NISM Series XA Investment Adviser Level 1 Study Notes: Chapter IV - Investment Products (Part 3: Fixed Income Instruments)

Fixed income instruments are debt contracts that provide investors with pre-determined interest payments and return of the principal amount on maturity. This section covers the key fixed income avenues available to Indian investors: Government Securities (G-Secs), Inflation Indexed Bonds (IIBs), Corporate Bonds, Infrastructure Bonds, and Bank Fixed Deposits.

1. Government Securities (G-Secs)

Government securities (G-secs) represent the sovereign debt of the nation, issued to fund the public deficit.

Issuance and Purpose

• Issuer: G-secs are issued by the Reserve Bank of India (RBI) on behalf of the Government of India.
• Purpose: They are issued primarily to meet the government's fiscal deficit—the gap between the government's total income and its total expenditure.
• Method of Issuance: These securities are issued through structured auctions announced by the RBI from time to time.

Core Features and Payouts

• No Cumulative Option: G-secs do not offer a cumulative interest option.
• Interest Payouts: Interest (coupon) is paid out periodically on pre-specified dates directly into the designated bank account of the investor.
• Taxation:
  • Interest income from G-secs is not subject to Tax Deducted at Source (TDS).
  • However, the interest earned is fully taxable in the hands of the investor as per their applicable tax slab.

2. Inflation Indexed Bonds (IIBs)

Inflation Indexed Bonds (IIBs) are a specialized category of government securities issued by the RBI designed to safeguard an investor's returns from the eroding effects of inflation.

Mechanics of IIBs

• Issuer: Issued by the Reserve Bank of India (RBI) on behalf of the government.
• Inflation Protection: Unlike standard bonds where the principal is fixed, IIBs provide inflation-protected returns by adjusting the principal value.
• Fixed Real Coupon Rate: These bonds carry a fixed "real" coupon rate, which is applied directly to the inflation-adjusted principal on each interest payment date to determine the interest payout.
• Redemption Value: Upon final maturity, the investor is paid the higher of the face value or the inflation-adjusted principal. This ensures that the investor's nominal principal remains protected.

3. Corporate Bonds

Corporate bonds are debt instruments issued by entities in both the private and public sectors to raise capital.

Key Characteristics

• Tenor: These bonds are issued for terms ranging from 2 to 15 years.
• Popular Tenors: The most widely issued and popular tenors in the Indian market are 5-year and 7-year bonds.

Distribution Channels

• Private Placement (Institutional): Most corporate bonds are issued to institutional investors—such as mutual funds, insurance companies, and provident funds—through private placement.
• Public Issues (Retail): Companies may also raise funds from the public by making public issues of bonds, inviting retail investors to invest.

4. Infrastructure Bonds

Infrastructure bonds are specialized debt securities announced by the government to channel retail savings into major national projects.

Tax Benefits and Eligibility

• Section 80C Eligibility: The government announces a list of infrastructure bonds from time to time, investment in which is eligible for a tax deduction under Section 80C of the Income Tax Act.
• Eligible Issuers: Bonds issued by specific financial institutions are eligible for this deduction. Examples of such eligible institutions include:
  • Industrial Development Bank of India (IDBI)
  • India Infrastructure Finance Company Ltd. (IIFCL)
  • National Bank for Agriculture and Rural Development (NABARD)

Common Terms & The Lock-In Period

• Variable Features: Features such as the tenor, rate of interest, and minimum investment requirements can differ across different bonds.
• Mandatory Lock-In: The defining common feature of these bonds is a minimum lock-in period (which could be 3 years or 5 years). During this lock-in period, the bonds cannot be transferred or pledged.

5. Bank Deposits

Bank Fixed Deposits (FDs), also known as term or time deposits, are standard banking products where investors lock in their money with a bank for a fixed duration.

Core Features

• Definition: A deposit account with a bank for a fixed period of time.
• Investor Entitlements: The investor is entitled to receive pre-determined interest payments and the return of the deposited sum upon maturity.
• FDs vs. Savings Accounts: Fixed deposits offer higher returns than savings accounts because the deposited money is made available for the bank's use for a longer period of time.
• Target Audience: FDs are highly preferred by investors who value the safety that a bank provides and who do not have an immediate need for the funds.

Comparative Matrix: Core Fixed Income Instruments

The following table provides a direct comparison of the key fixed income instruments covered in this section:

Key Takeaways for Investment Advisers

1. Sovereign Safety: G-Secs and IIBs are backed by the government, meaning they carry virtually zero default risk. They are essential for low-risk portfolios or capital preservation goals.
2. Inflation Protection: IIBs are highly recommended during high-inflation environments because both interest and principal payments adjust upwards to maintain purchasing power.
3. Yield vs. Credit Risk: Corporate bonds offer higher yields than G-Secs but introduce corporate credit risk. Portfolio managers should evaluate credit ratings before suggesting them.
4. Lock-In Trade-off: Infrastructure bonds provide tax relief under Section 80C but require clients to sacrifice liquidity for at least 3 to 5 years.

Important Terms to Remember

• Fiscal Deficit: The excess of government expenditure over its total income, which is bridged by borrowing through G-secs.
• Real Coupon Rate: The fixed coupon rate of an Inflation Indexed Bond that is applied to the adjusted principal rather than the original nominal principal.
• Private Placement: The sale of securities directly to a select group of institutional investors (like mutual funds and insurance companies) rather than a public offering.
• Lock-In Period: A mandatory timeframe during which an investment cannot be sold, transferred, or pledged (e.g., 3 to 5 years for Infrastructure Bonds).