currency as the sovereign can print money to repay obligations.
• Pricing: Due to low risk, they offer lower interest rates compared to other domestic issuers.
• Indian Context: Includes State Development Loans (SDLs) issued by State Governments/UTs and Special Securities issued for subsidies like oil and fertilizer.

2.1.2 Municipal Bonds ("Muni Bonds")

Issued by local authorities to fund public projects like parks, libraries, or infrastructure.

• General Obligation (GO) Bonds: Backed by the general credit and taxing power of the jurisdiction rather than a specific project.
• Revenue Bonds: Secured by the revenue generated from a specific project, such as a toll bridge or highway.
• Example: The Ahmedabad Municipal Corporation was the first in Southeast Asia to raise funds (₹100 crore) via public issuance in 1998.

2.1.3 Corporate Bonds

Issued by private or public corporations to raise capital without diluting ownership.

• Risk and Return: Carry higher risk than government bonds, requiring higher interest rates to compensate investors.
• Credit Rating: Rated by agencies using letter grades (e.g., AAA for highest safety; Junk/High-Yield for high risk).
• Credit Spread: The difference between the yield of a corporate bond and a government bond of similar maturity.

2.1.4 Securitized Debt

This involves securitization, the process of pooling illiquid loan assets (like bank loans) and converting them into liquid, tradable bonds.

• Mechanism: Assets are transferred to a Special Purpose Vehicle (SPV) which issues asset-backed securities.

2.2 Classification Based on Maturity

Bonds are structured across different time horizons to meet the specific funding needs of issuers and the liquidity requirements of investors.

Maturity Spectrum

1. Overnight Debt: Typically used by banks for collateralized or clean borrowing from the money market or RBI.
2. Ultra Short Term (Money Market): Maturities up to one year. Includes Commercial Paper (CP), Certificates of Deposit (CD), and Treasury Bills (TB).
3. Short Term Debt: Bonds with a maturity of 1 to 5 years.
4. Medium Term Debt: Bonds maturing in 5 to 12 years. This segment accounts for the bulk of debt issuances.
5. Long Term Debt: Maturities beyond 12 years, predominantly consisting of Government of India bonds.

2.3 Classification Based on Coupon Structure

The coupon is the promised interest frequency and rate specified in the bond indenture.

2.3.1 Plain Vanilla (Straight) Bonds

The simplest bond form with a fixed coupon and defined maturity. They are usually issued and redeemed at face value and provide intermittent cash flows.

2.3.2 Zero-Coupon Bonds (ZCB)

These instruments do not pay periodic interest.

• Issuance: Sold at a discount to face value.
• Return: The difference between the purchase price and the face value at maturity.
• Examples: Treasury Bills, Cash Management Bills, and STRIPS (where coupons are "stripped" and traded separately).
• Sensitivity: Highly sensitive to interest rate changes due to the lack of intervening cash flows.

2.3.3 Floating Rate Bonds (FRB)

Coupons are not fixed but linked to a benchmark interest rate (e.g., the 182-day Treasury bill rate in India) and reset periodically.

• Key Advantage: They are generally immune to interest rate risk because the coupon adjusts to market conditions.

2.3.4 Specialized Coupon Features

• Caps and Floors: A Cap limits the maximum interest an issuer pays; a Floor ensures a minimum interest for the investor. Together, they form a Collar.
• Inverse Floater: The coupon moves in the opposite direction of the benchmark. If market rates rise, the coupon falls.
• Inflation Indexed Bonds (IIB): Protect against rising prices by indexing either the face value, the coupon, or both to an inflation measure like WPI or CPI.
• Step Up/Step Down Bonds: Step Up bonds start with lower coupons that increase over time (favored by start-ups); Step Down bonds start high and decrease (used in leasing where asset revenue declines).
• Deferred Coupon Bonds: A hybrid of a ZCB and a coupon bond. No interest is paid in the initial years, followed by very high payments towards the end.
• Deep Discount Bonds: ZCBs issued at a very high discount (typically 20% or more) with long maturities, often used by infrastructure firms.

Key Takeaways for Part 1

• Bonds are versatile: They can be classified by issuer (Sovereign vs. Corporate), maturity (Overnight to 40+ years), or coupon (Fixed vs. Floating).
• Risk vs. Return: Sovereign bonds are generally credit-risk-free, while corporate bonds offer a credit spread to compensate for higher risk.
• Liquidity: Short-term money market instruments provide high liquidity, while long-term bonds are used for capital infrastructure.

Important Terms to Remember

• Indenture: The legal contract between the issuer and bondholder.
• Coupon: The annual interest rate promised by the issuer.
• Special Purpose Vehicle (SPV): An entity created specifically for securitization.
• STRIPS: Separate Trading of Registered Interest and Principal of Securities.

Note: This concludes Part 1 of Chapter 2. Part 2 will cover classifications based on Currencies, Embedded Options, Security, and other Indian-specific fixed income products.