What Is Debt…?
- Debt is an amount of money borrowed by one party from another.
- Debt is used by many corporations and individuals as a method of making large purchases that they could not afford under normal circumstances.
- A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest.
Risks in Debt
- Credit Risk
- Default Risk
- Interest Rate Risk
Credit Risk
Credit risk is better termed “Credit RATING RISK” which is the risk that a bond gets its credit rating changed. If bond ratings changes from AAA to A, it means there is a large increase in risk, usually due to a worsening financial or political situation.
Let us take an example of a company TCS
TCS issues a bond for ₹100/- per bond at 9% interest. Suppose the credit ratings of TCS Bond is AA. If credit rating improves from AA to AAA the bond can trade at ₹105/- instead of ₹100/-. If the credit rating impared from AA to A then the bond can trade at ₹95/- instead of ₹100/-. Now, this is called credit risk.
Default Risk
Default risk is the risk that a borrower fails to make Principle or interest payments when they are due. Default risk affects the interest rate charged on a debt instrument. The greater the default risk, the higher the interest rate charged by lenders.
Interest Rate Risk
The risk of value depreciation of bonds and other fixed-income investments is known as interest rate risk. Primarily due to depreciation in their interest rates, this happens because of market fluctuations. Such risk affects many types of investments, though it primarily affects fixed-income investments.
Effects of Interest Rates on Bond Prices and Debt Fund Net Asset Value (NAV)
Interest Rates ↑ Bond Value ↓ Debt Fund NAV ↓
Interest Rates ↓ Bond Value ↑ Debt Fund NAV ↑
Let us take an example of the Company TCS
TCS issues a 5 year bond for ₹100/- per bond at 9% interest. If the interest rate comes down to 8% the price of the bond can rise to ₹105/- and if the interest rate rise to 10% the price of the bond can depreciate to ₹95/-.
Types of Debt:-
| Money Market | Long Term Fixed Income |
| Invests for less than one Year | Invests for More than one year |
| Treasury Bill (TBill’s) | |
| Commercial Papers (CP’s)
Certificate of Deposits (CD’s) |
Bonds
· Government of India & State Development Loans (SDL’s) · Corporate Securities |
| Collaterized Borrowing and Lending Obligation (CBLO), Triparty Repo (TREP’s) | Non-Convertible Debentures (NCD’s), Pass Through Certificates (PTC’s) |
Do you know?
Why Debt have different names like TBill’s, CP’s, CD’s, CBLO, Gsec, SDL’s, NCD’s, PTC’s?
Because the tenure of the product is different and Borrowers are different.
| Borrowers | Money Market | Long Term Fixed Income |
| Tenure | Invests for less than one Year | Invests for More than one year |
| Central Government | Treasury Bill (TBill’s) | Government Securities (Gsec), State Development Loans (SDL’s) |
| Banks | Certificate of Deposits (CD’s) | Fixed Deposits |
| Corporates | Commercial Papers (CP’s) | NCD’s, Debentures, Corporate Securities |
Is there any risk associated with the Money Market and Long-Term Fixed Income instruments?
| Product | Borrowers | Can Default or not |
| Treasury Bill (TBill’s) | Central Government | No |
| Commercial Papers (CP’s) | Corporates | Yes |
| Certificate of Deposits (CD’s) | Banks | No |
| CBLO / TREPS | Banks | No |
| NCD’s, Debentures, Corporate Securities | Corporates | Yes |
| Gsec, SDL’s | Central / State Government | No Since Guaranteed by RBI |
Collateralized Borrowing and Lending Obligation (CBLO)
- CBLO is a money market instrument that represents an obligation between a borrower and a lender concerning the terms and conditions of a loan.
- These instruments are operated by the Clearing Corporation of India Ltd. (CCIL) and Reserve Bank of India (RBI), with CCIL members being institutions with little to no access to the interbank call money market in India.
- The instrument works like a bond where the lender buys the CBLO and a borrower sells the money market instrument with interest.
- CBLOs allow those restricted from using the interbank call money market in India to participate in the short-term money markets.
State Development Loans (SDL)
- State Development Loans (SDL) are debt issued by state governments to fund their fiscal deficit. SDL issues are managed by the RBI, which also makes sure that the SDL\’s are serviced by monitoring escrow accounts for payment of interest and principal.
- The SDL market is similar to that of the government bond market. SDL\’s are traded electronically on the NDS-OM (Negotiated Dealing System-Order Matching) and traded in the voice market (NDS).
Triparty Repo (TREPs)
- Transactions in the overnight triparty Repo Dealing and Settlement (TREPs) are being done by banks, mutual funds, NBFCs and others with government securities as collateral. These transactions can be done for various duration ranging from overnight to as long as 365 days.
Pass Through Certificate (PTC)
Pass Through Certificates are high quality debt instruments that represents ownership in a pool of assets and derive monthly principle and interest payments from those assets. PTC’s are nothing but securitization i.e. transforms illiquid assets in to liquid assets.
Modified Duration
Modified duration is a formula that expresses the measurable change in the value of a security in response to a change in interest rates. Modified duration follows the concept that interest rates and bond prices move in opposite directions.
Let us take an example where interest decreases, what will be the effect on the Fund.
| Interest Rate Decreases by | Fund A Modified Duration
5 Years |
Fund B Modified Duration
2 Years |
| 1% | 1% * 5 Years = 5%
Yield to Maturity + 5% |
1% * 2 Years = 2%
Yield to Maturity + 2% |
| 0.5% | 0.5% * 5 Years = 2.5%
Yield to Maturity + 2.5% |
0.5% * 2 Years = 1%
Yield to Maturity + 1% |
When Interest rates falls invest in medium duration or long duration debt funds.
Let us take another example where interest increases, what will be the effect on the Fund.
| Interest Rate Increases by | Fund A
Modified Duration 5 Years |
Fund B
Modified Duration 2 Years |
| 1% | 1% * 5 Years = 5%
Yield to Maturity – 5% |
1% * 2 Years = 2%
Yield to Maturity – 2% |
| 0.5% | 0.5% * 5 Years = 2.5%
Yield to Maturity – 2.5% |
0.5% * 2 Years = 1%
Yield to Maturity – 1% |
When Interest rates falls invest in Low duration or Short duration debt funds.