debt_market_81_-_i_1_

DEBT MARKET: INDIAN OUTLOOK

EXECUTIVE SUMMARYEXECUTIVE SUMMARY

The Indian Debt Market has grown rapidly since the mid-1990s, and with a daily

turnover of over $1 bn is today one of the largest in Asia. This growth in the markets has

been encouraged by a host of reforms in the sector.

One has to scratch the surface to that the different components have performed

differently – and the sum of the parts adds up to less than the whole.

There is a special section on "Wholesale and Retail Debt". This section looks at various

investment options available for investors. There is also an information on the both of

these markets but primarily from institutional clientele.

For learners, I have de-mystified the complex structure of the Money and Debt Markets

in a simplified framework so that even a common man understands the intricacies of this

market.

The project also focuses on the Valuation and Duration. There is also a brief

description of Yield and the Price-Yield Relationship.

Various Advantages and Instruments of International Market is mentioned which is

needed in order to diversify the funding risk, developing of brand image in

International market and most important of it, is the Cost of raising Capital from

International market.

Recent developments talked about how Interest Rates reflect human behaviour which is

highly complex. This complexity has been compounded by the Internationalization of

Economies and the Financial markets. The direction of Interest rates in India is partially

set by those of other countries, particularly U.S. and European countries. And then there

is recommendations for improvement.

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OBJECTIVEOBJECTIVE

The purpose behind seeking this project is to cotton on the Indian and International

Debt Market.

But the main reason that enticed me to undertake this project was my keen interest in

analysing the Debt Market.

I also wanted to know about the present and future scenario of the Debt Market and

benefits of International Financing to Indian Corporates.

This project has helped me to learn a lots of new things.

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METHODOLOGYMETHODOLOGY

My Guide had given me the idea about the functioning of the Debt Market. The

information for the project was collected from NCFM Debt Market Module. Data was

also collected from various website and also from some books related to Debt Market.

In order to find out the market performance over the years, past financial data was

collected. The data was then sorted out and compared with that of the present year and

accordingly inference were drawn.

The different people form the Industry were the source of the primary data for the project

while NCFM Module, Books and Websites served as the source of secondary data.

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INTRODUCTIONINTRODUCTION

When a nation has Capital, it can utilize it in two ways: either consume the capital i.e.

spend it on things that will not give any future benefit or invest the capital into capacity

building that will help the economy to grow. Sustainable economic growth is dependent

on the level of investment activity. Therefore, Industries and the Government need

money to grow. Household savings that accounted for 22.5% of the GDP (2002) is one of

the key supply avenues. And the job of Financial Markets is to Channelize this money

into the Industrial Sector. In 2002, 14.4% of household savings was in the form of

financial assets. However, a majority of this comprised of fixed deposits with the banks.

However, if the same investor would hold a bond that had fixed returns, the bond would

become valuable in a scenario where interest rates declined. But the present scenario is

quite opposite. The retail investor in India did not have much of a choice. Either he was

at the mercy of the banks for fixed deposits or at the mercy of the Securities and the Real

Estate Market. Equities and Real Estates are risky. The numerous scams have time and

again highlighted the so-called ‘credibility’ of the equities markets in the country. Also,

due to the inherent uncertainty in returns, these markets did not suit the risk appetite of

many investors. Therefore, the need of the hour was to have a market in which the price

discovery was far more realistic, market determined and more in favour of the investor.

Also, important was liquidity. The answer to this was Debt Markets, where instruments

with fixed returns could be traded.

THE DEBT MARKET

Debt Market as the name suggests is where Debt instruments or bonds are traded. The

most distinguishing feature of these instruments is that the return is fixed i.e. they are as

close to being risk free as possible, if not totally risk free. The fixed return on the bond is

known as the interest rate or the coupon rate. Thus, the buyer of a bond gives the seller a

loan at a fixed rate, which is equal to the coupon rate.

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CHRONICLE

The development of these markets started in 1992, the year of glasnost (openness) and

perestroika (restructuring) for India. The financial systems underwent changes as the

country began its journey from a regulated to a free market economy. There were steps

taken to de-regulate India’s financial system and as a result interest rates would be

increasingly determined by the market forces and decreasingly the Reserve Bank. The

Government began to borrow from the markets at rates determined by the market forces

by a system of auctions. Previously this was being done at pre-announced rates. Other

reforms instituted by the RBI, in close coordination with Government of India included,

introduction of new instruments such as Zero-Coupon Bonds, Floating-Rate Bonds and

Capital Index Bonds, introduction of Treasury Bills of varying maturities, conversion of

Treasury Bills into dated Securities. And setting up system so that trading in Debt

instruments could be facilitated. This included the establishment of specialized

institutions such as DFHI (Discount and Finance House of India) and STCI (Securities

Trading Corporation of India) as Primary Dealers in Government Securities. When the

Government auctions the Debt Instruments through the RBI, Primary Dealers are allowed

to bid.

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STRUCTURE OF THE DEBT MARKETSTRUCTURE OF THE DEBT MARKET

The market for Debt Market Securities comprises of the Centre, State and State

Sponsored Securities. In recent past, local bodies such as Municipalities have also

begun to tap the Debt Market for funds.

CCHARACTERISTICHARACTERISTIC

MMARKETARKET FORFOR S SALEALE ANDAND P PURCHASEURCHASE OFOF D DEBTEBT I INSTRUMENTNSTRUMENT

These are markets where the Debt Instruments are available or can be purchased from:

PRIMARY MARKET

SECONDARY MARKET

PRIORITYPRIORITYJunior or

SubordinatedSenior or

Unsubordinated

COUPON COUPON RATERATE

Fixed IncomeFloater

Inverse FloaterZero Coupon

INTERNATIONAl

Bond IssuesBond IssuesEurobondForeignGlobal

ISSUERISSUERCorporationMunicipalityGovernmentGovernmentInternationalInternational

INDIA GOVERNMENT

TreasuriesTreasuriesBond ( 10yrs. )

Note ( 1 – 10 yrs. )T – Bills ( < 1 yrs. )

REDEMPTIOREDEMPTIONN

FeaturesCallable

ConvertiblePuttable

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PRIMARY MARKET

The Primary Market composes of the new issue market. This market deals with the new

Securities that were earlier not available for investment, i.e. the Securities that are been

offered to the investors for the first time. This market therefore makes available a new

block of Securities for subscription. In other words this market deals with raising of new

capital by Government or Companies either for cash or for consideration other than cash.

Thus primary market facilitates capital formation.

Function of the Primary Market

The main function of Primary Market is to transfer the resources from savers to the users.

The savers are Banks Insurance Companies, Mutual Funds, etc. whereas the users are

Government and Public Limited Companies. The Primary Market plays an important role

of mobilizing the funds from savers and transfers them to borrowers for production

purposes, an important requisite of economic growth. It is not only a platform for raising

finance to establish new enterprises but also for expansion/diversification/and

modernization of existing units.

In case on G-Secs RBI’s is the chief authority. The RBI on behalf of the Government of

India issues the Securities. The Public Debt Office (PDO) of RBI services these new

issues. Dated Securities are sold through auctions or through sale. Actually, the sale or

auction in dated security would mean that the coupon for the security is either auctioned

or is fixed. Fixed Coupon Securities are sometimes also sold on tap that is kept open for a

few days.

SECONDARY MARKET

The market where existing Securities are traded is referred to as Secondary Market. In

this market purchases and sales of Securities whether Government or Semi-Government

or other public bodies or debentures of joint stock companies are affected. The

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Government Securities are traded as a separately component called Gilt-edged market.

They are traded in the from of over the counter sales or purchases. Another component of

this market deals in trades of debentures of limited companies. The well functioning

secondary market is a crucial issue in the development of Government. Securities market.

The main reason behind the formation of a Securities market is from the liquidity point of

view. Besides this Securities can also be purchases from this market. i.e. Securities can be

purchase even after its issue in primary market. The Whole Sale Debt Market (WDM)

segment of the NSE is a specialized segment in this regard.

Wholesale Debt Market (WDM)

The Wholesale Debt Market (WDM) segment deals in fixed income Securities and is fast

gaining ground in an environment that has largely focused on Capital Markets. There is

no single location or exchange where Debt Market participants interact for common

business. Participants talk to each other, conclude deals, send confirmations etc. On the

telephone, with clerical staff doing the running around for settling trades. In that sense,

the Wholesale Debt Market is a virtual market. The daily transaction volume of all the

traded instruments would be about Rs. 5 billion per day excluding Call Money and

Repos.

Background of WDM

The Wholesale Debt Market (WDM) segment commenced operations on June 30,1994.

The NSE-WDM segment provides the only formal trading platform for trading of a wide

range of Debt Securities. Initially, Government Securities, Treasury Bills and bonds

issued by Public Sector Undertakings (PSUs) were made available for trading. This range

has been widened to include non-traditional instruments like, Floating Rate Bonds, Zero

Coupon Bonds, Index Bonds, Commercial Papers, Certificates of Deposit, Corporate

Debentures, State Government Loans, SLR and Non-SLR bonds issued by Financial

Institutions, units of Mutual Funds and Securitized Debt. The WDM trading system,

known as NEAT (National Exchange for Automated Trading), is a fully automated

screen based trading system that enables members across the country to trade

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simultaneously with enormous ease and efficiency. The trading system is an order driven

system, which matches best buy and sell orders on a price/time priority.

Turnover

The trading volume on WDM segment has been growing rapidly. The trading volume

(face value) increased from Rs. 6,781 crore during 1994-95 (June-March) to Rs.

1,316,096 crore during 2003-04. The average daily trading volume increased from Rs. 30

crore to Rs. 4,477 crore during the same period. The WDM segment registered a record

trading volume of Rs. 13,912 crore on August 25, 2003. The business growth of the

WDM segment is presented in Table.

Growth of Trading Value at NSE WDM

Retail Debt Market (RDM)

NSE has introduced a trading facility through which retail investors can buy and sell

Government Securities from different locations in the country through registered NSE

brokers and their sub-brokers in the same manner as they have been buying and selling

equities. This market is known as “Retail Debt Market” of NSE.

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Prior to introduction of NSE’s Retail Debt Market in January 2003, Government

Securities were not available for purchase and sale to the retail investors.

Importance of making Government Securities available to Retail Market.

Cost effective means of raising long term funds for Government.

Provide effective and accessible means for long term investments for retail

investors.

Develop a stable Debt Market for different classes of investors.

Create broad base holding pattern and depth.

Provide efficient price discovery mechanism in Primary and Secondary market

thereby strengthening the existing system.

Diversification of risk.

Low cost of intermediation for investors.

THE MARKET IN INDIA COMPRISES OF MAINLY THREE SEGMENTS.

Government Securities Market

PSU Bond Market

Corporate Debentures Market

Out of these three markets the most active market is the market for Government

Securities. It is evident for the fact that the Government Securities market comprises of

about 90% of the Wholesale Debt Market.

The Government Securities market is the market where the Government Securities are

traded and issued. In India there are two kinds of G-Secs – short term and long term.

The long-term Securities are traded in the market whereas the short-term Securities are

traded in the money markets.

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G-Secs are issued in denominations of Rs. 100 interest is payable half yearly and they

carry tax exemptions also. The role of brokers in particularly marketing these Securities

is very limited, only to the extent of introducing the two parties who want to strike the

deal.

Generally the Government Securities are in various forms

Stock Certificates or Inscribed Stock.

Promissory Notes

Bearer Bonds, which can be discounted.

Participants and Products in Debt Markets

Issuer Instrument Maturity InvestorsCentral Government

Dated Securities 2 – 20 years RBI, Banks, Insurance Companies, Provident Funds, Mutual Funds, PDs

Central Government

T-Bills 91/364 days RBI, Banks, Insurance Companies, Provident Funds, Mutual Funds, PDs, Individuals

State Government

Dated Securities 5 -10 years Banks, Insurance Companies, Provident Funds

PSUs Bonds, Structured Obligations

5 – 10 years Banks, Insurance Companies, Provident Funds, Mutual Funds, PDs, Individuals

Corporates Debentures 1 -12 years Banks, Mutual Funds, Corporates, Individuals

Corporates, PDs

Commercial Paper

3 months to 1 year

Banks, Corporate, Financial institutions, Mutual funds, Individuals

Banks Certificates of Deposits

3 months to 1 year

Banks, Corporates

GEOGRAPHIC REACH

The system is available for trading from Mumbai, Delhi, Chennai, and Calcutta on all

trading days except Sundays and other holidays, as specified by the Exchange.

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ENTITIES

Due to the high trade values and the market practice of settling deals bilaterally,

participants generally set a maximum risk exposure vis-à-vis all potential counter parties

in the market to ensure that they do not take any undue risk exposure against any

particular counter party. Recognizing this feature of the market, the WDM trading

system provides for two kinds of entities on the segment. Hence this market segment has

a two tier system that recognize trading members and participants and their roles have

been clearly explained in Exchange guidelines.

MARKET INFORMATION

NSE Subsidiary General Ledger A/c Facility for Constituents

Trade information

Exchange information

Subsidiary General Ledger A/C (SGL)

SGL stands for Subsidiary General Ledger account. It is a facility provide by RBI to

large Banks and Financial Institutions to hold their investments in Government Securities

and Treasury Bills in the electronic book-entry form. Such institutions can settle their

trades for Securities held in SGL through a Delivery-versus-Payment(DVP) mechanism,

which ensures movement of funds and Securities simultaneously. As all investors in

Government Securities do not have an access to the SGL accounting system, RBI has

permitted such investors to hold their Securities in physical stock certificate form. They

may also open a Constituent SGL(CSGL) account with any entity authorized by RBI for

this purpose and thus avail of the DVP settlement. Such client accounts are referred to as

constituents SGL accounts.

The facilities offered by the constituent SGL account are as follows:

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i. Dematerialisation

ii. Re-materialisation

iii. Buy/sell transactions with

Any other NSCCL constituent account holder

Any SGL account holder with RBI

Any constituent of other SGL account holder with RBI

RBI under its Open Market Operations

iv. Corporate Actions

Interest payment

Redemption

Conversion into any other security

v. Primary Markets.

Trade Information

The WDM segment has seen a sharp growth in the traded volumes in the last few

months. Some interesting trends can be seen from the trades in the same period. This

section provides some of the reports that the Exchange generates at the end of each

trading session.

Exchange Information

This section provides information about the Exchange, like Market Time Schedule,

Brokerage Rates and List of Holidays.

Further in order to understand the entirety of the Debt Market this project has to look at it

through a framework based on its main elements. The market is best understood by

understanding these elements and their mutual interaction.

This elements are as follows:

Instruments – the Instruments that are being traded in the Debt Market.

Issuers – Entities which issue these instruments.

Investors – Entities which invest in these instruments or trade in these

instruments.

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Interventionists or Regulators – The Regulators and The Regulations

governing the market.

Each of these is discussed below in separate sections. There is an inevitable degree of

overlap in each of these sections as it is often difficult to talk about one without the other.

INSTRUMENTSINSTRUMENTS

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Debt Instruments are basically obligations undertaken by the issuer of the

instrument as regards certain Future Cash Flows representing interest and principal,

which the issuer would pay to the legal owner of the instrument. Debt Instruments

are of various types. The key terms that distinguish one Debt instrument from

another are as follows:

Issuer of the Instrument

Face Value of the Instrument

Interest Rate

Repayment terms (and therefore maturity period/tenor)

Security or Collateral provided by the issuer

Different kinds of Debt instruments and their key terms and characteristics are

discussed below.

MONEY MARKET INSTRUMENTS:

By convention, the term "Money Market" refers to the market for short-term

requirement and deployment of funds. Money market instruments are those

instruments, which have a maturity period of less than one year. The most active

part of the money market is the market for overnight and term money between banks

and institutions (called Call Money) and the market for Repo transactions. The

former is in the form of loans and the latter are sale and buy back agreements – both

are obviously not traded. The main traded instruments are Commercial Papers

(CPs), Certificates of Deposit (CDs) and Treasury Bills (T-Bills). All of these are

discounted instruments i.e. they are issued at a discount to their maturity value and

the difference between the issuing price and the maturity/face value is the implicit

interest. These are also completely unsecured instruments. One of the important

features of money market instruments is their high liquidity and tradability. A key

reason for this is that these instruments are transferred by endorsement and delivery

and there is no stamp duty or any other transfer fee levied when the instrument

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changes hands. Another important feature is that there is no tax deducted at source

from the interest component. A brief description of these instruments is as follows:

Call Money / Notice Money & Term Money

Call Money is essentially a money market instrument wherein funds are borrowed/lent

for a tenure ranging from overnight to 14 days and are at call or notice. The borrower or

lender must convey his intention to repay / recall with at least 24 hours notice. However,

monies can also be borrowed / lent with a specified maturity date i.e. repaid / recalled on

the maturity.

Money lent for a fixed tenor for more than 14 days is called Term Money

Interest to be calculated on a daily / 365 –day year basis.

Interest to be payable on maturity and rounded-off to the nearest rupee.

In case of Maturity of Term Money falling on a holiday the repayment will be

made on the next working day at the contracted rate.

The receiver of funds will collect the cheque and give the receipt. The same

procedure should be followed on the reversal of the deal.

Call Rates

The concentration in the borrowing and lending side of the call markets impacts liquidity

in the call markets. The presence or absence of important players is a significant

influence on quantity as well as price. This leads to a lack of depth and high levels of

volatility in Call Rates, when the participant structure on the lending or borrowing side

alters.

Call Money Rates

Year Maximum (%

p.a.)

Minimum (% p.a.)

Average (% p.a.)

Co-efficient

of variation

*

Bank rate (End

March) (% p.a.)

1996 – 97 14.6 1.05 7.8 37.3 12.0

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1997 - 98 52.2 0.2 8.7 85.7 10.51998 - 99 20.2 3.6 7.8 14.9 8.01999 - 00 35.0 0.1 9.0 12.7 8.02000 - 01 28.0 2.0 7.5 11.2 7.5

*Of monthly weighted average

Short-term liquidity conditions impact the call rates the most. On the supply side the call

rates are influenced by factors such as: Deposit Mobilisation of Banks, Capital Flows,

and Banks Reserve Requirements; and on the demand side, call rates are influenced by

tax outflows, Government borrowing programme, seasonal fluctuations in credit off take.

The external situation and the behaviour of exchange rates also have an influence on call

rates, as most players in this market run integrated treasuries that hold short term

positions in both rupee and Forex Markets, deploying and borrowing funds through call

markets.

Monthly Average Call Rates ( %)

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During normal times, Call Rates hover in a range between the Repo Rate and the Reverse

Repo rate. The Repo rate represents an avenue for parking short-term funds, and during

periods of easy liquidity, call rates are only slightly above the Repo rates. During periods

of tight liquidity, call rates move towards the reverse Repo rate. Table provides data on

the behaviour of call rates. Figure displays the trend of average monthly call rates.

REPO (Repurchase Obligation):

Repo is a money market instrument, which enables collateralized short term borrowing

and lending through sale/purchase operations in Debt instruments. Under a Repo

transaction, a holder of Securities sells them to an investor with an agreement to

repurchase at a predetermined date and rate. In the case of a Repo, the Forward Clean

Price of the bonds is set in advance at a level, which is different from the spot clean price

by adjusting the difference between Repo interest and coupon earned on the security.

In other words, the inflow of cash from the transaction can be used to meet temporary

liquidity requirement in the short-term money market at comparable cost.

In a typical Repo transaction, the counter-parties agree to exchange Securities and cash,

with a simultaneous agreement to reverse the transactions after a given period. To the

lender of cash, the Securities lent by the borrower serves as the collateral; to the lender of

Securities, the cash borrowed by the lender serves as the collateral. Repo thus represents

a collateralized short term lending. The lender of Securities (who is also the borrower of

cash) is said to be dong the Repo; the same transaction is a Reverse-Repo in the books of

lender of cash(who is also the borrower of Securities).

A Reverse-Repo is the mirror image of a Repo. For, in a Reverse-Repo, Securities are

acquired with a simultaneous commitment to resell. Hence whether as transaction is a

Repo or a Reverse-Repo is determined only in terms of who initiated the first leg of the

transaction.

A Repo is also sometimes called a ready forward transaction as it is a means of funding

by selling a security held on a spot (ready) basis and repurchasing the same on a forward

basis. Though there is no restriction on the maximum period for which Repos can be

undertaken, generally, Repos are done for a period not exceeding 14 days. While banks

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and PDs are permitted to undertake both Repos and Reverse-Repos, other participants

such as institutions and Corporates can only lend funds in the Repo markets.

Repos are settled on DVP basis on the same day. It is essential for participants in Repo

transactions to hold SGL accounts and current account with RBI. Repo transactions are

also reported in the WDM segment of the NSE.

REPO Rate

Repo rate is nothing but the annualized interest rate for the funds transferred by the

lender to the borrower. Generally, the rate at which it is possible to borrow through a

Repo is lower than the same offered on unsecured (or clean) inter-bank loan for the

reason that it is a collateralized transaction and the credit worthiness of the issuer of the

security is often higher than the seller. Other factors affecting the Repo rate include the

credit worthiness of the borrower, liquidity of the collateral and comparable rates of other

money market instruments.

Calculating Settlement Amounts in Repo Transactions

Repo transactions involve 2 legs: the first one when the Repo amount is received by the

borrower, and the second, which involves repayment of the borrowing.

The settlement amount for the first leg consists of:

a. Value of Securities at the transaction price

b. Accrued interest from the previous coupon date to the date on which the first leg

Is needed.

The settlement amount for the second leg consists of:

a. Repo interest at the agreed rate, for the period of the Repo transaction

b. Accrued interest from the previous coupon date to the date on which the second

leg is settled.

c. Return of principal amount borrowed.

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Example

Consider the following Transaction details:

Trade Date: 13-July 2001

Settlement Date: 13-July-2001

Trade Price: 108.5

Face Value: Rs. 10000

Security: 12.5% 2004

Repo Rate: 7.5%

Repo Term: 2 days

First Leg:

On 13th July the seller of the Repo (borrower) receives the following amount:

Value of the security: 108.5/100 * 10000 = 1,08,500. 00

Accrued Interest: (12.5 *10000) * (112/360) = 3,888. 89

Settlement Amount = 1,12,388. 89

Second Leg:

On 15th July (Repo term is 2 days), the seller returns the following amount:

Original Borrowing: = 1,08,500. 00

Accrued interest: (12.5 *10000) * (114/360) = 3,958. 33

Repo Interest: 10000 * 0.075 * 2.360 = 41. 67

Settlement Amount: = 1,12,500.

Secondary Market Transactions in Repos:

Secondary Market Repo transactions are settled through the RBI SGL accounts, and

weekly data is available from the RBI on volumes, rates and number of days. The

average weekly volume in the Secondary Markets for Repos (as reported in the SGL) has

grown from Rs. 788 crore in 1998-99 to Rs. 1591 crore in 1999-2000. In the first six

months of the year 2000-01 weekly transactions averaged Rs. 1782 crore. Repos in

Central Government Securities dominate Secondary Market transactions. Repos in T-

bills have grown from an average of Rs. 29 crore in 1998-99 to Rs. 134 crore in 1999-

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2000 and Rs. 232 crore in the first six months of 2000-2001. Volumes are markedly high

in the end-march week.

The minimum number of days for which Repos could be done was 3 days, and has been

brought down to 1 day. The maximum number of days for which Repos have been

entered into has varied over the period 1998-2001. The most commonly occurring period

however, is 14 days. The minimum 1-day Repo rate represents the floor rate in the money

markets. During March end, when volumes have been very high, Repo rates have

touched a low of 2%. During normal times these rates averaged 6-8%.

The transition of non-bank players from call markets to Repo markets is expected to

bring about significant changes in volumes and rates. The concentration of liquidity in

few Securities and the relatively low volume of transactions are expected to be important

impediments to a smooth transition, though.

Interest Rate Swap (IRS)

An IRS (acronym for Interest Rate Swap) is a transaction in which two parties agree to

swap the coupon payments arising on account on issuing of investing in fixed income-

bearing Securities. The essence of the transaction is the exchange of coupon/interest

payments that originally could have had any characteristic. Extending the logic one step

further, it is again not necessary for the two coupon flows to be in the same currency.

Types of IRS

The most common IRS exchanges Fixed Rate coupon payments with coupon payments

linked with some Floating Rate. Again, the two streams of coupon flows might be in the

currency or in different currencies. An IRS is a derivative instrument and like any

derivative it derives its value from the value of the underlying. In this case the underlying

is the Interest Rate. We shall refrain from the matter of pricing IRS products as it is

beyond the scope of this write-up (and the math is slightly messy!)

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These are examples of some popular IRS transactions

Swap of Rupee Fixed Rate to Rupee Floating Rate (and vice versa)

Swap of Currency X Fixed Rate to Currency X Floating Rate (and vice-versa)

Swap of Currency X Fixed Rate to Currency Y Floating Rate (and vice-versa)

There are several variants within these options like Spot Start, Delayed Start etc. As far

as the Floating Rate benchmarks go, in developed economies there are several and the

choice is quite wide. However the most popular ones are based on LIBOR or Treasuries.

IRS in India

Interest Rate Swaps are nascent in India. The market deepened only after RBI allowed

Corporates and Mutual Funds to participate in the market sometime in late 1999.

Unfortunately the market has not seen too much of development and activity has been

restricted between a handful of foreign and private sector banks and a few large

Corporates. The shallowness of the market is also evident in the wide prices that prevail

in the market.

The major roadblock in development of the market has been inadequate benchmark

floating rates. Almost all the IRS deals that have been done till date have been

benchmarked on the overnight MIBOR (Mumbai Overnight Borrowing Rate), released

either by the NSE or Reuters, with the former being more popular. This has effectively

truncated the IRS market in India to that of an OIS (Overnight Indexed Swap). Of late

some swap deals have been reported in which longer term benchmarks have been used

like 90 day Reuters CP Rate (GE Capital) and 5 Year GOI Rate (IL&FS), but these deals

continue to remain sporadic in nature.

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How does an OIS work?

The best way to represent an OIS is through a diagram. The following figure shows the

dynamics of an Overnight Indexed Swap

This is the representation of a "Pay Fixed" IRS, in which the user pays a fixed rate.

In the original scheme of things, Corporate A borrowed money at MIBOR plus 60 basis

points from a Lender (Flows represented by the red arrows). Apprehensive that the

MIBOR rate would go up, and adversely affect his cost of funds, he enters into an OIS

with a Bank/Institution. In the deal, Corporate A agrees to pay 9.05% fixed. This means

the Bank/Institution will pay Corporate A overnight MIBOR against which Corporate A

will pay the Bank/Institution a fixed rate of 9.05% (flows represented by black arrows).

Note that now Corporate A is hedged against any movement in MIBOR as whatever is

the rate, he will receive the "rate" from the Bank/Institution and pass it on to the Lender.

It should be remembered that the calculations are made on a daily compounding basis and

the settlement is netted and made at the end of the transaction.

Benefits of an OIS

Let us turn to the above example. Corporate A has effectively hedged itself against any

movements in the MIBOR. The company has de-risked his liability book by entering into

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this transaction. After entering into the OIS, Corporate A's cost of funds in this

transaction has been frozen at 9.05% + 0.60 = 9.65%. Note that the 60 bps is a sunk cost

which Corporate A has to bear anyway.

Looking at the transaction from the perspective of the Bank/Institution it might seem that

it has increased its risk by this transaction. This might not be the case. The

Bank/Institution might have had lent and created a Floating Rate asset in its books. In that

portfolio it runs the risk that the Floating Rate might fall and diminish its returns. By

doing this transaction, the Bank/Institution has effectively frozen its returns at 9.05%

(ignoring whatever spread it might have earned on the asset).

Commercial Paper (CP)

These are issued by Corporate entities in denominations of Rs. 2.5 mn and usually

have a maturity of 90 days. CPs can also be issued for maturity periods of 180 and

one year but the most active market is for 90 day CPs.

Two key regulations govern the issuance of CPs-firstly, CPs have to be

compulsorily rated by a recognized credit rating agency and only those companies

can issue CPs which have a short term rating of at least P1. Secondly, funds raised

through CPs do not represent fresh borrowings for the Corporate issuer but merely

substitute a part of the banking limits available to it. Hence, a company issues CPs

almost always to save on interest costs i.e. it will issue CPs only when the

environment is such that CP issuance will be at rates lower than the rate at which it

borrows money from its banking consortium.

Certificates of Deposit (CD)

These are issued by banks in denominations of Rs. 0.5 mn and have maturity

ranging from 30 days to 3 years. Banks are allowed to issue CDs with a maturity of

less than one year while financial institutions are allowed to issue CDs with a

maturity of at least one year. Usually, this means 366 day CDs. The market is most

active for the one year maturity bracket, while longer dated Securities are not much

in demand. One of the main reasons for an active market in CDs is that their

24


issuance does not attract reserve requirements since they are obligations issued by a

bank.

Treasury Bills (T-Bills)

These are issued by the Reserve Bank of India on behalf of the Government of India

and are thus actually a class of Government Securities. At present, T-Bills are issued

in maturity of 14 days, 91 days and 364 days. The RBI has announced its intention

to start issuing 182 day T-Bills shortly. The minimum denomination can be as low

as Rs. 100, but in practice most of the bids are large bids from institutional investors

who are allotted T-Bills in dematerialized form. RBI holds auctions for 14 and 364

day T-Bills on a fortnightly basis and for 91 day T-Bills on a weekly basis. There is

a notified value of bills available for the auction of 91 day T-Bills, which is

announced 2 days prior to the auction. There is no specified amount for the auction

of 14 and 364 day T-Bills. The result is that at any given point of time, it is possible

to buy T-Bills to tailor one’s investment requirements.

Potential investors have to put in competitive bids at the specified times. These bids

are on a price/interest rate basis. The auction is conducted on a French auction basis

i.e. all bidders above the cut off at the interest rate/price which they bid while the

bidders at the clearing/cut off price/rate get pro-rata allotment at the cut off

price/rate. The cut off is determined by the RBI depending on the amount being

auctioned, the bidding pattern etc. By and large, the cut off is market determined

although sometimes the RBI utilizes its discretion and decides on a cut off level,

which results in a partially successful auction with the balance amount devolving on

it. This is done by the RBI to check undue volatility in the interest rates.

Non-competitive bids are also allowed in auctions (only from specified entities like

State Governments and their undertakings and statutory bodies) wherein the bidder

is allotted T-Bills at the cut off price.

Recent developments with respect to T-Bills

25


These Bills are now issued for only two tenures, namely 91 days and 364 days. The

Monetary and Credit Policy for 2001-2002 has announced that the 14-day Treasury

Bill and 182-day Treasury Bill auctions will be discontinued and instead, the

notified amount in the 91-day Treasury Bill auctions will be increased to Rs.250

crore w.e.f. May 14, 2001. The notified amount in the 364-day Treasury Bill auction

will remain at Rs.750 crore. Also, the auctions of 91-day Treasury Bills will now be

conducted on every Wednesday with payment on the following Friday and the

auctions of 364-day Treasury Bills will be conducted on Wednesdays preceding the

reporting Friday with payment on the following Friday. It is proposed to

synchronize the dates of payment for both 91-day and 364-day Treasury Bills. As

such, both the 91-day and 364-day Bills will mature on same dates and together they

can provide adequate fungible stock of Treasury Bills of varying maturities in the

secondary market. The market clearing yields and the increased floating stocks,

which are fungible are expected to activate the secondary market in Treasury Bills.

T-Bills of Different Maturity (Rs. Crore)

Holders Total14 Day 91 Day 364 Day (2+3+4)

(Intermediate) (Auction) (Auction)Reserve Bank of India — — — —Banks — 15,895 27,474 43,369State Governments 11,393 1,170 — 12,563Others 438 8,872 8,648 17,958

Apart from the above money market instruments, certain other short-term

instruments are also in vogue with investors. These include short-term Corporate

Debentures, Bills of Exchange and Promissory Notes.

Like CPs, short-term debentures are issued by Corporate entities. However, unlike

CPs, they represent additional funding for the Corporate i.e. the funds borrowed by

issuing short term debentures are over and above the funds available to the

Corporate from its consortium bankers.

26


Normally, debenture issuance attracts stamp duty; but issuers get around this by

issuing only a letter of allotment (LOA) with the promise of issuing a formal

debenture later – however the debenture is never issued and the LOA itself is

redeemed on maturity. These LOAs are freely tradable but transfers attract stamp

duty.

Bills of exchange are promissory notes issued for commercial transactions involving

exchange of goods and services. These bills form a part of a company’s banking

limits and are discounted by the banks. Banks in turn rediscount bills with each

other.

LONG TERM DEBT INSTRUMENTS:

By convention, these are instruments having a maturity exceeding one year. The

main instruments are Government of India dated Securities (G-SEC), State

Government Securities (State loans) Public Sector Bonds (PSU bonds), Corporate

Debentures etc.

Most of these are coupon bearing instruments i.e. interest payments (called coupons)

are payable at pre specified dates called "coupon dates". At any given point of time,

any such instrument has a certain amount of accrued interest with it ie interest,

which has accrued (but is not due) calculated at the "coupon rate" from the date of

the last coupon payment. e.g. if 30 days have elapsed from the last coupon payment

of a 14% coupon debenture with a face value of Rs 100, the accrued interest will be

100*0.14*30/365 = 1.15

Whenever coupon-bearing Securities are traded, by convention, they are traded at a

base price with the accrued interest separate – in other words, the total price would

be equal to the summation of the base price and the accrued interest.

Government of India dated Securities (G-SECs)

27


The Government Securities comprise dated Securities issued by the Government of

India and State Governments. The date of maturity is specified in the Securities

therefore it is known as dated Government Securities. Government Paper with tenor

beyond one year is known as dated security.

Like Treasury Bills, G-SECs are issued by the Reserve Bank of India on behalf of

the Government of India. These form a part of the borrowing program approved by

Parliament in the Finance Bill each year (Union Budget). They are issued in

dematerialized form but can be issued in denominations as low as Rs. 100 in

physical certificate form. They have maturity ranging from 1 year to 30 years. Very

long dated Securities i.e. those having maturity exceeding 20 years were in vogue in

the seventies and the eighties while in the early nineties, most of the Securities

issued have been in the 5 – 10 year maturity bucket. Very recently, Securities of 15

and 25 years maturity have been issued.

Like T-Bills, G-SECs are most commonly issued in dematerialized form in the

"SGL" account although it can be issued in physical certificate form on specific

request. Tradability of physical Securities is very limited. The SGL passbook

contains a record of the holdings of the investor. The RBI acts as a clearing agent

for G-SEC transactions by being the custodian and operator of the SGL account. G-

SECs are transferable by endorsement and delivery for physical certificates.

Transactions of Securities held in SGL form are effected through SGL transfer

notes. Transfer of G-SECs does not attract stamp duty or transfer fee. Also no tax is

deductible at source on the coupon payments made on G-SECs. ( most of the

Securities are now held in SLG from as RBI has made it obligatory on the part of

the investors. )

Like T-Bills, G-SECs are issued through the auction route. The RBI pre specifies

an approximate amount of dated Securities that it intends to issue through the year.

However, it has broad flexibility in exceeding or being under that figure. Unlike T-

Bills, it does not have a pre-set timetable for the auction dates and exercises its

28


judgement on the timing of each issuance, the duration of instruments being issued

as well as the quantum of issuance.

Sometimes the RBI specifies the coupon rate of the security proposed to be issued

and the prospective investors bid for a particular issuance yield. The difference

between the coupon rate and the yield is adjusted in the issue price of the security.

On other occasions, the RBI just specifies the maturity of the proposed security and

prospective investors bid for the coupon rate itself. In either case, just as in T-Bills,

the auction is conducted on a French auction basis. Also, the RBI has wide latitude

in deciding the cut off rate for each auction and can end up with unsold Securities,

which devolve on itself.

Apart from the auction program, the RBI also sells Securities in its Open Market

Operations (OMO), which it has acquired in devolvement or sometimes directly

through private placements.

Similarly, it also buys Securities in open market operations if it feels fit.

State Government Securities (State Loans)

These are issued by the respective State Governments but the RBI coordinates the

actual process of selling these Securities. Each State is allowed to issue Securities

up to a certain limit each year. The planning commission in consultation with the

respective State Governments determines this limit. While there is no Central

Government guarantee on these loans, they are deemed to be extremely safe. This is

because the RBI debits the overdraft accounts of the respective States held with it

for payment of interest and principal. Generally, the coupon rates on State loans are

marginally higher than those of G-SECs issued at the same time.

The procedure for selling of State loans, the auction process and allotment

procedure is similar to that for G-SECs. They also qualify for SLR status and

interest payment and other modalities are similar to G-SECs. They are also issued in

29


dematerialized form and no stamp duty is payable on transfer. The procedure for

transfer is similar to G-SECs. In general, State loans are much less liquid than G-

SECs.

Example: ISSUANCE OF STATE GOVERNMENT BOND

Gujarat Electricity Board (GEB) is entering the market with a private placement of Debt

in the last week of August. GEB is a statutory board constituted under the Electricity

(supply) Act, 1948. it was set up in 1960 to and acted as a regulated monopoly till

recently. It carries out the functions of generation, transmission and distribution of power

in the State of Gujarat.

ISSUER GUJARAT Electricity Board (GEB)

Issue Size Rs. 300 crore

Face Value Rs. 1 lakh per bond

Minimum Application One bond and in multiples of one bond thereafter

Coupon Rate 8% p.a.

Payable Annually

Tenure 12 years

RedemptionAt par at the end of 10th, 11th and 12th years from allotment

in the ratio of 30-30-40.

Put/Call Option At the end of the 7th year from allotment

Credit Rating A-(SO) by CARE Ltd.

Security An unconditional and irrevocable guarantee by the

Government of Gujarat.

Source: The Economic Times, Big Bucks dated August 16th, 2004

The issue opened on July 29, 2004 and will close on October 15, 2004.

30


Municipal Securities (“munis”)

The primary advantages attracting an investor to Treasury bills or money market mutual

funds are their liquidity and safety. But there is another significant benefit offered by

particular money market instruments known as "munis," or short-term Municipal

Securities: federal tax savings, which are particularly beneficial to those who fall with a

high federal. Individuals can purchase “munis” directly through a Securities dealer, but

the more popular way is through a tax-exempt money market fund. But this concept of

“munis” is still not develop in Indian markets, because of less popularity in other foreign

markets.

Municipal Bonds Traded at NSE

Municipal

Bonds Issue STIssue Description

Last

Trading

Date

Last

Trading

Quantity

Last Trading

Price

AMC05 14% MT

AHMEDABAD MUN.

CORP. 14% 200528 June

1998 50.00 99.2500

NMC06 14.75% MT

NASHIK MUNICIPAL

14.75% 200608 may

2002 500.00 106.558

Municipal Securities (“munis”) are interest-paying Debt Securities that State and

Municipal Governments issue to finance operating expenditures, to fund certain tax-

exempt entities including colleges and non-profit hospitals, and occasionally to provide

funds to firms and individuals. The Tax-exempt status of “munis” not only relieves

buyers from paying tax on the interest income, but also allows the Government issuers to

borrow at favorable rates.

Public Sector Undertaking Bonds (PSU Bonds)

These are long-term Debt instruments issued by Public Sector Undertakings (PSUs).

The term usually denotes bonds issued by the Central PSUs (i.e. PSUs funded by

31

http://www.investopedia.com/articles/04/

http://www.investopedia.com/articles/04/securities%20dealer

http://www.investopedia.com/terms/m/municipalbond.asp

http://www.investopedia.com/terms/m/moneymarket.asp

http://www.investopedia.com/terms/l/liquidity.asp

http://www.investopedia.com/terms/m/money-marketfund.asp

http://www.investopedia.com/terms/m/money-marketfund.asp

http://www.investopedia.com/terms/t/treasurybill.asp


and under the administrative control of the Government of India). The issuance of

these bonds began in a big way in the late eighties when the Central Government

stopped/reduced funding to PSUs through the general budget. Typically, they have

maturities ranging between 5-10 years and they are issued in denominations (face

value) of Rs. 1000 each. Most of these issues are made on a private placement basis

to a targeted investor base at market determined interest rates. Often, investment

bankers are roped in as arrangers for these issues.

These PSU bonds are transferable by endorsement and delivery and no tax is

deductible at source on the interest coupons payable to the investor (TDS exempt).

In addition, from time to time, the Ministry of Finance has granted certain PSUs, an

approval to issue limited quantum of Tax-Free bonds i.e. bonds for which the

payment of interest is tax exempt in the hands of the investor. This feature was

introduced with the purpose of lowering the interest cost for PSUs which were

engaged in businesses which could not afford to pay market determined rates of

interest e.g. Konkan Railway Corporation (KRC) was allowed to issue substantial

quantum of tax free bonds. Thus we have taxable coupon PSU bonds and tax free

coupon PSU bonds.

Bonds of Public Financial Institutions (PFIs)

Apart from public sector undertakings, Financial Institutions are also allowed to

issue bonds, that too in much higher quantum. They issue bonds in 2 ways – through

public issues targeted at retail investors and trusts and also through private

placements to large institutional investors. Usually, transfers of the former type of

bonds are exempt from stamp duty while only part of the bonds issued privately

have this facility. On an incremental basis, bonds of PFIs are second only to G-Secs

in value of issuance.

Retail bond issues of PFI bonds have become a big rage with investors in the last

three years. PFIs have also been offering bonds with different features to meet

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differing needs of investors e.g. monthly return bonds (which pay monthly

coupons), cumulative interest bonds, step up coupon bonds etc

Corporate Debentures

These are long term Debt instruments issued by private sector companies. These are

issued in denominations as low as Rs 1000 and have maturities ranging between one

and ten years. Long maturity debentures are rarely issued, as investors are not

comfortable with such maturities. Generally, debentures are less liquid as compared

to PSU bonds and the liquidity is inversely proportional to the residual maturity.

A key feature that distinguishes debentures from bonds is the stamp duty payment.

Debenture stamp duty is a State subject and the quantum of incidence varies from

State to State. There are two kinds of stamp duties levied on debentures viz issuance

and transfer. Issuance stamp duty is paid in the State where the principal mortgage

deed is registered. Over the years, issuance stamp duties have been coming down

and are reasonably uniform. Stamp duty on transfer is paid to the State in which the

registered office of the company is located. Transfer stamp duty remains high in

many States and is probably the biggest deterrent for trading in debentures resulting

in lack of liquidity.

NEWLY INCLUDED BONDS

Zero Coupon Bond

In such a bond, no coupons are paid. The bond is instead issued at a discount to its face

value, at which it will be redeemed. There are no intermittent payments of interest. When

such a bond is issued for a very long tenor, the issue price is at a steep discount to the

redemption value. Such a zero coupon bond is also called a deep discount bond. The

effective interest earned by the buyer is the difference between the face value and the

discounted price at which the bond is bought.

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Treasury Strips

In the United States, Government dealer firms buy coupon paying treasury bonds, and

create out of each cash flow of such a bond, a separate zero coupon bond. For example, a

7-year coupon paying bond comprises of 14 cash flows, representing half-yearly coupons

and the repayment of principal on maturity and sell them separately, to zero coupon

bonds, each one with a differing maturity and sell them separately, to buyers with varying

tenor preferences. Such bonds are known as Treasury Strips. (STRIPS are an acronym for

separate trading of registered interest and principal Securities). We do no have Treasury

Strips yet in the Indian market.

Floating Rate Bonds

Instead of a pre-determined rate at which coupons are paid, it is possible to structure

bonds, where the rate of interest is re-set periodically, based on a benchmark rate. Such

bonds whose coupon rate is not fixed, but reset with reference to a benchmark rate is

called Floating Rate Bonds. For example, IDBI issued a 5 year floating rate bond, in July

1997, with the rates being re-set semi annually with reference to the 10 year yield on

Central Government Securities and a 50 basis point mark-up. In the bond, every six

months, the 10-year benchmark rate on Government Securities is ascertained. The

coupon rate IDBI would pay for the next six months is this benchmark rate, plus 50 basis

points. The coupon on a floating rate bond thus varies along with the benchmark rate, and

is re-set periodically. . Floating rate bonds, whose coupon rates are bound by both a cap

and floor, are called as range notes, because the coupon rates vary within a certain range.

Callable Bonds

Bonds that allow the issuer to alter the tenor of a bond, by redeeming it prior to the

original maturity date, are called Callable Bonds. The inclusion of this feature in the

bond’s structure provides the issuer the right to fully or partially retire the bond, and is

therefore in the nature of call option on the bond. Since these options are not separated

form the original bond issue, they are also called embedded options. A call option can be

a European option, where the issuer specifies the date on which the option could be

34


exercised. Alternatively, the issuer can embed an American option in the bond, providing

him the right to call the bond on or anytime before a pre-specified date.

Puttable Bonds.

Bonds that provide the investor with the right to seek redemption from the issuer, prior to

the maturity date, are called Puttable Bonds. The put options embedded in the bond

provides the investor the rights to partially or fully sell the bonds back to the issuer, either

on or before pre specified dates. The actual terms of the put option are stipulated in the

original bond indenture.

A put option provides the investor the right to sell a low coupon paying bond to the

issuer, and invest in higher coupon paying bonds, if interest rates move up. The issuer

will have to reissue the put bonds at higher coupons. Puttable bonds represent a re-pricing

risk to the issuer

Convertible Bonds.

A Convertible Bond provides the investor the option to convert the value of the

outstanding bond into equity of the borrowing firm, on pre-specified terms. Exercising

this option leads to redemption of the bond prior to maturity, and its replacement with

equity. At the time of the bond’s issue, the indenture clearly specifies the conversion ratio

and the conversion price. The conversion ratio refers to the number of equity shares,

which will be issued in exchange for the bond that is being converted. The conversion

price is the resulting price when the conversion ratio is applied to the value of the bond,

at the time of conversion.

Amortising Bonds

The structure of some bonds may be such that the principal is not repaid at the

end/maturity, but over the life of the bond. A bond, in which payments, made by the

borrower over the life of the bond, includes both interest and principal, is called an

Amortising Bond. Auto loans, consumer loans and home loans are examples of

Amortising Bonds. The maturity of the Amortising Bond refers only to the last payment

in the amortising schedule, because the principal is repaid over time.

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Bonds with Sinking Fund Provisions

In certain bond indentures, there is a provision that calls upon the issuer to retire some

amount of the outstanding bonds every year. This is done either by buying some of the

outstanding bonds in the market, or as is more common, by creating a separate fund,

which calls the bonds on behalf of the issuer. Such provisions that enable retiring bonds

over their lives are called Sinking Fund Provisions. In many cases the sinking fund is

managed by Trustees, who regularly retire part of the outstanding bonds, usually at par.

Sinking funds also enable paying off bonds over their life, rather than at maturity.

Asset Backed Securities

Asset Backed Securities represent a class of fixed income Securities, created out of

pooling together assets, and creating Securities that represent participation in the cash

flows from the asset pool. For example, select housing loans of a loan originator (say, a

housing finance company) can be pooled, and Securities can be created, which represent

a claim on the repayments made by home loan borrowers. Such Securities are called

Mortgage–Backed Securities. In the Indian context, these Securities are known as

Structured Obligations (SO). Since the Securities are created from a select pool of assets

of the originator, it is possible to ‘cherry-pick’ and creates a pool whose asset quality is

better than that of the originator. Assets with regular streams of cash flows are ideally

suited for creating Asset-Backed Securities.

36


ISSUERS AND INTERMIDERIESISSUERS AND INTERMIDERIES

Issuers of Debt Instruments can be classified into Five board categories. These are as

follows:

GOVERNMENT OF INDIA AND OTHER SOVEREIGN BODIES

PRIMARY DEALERS (PDS)

BANKS AND DEVELOPMENT FINANCIAL INSTITUTIONS

PSUS

PRIVATE SECTOR COMPANIES

GOVERNMENT OR QUASI GOVERNMENT OWNED NON-CORPORATE ENTITIES.

GOVERNMENT OF INDIA AND OTHER SOVEREIGN BODIES

The largest volumes of instruments issued and traded in the Debt Market fall in this

category. Issuers within this category include the Government of India, various State

Governments and some statutory bodies. Instruments issued by the Central Government

carry the highest credit rating because of the ability of the Government to tax and repay

its obligations.

As mentioned earlier, Government of India issues T-Bills and G-Sec of varying

maturities, while State Government’s issue State loans. Municipality is also a legal

body who issue its Bonds in the market. Apart from these, the Government also issues

instruments, which are tailor-made for retail investors. These include Tax-Free Relief

Bonds, Indira Vikas Patra, Kisan Vikas Patra etc.

As on March 31, 1999, the total value of outstanding G-Sec is about Rs. 2750 bn. The

total value of outstanding State loans is about Rs. 500 bn. The incremental gross issuance

for 1999-2000 is estimated at Rs. 840 bn. Net of repayment falling due within the year

(about Rs. 300 bn) the net increase in the value of outstanding Securities in the current

year would be about Rs.540 bn.

37


PRIMARY DEALERS (PD)

Primary Dealers are important intermediaries in the Government Securities markets

introduced in 1995. There are now 19 primary dealers in the Debt markets. They act as

Underwriters in the Primary Debt Markets, and as Market Makers in the Secondary Debt

Markets, apart from enabling the participation of a number of constituents in the Debt

markets.

The objectives of setting up the system of Primary Dealers are:

(i) To strengthen the infrastructure in the Government Securities market in order

to make it vibrant, liquid and broad-based,

(ii) To develop underwriting and market making capabilities for Government

Securities outside the Reserve Bank, so that the Reserve Bank could gradually

divest these functions,

(iii) To improve secondary market trading system that would contribute to price

discovery, enhance liquidity and turnover and encourage voluntary holding of

Government Securities among a wider investor base, and

(iv) To make Primary Dealers and effective conduit for conducting open market

operations.

Eligibility of Primary Dealer

A person who satisfies the following criteria can apply for primary dealership:

Subsidiaries of scheduled commercial banks and all India Financial

Institutions and engaged predominantly in Securities business and in

particular the Government Securities market, or

Companies incorporated under the Companies Act, 1956 and engaged

predominantly in Securities business and in particular the Government

Securities market,

Subsidiaries/joint ventures set up by entities incorporated abroad under FIPB

approval, and

The company should have net owned funds of Rs. 50 crore.

38


Reporting System of Primary Dealer

Primary Dealers are required to submit to the Reserve Bank:

A daily report on market information,

A daily report on transactions in the prescribed format PDR-1,

A monthly report of transactions in Securities, risk position and performance with

regard to participation in auctions, in the prescribed format PDR-2, and

An annual report on its performance together with annual audited accounts.

SATELLITE DEALERS

Following the introduction of a system of Primary Dealers in the Government Securities

market, a need was felt to develop the supporting infrastructure. The Reserve Bank of

India, therefore, introduced the concept of satellite dealers. The objective behind creating

satellite dealers was to widen the scope of organized dealing and distribution

arrangements in Government Securities market. Satellite dealers form the second tier in

trading and distribution of Government Securities.

The objectives of the system of Satellite Dealers are to:

Further strengthen the infrastructure in Government Securities market by

including intermediaries that have good distribution channels and thus add depth

to secondary market trading and widen the investor base;

Enhance liquidity and turnover in Government Securities;

Provide a retail outlet for Government Securities and encourage voluntary holding

of Government Securities among a wider investor base.

Reporting System

A Satellite Dealer has to submit to the Reserve Bank a monthly report on transactions in

Securities, risk position and performance with regard to outright sales. The report has to

39


be submitted in specified formats. Satellite dealers also have to submit to the Reserve

Bank an annual report on its performance along with the annual audited accounts.

BANKS AND DEVELOPMENT FINANCIAL INSTITUTIONS (DFI)

Instruments issued by DFIs and banks carry the highest credit ratings amongst non-

Government issuers primarily because of their linkage with the Government. There is

also a perception that the Government will not allow important DFI’s and banks to fail or

default on their obligations.

Prominent DFI issuers include ICICI, IDBI, IFCI, IRBI, as well as some State level DFIs

like SICOM, GIIC etc. ICICI and IDBI have been the most aggressive issuers.

Virtually all banks raised CDs while prominent bond issuers have been SBI, Bank of

Baroda, Bank of India etc. most banks have floated issues last year in order to raise tier II

capital to meet their capital adequacy requirements.

DFIs issue 1-3 year CDs as well as longer maturity bonds, banks mainly issue short-term

CDs and they have also issued bonds from time to time (although infrequently). For

DFIs, bonds used to originally account for a very small part of their overall resource

raising; but the picture has changed dramatically in the past 5 years as Government has

discontinued other cheaper avenues of funds to them. For new Private Sector Banks and

Foreign Banks, which do not have access to a large branch network, CDs constitute an

extremely important part of overall resource rising.

DFIs are the second largest issuer of Debt instruments after the Government and

sovereign bodies. The total value of outstanding bonds and CD issued by DFIs is

estimated at Rs. 1 trillion while the total outstanding value of CDs and bonds issued by

scheduled Commercial Banks is estimated at Rs. 60 bn.

PUBLIC SECTOR UNDERTAKINGS (PSUS)

PSUs issued PSU bonds, which enjoy special concessions. These concessions are indirect

i.e. these PSU bonds are approved Securities for investment by various Trusts, Provident

Funds etc.

The prominent PSU issuers include Mahanagar Telephone Nigam Ltd. (MTNL), National

Thermal Power Corporation (NTPC), Indian Railway Finance Corporation (IRFC),

40


Konkan Railways Corporation (KRC), Neyveli Lignite Corporation (NLC), steel

Authority of India (SAIL), National Hydel Power Corporation (NHPC), HUDCO, Coal

India, Rashtriya Ispat Nigam Ltd (RINL) etc. IRFC is the fund raising arm of the Indian

railways while MTNL raises funds for itself as well as for the Department of Telecom. In

addition to PSU bonds, PSUs issue CDs like any other Corporate.

The total value of PSU bonds outstanding as at March 31, 1999 is estimated at Rs 500 bn

with MTNL, NTPC, IRFC and SAIL being the largest issuers. The overall issuance of

PSU bonds was very high in the late eighties and early nineties when they were the

biggest issuers after Government of India and other sovereign bodies. However the total

issuance has declined considerably in the last 3 – 4 years.

PRIVATE SECTOR COMPANIES

Private sector companies issue Commercial Papers (CPs) and short and long term

debentures. The total value of outstanding debentures issued by private sector Corporate

is estimated at Rs. 500 bn.

There were large issues of debentures by private sector companies in the early and mid

nineties. Capital investment in the private sector was booming on the back of a strong

capital market and private sector companies were rising loans by way of debentures

(among other means) in order to meet their overall fund requirements. Sometimes,

debentures were issued together with equity issues in the form of partly convertible

debentures. Since then three developments have taken place. Firstly, there was overall

decline in the investment spending by the private Corporate sector leading to decline in

demand for raising money in all forms including this one. On the other hand the demand

for top quality debentures – i.e. debentures issued by top rated companies – has

increased substantially due to general flight to quality. Thirdly, banks have been allowed

to invest in private sector debentures, which is an indirect way of giving term loans to

these companies.

Banks have begun debenture investment in a big way and demand for debentures by

banks and newer investors like Mutual Funds have been high.

41


GOVERNMENT OWNED OR QUASI GOVERNMENT NON-CORPORATE

ENTITIES

This is a new class of issuers which has emerged in the last 3 years. The origin of these

issuers lies in the inability of State Governments to execute large infrastructure projects

through budgetary allocations. Consequently, these State Governments have created

Special Purpose Vehicles (SPVs) for executing these projects. These SPVs issued

bonds/debentures. Typical maturity of the instruments ranges from 3-7 years.

42


INVESTORSINVESTORS

While understanding the behavior of Institutional Investors, one will have to appreciate

the very fundamental point that in most cases Debt Market is a market of compulsion as

against the equity market which is a market of choice. Many Institutional Investors have

no choice but to invest in specific Debt instruments, which govern their functioning or by

their orientation as to whom they represent.

We have classified Institutional Investors operating in the Indian Debt Market in the

following main categories:

Banks

Insurance Companies

Provident Funds

Mutual Funds

Trusts

Corporate Treasuries

Foreign Investors (FIIs)

Individuals

While Banks, Corporate Treasuries, Mutual Funds and some FIIs can and do invest in

other kinds of Securities like Equities, Provident Funds, Insurance Companies and Trusts

almost exclusively invest in various Debt instruments.

BANKS

Collectively, all the banks put together are the largest investors in the Debt market. They

invest in all instruments ranging form T-Bills, CPs and CDs to G-Secs, private sector

debentures etc. by regulation, a bank has to invest 25% of its total deposits in G-Secs or

other approved Securities. This percentage figure (25%) is called the Statutory Liquidity

Ratio (SLR) and these eligible Securities are called SLR Securities. These Securities are

the ones, which are supposed to be extremely safe and carry minimal risk weightage. G-

43


Secs used to carry zero risk weightage till very recently, which has now been changed to

5%.

The SLR regulation makes the banks the largest investors in the market for Government

of India Securities. In reality most banks have exposure to Government of India

Securities much higher than the minimum 25% stipulated by regulation. This is because

of the prevailing recessionary environment wherein many Industrial and Commercial

borrowers have been performing poorly and have been unable to meet their repayment

obligations on time. In such an environment, investing in G-Secs represents a sure fire

way of avoiding non performing assets (NPAs). Similarly, investment in bonds and CDs

of DFIs is another safe investment in the present environment. Banks would be amongst

the largest investors in DFI bonds.

Banks lend to Corporate sector directly by way of loans and advances and also invest in

debentures issued by the Private Corporate Sector and in PSU bonds. A few years ago,

the total ceiling for investment by banks in Corporate Debentures, Shares and other

Securities was fixed at 5% of the incremental deposits of the previous year. This

regulation has since been changed. Banks can now invest 5% of the incremental deposits

of the previous year in shares of private sector while there is no ceiling for debentures.

Banks investment in private sector investment has grown manifold due to this relaxation.

Banks.

Also keep on investing in CDs and CPs – but that is more as a way of managing their

liquidity on a day-to-day basis. By and large bank treasuries are not very active. In most

cases, banks just buy and hold the investments, which they make and not trade too much

on them.

Things have been changing in recent times with some of the more aggressive banks

churning over part of their portfolio and having a more active treasury.

INSURANCE COMPANIES

The second largest category of investors in the Debt market are the Insurance Companies

which have aggregate outstanding investments of Rs. 1250 bn and gross annual

incremental investments of Rs 250 bn. By regulation, LIC has to allocate 60% of its

44


annual incremental investments to G-Secs while the GIC and its 4 subsidiaries (New

India Assurance, Oriental Insurance, United India Insurance and National Insurance) are

supposed to allocate 40% of their annual incremental investments in G-Secs. LIC is

allowed to invest up to a maximum of 15% of its incremental investments in private

sector debentures and shares while GIC and its subsidiaries are allowed to invest up to a

maximum of 25% of their incremental investments in private sector shares and

debentures. Hence, collectively, the insurance companies are one of the largest investors

in G-Sec’s. of their annual incremental investments of Rs 250 bn, not less than Rs. 150

bn would be in G-Secs.

PROVIDENT FUNDS

Provident Funds are estimated to have a total corpus of Rs 800 bn. The total incremental

investment by Provident Funds every year is approximately Rs. 150 bn which makes

them the third largest investors in the Debt market. Again by virtue of regulation,

Provident Funds are supposed to invest a minimum of 25% of their incremental

accretions each year in G-Secs, 15% in State Government Securities, 40% in PSU bonds

etc with a maximum of 10% in rated private sector debentures. Investment in private

sector debentures is one step in this direction.

Most of the provident funds are very safety oriented and tend to give much more

wightage to investment in Government Securities although they have been considerable

investors in PSU bonds as well as State Government backed issued like SSNL, MSRDC,

etc. the largest provident fund is the one managed by the State bank of India on behalf of

the Central Provident Fund Commissioner. This has an estimated corpus of Rs. 40 bn and

fresh annual investments of Rs. 70 bn. This provident fund has taken a policy decision

not to invest in private sector debentures although recent regulations allow it to do so. By

their very orientation as well as by regulation, provident funds are buy and hold investors

and almost never trade on their investments.

45


MUTUAL FUNDS ( MF )

Mutual Funds represent an extremely important category of investors. World over, they

have almost surpassed banks as the largest direct collector of primary savings from retail

investors and therefore as investors in the Wholesale Debt Market.

Mutual Funds include the unit trust of India, the Mutual Funds set up by Nationalized

Banks and Insurance Companies like the SBI Mutual Fund, the GIC Mutual Fund, the

LIC Mutual Fund etc. as well as the new private sector Mutual Funds set up by Corporate

and overseas Mutual Fund companies. Of these, the largest is the Unit Trust of India

which has almost 85% of the market share of the Mutual Fund business and a total corpus

of about Rs. 700 bn. The total corpus of all the Mutual Funds put together is about Rs.

850 bn while the annual gross incremental investments are in the range of around Rs. 150

bn.

While all mutual funds including the unit trust of India invest in G-Secs in a big way,

they are collectively one to the largest investors in PSU bonds and private sector

Corporate debentures.

Private sector mutual funds like Birla, Prudential, ICICI etc have emerged as major

investors in the debentures issued by top rated private sector companies. Short term

debentures are a favorite of Mutual Funds. This has resulted in a scenario where the yield

on some of the top quality private sector Corporate is at a very low differential compared

to risk free sovereign instruments and bonds of Financial Institutions.

TRUSTS

Trusts include Religious and Charitable Trust as well as statutory trust formed by the

Government and Quasi Government Bodies. The largest trusts in India are the Port

Trusts, which have been constituted under the Major Port Trust Act. These include the

Bombay Port Trust, Madras Port Trust, Calcutta Port Trust, Cochin Port Trust etc the

aggregate corpus of the Port Trusts is estimated at Rs. 80 bn while their annual

investments would be about Rs. 20 bn of that amount. Religious Trusts and Charitable

Trusts range from the very small one to large ones like Tirupati Devasthanam , Mata

Amritanandmayi, Ramkrishna Mission etc. other trusts include Hospital Trusts like

Jaslok, Bombay Hospital etc, armed forces trusts like Army Wives Welfare Association,

46


Air Force officers association and many other general trusts like the Rajiv Gandhi

foundation, Birla science foundation etc.

CORPORATE TREASURIES

Corporate Treasuries have become prominent investors only in the last few years.

Treasuries could be either those of the Public Sector units or Private Sector Companies or

any other Government Bodies or Agencies.

The treasuries of private sector units, as well as the Governmental Bodies are heavily

regulated in the instruments they can invest in . These regulations were put in place by

the administrative

Ministries as a reaction to the Harshad Mehta scam. These treasuries are allowed to

invest in papers issued by DFIs and banks as well as G-Secs of various maturities.

However the orientation of the investments is mostly in short term instruments or

sometimes in extremely liquid long term instruments which can be sold immediately in

the markets. Some have been investing in preference shares issued by DFIs.

FOREIGN INSTITUTIONAL INVESTORS ( FII )

India does not allow capital account convertibility either to overseas investors or to

domestic residents. Registered FIIs are an exception to this role. More than 300 FIIs

invest in Indian Equities while the number of FIIs investing in Indian Domestic Debt is

less than 20.

FIIs have to be specifically and separately approved by SEBI for Equity and Debt. Each

Debt FII is allocated a limit every year up to which it can invest in Indian Debt

Securities. It can do so with out asking for any permission from anyone. They are also

free to disinvest any of their holdings, at any point of time, without asking for any

permission from anyone.

The total aggregate limit or ceiling of investments by Debt FIIs is US $ 1.5 bn. As on

date, the aggregate investments are less than US $100 mn. Most of the Debt FIIs are

extremely quick traders. They invest wherever they can make a quick buck. They are

47


unlikely to invest in Indian Debt at a time when he currency risk is high and the expected

gains form price appreciation in Indian Debt paper are not very high.

INDIVIDUAL INVESTORS

The Retail Debt Markets in the new millennium, presents a vast kaleidoscope of opportunities

for the Indian individual investors whose knowledge and participation hitherto has been

restricted to the equities markets in India.

Today, there exists on inherent need of households to diversify their investment portfolio so as

to include various debt instruments and especially Government Securities. The growing

investments in the Bond Funds and the Money Market Mutual Funds are a sign of the

increasing recognition of this fact by the individual investors.

Retail Investors would have a natural preference for fixed income returns and especially so in

the current situation of increasing volatility in the financial markets. The Central Government

Securities (G-Secs) are the one of the best investment options for an individual investor today

in the financial markets.

48


REGULATORSREGULATORS

The Reserve Bank of India is the main regulator for the Debt Market. Apart from its role

as a regulator, it has to simultaneously fulfill several other important objectives viz.

managing the borrowing program of the Government of India, Controlling Inflation,

ensure adequate credit at reasonable costs to various sectors of the Economy, managing

the Foreign Exchange Reserves of the country and ensuring a stable currency

environment.

RBI controls the issuance of new banking licenses to either foreign banks or to new

private sector banks. It controls the manner in which various scheduled banks raise

money from depositors. Further, it controls the deployment of money through its policies

on CRR, SLR, Priority Sector Lending, Export Refinancing, guidelines on investment

assets etc. E.g. Its policy on the Cash Reserve Ratio and the Statutory Liquidity Ratio

determines the extent to which banks money is impounded and the extent to which

money is available for lending/investment. Incremental changes in these ratios can result

in substantial change in the liquidity scenario and hence the short term interest rates. The

Reserve Bank also regulates the market through the control of the investment policy

followed by banks. As an Example RBI has recently allowed banks to invest in

debentures of private sector companies. This was earlier controlled by a limit and

therefore in earlier days banks were unable to invest in debentures to a worthwhile extent.

Similarly, the limit for investment in shares has been enlarged substantially making banks

active investors in shares after decades. For the Non-Banking Financial Companies

(NBFCs), the RBI determines the extent to which these companies can be leveraged and

the extent to which they can raise deposits form public depositors. Simultaneously it

controls the asset portfolio through changes in liquidity ratios etc.

The primary interest of the Reserve Bank of India, in financial market is because of its

criticality in acting as the transmission channel of monetary policy especially while

moving towards reliance o indirect instruments of policy. Currently, the Government

Securities market is the overwhelming part of the overall Debt market. Interest Rates in

this market provide benchmark for the system as whole. In the recent past, several

49


initiatives have launched the market into a high growth trajectory, in terms of depth,

liquidity and turnover, participants, etc. several initiatives for development of this market

have helped the success of a large borrowing programme I recent years. This is critical

not only from the point of view of Reserve Bank, which is both Debt manager and

regulator, but also from the point of investors who are concerned about the Monetary and

Fiscal Management in the country.

The reserve bank’s strategy takes into account the consideration of both the policy

makers and investors. Reform has encompassed market practice in both the Primary

Market and Secondary Markets, strengthening the institutional structure, developing new

and innovative instruments, widening the participant base, rationalizing the tax measures,

establishing a regulatory framework, initiating changes in legal framework, and imparting

transparency in operations.

SECONDARY MARKET WINDOW ROLE OF RBI

The Central banks often play the role of market makers providing two-way quotes

through their sales window to infuse liquidity in the secondary market for the

Government Securities. Generally, two approaches are adopted for operating the

secondary market window by the Central banks: (i) fixing buying and selling prices and

announcing them to the market, and (ii) using a dynamic approach whereby the

secondary market window pricing is continuously adjusted in response to the market

dynamics. During the initial stages of market development, the Reserve Bank used to

announce the sale and purchase prices of Securities. In the recent period, however , the

Reserve Bank has offered a select list of Securities for sale, depending upon supply and

demand conditions. A few Securities are also included in the purchase list, with a view to

improving liquidity through select Securities. The sale/purchase prices and the Securities

offered on sale are frequently revised.

Another regulator for the Debt market is the Securities and Exchange Board of India

(SEBI). SEBI gets involved whenever there is any entity raising money from Indian

individual investors through public issues. It regulates the manner in which such moneys

are raised and tries to ensure a fair play for the retail investor. It forces the issuer to make

the retail investor aware pf the risks inherent in the investment. SEBI is also a regulator

50


for the entire family of Mutual Funds, which are becoming an increasingly important

player in the Debt market. SEBI regulates the entry of new Mutual Funds in the industry.

It also regulates the investments of Debt FIIs. Apart from the two main regulators, the

RBI and SEBI, there are several other regulators specific for different classes of

investors, e.g. the Central Provision Fund Commissioner and the Ministry of Labour

regulate the Provident Funds. The Religious and Charitable Trust are regulated by some

of the State Governments of the States in which the trusts are located. Port Trusts are

regulated by the Ministry of Surface Transport. Some Religious Trusts are regulated by

the Ministry of Human Resource Development of the Government of India.

51


ISSUANCE PROCESS

The Issuance process activities has been expanding in India over the years. The recent

changes in the Indian economy and financial market has given further impetus to the

faster development in the economy. Primary Dealers plays very important role in the

issue process. Various types of Bonds, T-Bills and Commercial Papers has been issue at a

regular intervals in the market.

CENTRAL GOVERNMENT SECURITIES : BONDS

CENTRAL GOVERNMENT SECURITIES : TREASURY BILLS

CORPORATE DEBT : BONDS

COMMERCIAL PAPER

CENTRAL GOVERNMENT SECURITIES: BONDS

The Government bond market, made up of the long-term market borrowings of the

Government, is the largest segment of the Debt Market. In the year 2000-2001, nearly

65% of all borrowings in the primary market were by the Government and over 90% of

secondary market volumes were in Government Securities. The market capitalization of

outstanding Government bonds is estimated at Rs.5,25,000 crore.

Primary Issuance Process

The issuance process for G-Secs has undergone significant changes in the 1990s, with the

introduction of the auction mechanism, and the broad basing of participation in the

auctions through creation of the system of Primary Dealers, and the introduction of non-

competitive bids. RBI announces the auction of Government Securities through a press

notification, and invites bids. The sealed bids are opened at an appointed time, and the

allotment is based on the Cut-off price decided by the RBI. Successful bidders are those

that bid at a higher price, exhausting the accepted amount at the Cut-off price.

The design of treasury auctions is an important issue in Government borrowing.

52


The objectives of auction design are:

Enabling higher auction volumes that satisfy the target borrowing requirement,

without recourse to underwriting and/or devolvement;

Broadening participation to ensure that bids are not concentrated or skewed; and

Ensuring efficiency through achieving the optimal (lowest possible) cost of

borrowing for the Government.

The two choices in Treasury Auctions, which are widely known and used, are:

Discriminatory Price Auctions (French Auction)

Uniform Price Auctions (Dutch Auction)

In both these kinds of auctions, the winning bids are those that exhaust the amount on

offer, beginning at the Highest Quoted Price (or Lowest Quoted Yield). However, in a

uniform price auction, all successful bidders pay a uniform price, which is usually the

Cut-off Price (Yield). In the case of the discriminatory price auction, all successful

bidders pay the Actual Price (Yield) they bid for.

If successful bids are decided by filling up the notified amount from the lowest bid

upwards, such an auction is called a Yield-Based auction. In such an auction, the name

of the security is the Cut-off Yield. Such auction creates a new security, every time an

auction is completed. For example, the G-Sec 10.3% 2010 derives its name from the

Cut-off yield at the auction, which in this case was 10.3%, which also becomes the

coupon payable on the bond. A Yield-Based auction thus creates a new security, with a

distinct coupon rate, at the end of every auction. The coupon payment and redemption

dates are also unique for each security depending on the deemed date of allotment for

Securities auctioned.

If successful bids are filled up in terms of prices that are bid by participants from the

highest price downward, such an auction is called a Price-Based auction. A Price-Based

Auction facilitates the re-issue of an existing security. For example, in March 2001, RBI

auctioned the 11.43% 2015 security. This was a G-Sec, which had been earlier issued

and trading in the market. The auction was for an additional issue of this existing

53


security. The coupon rate and the dates of payment of coupons and redemption are

already known. The additional issue increases the gross cash flows only on these dates.

The RBI moved from Yield-Based auction to price-based auction in 1998, in order to

enable consolidation of G-Secs through re-issue of existing Securities. Large issues

would also facilitate the creation of Treasury Strips, when coupon amounts are large

enough for ensuring liquidity in the secondary markets. The RBI however, has the

flexibility to resort to Yield-Based auctions, and notify the same in the auction

notification.

For example, assume that the bids as given in Table 3.2 are received in a Price-Based

auction for 12.40% 2013 paper, with a notified amount of Rs. 3000 crore. If the RBI

decides that it would absorb all the notified amount from the bids, without any

devolvement on itself or the PDs, it would fill up the notified amount from the highest

price (lowest yield) bid in the auction. At a Cut-off price of Rs. 111.2 (yield 10.7402),

the cumulative bids amount to Rs. 3700 crore. All the bids up to the next highest price of

Rs. 111.2952 will be declared as successful, while bidders at the Cut-off price, will

receive allotments on a pro-rata basis.

If all the successful bidders have to pay the Cut-off price of Rs. 111.2, the auction is

called a Dutch auction, or a uniform price auction. If the successful bidders have to pay

the prices they have actually bid, the auction fills up the notified amounts, in various

prices at which each of the successful bidders bid. This is called a French auction, or a

discriminatory price auction. Each successful bidder pays the actual price bid by him.

Illustration of Auctions

Amount bid

(Rs. cr.)

Implied YTM at bid price

(% per annum)Price (Rs.)

100 10.6792 111.6475

650 10.6922 111.5519

300 10.7102 111.4198

1400 10.7272 111.2952

1250 10.7402 111.2000

1000 10.7552 111.0904

54


750 10.7722 110.9663

400 10.7882 110.8497

300 10.8002 110.7624

CENTRAL GOVERNMENT SECURITIES: T-BILLS

Treasury bills are short-term Debt instruments issued by the Central Government. Until

recently, 4 types of T-bills were issued: 14-day, 91-day, 182-day and 364-day,

representing the 4 types of tenors for which these instruments are issued. The RBI

announced the decision to do away with the 14 and 182-day bills, in the credit policy

announcement made in April 2001.

Issuance Process

Treasury bills are sold through an auction process, in which banks and Primary Dealers

are major bidders. Non-competitive bids are allowed in the auctions, in which provident

funds and other investors can participate. Non-competitive bidders need not quote the

rate of yield at which they desire to buy the T-bills. The Reserve Bank allots bids to the

non-competitive bidders at the weighted average yield arrived at on the basis of the yields

quoted by accepted competitive bids at the auction. Allocations to non-competitive

bidders are outside the amount notified for sale. Non-competitive bidders therefore do not

face any uncertainty in purchasing the desired amount of T-bills from the auctions. The

Reserve Bank of India issues a calendar of T-bill auctions (Table). It also announces the

exact dates of auction, the amount to be auctioned and payment dates by issuing press

releases prior to every auction.

Table: Treasury Bills - Auction Calendar

Type of

Treasury

bill

Periodic

ity

Notified

Amount

(Rs. cr.)

Day of AuctionDay of

Payment

55


91-day Weekly 250Every

Wednesday

Following

Thursday

364-dayFortnigh

tly750

Wednesday

preceding the

reporting Fridays

Following

Thursday

Since May 1999, devolvements on PDs in T-bill auctions has been done away with, any

devolvement being on the RBI alone, thus enabling them to manage T-bill yields as an

interest rate policy tool. The system for underwriting the T-bills by PDs was replaced by a

system of minimum bidding commitment. Each PD is required to make a minimum

bidding commitment for auctions of T-bills so that they together absorb 100% of notified

amount. Both discriminatory and uniform price auction methods are used in issuance of

T-bills. The auctions of 91-day T-bills are uniform price auctions, where all successful

bidders are allotted at the Cut-off prices. Therefore, the weighted average price and the

Cut-off price is the same in the 91-day T-bill auction. In case of all other bills,

discriminatory price auction is followed, where the successful bidders have to pay the

prices they have actually bid for. T-bills are available for a minimum amount of

Rs.25,000 and in multiples of Rs. 25,000.

CORPORATE DEBT: BONDS

The market for long term Corporate Debt has two large segments:

a. Bonds issued by Public Sector units, including Public Financial Institutions, and

b. Bonds issued by the Private Corporate Sector

PSU bonds can be further classified into Taxable and Tax-free bonds.

The markets for Corporate Debt have witnessed significant innovations since 1992, when

the regulation on interest rates on these bonds was removed. Corporate bonds with

embedded options, floating-rate interest, conversion options, and a variety of structured

obligations are issued in the markets. However, the market for Corporate Debt, which

was nearly fully retail, is now dominated by institutional investors. Even PSU bonds and

56


DFI bonds, which used to be earlier retailed, are now privately placed, and there are

hardly any public issue of bonds.

Issue Process

The process of issue of Corporate Securities issuance involves the following steps:

Board meeting and Approval for Issue at the AGM

Credit rating of the Issue

Creation of security for the said bonds/debentures through appointment of

Debenture Trustees

Appointment of Advisors and Investment bankers for Issue management

Finalisation of the initial terms of issue

Preparation of the offer document (for public issue) and Information

Memorandum (for private placement)

SEBI approval of Offer Document for public issue

Listing agreement with stock exchanges

Offer the issue to prospective investors and/or book building

Acceptance of application money/advance deposits for the issue

Allotment of the issue

Issue of letters of allotment and certificates/ Depository confirmation

Collect final amounts from investors

Refund excess application money/ interest on application money.

Authority for the Issue

Companies have to pass ordinary resolutions in their Annual General meeting, where the

company authorises the Board of Directors, to borrow the required funds (usually the

approval is in form of a maximum amount of borrowing represented as a ratio/absolute

57


amount with respect to the share capital and the free reserves of the company). The

company also authorises the Board of Directors to mortgage the property of the company,

as security for the borrowing (in the case of secured borrowings) and empowers the

Board of Directors to execute deeds and documents that enable the creation of such

mortgages.

Listing Criteria on NSE – WDM

In order for a security to be eligible for listing on the WDM segment of the NSE, the

issuing Corporate has to adhere to the applicable eligibility conditions for listing. The

security proposed for listing on the

WDM segment of the NSE should comply with the requirements indicated hereunder:

Public Sector Undertaking

Minimum 51% holding by Central Government, and/or State Governments and/or

Government Company.

If less than 51% shareholding is by Central Government, and/or State

Governments and/or Government Company, investment grade credit rating

required

Banks

Should be Scheduled banks, and having net worth of Rs. 50 crore or above.

Investment grade credit rating required

Corporate Bodies

Paid up capital of Rs. 10 crore, or Market capitalization of Rs. 25 crore.

(Net worth in case of unlisted companies)

Investment grade credit rating required

Infrastructure Companies

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Tax exemption & recognition as Infrastructure Company under related

statues/regulation.

Credit rating—investment Grade

Mutual Fund Units

Any SEBI registered Mutual Fund/ Scheme

Investment objective to invest predominantly in Debt or

Scheme is traded in secondary market as Debt instrument.

Securitized Debt

Minimum tranche: Rs. 20 crore, and

Credit rating – Investment Grade

COMMERCIAL PAPER ISSUE

The summary of the latest guidelines announced in the Monetary and Credit Policy of

RBI in October 2000, is as follows:

Eligibility: Corporates, Primary Dealers (PDs), Satellite Dealers (SDs), and All-

India Financial Institutions (FIs): For a Corporate to be eligible,

The tangible Net Worth of Rs. 4 crore;

Having a sanctioned Working Capital limit from a Bank/FI; and

The borrower account is a Standard Asset.

Rating Requirement: The minimum Credit Rating shall be P-2 of CRISIL or such

equivalent rating by other approved agencies.

Maturity: A minimum of 15 days and a maximum upto one-year.

Denomination: Minimum of Rs. 5 lakh and multiples thereof.

59


Limits and Amount: CP can be issued as a “stand alone” product. Banks and FIs

will have the flexibility to fix Working Capital limits duly taking into account the

resource pattern of companies’ financing including CPs.

Issuing and Paying Agent (IPA): Only a scheduled bank can act as an IPA.

Investment in CP: CP may be held by Individuals, Banks, Corporates,

UninCorporated Bodies, NRIs and FIIs.

Mode of Issuance: CP can be issued as a promissory note or in a dematerialised

form. With effect from June 30, 2001, banks, FIs, PDs and SDs will be permitted to

make fresh investments and hold CP only in dematerialised form. Outstanding

investments in scrip form should also be converted into dematerialised form by

October 31, 2001. Underwriting is not permitted.

Stand-by Facility: It is not obligatory for Banks/FIs to provide stand-by facility.

They have the flexibility to provide credit enhancement facility within the prudential

norms.

Role and Responsibilities: The Guidelines prescribe role and responsibilities for

issuer, IPA and Credit Rating Agency. FIMMDA may prescribe standardised

procedure and documentation in consonance with the international best practices.

Till then, the procedures/documentations prescribed by the IBA should be followed.

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VALUATION OF BONDSVALUATION OF BONDS

BOND VALUATION: FIRST PRINCIPLES

The value of a financial instrument is well understood as the present value of the

expected future cash flows from the instrument.

The actual dates on which these cash flows are expected are also known in advance, in

the case of a simple non-callable bond. Therefore, valuation of a bond involves

discounting these cash flows to the present point in time, by an appropriate discount rate.

The key issue in bond valuation is this rate. We shall begin with a simple assumption that

the rate we would use is the “required rate” on the bond, representing a rate that we

understand is available on a comparable bond (comparable in terms of tenor and risk).

For example, consider a Central Government bond with 11.75% coupon, maturing on

April 16, 2006 (Table). The cash flows from this bond are the semi-annual coupon and

the redemption proceeds receivable on maturity. In order to value the bond, we need the

tenor for which we have to value the bond and the “required rate” for this tenor. Let us

assume for simplicity, that we are valuing the bond on its issue date and the “required

rate” or the 8-year rate in the market is 12%. Since Government bonds pay coupons semi-

annually, this bond would pay (11.75/2) = Rs. 5.875, every six months as coupon. In

order to value this bond, we need to list these cash flows and discount them at the

required rate of 6% (semi-annual rate for the comparable12% rate).

Therefore, the value of the bond can be Stated in general terms as:

where Po is the value of the bond

C1, C2 …..Cn are cash flows expected form the bond, over n periods

r is the required rate at which we shall discount the cash flows.

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Value of a 11.75% bond with 8 years to redemption at par

Semi-annual period

Cash flow (Rs.)

Present value after discounting @ 6% (Rs.)

1 5.875 5.5422 5.875 5.2293 5.875 4.9334 5.875 4.6545 5.875 4.3906 5.875 4.1427 5.875 3.9078 5.875 3.6869 5.875 3.47710 5.875 3.28111 5.875 3.09512 5.875 2.92013 5.875 2.75414 5.875 2.59915 5.875 2.45116 105.875 41.677

Value of the bond 98.737

It is important to see that the value of the bond depends crucially on the required rate.

Higher the rate at which we Discount the Cash Flows (DCF), lower the value of the

bond. In other words, the required rate and the value are inversely related. This is an

important principle in bond analytics and we shall return to this principle in some detail

later in the workbook. Since the required rate is the rate at which we are discounting the

Cash Flows, given the same level of Cash Flows (same coupons), higher the rate at which

Cash Flows are discounted, lower the present value of the bond. It is also important that

we use an appropriate rate in the discounting process. We shall examine this issue also in

some detail in later parts of the workbook.

62


YIELDYIELD

The returns to an investor in bond is made up of three components: Coupon, Interest

from re-investment of coupons and Capital Gains/Loss from selling or redeeming the

bond. When we are able to compare the cash inflows from these sources with the

investment (cash outflows) of the investor, we can compute yield to the investor.

Depending on the manner in which we treat the time value of cash flows and re-

investment of coupons, we are able to get various interpretations of the yield on an

investment in bonds.

CURRENT YIELD

One of the earlier measures on yield on a bond, Current Yield was a very popular

measure of bond returns in the Indian markets, until the early 1990s. Current yield is

measured as

= Annual coupon receipts/ Market price of the bond

This measure of yield does not consider the time value of money, or the complete series

of expected Future Cash Flows. It instead compares the coupon, as pre-specified, with

the market price at a point in time, to arrive at a measure of yield. Since it compares a

pre-specified coupon with the current market price, it is called as Current Yield.

For example, if a 12.5% bond sells in the market for Rs. 104.50, current yield will be

computed as

= (12.5/104.5) * 100

= 11.96%

Current Yield is no longer used as a standard yield measure, because it fails to capture the

Future Cash Flows, re-investment income and capital gains/losses on investment return.

Current Yield is considered a very simplistic and erroneous measure of yield.

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YIELD TO MATURITY (YTM)

In the previous section on bond valuation, we used equation to show that the value of a

bond is the discounted present value of the expected Future Cash Flows of the bond. We

solved the equation to determine a value, given an assumed required rate. If we instead

solve the equation for the required rate, given the price of the bond, we would get an

yield measure, which is knows as the YTM or Yield To Maturity of a bond. That is,

given a pre-specified set of cash flows and a price, the YTM of a bond is that rate which

equates the Discounted Value of the Future Cash Flows to the present price of the bond.

It is the internal rate of return of the valuation equation.

Let us illustrate this limitation of YTM with an example. Suppose an investor buys the

11.75% 2006 bond at Rs. 106.84. The YTM of the bond on this date is 10.013%.

Consider the information about the Cash Flows of the 11.75% 2006 bond in Table. It is

seen that Cash Flows from coupon and redemption are Rs. 164.625, if the bond is held to

maturity. However, the actual yield on the bond depends on the rates at which the

coupons can be re-invested. The YTM of 10.02 is also the actual return on the bond, at

maturity, only if all coupons can be re-invested at 10.02%. If the actual rates of re-

investment of the bond are different, as in columns 5 and 7 in Table 13.6, as is mostly the

case, the actual yield on the bond could be different.

PRICE – YIELD RELATIONSHIP OF BONDS

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Yield–Price Relationships of BondsThe basic bond valuation equation shows that the yield and price are inversely related.

This relationship is however, not uniform for all bonds, nor is it symmetrical for increases

and decreases in yield, by the same quantum.

Price – Yield Relationship: Some Principles

a. Price-Yield relationship between bonds is not a straight line, but is convex. This

means that price changes for yield changes are not symmetrical, for increase and

decrease in yield.

b. The sensitivity of price to changes in yield in not uniform across bonds.

Therefore for a same change in yield, depending on the kind of bond one holds,

the changes in price will be different.

c. Higher the term to maturity of the bond, greater the price sensitivity. We notice,

that CG2013 had the steepest slope, while in 2001 and 2002 are virtually flat.

Price sensitivities are higher for longer tenor bonds, while in the short-term bond,

one can expect relative price stability for a wide range of changes in yield.

d. Lower the coupon, higher the price sensitivity. Other things remaining the same,

bonds with higher coupon exhibit lower price sensitivity than bonds with higher

coupons.

65


DURATIONDURATION

Duration, as the name suggests is, in a simple framework, a measure of time, though its

applications in understanding the Price-Yield relationship are more intense.

In the case of bonds with a fixed term to maturity, the tenor of the bond is a simple

measure of the time until the bond's maturity. However, if the bond is coupon paying, the

investor receives some cash flows prior to the maturity of the bond. Therefore it may be

useful to understand what the ‘average’ maturity of a bond, with intermittent Cash Flows

is. In this case we would find out what the contribution of each of these Cash Flows is, to

the tenor of the bond. If we can compute the weighted average maturity of the bond,

using the Cash Flows as weights, we would have a better estimate of the tenor of the

bond. Since the coupons accrue at various points in time, it would be appropriate to use

the Present Value of the Cash Flows as weights, so that they are comparable. Therefore

we can arrive at an alternate measure of the tenor of a bond, accounting for all the

intermittent Cash Flows, by finding out the weighted average maturity of the bond, the

66


Present Value of Cash Flows being the weightage used. This technical measure of the

tenor of a bond is called Duration of the Bond.

Lets us attempt an intuitive understanding of Duration, with the help of an example.

Suppose one had two options:

Buy bond A selling at Rs. 100.25 with 1 year to maturity. The redemption value of

the bond is Rs. 110.275.

Buy bond B, also selling at Rs. 100.25, and 1 year to maturity. However, the bond

pays Rs. 50.5 at the end of 6 months, and Rs. 57.5 at the end of 1 year, on maturity.

Though the two options are for 1 year’s tenor, we intuitively understand that the second

option places some funds earlier than a year with us, and therefore must have an average

maturity of less than 1 year. If we are able to compute what percentage of funds, in

present value terms is available to us, in the case of bond B, we can understand what the

average maturity of bond B is.

The 2 Cash Flows accruing at the end of 6 months and 1 year have different present

values. At a discounting rate of 5% (bond equivalent yield of 10% for half year), the

Cash Flows’ Present Values are Rs.48.1 and Rs. 52.15 respectively.

This Present Value-Cash Flow stream actually means that 48% of the bond’s Cash Flows

accrue at the end of 6 months, and 52% of Cash Flows accrue at the end of 1 year. (Note

that the sum of the Cash Flows is the Current Value of the bond, i.e. Rs. 100.25; and the

sum of the weights of the Cash Flows adds up to 1. If we apply these weights to the

period associated with the Cash Flow, we know that the weighted maturity of the bond is

1.52 half years, or 0.76 years.

This is why we seem to prefer bond B, whose average maturity is actually less than a

year. The duration of this bond is 0.76 years. In the case of bond A, all the Cash Flows

accrue at the end of the year. Therefore, the duration of the bond is also 1 year.

In any bond with intermittent Cash Flows accruing prior to maturity, the average maturity

will be lesser, and duration is a measure of this average maturity of a bond.

Weighted Present Values and Duration

67


Period Cash

flow

(Rs.)

Present value

of cash flow

(Rs.)

Weight of

the present

value

Weighted

tenor of the

bond (Year)

1 50.5 48.10 0.48 0.48

2 57.5 52.15 0.52 1.04

Total 100.25 1.000 1.52

Duration 1.52/2 = 0.76 yrs

CALCULATING DURATION OF A COUPON PAYING BOND

Let us consider an example. Column 1 lists the period in which the Cash Flows accrue.

Column 2 is the list of Cash Flows, which in this case are the coupons for all the periods,

except the last one, when the coupon and redemption amount are due. Column 3 is the

Present Value of each of the Cash Flows, discounted for the appropriate period, at the

YTM rate of 9%. (4.5% on a semi-annual basis). For example, Rs. 5.26 is the discounted

value of Rs. 5.5 receivable in six months, discounted at the rate of 4.5%.

The sum of the present values is Rs. 107.91 which is the value of the bond at a YTM of

9%. Column 4 provides the weighted value of the Present Values, by computing the

product of the Present Values and the period in column 1. Duration of the Bond is the

sum of these weighted values divided by the sum of the Present Value of the Cash Flows.

8.039 is the duration in half-years. Therefore duration in years is 8.039/2, which is 4.02

years.

Duration of a 5 year 11% bond, at a YTM of 9%

Period Cash flows (Rs.)

Present Value of Cash Flows (Rs.)

Weighted Present Values(a)

Weighted Cash Flows(b)

Duration( c)

1 5.5 5.26 5.263 0.049 0.049

2 5.5 5.04 10.073 0.047 0.093

3 5.5 4.82 14.459 0.045 0.134

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4 5.5 4.61 18.448 0.043 0.171

5 5.5 4.41 22.067 0.041 0.204

6 5.5 4.22 25.341 0.039 0.235

7 5.5 4.04 28.291 0.037 0.262

8 5.5 3.87 30.940 0.036 0.287

9 5.5 3.70 33.309 0.034 0.309

10 105.5 67.93 679.344 0.630 6.295

Total 107.91 867.535 1.00 8.04 (a) Present Value in column (3) times period in column (1).(b) Present Value in column (3) as fraction of Total present value.(c) Weighted Cash flows in column (5) times period in column (1).

We can arrive at the same result by finding out the weight of each of the Discounted Cash

Flows to the total, and applying this weight to the periods in which Cash Flows accrue.

In column 5 we find the proportion of Cash Flows accruing in each of the periods, to the

total Cash Flows. Duration is the sum product of these weights, multiplied by the period

in column 1, and summed up. We arrive at the same value of 4.02 years. We also notice

what proportion of the Cash Flows of the bond accrue in each of the periods, in column 5.

Only 63% of the bonds Cash Flows accrue in 5 years.

69


INTERNATIONAL FINANCINGINTERNATIONAL FINANCING

The International Financing decision has several dimensions which must be weighed

against each other before choosing a particular mode of funding. International Financing

provides better image to Corporates both in India and abroad which is useful for

strengthening the business operations in the overseas market. It is a means of raising

capital abroad in Foreign Exchange. These Foreign Exchange can be use for activities

like overseas acquisition, setting up offices abroad and other capital expenditure.

International exposure increases recognition and develop brand image of Corporates

internationally among bankers, customers, suppliers etc.

Exchange controls, functional and geographical restrictions on Financial Institutions,

restrictions on the kind of Securities they can issue and hold in their portfolios, interest

rate ceilings and withholding taxes, barriers to foreign entities accessing national markets

as borrowers and lenders and to Foreign Financial Intermediaries offering various

types of financial services have already been dismantled or are being gradually eased

away in many countries.

70


Finally, the markets themselves have proved to be highly innovative, responding rapidly

to changing investor preferences ad the increasingly complex needs of the borrowers by

designing new instruments and highly flexible risk management products.

BENEFITS FROM INDIAN OUTLOOK

LIQUIDITY: as there are fewer restriction in the international markets, investors

can make investments in bearer Securities.

CHEAP SOURCE OF WORKING CAPITAL: international loans attract lesser interest

rate than the loans of the domestic economy.

MATURITY: International markets provides longer-term maturity.

SIZE OF ISSUE: As Corporate started realizing saving of cost in issue process of

bonds, the size expanded dramatically.

SPEED: internationally known borrowers can raised funds in market very quickly.

EXTERNAL COMMERCIAL BORROWING (ECB)

ECB is any External Commercial Borrowing of over 180 days. ECB is the borrowing by

Corporates and Financial Institutions from International Markets. ECBs include

Commercial Bank Loans, Buyers Credit, Suppliers Credit, Security Instruments such as

floating rate notes and fixed rate bonds, credit from export credit agencies, borrowings

from International Financial Institutions such as IFC etc. The incentive available for such

loans is the relative lower financing cost. ECB’s can be taken in any major currency and

for various maturities.

ECBs are being permitted by the Government for providing an additional source of

funds to Indian Corporates and PSU’s for financing expansion of existing capacity as

well as for fresh investment to augment the resources available domestically. ECBs are

approved with an overall annual ceiling. Consistent with prudent Debt-Management

keeping in view the balance of payments position and level of Foreign Exchange

Reserves.

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Average Maturities for ECB

ECBs should have the following minimum average maturities:

Minimum average maturity of three years for external commercial borrowings equal to or

less than US $ 20 million equivalent in respect of all sectors except 100% EOUs.

Minimum average maturity of 5 years for external commercial borrowings greater than

US$ 20 million equivalent in respect of all sectors except 100% EOUs.

100% Export Oriented Units (EOCs) are permitted ECB at a minimum average maturity

of three years for any amount.

Bonds and FRNs can be raised to tranches of different maturities as long as the average

maturity of the different tranches within the same overall approval taken together satisfies

the maturity criteria prescribed in the ECB guidelines.

All-in-cost ceilings

All-in-cost includes rate of interest, other fees and expenses in foreign currency except

commitment fee, pre-payment fee, and fees payable in Indian Rupees. Moreover, the

payment of withholding tax in Indian Rupees is excluded for calculating the all-in-cost.

The all-in-cost ceilings for ECB will be indicated from time to time. The following

ceilings will be valid till reviewed.

Minimum Average Maturity Period All-in-cost Ceilings over sixmonth LIBOR*

Three years and up to five years 200 basis pointsMore than five years 350 basis points

*for the respective currency of borrowing or applicable benchmark.

FOREIGN CURRENCY CONVERTIBLE BONDS (FCCB)

Means a bond issued by an Indian Company expressed in foreign currency and the

principle and interest in respect of which is payable in foreign currency. The regulatory

framework for FCCB is covered under FEMA regulations on Out Bound Investments

72


however it has been clarified that the recent guidelines on ECBs as Stated above is

applicable to FCCB in all respects.

Eligible :

Indian company or a body Corporate created by an Act of Parliament.

Limits :

Issue size upto US $ 500 million in any one financial year under automatic route.

Where issue size exceeds US $ 500 million, RBI permission necessary

Conditions :

FCCBs to be issued will have to confirm to the FDI policy (including sectoral

caps and sectors where FDI is permitted) of Government of India.

Public issue of FCCB can only be through any reputed Merchant Banker/lend

Managers in the international capital market.

Private placements can only be made either to banks or multilateral and bilateral

FIs or foreign collaborators or foreign equity holder having a minimum holding

of 10% (earlier 5%) of paid up equity capital of the company.

Minimum maturity period, all-in-costs, end-use restrictions, etc. of the ECB

guidelines are now squarely applicable to FCCBs.

Issue of FCCBs with attached warrants is not permitted.

“All in Costs” shall include coupon rate, redemption premium, default

payments, commitment fees and formatting fees (it can be net of taxes), if any

but shall not include issue- related expenses such as legal fees, lead Managers

fees out of pocket expenses.

It may be used for such purposes as permitted under ECB guidelines

FCCBs proceeds can only be retained outside India if issued for financing

imports/foreign exchange capital expenditure. In all other cases the proceeds

needs to be repatriated to Indian immediately on completion of issue process.

Recently issued FCCB

73


Essar Oil Ltd has informed BSE that at the meeting of the BoD of the company held

on July 5, 2004, the Board transacted the following business: Issue of Foreign

Currency Convertible Bonds (FCCBs) on preferential issue basis for an amount of

US$ 166 million with an option to issue additional FCCBs for US $41 million,

aggregating to US$ 207 million. Denomination – US$ 1000 per Bond. Maturity at par

value on December 31, 2017. To be listed on Luxembourg Stock Exchange.

OTHER BONDS

Yankee Bonds:

Yankee bond is a dollar-denominated bond issued in the capital markets in the US by a

non-American Company. Yankee bonds are sold in the United States, denominated in

U.S. dollars, but issued by a borrower of different nationality (e.g., a India or French

corporation). This allows a U.S. citizen to buy a bond of a foreign firm but received all

payments in U.S. dollars, eliminating exchange rate risk.

Yankee market is proved to be the vital funding area for institutional borrowers form the

U.S., financial markets. The Yankee market has grown rapidly in recent years with close

to US $ 220 billion in outstanding issues currently. It now accounts for 9 per cent of the

US Corporate bond market, as against only 3 per cent five years ago. The Corporate bond

market is the second largest market in the US after the US Government bond market,

which is roughly twice large.

Advantages:

The Yankee market also offers important advantages to issuers and investors.

They gain diversification into the world’s largest, most sophisticated capital

market.

Yankee issuers have access to longer-term financing than is available in other

markets. The US market consistently offers attractively priced funding at

maturities from 2 to 30 years. In the Eurodollar market long-term financing are

available only for high quality credits with name recognition among European

investors.

74


Issuers will find that the Yankee market offers them greater flexibility of issuance

structure. Unlike the Euromarkets, the US market offers numerous sophisticated

bond features, including puts, calls delays and other embedded options.

Multiple Currency Bonds:

Certain bonds giver the option to the holder of the bond to claim payment of coupon or

principal in currencies of his option, the bond holder may insist for payment of coupon in

DM and principal portion in US $. The exchange rate is fixed at the time of issue.

Another feature of this bond is conversion option might be given which permits as

instrument denominated in one currency to be converted into an instrument denominated

in another. For example, UK based company might issue a US dollar bond which is

convertible into shares of stock quoted in Pound Sterling. These bonds are also called

Currency Option Bonds

Junk Bonds:

Junk bonds are a high yield security which because a widely used source of finance in

takeovers and leveraged buyouts. Firms with low credit ratings are willing to pay 3 to 5

per cent more than he high grade Corporate Debt to compensate for the greater risk.

Index Bonds:

Fixed income and fixed sum repayments are uneconomic in times of rapid inflation.

Indexed bond is a financial instrument which retains the security and fixed income of the

debenture but which also provides some safeguard against inflation.

Inflation Linked Bonds:

These are bonds for which the coupon payment in a particular period is linked to the

inflation rate at that time – the base coupon rate is fixed with the inflation rate

(Consumer Price Index-CPI) being added to it to arrive at the total coupon rate.

Investors are often loath to invest in longer dated Securities due to uncertainty of future

75


interest rates. The idea behind these bonds is to make them attractive to investors by

removing the uncertainty of future inflation rates, thereby maintaining the real value of

their invested capital.

Example - Let's say that you wanted a new car which costs $10,000, but you decide to

wait for a year. You put your $10,000 in the bank or a bond at 6%. You wait the year.

Your $10,000 has grown to $10,600. You withdraw your money and wander over to the

car dealership. The dealer informs you that the price of the car you want is $11,000. You

question the price and the answer is: "We have raised the price of our car in line with

Inflation, which was 10%.

Samurai Bonds:

These are publicity issued yen denominated bonds, issued in the Japanese market and are

the most prestigious funding vehicle. Syndication and underwriting procedures are quite

elaborate and so is the documentation. Hence flotation costs tend to be high. Pricing is

done with reference to the Long-Term Prime Rate (LTPR).

Rembrandt Bonds:

These are denominated in Dutch guilder and sold in the market of The Netherlands.

Shibosai Bonds:

These are yen denominated private placement bonds, limited to financial institutions and

banks. While eligibility criteria are less stringent, the Ministry of Finance still controls

the market in terms of rating, size and maturity of the issue. Indian-entities have tapped

the Japanese market to a considerable extent starting with the Shibosai issue made by

IDBI in 1984.

Bulldog Bonds:

These are sterling denominated foreign bonds, sold in UK market and priced with

reference to UK gilts.

Kiwi Bonds: Kiwi bonds are issued in the markets of New Zealand.

76


RECENT DEVELOPMENT IN MARKETRECENT DEVELOPMENT IN MARKET

SEPTEMBER 04

The disconnect between Inflation and Bond Yield following the relaxation of investment

norms for banks by the Reserve Bank of India (RBI) on 5 September has led to bond

yields moving the opposite direction to inflation. In an efficient financial market,

inflation pushes down asset prices and reduces their value. For bonds, this translates into

fall in prices and rise in yields. In the current scenario, this has not taken place.

Inflation as onDate of Inflation

releaseInflation(%)

10-year Bond Yield (%) (on

date of Inflation release)

May 15 May 28 4.96 5.24

77


May 22 June 4 5.20 5.28

May 29 June 11 5.61 5.32

June 5 June 18 5.55 5.47

June 12 June 25 5.89 5.82

June 19 July 2 5.87 5.78

June 29 July 9 6.09 5.8

July 3 July 16 6.16 5.95

July 10 July 23 6.52 5.95

July 17 July 30 6.52 6.16

July 24 Aug 6 7.51 6.28

July 31 Aug 13 7.61 6.54

Aug 7 Aug 20 7.96 6.55

Aug 14 Aug 27 7.94 6.07

Aug 21 Sep 3 8.17 5.88

This absence of correlation between inflation and bond yields has exacerbated after last

week’s relaxation of investment norms.

A comparison of inflation and 10-year bond yield between May 15 and September further

confirms this disconnect. It may be noted that there is a 13-day lag between the date of

releasing the inflation data, and the date to which inflation relates to. What’s more

interesting is when one compares data between June 25 and September 3, inflation moved

up 228 bps to 8.2% (5.9%), while 10-year yield rose by 6 bps to 5.9% (5.8%).

Significantly, RBI allowed banks to shift SLR Securities to the HTM (Held To

Maturity) category any time, during the current accounting year. It can be done at either

cost price/book value/market value on the date of transfer, whichever is the least.

78


State Bank of India bought heavily in the market, which pushed up prices of bonds.

Trader say that more banks are expected to follow suit this week. By pushing up prices,

banks are able to account for the Securities at the higher market price in their books.

SEPTEMBER 13

The surge in Inflation to a three-and-a-half-year high of 8.33% has completely spooked

the market. Bond Prices reacted sharply, pushing yield on 10-year benchmark

Government Paper to 5.88% up over 82 basis points from the record low of 5.06% in

the first week of April 2004. More than Inflation and the rates in the Government bond

market, it is the liquidity in the banking system and the demand for bank credit that is

going to have a say on the bank lending rates.

The Cash-to-Deposit ratio of the scheduled commercial banks was 5.38% against the

stipulated cash reserve requirement of 4.5%. in the absolute terms, that is nearly Rs.

14,000 crore in excess of the required amount. Given this kind of liquidity, banks have

significant elbow-room for holding on to the current rates. This is the only reason the RBI

has announce to revised CRR (Cash Reserve Ratio) from current 4.5% to 5% in order

to curb the rising Inflation in the economy. Due to this benchmark 10-year paper fell by

a Rs. 1, while longer bonds by as much as Rs. 2.

CONCLUSIONCONCLUSION

When the equity markets are highly volatile, the returns on investments in them

are uncertain. In such a situation, exposure to fixed income market would be

desirable by some of the individual risk averse investors and portfolio managers

as they would be interested in earning an assured fixed return. Though the Debt

Instruments are more secured than Equity Instruments, the pricing of the former is

as crucial as that of the latter. Even though the fixed deposits are undoubtedly the

safest form of investments, they inherently have two disadvantages that work

against the investor. Firstly, the amount available to the investor on the upside is

79


always fixed. In a scenario where the interest rates are increased by the Central

Bank, the investor is the loser.

Given the low risk profile of Indian Investors, it is imperative to have a developed

Debt market where they can make investments. Also it would not be wrong to say

that the low risk profile of Indians would make Debt Market the engine of

financing requirements for Corporates and thus a developed Debt Market could

boost the growth of the country.

Enlargement of Retail Debt Market is also very much needed in order to help

Indian Capital markets to attain a place of pride among the leading Capital

Markets of the world.

IMPROVEMENT THROUGHIMPROVEMENT THROUGH

Introduction of new instruments like STRIPS, G-Secs, with Call and Put Option,

Securitized Paper etc.

Development of the Secondary Market in Corporate Debt.

Introduction of Interest Rate Derivates based on a wide range of underlying in the

Indian Debt and Money Market.

Development of the Secondary Repo Markets.

80


Priority should be given for the development of Municipal Bonds in the Indian

market.

Market making, making Corporate Bonds ‘repoable’, forcing banks to classify

Corporate paper as Held To Maturity and Held For Trading will no doubt help

enhance the share of Corporate bonds in the secondary market turnover.

Improving the transaction-processing Infrastructure.

Incentives to Retail & Foreign Investors to participate in the market.

Removal of Tax loop holes and efficient Price Discovery Mechanism.

Transparency in the System and most importantly Deep & Liquid Secondary

Market.

Finally, for the healthy development of the Debt Market, participants need to take not just

rate risk, but also credit risk. Plus, the availability of a risk spectrum is a prerequisite to

the development of the market. Complexity and variety of instruments, investors and

issuers will deepen the market and help it grow.

81


BIBLIOGRAPHYBIBLIOGRAPHY

BOOKS

NCFM Module

NSE Fact Book – 2004

NSE : Indian Securities Market.

International Financing – Maurice D. Levi

International Finance – P.G. Abhankar

Financial Management – Ravi M. Kishore

NEWSPAPER AND MAGAZINE

The Economic Times

Analyst

WEBSITE

www.debtonnet.com

www.investopedia.com

www.nseindia.com

www.icfai.com

www.financialpipeline.com

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http://www.financialpipeline.com/

http://www.icfai.com/

http://www.nseindia.com/

http://www.investopedia.com/

http://www.debtonnet.com/

debt_market_81_-_i_1_

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