1. These products assure a near fixed type return to the investor. The holders of these fixed income type securities are also usually senior in the entitlement of cash flows of the issuer/company. This means that in case the company/issuer runs into financial trouble, its cash balances will first be used to pay off the senior components in its capital providers, that is, the cash balances will first be used to pay off the fixed income investors. Because of this senior entitlement, these products are considered to be safer than equity type products as equity type products have a more junior entitlement to the issuer/company’s cash balances. While there many types of Fixed income Securities, the most fundamental ones are either bonds or debentures. A bond usually has a particular asset whose cash flows are committed for the payment of the bond holders. A debenture is a fixed income security that is provided based on the creditworthiness of the issuing organization.
2. Fixed income products have a complex structure as compared to equity products and so they don’t trade on exchanges. There are brokers who specialize on bonds, debentures and one can purchase from them. However investment amounts need to be large. For retail investors, the best way to invest in theses instruments is through mutual funds.
3. The following are typical fixed income products:
a. Fixed Deposits/Certificate of Deposit: These products are offered by banks or large financial institutions. Governments offer insurance to some extent on these financial products thereby adding some further safety to these products. In addition, these products are very liquid which means that whenever an investor wants to exit the product and get his/her funds back he/she can do so.
b. Government Bonds
These are securities issued by governments. They could be in domestic currency or local currency and can be issued for short term or long term. Given the control that governments have on economic decisions, these bonds are considered usually to be the safest type of investment. Most other fixed income securities provide higher returns when compared with similar tenor bonds issued by the government. Example, if a bond issued by Government of India that is expiring in 10 years is offering a return of 7%, then the return offered by a bond of HDFC will be 9%. This is because there is a very low probability that the government will default on its financial obligations. Some government bonds can be purchased on exchanges and through the post office. An easy way to invest in government bonds is through mutual funds that focus on government bonds.
c. Commercial Paper
These are short term debt instruments that are issued usually by companies.
d. Non Convertible Bonds issued by companies (NCDs)
These are Debentures issued by companies, financial institutions and other such organizations.
e. Compulsorily Convertible Debentures (CCDs)
These are fixed income securities wherein the securities mandatorily convert to equity when the equity price reaches a certain share price. The CCD holders are then provided equity some equity shares in a pre-determined ratio for each CCD instrument. These instruments are more risky from a holder’s perspective and are used in complex financial situations. The interest rate that is decided for this type of security is arrived at after some complex analysis based on probabilities and Black Scholes analysis.
f. Optionally Convertible Debentures (OCDs)
These are fixed income securities wherein the holder can convert the debentures to equity when the equity price reaches a certain share price. The OCD holders are then provided some equity shares in a pre-determined ratio for each OCD instrument. These instruments are more risky from a holder’s perspective and are used in complex financial situations but the optionality provides comfort to the OCD holder. The interest rate that is decided for this type of security is arrived at after some complex analysis based on probabilities and Black Scholes analysis. The holder of these securities will convert debentures to equity if the holder feels the equity value is now more lucrative than the debt securities and that the equity price of the company’s stock will go up.
g. External Commercial Borrowing (ECBs)
Any raising of capital from outside the country is called External Commercial Borrowing. Usually the approval of the central bank (Reserve Bank of India in the case of India) is required since India does not have a freely convertible Capital Account. In countries that have a freely convertible Capital Account, ECBs can be raised without approval from the central bank.
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