Sources of Income from Debt Products

Debt products generate returns primarily through contractual cash‑flows defined at issuance. The most common component is the coupon or interest payment, which is a fixed or floating rate paid periodically (usually semi‑annual or annual) to the bondholder. This cash‑flow is predetermined in the bond indenture and does not depend on the market price of the security.

Besides coupon, investors may earn income from the discount or capital gain that arises when a security is bought below its face value (zero‑coupon bonds) or when it is sold at a higher price in the secondary market. The gain is realised at maturity or at the time of sale and reflects the difference between purchase price and redemption value.

Other sources include redemption premium (extra amount paid at maturity for certain callable or high‑yield bonds), accrued interest (interest earned between coupon dates), and occasional call/put premiums when the issuer or holder exercises embedded options. Each source has distinct tax treatment, which the exam frequently tests.

• Coupon – regular interest paid as per the bond’s coupon rate.
• Discount/Capital Gain – profit from price appreciation or zero‑coupon discount.
• Redemption Premium – extra amount over face value at maturity.
• Accrued Interest – interest earned but not yet paid.

The coupon is expressed as a percentage of the bond’s face (par) value. For a ₹1,000 face value bond with a 7% annual coupon, the investor receives ₹70 each year, irrespective of the bond’s market price. Coupon income is taxed in the hands of the investor as "Income from Other Sources" under Indian tax law.

In floating‑rate notes (FRNs), the coupon is linked to a reference rate such as MCLR or RBI’s repo rate plus a spread. The cash‑flow varies with the reference rate, but the calculation principle remains the same – coupon = face value × applicable rate × day‑count fraction.

For the exam, you may be asked to compute annual coupon income, identify the tax head, or compare fixed‑rate versus floating‑rate interest. Pay attention to the frequency (semi‑annual vs. annual) because the total annual coupon is the sum of all periodic payments.

Zero‑coupon bonds are issued at a discount to face value and do not pay periodic interest. The investor’s income is the difference between the purchase price and the redemption amount, realised at maturity. For example, a ₹1,000 bond sold for ₹800 yields ₹200 as a capital gain.

When a regular coupon bond is sold before maturity at a price higher than its purchase price, the excess is treated as a capital gain. The gain is classified as short‑term if the holding period is ≤ 36 months for listed securities, otherwise long‑term. Tax rates differ accordingly, a frequent exam focus.

Capital gains are also generated through price appreciation in the secondary market due to changes in interest rates, credit spreads or macro‑economic factors. The exam may present a scenario where a bond’s market price rises and ask you to compute the gain or identify the tax head.

Some debt instruments carry a redemption premium – an extra amount paid over the face value at maturity. This premium compensates investors for higher risk or longer lock‑in periods. The premium is taxable as interest income because it is part of the contractual return.

Callable bonds allow the issuer to redeem before maturity, often at a price above par (call premium). Conversely, putable bonds give the holder the right to sell back at a pre‑agreed price (put premium). Both premiums are treated as part of the total income and must be added to coupon and discount gains.

Exam questions may ask you to identify which component (coupon, premium, or gain) is taxable under which head, or to calculate total income when a call premium of 2% is paid on a ₹1,000 bond.

When a bond is sold between coupon dates, the buyer must compensate the seller for interest earned up to the settlement date. This amount is called accrued interest. It is calculated as: Accrued Interest = Coupon × (Days Elapsed ÷ Days in Coupon Period), where the day‑count convention (e.g., 30/360, Actual/365) is specified in the bond’s terms.

Accrued interest does not constitute a separate taxable event; it is simply a transfer of the interest that the seller is entitled to receive. The buyer will receive the full coupon on the next payment date, effectively receiving the interest for the entire period.

In the exam, you may need to compute accrued interest for a trade settled on a specific date, or to identify the correct day‑count convention for government securities versus corporate bonds.

For exam purposes, remember the tax heads: Coupon, redemption premium and accrued interest are taxed under "Income from Other Sources" at the investor’s applicable slab rate. Discount gains on zero‑coupon bonds are treated as capital gains, with the holding period determining short‑term or long‑term classification.

Capital gains arising from price appreciation in the secondary market are also taxed as capital gains. The holding period rule (≤ 36 months = short‑term) applies to listed bonds, while unlisted securities have a 24‑month threshold. The exam often tests the distinction between income and capital gain tax treatment.

Finally, any premium received on redemption, call or put is added to the interest component and taxed accordingly. Mis‑classifying a premium as a capital gain is a common error that leads to loss of marks.