EXECUTIVE 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.
OBJECTIVE
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.
METHODOLOGY
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.
INTRODUCTION
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.
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 Indias 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.
CHARACTERISTIC
Issuer
Corporation
Municipality
Government
International
india Government
Treasuries
Bond ( 10yrs. )
Note ( 1 10 yrs. )
T Bills ( < 1 yrs. )
Priority
Junior or
Subordinated
Senior or
Unsubordinated
International
Bond Issues
Eurobond
Foreign
Global
Coupon Rate
Fixed Income
Floater
Inverse Floater
Zero Coupon
Redemption
Features
Callable
Convertible
Puttable
PRIMARY MARKET
SECONDARY MARKET
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.
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 SemiGovernment or other public bodies or debentures of joint stock companies are affected.
The 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.
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
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.
effective and accessible means for long term investments for retail
investors.
10
Diversification of risk.
Low cost of intermediation for investors.
Instrument
Dated Securities
Maturity
2 20 years
Central
Government
T-Bills
91/364 days
State
Government
PSUs
Dated Securities
5 -10 years
Bonds, Structured
Obligations
5 10 years
Corporates
Debentures
1 -12 years
Corporates,
PDs
Commercial
Paper
3 months to
1 year
Banks
Certificates of
Deposits
3 months to
1 year
Investors
RBI, Banks, Insurance Companies,
Provident Funds, Mutual Funds,
PDs
RBI, Banks, Insurance
Companies, Provident Funds,
Mutual Funds, PDs, Individuals
Banks, Insurance Companies,
Provident Funds
Banks, Insurance
Companies, Provident Funds,
Mutual Funds, PDs, Individuals
Banks, Mutual Funds, Corporates,
Individuals
Banks, Corporate, Financial
institutions, Mutual funds,
Individuals
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.
ENTITIES
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MARKET INFORMATION
Dematerialisation
ii.
Re-materialisation
iii.
iv.
v.
Corporate Actions
Interest payment
Redemption
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
instruments.
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Interventionists
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INSTRUMENTS
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:
Interest Rate
Different kinds of Debt instruments and their key terms and characteristics are
discussed below.
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.
17
Maxi
mum
(%
p.a.)
Minimu
m (%
p.a.)
Average
(% p.a.)
1996 97
1997 - 98
1998 - 99
1999 - 00
2000 - 01
14.6
52.2
20.2
35.0
28.0
1.05
0.2
3.6
0.1
2.0
7.8
8.7
7.8
9.0
7.5
Coefficient
of
variation
*
37.3
85.7
14.9
12.7
11.2
Bank rate
(End
March)
(% p.a.)
12.0
10.5
8.0
8.0
7.5
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Month-Year
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.
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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.
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the borrower, and the second, which involves repayment of the borrowing.
The settlement amount for the first leg consists of:
a.
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.
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
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= 3,888. 89
= 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
= 3,958. 33
= 41. 67
Settlement Amount:
= 1,12,500.
Repos in Central
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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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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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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 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
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26
(Rs. Crore)
Holders
Reserve Bank of India
Banks
State Governments
Others
14 Day
(Intermediate)
11,393
438
91 Day
(Auction)
15,895
1,170
8,872
364 Day
(Auction)
27,474
8,648
Total
(2+3+4)
43,369
12,563
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.
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
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29
30
31
Put/Call Option
Credit Rating
Security
Source: The Economic Times, Big Bucks dated August 16th, 2004
The issue opened on July 29, 2004 and will close on October 15, 2004.
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Municipal
Bonds
AMC05
NMC06
Issue
14%
14.75%
ST
MT
MT
Last
Last
Trading
Trading
Last Trading
Date
Quantity
Price
50.00
99.2500
500.00
106.558
AHMEDABAD MUN.
28 June
1998
NASHIK MUNICIPAL
08 may
14.75% 2006
2002
Municipal Securities (munis) are interest-paying Debt Securities that State and
Municipal Governments issue to finance operating expenditures, to fund certain taxexempt 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.
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Corporate Debentures
34
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
35
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
bonds 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
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.
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37
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.
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39
GOVERNMENT
PSUS
OF INDIA AND
40
(ii)
(iii)
(iv)
To make Primary Dealers and effective conduit for conducting open market
operations.
Subsidiaries
Companies
41
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
including intermediaries that have good distribution channels and thus add depth
to secondary market trading and widen the investor base;
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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 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.
rominent DFI issuers include ICICI, IDBI, IFCI, IRBI, as well as some State level
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.
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45
INVESTORS
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
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47
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 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-Secs. 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
48
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.
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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,
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.
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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.
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REGULATORS
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
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53
54
55
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.
56
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
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
57
58
Illustration of Auctions
Amount bid Implied YTM at bid price
(Rs. cr.)
100
650
300
1400
1250
1000
750
400
300
(% per annum)
10.6792
10.6922
10.7102
10.7272
10.7402
10.7552
10.7722
10.7882
10.8002
Price (Rs.)
111.6475
111.5519
111.4198
111.2952
111.2000
111.0904
110.9663
110.8497
110.7624
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
59
364-day
Periodic
ity
Weekly
Fortnigh
tly
Notified
Amount
Day of Auction
(Rs. cr.)
250
750
Day of
Payment
Every
Following
Wednesday
Wednesday
Thursday
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.
60
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
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:
Debenture Trustees
62
If
Should be Scheduled banks, and having net worth of Rs. 50 crore or above.
Investment grade credit rating required
Corporate Bodies
Tax
statues/regulation.
63
Eligibility:
Issuing and Paying Agent (IPA): Only a scheduled bank can act as an IPA.
Investment
64
Role and Responsibilities: The Guidelines prescribe role and responsibilities for
issuer, IPA and Credit Rating Agency.
VALUATION 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
65
Cash flow
(Rs.)
5.875
5.875
5.875
5.875
5.875
5.875
5.875
5.875
5.875
5.875
5.875
5.875
5.875
5.875
5.875
66
105.875
Value of the
bond
41.677
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.
YIELD
The returns to an investor in bond is made up of three components: Coupon,
Interest from re-investment of coupons and
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 reinvestment 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,
67
68
0.9
0.8
0.7
0.6
Price ( Rs.)
0.5
C G2001
0.4
C G2002
C G2005
C G2009
C G2013
0.3
0.2
0.1
0
0
0.05
0.1
0.15
0.2
0.25
YTM (%)
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DURATION
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 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.
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Though the two options are for 1 years 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 bonds 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
Period
1
2
Total
Cash
Present value
Weight of
Weighted
flow
of cash flow
the present
tenor of the
value
0.48
0.52
1.000
bond (Year)
0.48
1.04
1.52
1.52/2 = 0.76 yrs
(Rs.)
50.5
57.5
(Rs.)
48.10
52.15
100.25
Duration
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72
INTERNATIONAL FINANCING
The International Financing decision has several dimensions which must be
weighed against each other before choosing a particular mode of funding. International
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SPEED: internationally known borrowers can raised funds in market very quickly.
74
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,
75
FCCBs to be issued
sectoral
Public
Private
Minimum
76
Issue of FCCBs
All
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.
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
77
Advantages:
The Yankee market also offers important advantages to issuers and investors.
They
market.
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:
78
Rembrandt Bonds:
79
80
SEPTEMBER 2010
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 on
Date of Inflation
release
May 15
May 28
4.96
5.24
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 weeks relaxation of investment norms.
81
SEPTEMBER 2010
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.
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CONCLUSION
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
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.
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IMPROVEMENT 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.
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.
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BIBLIOGRAPHY
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
WEBSITE
www.debtonnet.com
www.investopedia.com
www.nseindia.com
www.icfai.com
www.financialpipeline.com
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