Debt market instruments:

The main debt instruments are bonds, which are fixed-income securities. The investor (who is the lender) gets periodic interest payments over the life of the bond and the principal payment at the time of redemption of the bond. The issuer of the bond (who is the lender, that is who undertakes to bear the debt) promises to pay the holder (buyer) of the bond this periodic stream of payments and the principal at the end. Debentures are like bonds, except that there is a clause that enables the investor to convert the debenture into equity shares on certain pre-specified terns and conditions.

There are short-term debt instruments, about which you studied in detail in the previous unit on money markets, like treasury bills, certificates of deposits, commercial paper etc. In this unit we limit ourselves to a study of bonds. Bonds are issued by governments and these are government-guaranteed. For example, in India, the Government of India is the largest borrower. The government sells short-term to medium-term bonds issued by the Reserve Bank of India. State governments also sell bonds. Apart from the central and state governments, a number of government agencies issue bonds that are guaranteed by the government. Other than government bonds, there are bonds issued by public sector companies, financial institutions, and private sector companies.

Over the last couple of decades, there have been several innovations in the types of bonds that have been issued.  Traditionally simple bonds have been issued (these are known as 'plain vanilla bonds' or straight bonds). These bonds usually pay a fixed periodic coupon over its life and return the principal on the maturity date. The new types of bonds are of several types: zero coupon bonds; floating rate bonds; bonds with embedded options; and commodity-linked bonds. These are explained below.

Zero coupon bonds do not give regular interest payments. It is issued at a large discount and redeemed at face value on maturity. Sometimes, these bonds carry call and put options. You will know about put and call options in the next unit. Floating rate bonds, unlike straight bonds that pay a fixed rate of interest, pay an interest rate that is linked to a benchmark rate such as the interest rate on Treasury bills. Bonds with embedded options include bonds like debentures that give the bond holder the right to convert them into equity shares; as well as callable bonds, which are bonds that give the issuer the right to redeem them prematurely on certain terms; and bonds with put options, which are bonds that give the investor the right to prematurely sell them back to the issuer on certain terms. Finally there are commodity-linked bonds that are bonds the return from which depend on the price of  certain specified commodities.