The Types of Bonds and Fixed Income Assets Finally Explained in Context of Nepal's Capital Market

Article by Nitesh Patel

Government securities

Government securities (G-secs) are issued by the NRB on behalf of the government. G-secs represent the borrowing of the government, mostly to meet the deficit. The deficit is the gap between the government’s income and expenditure. G-secs are issued through auctions that are announced by NRB from time to time. Banks, mutual funds, insurance companies, provident fund trusts, and such institutional investors are large and regular buyers of G-secs.

With a view to encouraging retail participation, the government has reserved 5% of the auction amount in every auction for non-competitive buyers, including retail investors. In order to buy G-secs, retail investors have to open a constituent SGL (CSGL) account with their bank or any other holder of SGL (Securities General Ledger) accounts. The CSGL account is held as part of the accounts of the offering bank, in which the G-secs are held as electronic entries in Demat form. Investors can also transfer the G-secs to their normal Demat account, after buying them. The minimum investment amount is Rs. 10000. Investors can apply for buying G-secs through their SGL-holding bank and make the payment through their bank. The price at which the retail investors are allotted G-secs as non-competitive bidders will be the weighted average price of the successful bids in the auction.

There is no cumulative option in a G-sec. Interest is paid out on pre-specified dates into the designated bank account of the investor. Interest is not subject to TDS but is fully taxable. Redemption proceeds are also paid into the bank account. Though there is a retail debt market segment in which all issued G-secs can be traded, there is limited liquidity for small lots of G-secs. The institutional market where the trading lot is Rs.5 crore is quite active.

Retail investors may have to hold the G-secs to maturity. G-secs can be offered as collateral for taking a loan from a bank. G-secs are benchmark securities in the bond market and tend to offer a lower interest rate compared to other borrowers for the same tenor. This is because there is no credit risk or risk of default in a G-sec.

The price of the bonds in the secondary market will respond to changes in interest rates. An increase in interest rates sees the price of existing bonds depreciate and vice versa. The extent of change in the price of bonds is a function of its features, and bonds with a higher tenor see a greater change in price for a change in interest rates. The low liquidity in the secondary retail markets may mean that investors may not be able to sell and realize the gains in price if any.

Inflation-Indexed Bonds

Inflation-Indexed Bonds (IIB) are a category of government securities issued by the NRB which provides inflation-protected returns to the investors. These bonds have a fixed real coupon rate which is applied to the inflation-adjusted principal on each interest payment date. On maturity, the higher the face value, and the inflation-adjusted principal is paid out to the investor. Thus, the coupon income, as well as the principal, is adjusted for inflation.

The inflation adjustment to the principal is done by multiplying it with the index ratio. The index ratio is calculated by dividing the reference index on the settlement date by the reference index on the date of issue of the security. The Wholesale Price Index (WPI) is the inflation measure that is considered for the calculation of the index ratio for these bonds.

Corporate Bonds

Corporate bonds are debt instruments issued by private and public sector companies. They are issued for tenors ranging from two years to 15 years. The more popular tenors are 5- year and 7-year bonds. Most corporate bonds are issued to institutional investors such as mutual funds, insurance companies, and provident funds through a private placement of securities. Companies may also raise funds from the public by making a public issue of bonds where retail investors are called upon to invest.

Bonds of all non-government issuers come under the regulatory purview of SEBON. They have to be compulsorily credit-rated and issued in the Demat form. The coupon interest depends on the tenor and credit rating of the bond. Bonds with the highest credit rating of AAA, for example, are considered to have the highest level of safety with respect to repayment of principal and periodic interest. Such bonds tend to pay a lower rate of interest than those that have a lower credit rating such as BBB which is seen as having a high credit or default risk. All public issues of bonds have to be mandatorily listed on a stock exchange. A privately placed bond may also be listed on a stock exchange if it meets the listing requirements.

Corporate bonds can be issued using various cash flow structures. A plain vanilla bond will have a fixed term to maturity with a coupon being paid at pre-defined periods and the principal amount is repaid on maturity. The bond is usually issued at its face value, say, Rs. 100 and redeemed at par, the same Rs. 100. The simple variations to this structure could be a bond issued at a premium or discount to the face value or redeemed at a premium or discount to face value. In some cases, the frequency of the interest payment could vary, from monthly, to quarterly and annual. Or, the bonds could feature a cumulative option where the interest is not paid out to the investor periodically but instead re-invested and paid out along with the principal at maturity. The yield to the investor is higher in such an option because of the re-investment returns. Apart from a regular fixed-interest-paying bond, the other types of bonds issued are: zero-coupon bonds, floating-rate bonds, and bonds with put or call options. Convertible bonds, allow investors to convert the bond fully or partly into equity shares, in a pre-determined proportion. Interest earned is fully taxable.

The price of the bonds in the market will respond to changes in interest rates. Secondary market trading in corporate bonds is usually concentrated among institutional investors and the market is not very liquid for retail investors. Apart from credit risk, retail investors also bear liquidity risk while buying these bonds.

Infrastructure Bonds

The government announces from time to time, a list of infrastructure bonds, investment in which is eligible for deduction. Bonds issued by financial institutions like the Industrial Development Bank of Nepal, Nepal Infrastructure Finance Company Ltd., and Agricultural bank eligible for such deduction. The bonds are structured and issued by these institutions as interest-paying bonds, zero-coupon bonds, or any other structure they prefer.

The terms of the issue such as tenor, rate of interest, and minimum investment may differ across the bonds. What is common is that these bonds have a minimum lock-in period (which could be three years or five years) during which they cannot be transferred or pledged.

Infrastructure bonds are compulsorily credit-rated and can be issued in the Demat form. Interest from these bonds is taxable. Infrastructure bonds do not carry any government guarantee.

Bank Deposits

A bank fixed deposit (FD) is also called a term or time deposit, as it is a deposit account with a bank for a fixed period of time. It entitles the investor to pre-determined interest payments and return of the deposited sum on maturity. Fixed bank deposits offer higher returns than savings accounts as the money is available for use by the bank for a longer period of time. Fixed deposits are preferred by investors who like the safety that a bank provides and do not have an immediate need for funds.

Bank FDs are considered to be a safe investment option. This is because each depositor is insured up to Rs. 1 lakh by the Deposit Insurance and Credit Guarantee Corporation (DICGC). It includes all deposits and interest on them, held across branches of a given bank. A fixed deposit is created by opening an FD account with the bank which in turn issues an FD receipt. Interest on an FD can be paid into the depositor’s savings bank account at a predefined frequency, or accumulated and paid at the end of the term. On maturity, the lump sum deposit amount is returned to the investor.

Investors can also choose to renew the deposit on the maturity date. The minimum deposit amount varies across banks. The duration of deposits can range from 14 days to 10 years though FDs longer than 5 years are not very common.

Alternate Investments

Alternative investments refer to those investments whose risk and return structures differ from the traditional asset classes such as equity and debt. They could be linked to the real economy more strongly than other financial instruments normally are. The low correlation of returns of such investments with that of traditional investments enhances the diversification benefits in a portfolio in which these investments are included. The overall risk in the portfolio reduces. However, such investments typically tend to have a higher risk and lower liquidity and do not trade like other assets. Investors have limited information available about them. They are therefore suitable as an investment option for investors willing to take greater volatility in returns, longer investment horizons, and lower liquidity for better returns. Some of the alternate investments may require investing in physical assets.

Alternate investments are relatively illiquid and therefore it is difficult to determine the current market value of the assets. This also leads to limited historical data on performance and a low concentration of analysts tracking alternates.

In general, alternate asset classes tend not to move in lock-step with traditional asset classes; i.e., they have low correlations to stocks and bonds. Notice in the picture how different asset classes perform in various phases of an economic cycle.

Article by Nitesh Patel, (MBA-B&FE_CU)