Key Fixed Income Terms

If you read about fixed income investments in fund factsheets, scheme information documents, fund manager interviews, blogs, etc you will come across some technical terms which you may not understand. Here we will try to briefly explain and demystify some key fixed income terms, so that you have a better understanding of fixed income as an asset class.

  • Repo rate: This is the rate at which the RBI lends money to commercial banks if they are facing funds shortfall. RBI uses repo rate to control inflation. If RBI increases repo rate, it is a signal for banks to increase lending rates and vice versa. It is therefore, the key interest rate of the economy.
  • Maturity: The maturity of a fixed income instrument is the date on which the issuer repays the principal (face value of the instrument) to the investor. The issuer will also make periodic interest payments (coupon) during the maturity term. The maturity of a debt fund is weighted average maturities of the individual instruments in the scheme’s portfolio.
  • Yield to Maturity (YTM): YTM of a fixed income instrument is the yield (return on investment) if you buy the instrument at its current price and hold it till its maturity. When calculating yields, both interest payments (coupons) and principal payment (face value) on maturity must be taken into consideration. YTM can change over time depending on interest rate movement – as interest rates rise, YTM will also rise and vice versa. YTM of a debt fund is weighted average YTMs of individual instruments in the scheme’s portfolio.
  • Duration: Modified Duration or simply duration is the interest rate sensitivity of a fixed income instrument. For example, if the duration of an instrument is 3 years, then for every 1% fall in interest rate, the price of the instrument will rise by 3% and vice versa. Duration is related to maturity i.e. longer the maturity, longer the duration.
  • Credit Rating: Credit rating is a measure of the creditworthiness, in other words, the financial ability of the issuer to meet interest and principal payment obligation. Credit ratings are assigned by specified agencies like CRISIL, ICRA etc. Credit rating of an instrument may change over time, depending on improving or worsening financial strength of the issuer. If the credit rating of an instrument gets downgraded, its price will fall and vice versa.
  • Non convertible debentures: Non convertible debentures (NCD) are long term debt instruments issued by companies to raise funds. They are also commonly known as corporate bonds. Please note that unlike convertible debentures, NCDs cannot be converted to equity. NCDs pay fixed interest (coupon) and principal (face value) on maturity. The interest paid by NCDs is usually higher than Bank FDs.
  • Commercial paper: Commercial papers (CPs) are short term fixed income instruments issued by companies to meet working capital or other short term funding requirements. CPs have maximum maturities of one year. CPs are usually issued at a discount to face value and you will get the face value on maturity. Since CPs are unsecured instruments, they usually pay higher interest than secured bond
  • Gilts:Government securities (G-Secs) are also known as Gilts. Like other bonds, Gilts have fixed maturities, during which they pay interest (coupons) and principal (face value) on maturity. Since they are issued by the Government, Gilts have no credit risk but long term Gilts have high interest rate sensitivity due to their long durations.
  • Yield curve: Yield curve is a line chart showing yields of bonds (usually G-Secs) of different maturities. Usually, longer the maturity of a bond, higher is its yield. Therefore, the most common shape of the yield curve is upward sloping. However, from time to time, the yield curve can also be downward. Fund managers use yield curve to adjust their investment strategies.
  • Indexation: With indexation, the investor is allowed to adjust the price of purchase to reflect inflation for capital gains tax. For example, if you invested in a debt fund in FY 2016 at a NAV of Rs 100 and sold it in FY 2020 at a NAV of Rs 125, you will be allowed to adjust your purchase NAV by a factor of 1.137 (ratio of cost of inflation index in FY 2020 and FY 2016) and your adjusted purchase price will be Rs 113.7. Long term capital gains (held for more than 3 years) in debt funds are taxed at 20% after indexation.

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