Introduction
There are two ways of raising capital: debt financing and equity financing. Entities raise money through equity dilution via various sources or transactions such as IPO (Initial Public Offer), FPO (Follow-on Public Offer), and private placements. Similarly, they raise capital by offering bonds or other forms of fixed income securities to the public. Corporates, governments, and state agencies (through municipal bonds) deal with fixed income securities such as bonds and treasury bills. These instruments are characterized by factors such as issuer, yield, face value (principal value), maturity period, interest rate or coupon, issue price, and credit ratings. Credit ratings indicate the overall risk associated with a security, along with factors such as interest rates, type of fixed income security, maturity period, and others. Investors in these instruments do not take ownership in a company, but they have a senior claim over equity holders in case of bankruptcy or default.
Characteristics of a Bond
Issuer – Firm, government, or any entity that issues the securities.
Face Value - The amount on which the issuer pays interest to the bond or security holder.
Maturity Period - The maturity of an instrument indicates the time period at which the principal value is due.
Issue Price - The price at which the issuer offers the bonds to investors.
Coupon - The coupon rate is the interest rate that the issuer pays to the holder. There are three types of bonds based on coupons:
- Zero coupon bond
- Floating rate bond
- Fixed income bond
Yield to Maturity (YTM) - It is the internal rate of return of the investment if held until maturity, including coupon payments and the face value of the bond.
Examples of Fixed Income Securities
- Bonds – A bond is an instrument of debt financing that represents the indebtedness of the issuer to investors or security holders. In simple terms, it can be defined as a loan made by investors to an issuer, with a promise to repay the principal amount at maturity along with regular coupon payments (generally at intervals of six months). The most common types of bonds are corporate bonds and government bonds, issued by corporations and governments respectively.
- Treasury Bills – Treasury bills or T-bills are among the safest short-term debt instruments issued by the government of a country. They have a short-term maturity period of less than one year. In India, they are issued in three tenors: 91-day, 182-day, and 364-day maturities. In the US market, they are also available for 28 days. T-bills are also known as zero-coupon securities because they do not pay periodic interest. Instead, they are issued at a discount to face value. For example, a T-bill with a face value of 100 may be purchased at 90, implying a discount rate of 10%.
- Money Market Instruments – Money market instruments include commercial papers, certificates of deposit (CDs), banker’s acceptances, and repurchase agreements (repos). Treasury bills are also considered money market instruments; however, due to their high trading volume, they are often discussed separately as a key example of fixed income securities.
- Asset-backed Securities (ABS) – Asset-backed securities are fixed income instruments backed by financial assets that have been securitized, such as credit card loans, car loans, and home loans.
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