Comprehensive Guide to Types of Fixed Income Securities: NISM Series XXII (Part 2)
This concluding part of Chapter 2 explores the advanced classifications of fixed income securities based on currencies, embedded options, and security/priority of claims, alongside a detailed overview of specialized debt instruments unique to the Indian financial landscape.
2.4 Classification Based on Currencies
In a globalised economy, bonds are often structured to yield cash flows in various currencies, helping issuers access international capital markets.
2.4.1 Foreign Currency Denominated Bonds
These are issued by governments or corporates in overseas markets and denominated in a foreign currency.
- Risk: They carry foreign currency risk; if the domestic currency devalues, the cost of repayment for the issuer increases.
- Common Names:
- Yankee Bonds: USD-denominated bonds issued in the USA by a non-US issuer.
- Samurai Bonds: Yen-denominated bonds issued in Japan by a non-Japanese issuer.
- Dual Currency Bonds: Structured with coupons payable in one currency and the principal in another.
2.4.2 Masala Bonds
These are Rupee-denominated debt securities issued by Indian entities in foreign markets.
- Currency Risk: Unlike dollar bonds, the investor bears the currency risk, not the Indian issuer.
- Historical Milestone: The International Finance Corporation (IFC) issued the first Masala Bond in 2014 to fund Indian infrastructure.
2.5 Classification Based on Embedded Options
Bonds with embedded options grant rights to either the issuer or the investor, significantly influencing the bond's price and risk profile.
2.5.1 Callable and Puttable Bonds
- Callable Bonds: Grant the issuer the right to repay the bond before maturity. Issuers typically "call" bonds when market interest rates fall, allowing them to refinance at a lower cost.
- Puttable Bonds: Grant the investor the right to seek early redemption. Investors typically "put" the bond when market interest rates rise to reinvest in higher-yielding securities.
2.5.2 Convertible Bonds and FCCBs
- Convertible Bonds: Corporate bonds that can be converted into a pre-fixed number of equity shares. They are hybrid securities whose price depends on interest rates, stock prices, and credit ratings.
- FCCB (Foreign Currency Convertible Bond): A convertible bond issued in a foreign currency. They are popular with foreign investors who wish to test a company's performance before committing to equity.
2.5.3 Warrants
A warrant is a bond that confers the right (but not the obligation) to buy the issuer's equity at a predetermined exercise price. They are often used as "sweeteners" to allow issuers to offer lower coupon rates.
2.6 Classification Based on Security and Claim Priority
The priority of claims determines who gets paid first in the event of an issuer's liquidation.
| Bond Type | Features |
|---|---|
| Secured Debt | Backed by specific collateral (assets). These holders are paid first during liquidation. |
| Unsecured Debt | Issued based on the issuer's reputation with no specific collateral. Paid after secured debt. |
| Subordinated Debt | Riskier bonds paid out just before equity holders. Banks use these to shore up Tier II capital. |
| Credit Enhanced | Use additional collateral, insurance, or third-party guarantees to improve creditworthiness and lower borrowing costs. |
2.7 Specialized Fixed Income Securities in India
India has developed several innovative instruments to meet specific regulatory and investment needs.
2.7.1 Sovereign Gold Bonds (SGB)
Issued by the RBI on behalf of the Government to reduce gold imports.
- Denomination: Units of one gram of gold.
- Interest: A fixed rate of 2.50% per annum on the initial investment.
- Redemption: Linked to the prevailing market price of gold.
2.7.2 AT1 and Tier-2 Bonds
- AT1 (Additional Tier-1) Bonds: Unsecured, perpetual bonds issued by banks to meet Basel III capital norms. They are "quasi-equity"; the bank can skip interest or even write down the principal if capital falls below certain thresholds.
- Tier-2 Bonds: Subordinated debt with fixed maturities (e.g., 15 years for upper tier) used for raising bank capital.
2.7.3 Environment and Infrastructure Vehicles
- Green Bonds: Specifically earmarked for environmental or climate-change mitigation projects.
- REITs and InvITs: Vehicles allowing developers to monetize real estate and infrastructure assets while offering investors a share in generated revenue.
2.7.4 Other Noteworthy Bonds
- Savings Bonds: Safe, 7-year lock-in instruments for retail investors.
- Tax-Free Bonds: Issued by government enterprises; interest earned is exempt from tax.
- Asset-Linked Bonds (ABS): Collateralized by a pool of assets like loans or credit card receivables.
- Payment in Kind (PIK) Bonds: Pay interest in the form of additional bonds rather than cash.
Key Takeaways for Chapter 2
- Currency Choices: Masala bonds allow Indian issuers to shift currency risk to global investors.
- The Power of Options: Call and Put features directly impact bond valuation and investor strategy during interest rate shifts.
- Safety Hierarchies: Understanding the seniority of claims (Secured vs. Subordinated) is critical for assessing recovery rates during defaults.
- Specialized Assets: Instruments like AT1 bonds and SGBs offer higher yields or gold-linked returns but come with unique regulatory and market risks.
Important Terms
- FEMA: Foreign Exchange Management Act, governing foreign currency issues.
- Novation: The process by which a central counterparty becomes the buyer to every seller and seller to every buyer.
- Green-shoe Option: A clause allowing the government to retain additional subscription amounts in an auction.
This concludes the complete short notes for Chapter 2: Types of Fixed Income Securities.