Bonds and Debentures

🟢 Lite — Quick Review (1h–1d)

Rapid summary for last-minute revision before your exam.

Bonds and debentures are debt instruments that allow issuers (governments, corporations, municipalities) to borrow money from investors. Understanding these instruments — their pricing, yields, risk profiles, and tax treatments — is critical for the RBI Grade B examination, especially for the Finance and Economic & Social Issues sections.

Key Facts for RBI Grade B:

• A bond is a fixed-income instrument with a face value (typically ₹1,000), a coupon rate (interest), and a maturity date.
• The yield is the effective return on a bond — influenced by the coupon rate, purchase price, and time to maturity.
• Government Securities (G-Secs) are the safest bonds in India — backed by the government.
• Corporate bonds carry credit risk — rated by agencies (CRISIL, ICRA, CARE).
• The Yield Curve plots bond yields against maturities — an important tool for predicting economic conditions.
• YTM (Yield to Maturity) is the total return anticipated if a bond is held until it matures.

⚡ Exam tip: Bond pricing, YTM calculations, yield curve concepts, and the distinction between different types of bonds are frequently asked in RBI Grade B.

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🟡 Standard — Regular Study (2d–2mo)

Standard content for students with a few days to months.

Bond Fundamentals

Definition and Key Terms

A bond is a debt security where an investor lends money to a borrower (issuer) for a specified period at a predetermined interest rate (coupon):

Key Terms:

Term	Definition
Face Value (Par Value)	The nominal value of the bond, typically ₹1,000 — returned at maturity
Coupon Rate	Annual interest rate paid on the bond (e.g., 7% of face value)
Maturity Date	Date when the bond expires and face value is repaid
Current Price	Market price of the bond — may be above or below par
Yield	The effective return on the bond, expressed as a percentage
Tenure	Time remaining until maturity

Types of Bonds

By Issuer

1. Government Securities (G-Secs):

• Issued by the Central Government (Gilt-edged securities) or State Governments (SDLs — State Development Loans)
• Risk: Zero default risk — backed by the government
• Tenure: 1 year to 30+ years
• Taxation: Interest taxable; capital gains taxable
• Tradable on NSE and BSE

2. Corporate Bonds:

• Issued by private companies, PSUs, banks
• Risk: Credit risk — possibility of default
• Rated by CRISIL, ICRA, CARE, Fitch, Brickwork
• Higher yields than G-Secs to compensate for higher risk

3. Public Sector Undertakings (PSU) Bonds:

• Issued by government-owned corporations
• Backed (implicitly) by the government
• Considered nearly risk-free

By Coupon Type

1. Fixed Rate Bonds:

• Coupon rate remains constant throughout the bond’s life
• Most common type

2. Floating Rate Bonds:

• Coupon rate changes with a reference rate (e.g., linked to repo rate or Treasury bill rate)
• Advantage: Investor benefits if rates rise

3. Zero Coupon Bonds:

• No periodic interest payments
• Issued at a deep discount to face value
• Face value paid at maturity
• Example: T-Bills are zero coupon instruments

By Security

1. Secured Bonds:

• Backed by collateral — specific assets
• In case of default, bondholders can claim the collateral

2. Unsecured Bonds (Debentures):

• Not backed by collateral
• Relies on the issuer’s creditworthiness
• Higher risk than secured bonds

Bond Pricing — Core Concept

Bond Price = PV of Coupon Payments + PV of Face Value

The Present Value (PV) is calculated by discounting at the yield (YTM):

Bond Price = Σ [Coupon / (1+YTM)^t] + [Face Value / (1+YTM)^n]

Where:

• t = year (1, 2, 3… n)
• n = number of years to maturity
• YTM = Yield to Maturity

Example:

• Face Value: ₹1,000
• Coupon Rate: 7% (annual coupon = ₹70)
• Maturity: 5 years
• YTM: 8%

Bond Price = ₹70/(1.08)¹ + ₹70/(1.08)² + ₹70/(1.08)³ + ₹70/(1.08)⁴ + ₹70/(1.08)⁵ + ₹1,000/(1.08)⁵

Bond Price = ₹64.81 + ₹60.01 + ₹55.57 + ₹51.45 + ₹47.64 + ₹680.58 = ₹960.06

This bond trades at a discount because YTM (8%) > Coupon Rate (7%).

Rule: When YTM > Coupon Rate → Bond trades at discount When YTM < Coupon Rate → Bond trades at premium When YTM = Coupon Rate → Bond trades at par

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YTM (Yield to Maturity) — Detailed

Definition

YTM is the total return anticipated on a bond if held until maturity, assuming all payments are made on time.

YTM Formula (Approximation)

YTM ≈ [Annual Coupon + (Face Value - Current Price)/Years to Maturity] / [(Face Value + Current Price)/2]

Example:

• Face Value: ₹1,000
• Current Price: ₹960
• Annual Coupon: ₹70
• Years to Maturity: 5

YTM ≈ [70 + (1,000 - 960)/5] / [(1,000 + 960)/2] YTM ≈ [70 + 8] / 980 YTM ≈ 78 / 980 = 7.96%

Determinants of Bond Yields

1. Interest Rate Environment: Rising rates → bond prices fall → yields rise
2. Credit Quality: Lower rated bonds → higher yields to compensate
3. Time to Maturity: Longer tenure → typically higher yield (normal yield curve)
4. Liquidity: Less liquid bonds → higher yields

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The Yield Curve

Definition

The Yield Curve plots the yields (interest rates) of bonds against their maturities:

Yield (%)
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        1yr  3yr  5yr  10yr  20yr

Types of Yield Curves

1. Normal (Upward Sloping):

• Short-term yields < Long-term yields
• Most common — reflects normal economic conditions
• Interpretation: Investors demand higher returns for longer commitment

2. Inverted (Downward Sloping):

• Short-term yields > Long-term yields
• Interpretation: Often a predictor of recession — markets expect future rate cuts

3. Flat:

• Short-term and long-term yields are similar
• Interpretation: Transition between normal and inverted

What the Yield Curve Signals

Normal Curve → Economic expansion Inverted Curve → Recession ahead Steepening Curve → Recovery beginning

The RBI and the Yield Curve

The RBI’s Monetary Policy Committee (MPC) uses the yield curve to assess:

• Inflation expectations
• Economic growth prospects
• Market interest rate expectations

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Debentures — Distinction from Bonds

Feature	Debenture	Bond
Issuer	Usually corporations	Usually government or PSUs
Security	Generally unsecured	Usually secured by assets
Registration	Not always mandatorily registered	Usually registered
Trust Deed	Mandatorily issued with trust deed	Required for bonds

Types of Debentures

1. Non-Convertible Debentures (NCDs):

• Cannot be converted into equity shares
• Pay fixed interest — popular investment option

2. Partly Convertible Debentures (PCDs):

• Part converts into equity; part remains as debt

3. Fully Convertible Debentures (FCDs):

• Entire debenture converts into equity at a predetermined ratio

4. Zero Interest Debentures:

• No coupon — issued at deep discount
• Face value paid at maturity

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🔴 Extended — Deep Study (3mo+)

Comprehensive coverage for students on a longer study timeline.

Duration and Modified Duration

Duration

Duration measures a bond’s sensitivity to interest rate changes — expressed in years:

Macaulay Duration:

• Weighted average time to receive all cash flows (coupons and principal)
• Higher duration → Higher sensitivity to rate changes

Modified Duration:

• Modified Duration = Macaulay Duration / (1 + YTM/n)
• Measures the % change in bond price for a 1% change in yield

Example:

• Modified Duration = 5 years
• If yields rise by 1% → Bond price falls by approximately 5%
• If yields fall by 1% → Bond price rises by approximately 5%

Why Duration Matters

For RBI Grade B, understanding duration is crucial because:

• When RBI raises repo rates, bond prices fall
• The extent of price change depends on duration
• Portfolio managers use duration to manage interest rate risk

Practical application:

• If you expect RBI to raise rates, invest in short-duration bonds (lower duration)
• If you expect RBI to cut rates, invest in long-duration bonds (higher duration) — prices will rise more

Credit Rating Agencies

In India, credit rating agencies assess bond credit quality:

Agency	Rating Symbol
CRISIL	CRISIL AAA, AA, A, BBB
ICRA	ICRA AAA, AA, A, BBB
CARE	CARE AAA, AA, A, BBB
India Ratings	IND AAA, AA, A, BBB

Rating meanings:

• AAA (or highest): Extremely strong capacity to pay interest and principal — virtually no default risk
• AA: Very strong capacity — slightly higher risk than AAA
• A: Strong capacity — susceptible to adverse changes
• BBB: Adequate capacity — but adverse conditions could impair it
• Below BBB: Junk status — speculative

Taxation of Bonds

Bond Type	Interest/Tax	Capital Gains Tax
G-Secs	Taxable at slab rate	Capital gains taxable
Corporate Bonds	Taxable at slab rate	Capital gains taxable
Capital Gains Bonds (54EC)	Tax-free	Locked; 54EC bonds
Infrastructure Bonds	Section 80CCF eligible	—

Capital Gains Bonds (54EC):

• Exempt from capital gains tax if proceeds reinvested
• Lock-in: 5 years
• Available for: NHAI, REC, PFC bonds

Practice Questions for RBI Grade B

1. A bond with face value ₹1,000, coupon rate 8%, maturity in 5 years, is trading at ₹950. Calculate its approximate YTM.
2. What is the difference between a bond trading at par, at a discount, and at a premium?
3. What does an inverted yield curve indicate about the economy?
4. What is the difference between a debenture and a bond? Which is generally safer?
5. If the repo rate rises, what happens to bond prices? Explain with reference to duration.

Common Mistakes to Avoid

• Confusing coupon rate with yield — coupon rate is fixed; yield changes with bond price.
• Forgetting that bond prices and yields move in opposite directions — when yields rise, bond prices fall.
• Confusing duration with maturity — they are related but different; duration is a measure of interest rate sensitivity.

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