Interest Rate Concepts – Interest Rate Instruments | Fixed Income Securities

An interest rate is the percentage of principal charged by the lender for the use of its money or paid by a bank for keeping money in an account. It is the cost of borrowing money or the reward for saving it, typically expressed as an annual percentage rate (APR). In lending, it serves as compensation for the risk the lender takes and the  opportunity cost of forgoing other investments. In savings, it provides an incentive for depositing funds by earning a return on the deposited amount. Interest rates influence economic activity by affecting spending, saving, and investment decisions.

Table of Contents

1. Understanding the Interest Rate Concept
2. Fixed Income Securities
3. Type of Fixed Income Securities

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1. Understanding the Interest Rate Concept

Debt is a concept of “I owe You” in which the receiver of the favour is willing to return the favour with agreed rate of return for using the favour for the time period. In simple terms, Mr A is borrowing some money “X” from Mr B for 3 months with a promise to pay back “X+Δ”. This “Δ” is calculated as a percentage or rate of return on the Principal X. For example, Δ = X × R% × 3/12 where “R% is the annual rate of interest agreed to be paid for the use of Principal amount “X” by Mr A. In this example, Mr A is the “Borrower”, Mr B is the “Lender” and “R” is the agreed rate of interest expressed as percentage per annum and time period is “3/12” years (i.e., 3 months). To make the process formal and enforceable, Mr A and Mr B can sign the agreement and then the same is treated as “Loan”. Loans are generally non-tradable. On the other hand, Mr A can give in writing a “Note” that he would return the borrowed Principal money “X” to Mr B after 3 months with agreed rate of interest at R% per annum. Simply put, we can state that the “Note” given by Mr A is treated as a “Debt instrument” or “Debt Securities” which is a tradable security (Mr B can assign the same to someone against appropriate payment before 3 months, if he requires liquidity and wants to exit the transaction): Mr A here is the Issuer, Mr B is the Investor, R is the yield or rate of interest on the date of transaction for the borrowed time (here 3 months).

In the above example “R” is the Interest rate which is essentially a charge to the borrower for the use of an asset. Assets borrowed can include cash, consumer goods, vehicles, property, etc. Interest rates apply to most lending or borrowing transactions. Individuals borrow money to purchase homes, fund projects, launch or fund businesses, or pay for college fees. Businesses take loans to fund capital projects and expand their operations by purchasing fixed and long-term assets such as land, buildings, and machinery. Borrowed money is repaid either in a lump sum by a pre-determined date or in periodic instalments. The interest rate is the cost of debt for the borrower and the rate of return for the lender. Interest rates are typically quoted as the annual percentage rate which is generally termed as nominal annual interest rate.

Interest rate is subjective. If we say, interest rate is 6%, it does not provide any clarity on the interest rate. To understand let us take few examples:

• The housing loan up to Rs. 50 lacs for 15 years is at the rate of 6% p.a.
• The personal loan up to Rs. 50 lacs for 15 years is at the rate of 7% p.a.
• The housing loan up to Rs. 50 lacs for 20 years is at the rate of 6.5% p.a.
• The housing loan above Rs. 50 lacs for 15 years is at the rate of 6.25% p.a.
• The coupon for government securities with 5-year maturity is 5% p.a.
• The coupon for AAA corporate bonds with 5-year maturity is 5.50% p.a.

For above example you can see that the interest rate changes with change in tenor, amount, credit risk etc., as interest rate will be determined based on various factors.

The interest rate is dependent upon various factors. When the borrower is considered to be low risk by the lender, the borrower will usually be charged a lower interest rate. If the borrower is considered high risk, the interest rate that they are charged will be higher. Factors like inflation, liquidity, duration, central bank policy, price of competing assets, etc., influence the movement and level of general interest rates in the market.

Following are a few factors that influence the interest rates in the economy:

1. Demand for money: This will be best explained by looking at the economic activity in the market. When the economy is doing better, there will be more demand for funds and investors would be willing to take higher risk by investing in various projects. Hence, the demand for funds would see an uptick which will possibly raise the cost of money (interest rate). However, during recession when the effective demand is very low, the demand for funds from investors would be low and interest rate would show a depression.
2. Supply of money: The supply of money is typically controlled by the central bank of the country. When the inflation kicks in, the central bank would like to tighten the supply of money which will reduce effective demand and it would possibly think of increasing policy rate to make the cost of funds higher.
3. Fiscal deficit and government borrowing: When fiscal deficit is high and Government has to borrow higher amount from the market, the traders would demand higher interest rate to support such borrowing and the funds for corporates would be constrained.
4. Inflation: When inflation level increases, the savers need compensation, as the real value of their money would drop, and therefore the nominal interest rate has to be higher to compensate for the same. As inflation drops, the nominal interest rate also comes down.
5. Global interest rates and foreign exchange rates: Global investors would arbitrage between various markets. When interest rates rise in other countries, investors would move to such locations to take advantage of the higher rate of return. Hence, to attract foreign investment and to keep in sync with the global scenario, the domestic interest rate also has to increase.
6. Central bank actions: At times, the central banks raise policy rates which affect all commercial interest rates in the system. A rise in policy Repo rate would lead to increase in money market rates which will affect the bond market yields.

1.1 Effective Rate

The effective interest rate can be different from annual interest rate due to compounding effect. Let us understand the same with an example. If a debt security pays 6% annually and compounds semi-annually, an investor who places Rs. 1,000 in this bond will receive Rs. 30 of interest payments after the first 6 months (Rs. 1,000 x .03), and Rs.30.90 of interest after the next six months (Rs. 1,030 x .03), assuming Rs. 30 received after 6 months is invested in same bond. In total, this investor receives Rs. 60.90 for the year. In this scenario, while the nominal rate is 6%, the effective rate is 6.09%.

Typically, Effective interest rate = [(1 + annual interest rate/n)n– 1]
Where n = number of compounding periods.

1.2 Nominal and Real Interest Rate

The nominal interest rate is the stated interest rate (coupon rate) of a bond. The nominal interest rate denotes the rate that the bond issuer pays to the bond holder. However, the inflation reduces the purchasing power of money. Therefore, the nominal interest rate has to be adjusted for the rate of inflation in order to understand the real growth of money for the bond holder. The nominal interest rate adjusted for inflation is called real interest rate. The relationship between real and nominal interest rates can be described in the equation:

(1 + r ) x ( 1 + i ) = ( 1 + R )

where r is the real interest rate, i is the inflation rate and R is the nominal interest rate.
For low-level rates, this relation can be approximated as r = R – i
i.e., Real interest rate = Nominal interest rate – Rate of Inflation

For example, if the nominal interest rate on a bond is 9% and the inflation rate is 6%, then the real interest rate will be around 3%. Therefore, if the rate of inflation exceeds the coupon rate of a bond, the real interest rate on the bond will be negative. For example, a bond with a 7% nominal interest rate will have a real interest rate of -2% (approximately), if the rate of inflation is 9%.

In brief:

• The interest rate is the amount charged on top of the principal by a lender to a borrower for the use of assets.
• It is the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets.
• Interest rates are typically noted on an annual basis.
• Interest rate is subjective.
• Interest rate is decided based on various factors.
• Interest rate risk is the uncertainty in the movement of the interest rates.
• Both way movement of interest rate will impact the participants.

2. Fixed Income Securities

“Fixed Income Securities” are debt instruments that pay a fixed amount of interest in the form of coupon payments – to investors. The interest payments are made periodically while the principal invested returns to the investor at maturity. Bonds/Debentures are the most common form of fixed income securities. Companies raise capital by issuing fixed income products to investors. A bond is an investment product that is issued by corporations and governments to raise funds to finance projects and fund operations. Bonds are mostly comprised of corporate bonds and government bonds and can have various maturities and face value amounts. They are called “fixed-income” securities because of the following “fixed” features.

• Their life is fixed: they will be redeemed on a specified future date because all borrow-lend transactions are for a fixed period. The only exception to this rule is a Dutch perpetual bond issued in 1648. In recent years, some Indian banks and corporates have issued perpetual bonds, which are not strictly perpetuals because the issuer has call option.
• In most cases, their cash flows are fixed, too. In other words, the timing and size of cash flows are known in advance. In some securities (e.g. floating-rate bonds), the timing of cash flows is known in advance but not their size because the amount is linked to prevailing interest rate.

2.1 Key Components of Fixed Income Securities

Issue Price is the price at which the bonds are issued to the investors. Issue price is mostly same as face value in case of coupon bearing bond. In case of non-coupon bearing bond (zero coupon bond), security is generally issued at discount i.e., issue price is less than face value.

Face Value (FV) is also known as the par value or principal value. Coupon (interest) is calculated on the face value of bond. FV is the price of the bond, which is agreed by the issuer to pay to the investor, excluding the interest amount, on the maturity date. Sometime issuer can pay premium above the face value at the time of maturity.

Coupon/Interest is the cash flow that are offered by a particular security at fixed intervals/predefined dates. The coupon expressed as a percentage of the face value of the security gives the coupon rate. Coupons are typically given on annual basis.

Coupon Frequency means how regularly an issuer pays the coupon to holder. Bonds generally pay interest monthly, quarterly, semi-annually or annually.

Interest Payment Dates means dates on which interest/coupon is paid to bond holder by the issuer.

Maturity date is a date in the future on which the investor’s principal will be repaid. From that date, the security ceases to exist.

Call/Put option date is the date on which issuer or investor can exercise their rights to redeem the security before maturity date.

Maturity/Redemption Value is the amount paid by issuer other than coupon payment. If the redemption proceeds are more than the face value of the bond/ debentures, the debentures are redeemed at a premium. If one gets less than the face value, then they are redeemed at a discount and if one gets the same as their face value, then they are redeemed at par.

Example:
Security with FV of Rs. 1,000 issued on April 01, 2021, for a period of 10 years at Rs. 1,000, Coupon of 7% p.a. is paid every 6 months.

Issue price = Rs. 1,000
Face value = Rs. 1,000
Coupon = 7%
Coupon Frequency = Half yearly
Interest payment date: April 01st and October 01st.
Maturity Date = April 01, 2031
Put Option =Not applicable
Call option =Not applicable
Redemption Value = Rs. 1,000

3. Type of Fixed Income Securities

A bond is a financial security issued by a legal entity to raise funds from the financial market and agrees to refund/return the borrowed amount (principal) at the end of the contract period or at various time intervals as given in the indenture along with the promised interest or coupon. Agreed annual interest promised by the issuer on the bond is generally referred to as “Coupon”. A bond is akin to a loan with a maturity and coupon rate paid at various intervals viz. quarterly or half-yearly or annually. However, it differs from a loan mainly with respect to its tradability. A bond is usually tradable and can change many hands before it matures; whereas a loan usually is not traded or transferred freely. A loan brings permanent risk to the lender till the loan is repaid but the bond holder can transfer his risk to other risk takers through efficient pricing mechanism. The value of the loan does not change but the value of the bond changes on continuous basis depending on future interest rate regime in the economy as well as the credit worthiness of the borrower. While bonds can be classified in many ways, for ease of understanding, the basic classification of bonds can be considered based on the following criteria:

• Based on issuers;
• Based on maturity;
• Based on coupon;
• Based on currencies;
• Based on embedded options;
• Based on priority of claims;
• Based on purpose of issue;
• Based on underlying;
• Based on taxation.

Here we will discuss in brief few important classifications of bonds based on their inherent features.

3.1 Classification of fixed income securities based on the Type of Issuer

The borrowers of funds who borrowed by way of issuing of bonds are called Issuers. Bonds are usually gauged for their riskiness based on the issuer’s profile. The value of the bond mainly depends on the ability of the borrower to service the debt obligations as per the bond indenture.

3.1.1 Government Bonds/Sovereign Bonds/Gilt edged Bonds

A sovereign bond is issued by the government and is typically denominated in the domestic currency to support planned and unplanned expenditures. Government bonds are also known as “sovereign debt” and are generally issued via auctions and traded in the secondary market. Government bonds issued in local currency are considered risk free as the Government, being a sovereign entity, can print the currency to repay its obligation to bondholders. However, as demonstrated during the European debt crisis (2008-2012), Governments may also default in debt payments in case of an emergency situation. Because of their relative low risk, government bonds typically pay lower interest rates than the bonds issued by other issuers in the country.

In India, government bonds constitute the largest segment of the fixed income market. This also includes the securities issued by the various State Governments and Union Territories, which are known as State Development Loans (SDLs). Indian Government Securities market (G-sec) also includes the special securities issued by the central and state governments in India. Special securities are issued by the Government for providing various subsidies like oil, fertilizer, bank recapitalization, etc.

3.1.2 Municipal Bonds

Local authorities may also issue bonds to fund projects such as infrastructure, libraries, or parks. These are known as “municipal bonds”. Municipal bonds are also known as “muni bonds” or “muni”. A municipal bond is categorized based on the source of its interest payments and principal repayments. In India, while very few local authorities or municipal authorities have issued such bonds, the market is gradually picking up.

3.1.3 Corporate Bonds

A Corporate Bond and/or Non-Convertible Debentures (NCDs) is issued by a corporate to raise capital. The performance of the bond during its life depends on future revenues and profitability of the corporate. Debt is typically cheaper source of financing for corporates, and, unlike issuance of more equity, their ownership structure is not diluted. In some cases, the corporate’s physical assets may be used as collateral. Corporate bonds carry higher risk vis-a-vis government bonds and hence the bond holders expect higher interest rates to compensate for the additional risk they take while investing in the bond. Corporates issue short term papers like Commercial Papers (CPs) to fund their short-term requirement or for their working capital funding.

The corporate papers are issued either through public issuance or private placements. The creditworthiness of the issuer (i.e., issuer’s ability to discharge its financial obligations) is to be assessed periodically by one or more of credit rating agencies. The bond’s credit rating, and ultimately the company’s credit rating, impacts the market price of the bond in both primary and secondary markets. The Credit Rating Agencies (CRAs) assign ratings through letter grades for their common and global understanding. The highest quality (and safest) bonds are given “AAA”, while the high risk bonds are known as “junk” or “high-yield bonds”. The difference between the yields on corporate bonds and government bonds is called the credit spread.

3.1.4 Securitized Debt

Securitization is the process of monetizing illiquid loan assets of a lender such as a bank, into a liquid pool of tradable assets. Securitization is achieved by creation of a Special Purpose Vehicle (SPV) and structuring the pool of loans into tradable bonds. Securitized (or asset-backed) securities transfer ownership of assets (i.e., loans and receivables) to the SPV.

3.2 Classification of fixed income securities based on Maturity

Bonds are issued for various maturities depending on the requirement of funds as well as the demand from the investors. Long term bonds are generally costlier than short term loans as the funds are locked in for a longer period of time while investors may suffer from illiquidity. Bonds may be classified in terms of maturities like ultra- short term, short term, medium term and long term. Short term borrowings are typically made for working capital requirement where as long term funds are used for project, capital and infrastructure funding. The returns on bonds by similar rating class of issuers also vary according to the maturity, which forms the basis of yield curve theories.

3.2.1 Overnight Debt/Borrowings

Typically, banks borrow overnight funds from the money market as well as from the RBI. These borrowings can be collateralized or clean. Collateralized borrowings cost less vis-à-vis clean borrowings. The RBI plays a very important role in this market through absorption or supplying liquidity through banks and Primary Dealers.

3.2.2 Ultra-Short-Term Debt (Money Market)

Short term borrowings up to one year are covered under this category. Mostly, money market instruments like Commercial Papers (CP), Certificate of Deposits (CD), Treasury Bills (TB), Cash Management Bills (CMB), etc. belong to this category.

3.2.3 Short Term Debt

Bonds with maturity spanning from 1 to 5 years are referred to short term bonds. Bonds maturing within a year are classified under money market instruments as discussed above.

3.2.4 Medium Term Debt

These are bonds maturing in 5 to 12 years. These are also referred to as intermediate bonds. Generally, the bulk of debt issuances take place in this segment.

3.2.5 Long Term Debt

These are bonds with maturity beyond 12 years. Mostly Government of India bonds are of long-term maturity.

3.2.6 Staggered Maturities

Some bond issues are packaged as a series of different bonds with different or staggered maturities. Every few years a portion of the bond issue matures and is paid off. Staggering maturities in this fashion allows the issuing company to retire the debt in an orderly fashion without facing a large one-time need for cash, as would be the case if the entire issue were to mature at once. Serial payments pay off bonds according to a staggered maturity schedule.

3.3 Classification of fixed income securities based on Coupon

The promised interest as per the indenture of the bond is referred to as the coupon. The coupon payments on bonds have a pre-determined payment frequency and may be paid annually, semi-annually, quarterly or monthly. Bonds are classified on the basis of coupons, as these are returns on the investment made by the holders.

3.3.1 Plain Vanilla Bonds

A plain vanilla bond is the simplest form of a bond with a fixed coupon and defined maturity and is usually issued and redeemed at face value. It is also known as a straight bond or a bullet bond. These bonds have intermittent cash flows in the form of coupons received as well as the final cash flow of the face value of the bond on maturity.

3.3.2 Zero-Coupon Bonds

A zero coupon bond (ZCB) is a discounted instrument which does not pay any interest and are redeemed at the face value of the bond at the time of maturity. These bonds are issued at a discount and redeemed at the face value with the difference amounting to the return earned by the investor. ZCBs have a single cash flow at maturity which is equal to the face value of the bond. Common examples of ZCBs in India include Treasury Bills, Cash Management Bills and STRIPS created by separating and trading independently (in other words “stripping off”) the coupons from the final principal payment of normal bonds. ZCBs are highly sensitive to changes in the interest rate as they do not have intervening cash flows and are generally used by long term fixed income investors such as pension funds and insurance companies to gauge and offset the interest rate risk of these firms’ long-term liabilities.

3.3.3 Floating Rate Bonds

Floating rate bonds (FRBs) do not pay any pre-fixed coupons but are linked to a benchmark interest rate (generally a short-term rate like the 182-day Treasury bill rate etc. in India). The coupon rate is reset on each coupon payment date. When the general interest rate rises in the market, the benchmark interest rises and hence does the coupon on the FRBs. The same situation reverses when the interest rate falls. FRBs typically trade very close to their face value as interest resets happen at regular intervals. These instruments are generally immune to interest rate risk and are considered conservative investments.

3.3.4 Caps and Floor

Most FRB issuers may issue bonds which will cap their interest payment obligation if the interest rate rises. These instruments may also provide for a floor beyond which the interest rate will not fall in order to protect the interest of the investors. If an FRB has both a cap to protect the issuer and a floor to protect the investor, it is called a “Collar”.

3.3.5 Inverse Floater

These types of bonds are similar to FRBs in that the coupon is related to the benchmark linked to the bond (but it is inversely related in case of Inverse Floaters). If the benchmark increases, the Coupon falls and vice versa. For example, in India generally the interest rate on such bonds is linked to a negative spread over the fixed coupon rate. The spread is usually few percentage points over the benchmark MIBOR rate. If the interest rates go up, corporates end up paying less as the coupon will be a few percentage points lower than the original coupon rate. This has mostly been used by NBFCs to raise funds while mutual funds are the primary investors.

3.3.6 Inflation Indexed Bonds

These are a type of FRBs which protect investors from the adverse effects of rising prices by being indexed to an inflation measure like the WPI (Wholesale Price Index) or CPI (Consumer Price Index) in India. Only the face/par value or both par value and coupons may be indexed against the inflation measure.

3.3.7 Step Up/Down Bonds

Step up bonds are designed to pay lower coupon in the initial years of the bond and higher coupon towards maturity. These bonds are preferred by issuers like start- ups who expect their cash flows to balloon after some time and hence would like to service the bonds with lower cash flows at the beginning. The investors of these bonds also take higher risk as higher cash flows are expected after some time and hence expect higher interest rate to make the investment attractive. These bonds are generally risky.

Step down bonds are the exact opposite of step up bonds. These bonds pay high interest at the beginning of the bond and as the time moves towards maturity, the coupon drops. Such bonds are usually issued by companies where revenues/profits are expected to decline in a phased manner; this may be due to wear and tear of the assets or machinery as in the case of leasing. The step up and step down bonds are used for better cash flow planning of both issuers and investors.

3.3.8 Deferred Coupon Bonds

This is a mixture of coupon paying bond and a ZCB. In the initial years, these bonds do not pay any interest, but these bonds pay very high interest after a few years and typically few years before the maturity. The corporates having high gestation period typically prefer this kind of arrangement.