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The fixed-income asset class refers to investments in fixed-income securities such as FD, bonds, treasury bills etc. These investments are issued by the Banks, Indian government, Corporates, Financial institutions etc. The Reserve Bank of India (RBI) is the central bank of India and plays a key role in regulating the country's debt markets. It sets monetary policy, including the benchmark interest rate, and issues government securities, including treasury bills and bonds. Corporations and financial institutions in India also issue debt securities to raise capital. These may include commercial paper, certificates of deposit, and corporate bonds.
Investors in the debt asset class in India may include banks, insurance companies, pension funds, and individual investors. They may be attracted to the stability and income potential of these investments, as well as the relative safety of investing in high-quality issuers with strong credit ratings. However, as with any investment, there are risks to consider.
- Treasury bills (T-bills) are short-term fixed-income securities that mature within one year that do not pay coupon returns. Investors buy the bill at a price less than its face value and investors earn that difference at maturity.
- Treasury notes (T-notes) come in maturities between two and 10 years, pay a fixed interest rate, and are sold in multiples of $100. At the end of maturity, investors are repaid the principal but earn semiannual interest payments until maturity.
- Treasury bonds (T-bonds) are similar to the T-note except that it matures in 20 or 30 years. Treasury bonds can be purchased in multiples of $100.
- Treasury Inflation-Protected Securities (TIPS) protect investors from inflation. The principal amount of a TIPS bond adjusts with inflation and deflation.
- A municipal bond is similar to a Treasury since it is government-issued, except it is issued and backed by a state, municipality, or county, instead of the federal government, and is used to raise capital to finance local expenditures. Muni bonds can have tax-free benefits to investors as well.
- Corporate bonds come in various types, and the price and interest rate offered largely depend on the company’s financial stability and its creditworthiness. Bonds with higher credit ratings typically pay lower coupon rates.
- Junk bonds—also called high-yield bonds—are corporate issues that pay a greater coupon due to the higher risk of default. Default is when a company fails to pay back the principal and interest on a bond or debt security.
- A certificate of deposit (CD) is a fixed income vehicle offered by financial institutions with maturities of less than five years. The rate is higher than a typical saving account, and CDs carry FDIC or National Credit Union Administration (NCUA) protection
There are several types of risk that investors in the debt asset class should be aware of:
- Credit risk: This is the risk that the borrower (of money) will default on their debt payments. It is higher for bonds issued by lower credit-rated borrowers and lower for bonds issued by higher credit-rated borrowers.
- Interest rate risk: This is the risk that increase in interest rates [[ which the borrower (e.g. bank as borrower) offers to the depositor/lender (e.g a person who is depositing money in the bank) OR which the lender (e.g. bank as a lender) charges to the borrower (e.g a person who is taking loan from bank) ]] will affect the value of a bond. When interest rates rise, people (with money) will be attracted more towards other investment options as those options are now offering better interest rates as compared to their earlier self and at the same time they have same liquidity and risk as their earlier self. So the value of bonds (which you hold) falls. Fewer people will prefer to buy these bonds from you at discounted rate if you wish to sell it now.
- Inflation risk: This is the risk that inflation will erode the purchasing power of the bond's future cash flows. Inflation-protected bonds, such as Treasury Inflation-Protected Securities (TIPS), can help mitigate this risk.
- Liquidity risk: This is the risk that the bond will be difficult to sell at a reasonable price in the secondary market, especially during times of market stress.
- Reinvestment risk: Reinvestment risk is the risk that an investor will not be able to reinvest the bond's future cash flows at the same interest rate, leading to a lower overall return. For example, suppose an investor buys a bond with a 5% coupon rate. The investor receives interest payments of 5% of the bond's principal every year. If the investor reinvests these payments at a rate of 5%, they will earn the same return on their investment each year. However, if interest rates fall and the investor is only able to reinvest the payments at a rate of 3%, the investor will earn a lower return on their investment. Reinvestment risk is particularly relevant for investors in long-term bonds, as they will have more cash flows to reinvest over a longer period of time. It can also be an issue for investors in bond funds, as the fund may need to continuously reinvest the proceeds from maturing bonds into new ones with lower interest rates.
- Event risk: This is the risk that a specific event, such as a natural disaster or a change in government policy, will negatively impact the bond-issuer's ability to make debt payments.