PROJECT REPORT ON

DEBT MARKET

A PROJECT REPORT SUBMITTED TO THE UNIVERSITY OF MUMBAI FOR THE

AWARD OF THE DEGREE OF BACHELOR OF MANAGEMENT STUDIES
ACADEMIC YEAR
2012-2013

SUBMITTED BY:
FORAM MANSUKH SAVLA
MITHIBAI COLLEGE
MUMBAI

PROJECT GUIDE:
NAVEEN ROHATGI

CERTIFICATE
This to certify that Foram M. Savla has completed the project under the guidance of
Prof. Naveen Rohatgi in the academic year 2012-2013 and has submitted the same to the
University of Mumbai in partial fulfillment of the requirement of Bachelors of Management
Studies.

________________________
Signature of the Principal

______________________
Signature of Project Guide

__________________________
Signature of External Examiner

DECLARATION
This is to certify that the project report entitled CHANAKYA INC. is submitted by me in
partial fulfillment of the requirement of Bachelors of Management Studies in the academic
year 2010 2011. The information it comprises of is true and original as per my research and
observation.

_____________________
Signature of the Student
2

ACKNOWLEDGEMENT

I sincerely thank my guide and mentor Prof. Naveen Rohatgi for his valuable advice and
guidance in making this project.
I take this opportunity to thank a number of individuals whose guidance and encouragement
were of enormous help to me while working on this project.
I would like to thank the principal to provide the best facilities and good working
environment to prepare the project.
Last but not the least; I would also like to thank my parents, classmates and other people
associated with this project without whose support this project would not have been possible

EXECUTIVE SUMMARY
Financial market consisting of capital market and money market constitute one of the major
elements of the corporate firms operating environment. These firms use capital market in
raising long-term funds to take up their capital budgeting proposals and money markets to
fund their current working capital needs and requirements.
The debt instruments that constitute the entire financial markets (including capital markets
and money markets) represents contracts whereby one party lends money to another party on
pre-determined terms with regard to rate of interest to be paid by the borrower to the lender,
the periodicity of such interest payment, and the repayment of the principal amount
borrowed. In the Indian securities markets, we use the term bonds for debt instruments
issued by central or state governments and public sector organizations and the term
debentures for the securities issued by the private corporate organizations.
This project finds out the various instruments being issued by the government viz., Bonds,
Treasury Bills, Call Money Markets, Repo Markets etc., in order to finance its fiscal deficit.
It tries to analyze the basic issuance process of these instruments and the participants those
are involved in various transactions in the Wholesale Debt Market.
The project takes help of various tables and graphs in order to easily analyze the various
parameters viz., Market-wise distribution of various instruments traded, participant- wise
distribution, concentration of participants in the wholesale debt market, etc.
The project also seeks to analyze how an investor can judge whether his/her money invested
is safe by analyzing the credit rating of various securities and also to find out at what rate will
the money grow within the tenure of investment. This is basically achieved by using certain
formulae, viz., calculation of yield, given the price, calculation of price, given the yield, etc.
The current trends in the debt market for e.g., effect of interest rate , new policies being
proposed to be initiated by the new government, credit rating, rising inflation etc on the yield
of the securities and hence the price of the securities.
The Objectives of the Project Report:
1. to study the debt markets in Indiadifferent types of participants involved analysis of bond
yields and concept of Bond Pricing.
2. The study further tries to analyze the different types of securities being traded in the debt
markets in brief.
4

INDEX
Sr. No.

Contents

What is Debt

Debt Market and its Evolution

Structure of Debt Market

Instruments traded

Working

Credit Rating

Participants

Regulators

Impact on the Economy

10

Factors influencing Debt Market

11

Bonds

12

Debenture

13

Money market

14

Indian corporate debt market: Current

Status

15

Bibliography

Page No.

WHAT IS DEBT?
An

amount

of

money

borrowed

by

one

party

from

another

party

Many

corporations/individuals use debt as a method for making large purchases that they could not
afford under normal circumstances. A debt arrangement gives the borrowing party permission
to borrow money under the condition that it is to be paid back at a later date, usually with
interest.
An amount owed to a person or organization for funds borrowed. Debt can be represented by
a loan note, bond, mortgage or other form stating repayment terms and, if applicable, interest
requirements. These different forms all imply intent to pay back an amount owed by a
specific date, which is set forth in the repayment terms.
A debt is an obligation owed by one party (the debtor) to a second party, the creditor; usually
this refers to assets granted by the creditor to the debtor, but the term can also be used
metaphorically to cover moral obligations and other interactions not based on economic
value.
A debt is created when a creditor agrees to lend a sum of assets to a debtor. Debt is usually
granted with expected repayment; in modern society, in most cases, this includes repayment
of the original sum, plus interest.
In finance, debt is a means of using anticipated future purchasing power in the present before
it has actually been earned. Some companies and corporations use debt as a part of their
overall corporate finance strategy.
Debt is as old as economy. The anthropologist David Graeber argues in Debt: The First 5000
Years that trade starts with some sort of credit namely the promise to pay later for already
handed over goods. Therefore credit and debt existed even before coins
Before a debt can be made, both the debtor and the creditor must agree on the manner in
which the debt will be repaid, known as the standard of deferred payment. This payment is
usually denominated as a sum of money in units of currency, but can sometimes be

denominated in terms of goods or services. Payment can be made in increments over a period
of time, or all at once at the end of the loan agreement.

Types of debt
A company uses various kinds of debt to finance its operations. The various types of debt can
generally be categorized into:
1) Secured and unsecured debt,
2) Private and public debt,
3) Syndicated and bilateral debt
A debt obligation is considered secured, if creditors have recourse to the assets of the
company on a proprietary basis or otherwise ahead of general claims against the company.
Unsecured debt comprises financial obligations, where creditors do not have recourse to the
assets of the borrower to satisfy their claims.
Private debt comprises bank-loan type obligations, whether senior or mezzanine. Public debt
is a general definition covering all financial instruments that are freely tradable on a public
exchange or over the counter, with few if any restrictions.
A basic loan or "term loan" is the simplest form of debt. It consists of an agreement to lend a
fixed amount of money, called the principal sum, for a fixed period of time, with this amount
to be repaid by a certain date. In commercial loans interest, calculated as a percentage of the
principal sum per year, will also have to be paid by that date, or may be paid periodically in
the interval, such as annually or monthly. Such loans are also colloquially called bullet loans,
particularly if there is only a single payment at the end the "bullet" without a "stream" of
interest payments during the "life" of the loan. There are many conventions on how interest is
calculated see day count convention for some while a standard convention is the annual
percentage rate (APR), widely used and required by regulation in the United States and
United Kingdom, though there are different forms of APR.
In some loans, the amount actually loaned to the debtor is less than the principal sum to be
repaid; the additional principal has the same economic effect as a higher interest rate (see
7

point), and is sometimes referred to as a banker's dozen, a play on "baker's dozen" owe
twelve (a dozen), receive a loan of eleven (a banker's dozen). Note that the effective interest
rate is not equal to the discount: if one borrows $10 and must repay $11, then this is ($11
$10)/$10 = 10% interest; however, if one borrows $9 and must repay $10, then this is ($10
$9)/$9 = 11 1/9 % interest.
Rather than the entire principal amount of the loan being due at the end of the loan, the
principal may be slowly repaid or "amortized" over the course of the loan see amortizing
loan. This is particularly common in mortgages and in the minimum payment on credit cards.
A syndicated loan is a loan that is granted to companies that wish to borrow more money than
any single lender is prepared to risk in a single loan, usually many millions of dollars. In such
a case, a syndicate of banks can each agree to put forward a portion of the principal sum.
Loan syndication is a risk management tool that allows the lead banks underwriting the debt
to reduce their risk and free up lending capacity.

DEBT MARKET AND ITS EVOLUTION

The debt market is any market situation where the trading debt instruments take place.
Examples of debt instruments include mortgages, promissory notes, bonds, and Certificates
of Deposit. A debt market establishes a structured environment where these types of debt can
be traded with ease between interested parties.
Definition: The market for trading debt instruments.
The Debt market (also known as the bond, credit or fixed income market) is a financial
market where participants buy and sell debt securities.
Debt market is called by different names, based on the types of debt instruments that are
traded.

Bond market: if the market mainly deals with the trading of municipal and corporate

bond issues, the debt market may be known as bond market.

Credit market: if mortgages and promissory notes are the main focus of the trading,

the debt market may be known as a credit market.

Fixed income market: when fixed rates are connected with the debt instruments, the
market may be known as fixed income market.

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. Debt Markets are therefore,
markets for fixed income securities issued by:
o Central and State Governments
o Municipal Corporations
o Entities like Financial Institutions, Banks, Public Sector Units, and Public Ltd.
companies.

10

Individual investors as well as groups or corporate partners may participate in a debt market.
Depending on the regulations imposed by governments, there may be very little distinction
between how an individual investor versus a corporation would participate in a debt market.
However, there are usually some regulations in place that require that any type of investor in
debt market offerings have a minimum amount of assets to back the activity. This is true even
with situations such as bonds, where there is very little chance of the investor losing his or
her investment.

11

Indian Debt Markets - Pillars of the Indian Economy

State of Debt Market during 1980s
In India, fiscal policy compulsions rendered internal debt management before 1991-92
passive. To keep government borrowing costs down, Treasury bill rates were kept low, while
the low coupon rates offered on government securities made real rates of return negative for
several years till the mid-1980s. During the 1980s, the volume of debt expanded
considerably, particularly short-term debt, due to automatic accommodation through the
mechanism of ad hoc Treasury Bills. With captive investor base and interest rates below the
market rate, secondary market for government bonds remained dormant. Artificial yields on
government securities distorted the yield structure of financial assets in the system and led to
higher lending rates and cross subsidization. In view of the rising requirements of
Government, Reserve Bank's monetary management was dominated by a regime of
administered interest rates and rising CRR and SLR prescriptions. High CRR and SLR left
little room for monetary maneuvering. It is against this backdrop, and in the context of the
overall economic and financial sector reforms, that development of the government securities
markets was initiated in the 1990s.

Towards the eighteenth century, the borrowing needs of Indian Princely States were largely
met by Indigenous bankers and financiers. The concept of borrowing from the public in India
was pioneered by the East India Company to finance its campaigns in South India (the Anglo
French wars) in the eighteenth century. The debt owed by the Government to the public, over
time, came to be known as public debt. The endeavours of the Company to establish
government banks towards the end of the 18th Century owed in no small measure to the need
to rise term and short term financial accommodation from banks on more satisfactory terms
than they were able to garner on their own.
Public Debt, today, is raised to meet the Governments revenue deficits (the difference
between the income of the government and money spent to run the government) or to finance
public works (capital formation). Borrowing for financing railway construction and public
works such irrigation canals was first undertaken in 1867. The First World War saw a rise in
India's Public Debt as a result of India's contribution to the British exchequer towards the cost
12

of the war. The provinces of British India were allowed to float loans for the first time in
December, 1920 when local government borrowing rules were issued under section 30(a) of
the Government of India Act, 1919. Only three provinces viz., Bombay, United Provinces and
Punjab utilised this sanction before the introduction of provincial autonomy. Public Debt was
managed by the Presidency Banks, the Comptroller and Auditor-General of India till 1913
and thereafter by the Controller of the Currency till 1935 when the Reserve Bank commenced
operations.

Interest rates varied over time and after the uprising of 1857 gradually came down to about
5% and later to 4% in 1871. In 1894, the famous 3 1/2 % paper was created which continued
to be in existence for almost 50 years. When the Reserve Bank of India took over the
management of public debt from the Controller of the Currency in 1935, the total funded debt
of the Central Government amounted to Rs 950 crores of which 54% amounted to sterling
debt and 46% rupee debt and the debt of the Provinces amounted to Rs 18 crores.
Broadly, the phases of public debt in India could be divided into the following phases.
Up to 1867: when public debt was driven largely by needs of financing campaigns.
1867- 1916: when public debt was raised for financing railways and canals and other such
purposes.
1917-1940: when public debt increased substantially essentially out of the considerations of
1940-1946: when because of war time inflation, the effort was to mop up as much as
possible of the current war time incomes
1947-1951: represented the interregnum following war and partition and the economy was
unsettled. Government of India failed to achieve the estimates for borrowings for which
credit had been taken in the annual budgets.
1951-1985: when borrowing was influenced by the five year plans.
1985-1991: when an attempt was made to align the interest rates on government securities
with market interest rates in the wake of the recommendations of the Chakraborti Committee
Report.

13

1991 to date: When comprehensive reforms of the Government Securities market were
undertaken and an active debt management policy put in place. Ad Hoc Treasury bills were
abolished; commenced the selling of securities through the auction process; new instruments
were introduced such as zero coupon bonds, floating rate bonds and capital indexed bonds;
the Securities Trading Corporation of India was established; a system of Primary Dealers in
government securities was put in place; the spectrum of maturities was broadened; the system
of Delivery versus payment was instituted; standard valuation norms were prescribed; and
endeavours made to ensure transparency in operations through market process, the
dissemination of information and efforts were made to give an impetus to the secondary
market so as to broaden and deepen the market to make it more efficient.

In India and the world over, Government Bonds have, from time to time, have not only
adopted innovative methods for raising resources (legalised wagering contracts like the Prize
Bonds issued in the 1940s and later 1950s in India) but have also been used for various
innovative schemes such as finance for development; social engineering like the abolition of
the Zamindari system; saving the environment; or even weaning people away from gold (the
gold bonds issued in 1993).
Normally the sovereign is considered the best risk in the country and sovereign paper sets the
benchmark for interest rates for the corresponding maturity of other issuing entities.
Theoretically, others can borrow at a rate above what the Government pays depending on
how their risk is perceived by the markets. Hence, a well developed Government Securities
market helps in the efficient allocation of resources. A countrys debt market to a large extent
depends on the depth of the Governments Bond Market. In this context the recent initiatives
to widen and deepen the Government Securities Market and to make it more efficient have
been taken.
The Debt Markets play a very crucial role in any modern economy. And more so in the case
of developing countries like India which need to employ a large amount of capital and
resources for achieving the desired degree of industrial and financial growth. The Indian Debt
Markets are today one of the largest in Asia and includes securities issued by the Government
(Central & State Governments), public sector undertakings, other government bodies,
financial institutions, banks and corporate. The Indian Debt Markets with an outstanding
14

issue size of close to Rs.7000 Billion (or Rs. 7,00,000 Crores) and a secondary market
turnover of around Rs.24,000 Billion (in the previous year - 2002) is the largest of the Indian
financial markets.
The Government Securities (G-Secs) market is the oldest and the largest component of the
Indian Debt Market in terms of market capitalization, outstanding securities and trading
volumes. The outstanding volumes of Government Securities (Central & State) as at the end
of 2002 are estimated at around Rs. 5, 50,000 crores. The G-Secs market plays a vital role in
the Indian economy as it provides the benchmark for determining the level of interest rates in
the country through the yields on the government securities which are referred to as the riskfree rate of return in any economy.

15

Evolution of Indian Debt Market

Till 1991, money was collected and lent according to Plan. If planning went awry, the
government approached RBI, its banker. The central bank made a few phone calls to the
heads of banks and bonds were issued and the money arranged. No questions asked, no
explanations given. If anybody wanted a loan, they approached the banks to borrow money at
fixed rates. That, in short, was the debt market in India ten years ago.
From the rudimentary form of a debt market then to the threshold of vibrant, real-time trading
in a range of debt instruments, the journey has been long but rapid. The contours of the debt
market began taking shape in the late 1990s when the government started borrowing at
market rates. Slowly, but steadily, the market grew, adding fresh players and novel
instruments. The growth of the debt market, in terms of participation, competition, depth and
range, has been phenomenal.
Recent years have seen significant transformation in the debt market in India with far
reaching implications. As the process of reform continues, the role of financial markets in the
economy gets significantly enhanced. While this process essentially involves domestic
liberalization, the decision to open up the economy adds urgency and complexity to the
process of developing financial markets in India. The Reserve Bank of India has been taking
special efforts to develop the various segments of financial markets, in particular, money,
Government securities and forex markets. Government securities market constitutes a
predominant portion of debt markets in India. The relative share of non-Government bonds
has also picked up in recent years, as a logical extension of reforms in the Government
securities markets and opening up of the financial sector. Even so, given the size of the
sovereign debt, central to the development of debt market is the development of the
Government securities market.
Today, the size of the Indian debt market is a mammoth Rs 6.5 lakh crore, including
outstanding government debt, and is gradually attaining a level of sophistication comparable
to some of the other world markets.
While in 1996 there were around six PDs (primary dealers), today there are 18. The debt
market is growing and deepening and this is also indicated by the fact that it has given
16

benchmarks to other money market instruments such as the CPs and inter-corporate deposits.
With proper infrastructure in place, our markets will truly be integrated with international
markets in future. The apex bank issued floating rate bonds of short maturities which were an
instant hit in the market.

17

Reforms Leading to Development of Debt Market

While the first phase of reforms in 1991 addressed issues in the equity market, it is only in
the second half of the decade that the development of debt markets was given due
consideration. The focus of the reforms was on setting up a comprehensive system of primary
dealers, adoption of the DVP Delivery-versus-Payment (DvP) system for settlement of
government securities transactions, abolition of tax deductions at source on G-sects,
permitting foreign institutional investors to invest in debt instruments, including government
stock and allowing them to hedge their foreign currency risk in the forward market, and
placing investments of banks in preference shares, debentures and bonds of corporate outside
the 5 per cent limit. The relaxation of restrictions was the first step that spurred the
development of the debt market with private placements gaining prominence among
corporate. The Discount and Finance House of India (DFHI), which was set up by the RBI
along with public sector banks in the late 1980s to develop the money market, was accredited
as a Primary Dealer in 1996, along with the Securities Trading Corporation of India (STCI).
The RBI is pulling out of DFHI and STCI to get over any conflicts of interest.
The Narasimham Committee recommended that the Government must borrow at market
related rates. Only then a need was felt for Primary Dealers to enable price discovery, a debt
market analyst said. While DFHI was instituted for short-term instruments such as
commercial paper, STCI was floated for the development of G-secs. This was followed by
the gradual induction of other players, local and foreign, and PD operations gathered
momentum. According to dealers, one of the vital aspects of the development of debt markets
has been the increase in the number of active participants and the turnover. Earlier, while this
segment was dominated by nationalized banks, today commercial banks, mutual funds and
PDs are among the most important players.
The share of PDs in primary issuances of dated securities of the Central Government rose
four-fold in 2000-01 from Rs 11,916 crore in 1997-98. In the treasury bills market, the share
of PDs was 85 per cent of the total issues of treasury bills in 2000-01, as per RBI data.
Between August 1999 and August 2001, State governments raised Rs 4,680 crore from 18
auctions. The share of PDs in the State government auction issues held so far, including
purchases due to underwriting commitments, amounted to 36 per cent of total issues. The
central banks focus is also on the development of the money market and to this end several
18

strategies are being adopted ranging from the Liquidity Adjustment Facility operations to the
phased withdrawal of non-bank participants that lend in the call money market.
Sector-specific refinance support is being rationalized and the additional recourse to the
standing liquidity facilities of the RBI is being made increasingly market-based. Repo
markets are being developed with lending and borrowing access to non-banks in these
markets background and Role of RBI.
Recent years have seen significant transformation in the debt market in India with far
reaching implications. As the process of reform continues, the role of financial markets in the
economy gets significantly enhanced. While this process essentially involves domestic
liberalization, the decision to open up the economy adds urgency and complexity to the
process of developing financial markets in India. The Reserve Bank of India has been taking
special efforts to develop the various segments of financial markets, in particular, money,
Government securities and forex markets. Government securities market constitutes a
predominant portion of debt markets in India. The relative share of non-Government bonds
has also picked up in recent years, as a logical extension of reforms in the Government
securities markets and opening up of the financial sector. Even so, given the size of the
sovereign debt, central to the development of debt market is the development of the
Government securities market.
Since the sixties and until the nineties, the Government Securities market remained dormant
since the government was borrowing at preannounced coupon rates from basically a captive
group of investors, such as banks. In a way, we had a passive internal debt management
policy. This, coupled with automatic monetization of budget deficit prevented development of
a deep and vibrant Government Securities market. As long as automatic monetization existed,
it was difficult to assure a framework for Government securities market in terms of matching
demand and supply through a price discovery mechanism. Hence, a most significant
development has been the elimination of the practice of automatic monetization of the
Central Government budget deficit through Ad hoc Treasury Bills with effect from April 1,
1997 and the introduction of a new scheme of Ways and Means Advances (WMA). In the
nineties, several other measures were taken for creating an enabling environment for efficient
market conditions. For instance, the total effective statutory pre-emption of the banking
system has been progressively brought down, the administrative structure of interest rates has
almost been dismantled, prudential norms have been introduced gradually in line with
19

international best practices, banking supervision has been strengthened, transparency and
disclosure standards were enhanced to be on par with international standards, and risk
management practices have been prescribed.
Market Development Measures
There are several ways of analyzing market development, and perhaps a convenient way is to
track measures in regard to instruments, institutions and participants.
1) Instrument Development
From the investor point of view, a range of Treasury Bills give a variety of options for
managing cash surpluses. At the same time, for Government spending long-term funds are
needed to be raised in a cost-effective manner. Keeping these in view, over the reform period,
a variety of Treasury Bills of 14-day, 91-day, and 182-day and 364-day maturity have been
introduced. In the long-term segment, the vanilla or the fixed coupon bonds are the most
commonly issued instruments. However, over the years, given the large market borrowing
program of the Government and a large variety of investors, we have tried to innovate and
issued zero coupon bonds, floating rate bonds, and capital indexed bonds. Government dated
securities have been issued in a maturity range of 2 to 20 years depending on prevailing
conditions in the market. Currently, the weighted average maturity of outstanding marketable
debt is 7.75 years.
The non-Government debt market has a wider variety of bonds from very short-term to longterm maturity. These bonds have many innovative features like step-up, call and put options,
and include structured obligations, etc. Much of the PSU bonds and corporate securities are
privately placed.
Repos are permitted in Government securities. It has also been decided to extend repos in
PSU bonds and private corporate debt securities, provided they are held in dematerialized
form in a depository and the transactions are done in recognized stock exchanges. The system
is yet to be fully operationalised.

20

2) Institution Development
Early during the reform process, the Reserve Bank promoted the Discount and Finance House
of India and Securities Trading Corporation of India to promote the development of the
money market and secondary market for government securities. The Reserve Bank has
subsequently sold its majority shares to market participants and these institutions have since
obtained Primary Dealership in Government Securities.
Since the inception in 1995, the number of Primary Dealers (PDs) in Government Securities
has progressively increased from 6 to 18. The obligations cast upon PDs include an annual
minimum bidding commitment for dated securities and Treasury Bills with a minimum
success ratio and commitment to underwrite the gap between the subscribed/accepted amount
in respect of dated securities and the notified amount, where there is a short-fall. The PDs are
allowed access to call money as well as repos/reverse repo markets and to trade in all money
market instruments. They have access to Subsidiary General Ledger (SGL) and current
account facility with the Reserve Bank. The Reserve Bank also conducts exclusive Open
Market Operations (OMO) in T-Bills through PDs. A second level satellite dealer system
exits, with the main objective of retailing Government Securities. These satellite dealers are
also given some liquidity support by the Reserve Bank. A few of these SDs have graduated as
PDs.
It may be of interest to note that among the Primary Dealers, the newly licensed are, J.P.
Morgan, ABN Amro, Deutsche Bank, and DSP-Merrill Lynch.
The Reserve Bank has also encouraged the setting up of mutual funds dealing exclusively in
gilts, called gilt funds. Like PDs and SDs, these gilt funds are also provided with liquidity
support, among other facilities.
Significant reforms in the non-Government debt market should also be recognized. National
and local stock exchanges have been set up with facility for trading in corporate debt, and for
that matter, even Government debt, through screen based systems. The securities and
Exchange Board of India regulates the primary issuances in capital and non-Government debt
markets and ensures sound trading practices through stock exchanges. Depositories have been
set up to facilitate dematerialization and quicker transfer mechanisms.

21

3) Participants
As it is well known, a large participant base would result in lower cost of borrowing for the
Government. In fact, retailing of Government Securities is high on the agenda of further
reforms.
Banks are the major investors in the Government Securities markets. Traditionally, banks are
required to maintain a part of their net demand and time liabilities in the form of liquid assets
of which Government Securities have always formed the predominant share. Despite
lowering the Statutory Liquidity Ratio (SLR) to the minimum of 25 per cent, banks are
holding a much larger share of Government Stock as a portfolio choice. Other major
investors in Government Stock are financial institutions, insurance companies, mutual funds,
corporate, individuals, non-resident Indians and overseas corporate bodies. Foreign
institutional investors are permitted to invest in Treasury Bills and dated Government
Securities in both primary and secondary markets.
Often, the same participants are present in the non-Government debt market also, either as
issuers or investors. For example, banks are issuers in the debt market for their Tier-II capital.
On the other hand, they are investors in PSU bonds and corporate securities. Foreign
Institutional Investors are relatively more active in non-Government debt segment as
compared to the Government debt segment.
4) Technology Aspects
Development of technology is an integral part of reforming the debt market, especially in the
context of providing a technologically superior dealing and settlement system. Hence, the
RBI has embarked upon the technological up gradation of debt market. The RBI has just
commenced a project for complete automation of the operations of its Public Debt Office
(PDO) where the settlement for all Government Securities Transactions takes place. It will
provide for connectivity between different PDOs, and facilitate on-line screen based
execution for trade and settlement in Government Securities transactions. The project will be
implemented in phases. The first phase will cover the PDO computerization at Mumbai and
facilitate screen based negotiated dealings in Government securities and money market
instruments, tendering of screen based applications in auctions, full-fledged audit trail, debt
servicing, information dissemination, price list for open market operations, central
22

information system for access by monitoring and regulatory authorities, etc. It is expected
that the first phase will be operationalised well within a year. In the second phase, other
regional PDOs would be linked with the central PDO system. This phase will facilitate active
open market operations of RBI through all regional PDOs. The entire project is expected to
be operationalised in about a year. The RBI is also separately putting in place real time gross
settlement system, which is scheduled to be operational within the same time frame.
5) Regulatory Aspects
In order to curb certain unhealthy trends that had developed in the securities market and to
prevent undesirable speculation, the Government had prohibited forward trading in securities
in June 1969 through a Notification. Recognizing that rescinding the 1969 Notification is
necessary for developing the debt markets, at the recommendation of the Reserve Bank, the
Government recently brought about amendments to Securities Contracts (Regulation) Act
1956 which made it possible for Government to delegate some responsibilities to the RBI.
Currently the regulatory jurisdiction over the Government and non-Government debt markets
has been delegated to the Reserve Bank and Securities and Exchange Board of India by the
Government. The Reserve Bank will regulate in relation to any contracts in Government
securities, money market securities, and gold related securities and in securities derived from
these securities and in relation to ready forward contracts in bonds, debentures, debenture
stock, and securitized and other debt securities.
These amendments help RBI to put in place, from time to time, appropriate regulatory
framework, keeping in view rapid changes in financial institutions, instruments and practices
governing money, Government Securities and forex markets, apart from gold-related
financial products. With the delegation of powers by Government to RBI in these matters, the
procedural delays and constraints can be eliminated.
6) Transparency Aspects
Transparency in operations and data dissemination is the hallmark of our Government
Securities market. The process of policy making and implementation of reform are through
consultative mechanisms. The entire market borrowing program is announced at the
beginning of the year. Based on this, a calendar of Treasury Bills is pre-announced to the
market. Similarly, near real-time data is available with regard to auctions of Treasury Bills
23

and dated Government Securities. The Reserve Bank also publishes all relevant data
pertaining to Government securities market on daily, weekly, monthly and annual basis.
7) Legal Changes
The Government Securities and their management by the Reserve Bank of India are governed
by the Public Debt Act, 1944. The procedures prescribed are archaic and some of the
provisions have ceased to be of relevance in the present context. A new legislation titled the
Government Securities Act proposes to repeal and replace the Public Debt Act. The
Government Securities Bill has already been approved by the Cabinet and is awaiting
Parliament clearance. However, since the Public Debt Act, 1944, is applicable for marketable
loans raised by the RBI on behalf of both the Central and State Governments, the proposal
requires consent of all State Governments. The State Governments have to pass a Resolution
for the purpose either prior to enactment by the Centre or subsequently adopt the same by
passing a Resolution. Once the new Act is enacted, the RBI will have substantive powers to
design and introduce an instrument of transfer suited to computer environment.
There is a proposal to replace the existing Public Debt Act, 1944, by a new Government
Securities Act. All the States, except Jammu and Kashmir, have given their concurrence for
the proposal and the Bill is awaiting Parliamentary approval. The new Act will simplify the
procedures for transactions in Government securities, allow for nomination, lien marking/
pledging of securities, transfer of ownership in electronic form, etc.
The amended Securities Contract (Regulation) Act, 1956 (SCRA) has conferred on RBI the
responsibility of regulation of government securities, money market securities which include
repos in all securities including corporate debt securities since March 1, 2000.
The Fiscal Responsibility and Budget Management Bill, 2000, seek to place limit on revenue
and fiscal deficit of the Government. The Bill has been examined by the Standing Committee
on Finance and is at present before the Parliament.
8) Technological Developments
In the recent past, important landmarks in the development of Government securities market
were: operationalisation of Negotiated Dealing System and setting up of Clearing
Corporation of India Ltd. The Negotiated Dealing System (NDS) (Phase I) has been
24

operationalised on February 15, 2002. It provides on - line electronic bidding facility in

primary auctions, daily LAF auctions, screen - based electronic dealing and reporting of
transactions in money market instruments. It also facilitates secondary market transactions in
Government securities and dissemination of information on trades with minimal time lag. In
addition, the NDS enables "paperless" settlement of transactions in government securities.
The system has electronic connectivity to CCIL and the Public Debt Office.
The Clearing Corporation of India Limited (CCIL) commenced its operations in clearing and
settlement of transactions in Government securities (including repos) on February 15, 2002.
Acting as a central counterparty, the CCIL provides guaranteed settlement and has in place
risk management systems to limit settlement risk and operates a settlement guarantee fund
backed by lines of credit from commercial banks. All repo transactions have to be necessarily
put through the CCIL while all outright transactions up to Rs.20 crore have to be settled
through CCIL.

25

STRUCTURE OF DEBT MARKET

Market segments
There are three main segments in the debt markets in India, viz., Government Securities,
Public Sector Units (PSU) bonds, and corporate securities. The market for Government
Securities comprises the Centre, State and State-sponsored securities. In the recent past, local
bodies such as municipalities have also begun to tap the debt markets for funds. The PSU
bonds are generally treated as surrogates of sovereign paper, sometimes due to explicit
guarantee and often due to the comfort of public ownership. Some of the PSU bonds are tax
free, while most bonds including government securities are not tax-free. The RBI also issues
tax-free bonds, called the 6.5% RBI relief bonds, which is a popular category of tax-free
bonds in the market. Corporate bond markets comprise of commercial paper and bonds.
These bonds typically are structured to suit the requirements of investors and the issuing
corporate, and include a variety of tailor- made features with respect to interest payments and
redemption. The less dominant fourth segment comprises of short term paper issued by
banks, mostly in the form of certificates of deposit. The market for government securities is
the oldest and most dominant in terms of market capitalization, outstanding securities, trading
volume and number of participants. It not only provides resources to the government for
meeting its short term and long term needs, but also sets benchmark for pricing corporate
paper of varying maturities and is used by RBI as an instrument of monetary policy. The
instruments in this segment are fixed coupon bonds, commonly referred to as dated securities,
treasury bills, floating rate bonds, zero coupon bonds and inflation index bonds. Both Central
and State government securities comprise this segment of the debt market.
The issues by government sponsored institutions like, Development Financial Institutions, as
well as the infrastructure-related bodies and the PSUs, who make regular forays into the
market to raise medium-term funds, constitute the second segment of debt markets. The
gradual withdrawal of budgetary support to PSUs by the government since 1991 has
compelled them to look at the bond market for mobilizing resources. The preferred mode of
issue has been private placement, barring an occasional public issue. Banks, financial
institutions and other corporate have been the major subscribers to these issues. The tax-free
bonds, which constitute over 50% of the outstanding PSU bonds, are quite popular with
institutional players. The market for corporate debt securities has been in vogue since early
1980s. Until 1992, interest rate on corporate bond issuance was regulated and was uniform
26

across credit categories. In the initial years, corporate bonds were issued with sweeteners in
the form of convertibility clause or equity warrants. Most corporate bonds were plain coupon
paying bonds, though a few variations in the form of zero coupon securities, deep discount
bonds and secured promissory notes were issued. After the de-regulation of interest rates on
corporate bonds in 1992, we have seen a variety of structures and instruments in the corporate
bond markets, including securitized products, corporate bond strips, and a variety of floating
rate instruments with floors and caps. In the recent years, there has been an increase in
issuance of corporate bonds with embedded put and call options. The major part of the
corporate debt is privately placed with tenors of 1-12yrs. Information on the size of the
various segments of the debt market in India is not readily available. This is due to the fact
that many debt instruments are privately placed and therefore not listed on markets. While the
RBI regulates the issuance of government securities, corporate debt securities fall under the
regulatory purview of SEBI. The periodic reports of issuers and investors are therefore sent to
two different regulators. Therefore, aggregated data for the market as a whole is difficult to
obtain. The NSE provides a trading platform for most debt instruments issued in India.
Therefore, Table 2.1 on market capitalization can be said to be indicative of the relative size
of the various segments of the debt market. The debt markets also have a large segment
which is a non-securitized, transactions based segment, where players are able to lend and
borrow amongst themselves. These are typically short term segments and comprise of call
and notice money markets, which is the most active segment in the debt markets, inter-bank
market for term money, markets for inter-corporate loans and markets for ready forward deals
(repos).
Table 2.1: Market Capitalization - NSE-WDM Segment as on March 31,
2008.

27

PRIMARY MARKET
Primary market is the market for the new issues of financial instruments. Therefore, it is also
called as new issues market. It deals in those securities which are issued to the public for the
first time. There are three ways in which securities are issued in the market:

Public issue: This is the most common and popular method of raising capital by new
companies. Bond or debt securities issue is a means of generating funds by
borrowing money from the markets by issuing marketable securities. A bond issue is
a procedure of issuing the debt securities in the form of bonds, in order to raise funds
to meet certain business goals. In contrast to the private placements of debt, a public
issue of bond allows the participation from the market and not just some selected
institutions / investors. A bond issue involves an issuer (borrower) and a creditor
(lender). The issuer is the company or the organization who borrows the funds
whereas the lender is the investor. Bonds are issued by government agencies, credit
institutions or commercial corporations in the primary markets. The investor in the
bonds holds a creditor stake in the company and is assured a fixed income over his
investments in bonds. Public issue of bond is the most safe and cost-effective way of
fund raising. Bonds are less risky and volatile as compared to equities. Bonds also
have a definite period term or maturity after which the bonds may be redeemed. The
transaction of issuing the bond by the organization to the lender takes place in the
primary market, while the bonds that are issued earlier are traded in the secondary
market. Debt market potential is huge in India. However, low penetration and
awareness amongst masses, especially retail investors, mainly due to the lack of
subject knowledge is a big hindrance to its growth. Gradually as the tides in the Indian
economic sphere are changing, the growing and ambitious economy of India is all set
to unravel the potential of this untapped segment. AK Capital has always worked very
hard to serve their clientele in the best possible manner. With over a decade of
experience in the debt market and an expert team who have been playing a critical
role in developing and contributing significantly to the Indian bond market, AK
Capital has carved a niche of itself in providing the best solutions in the debt industry.
AK Capital has the rare distinction of managing one from a total of three debt IPOs
issued in the Indian capital market so far AK Capital was the Lead Manager,
ranked amongst the top 2 mobilizes in public issue of NCDs aggregating INR 10,000

28

million by Shriram Transport Finance Company Ltd., with maximum subscription on

the very first day of issue.

Rights issue: When existing companies want to issue securities to public, they are

first offered to existing shareholders. It is called as rights issue.

Private placement: It is a way of selling securities privately to a small group of
investors.

SECONDARY MARKET FOR DEBT INSTRUMENTS

The NSE- WDM segment provides the 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. Central
Government securities and treasury bills are held as dematerialized entries in the Subsidiary
General Ledger (SGL) of the RBI. In order to trade these securities, participants are required
to have an account with the SGL and also a current account with the RBI. The settlement is
on Delivery versus Payment (DvP) basis. The Public Debt Office which oversees the
settlement of transactions through the SGL enables the transfer of securities from one
participant to another. Since 1995, settlements are on delivery-versus payment basis.
However, after creation of Clearing Corporation of India, most of the institutional trades are
being settled through CCIL with settlement guarantee. The settlement through CCIL is taking
place on DvP-III where funds and securities are netted for settlement.
Government debt, which constitutes about three-fourth of the total outstanding debt, has the
highest level of liquidity amongst the fixed income instruments in the secondary market. The
share of dated securities in total turnover of government securities has been increasing over
the years. Two way quotes are available for active gilt securities from the primary dealers.
Though many trades in gilts take place through telephone, a larger chunk of trades gets routed
through NSE brokers. The instrument-wise turnover for securities listed on the NSE-WDM is
29

shown in Table 2. It is observed that the market is dominated by dated government securities
(including state development loan).
Table 2: Security-wise Distribution of Turnover on NSE WDM

The major participants in the WDM are the Indian banks, foreign banks and primary dealers,
who together accounted for over 59.51% of turnover during 2007-08. The share of Indian
banks in turnover is about 23.78% in 2007-08 while foreign banks constitute about 27.09%
and primary dealers account for 8.64%. Financial institutions and mutual funds contribute
about 2.34% of the turnover. The participant-wise distribution of turnover is presented in
Table 3
Table 3: Participant-wise Distribution of Turnover (%)

As seen in Table 4, the share of top 10 securities in turnover is 39.65% in 2007-08 and top
50 securities accounted for nearly 79.64% of turnover in the same period

30

Table 4: Share of Top 'N' Securities in the Turnover of WDM Segment

Retail Debt Market

With a view to encouraging wider participation of all classes of investors across the country
(including retail investors) in government securities, the Government, RBI and SEBI have
introduced trading in government securities for retail investors. Trading in this retail debt
market segment (RDM) on NSE has been introduced w.e.f. January 16, 2003.
RDM Trading:
Trading takes place in the existing Capital Market segment of the Exchange and in the same
manner in which the trading takes place in the equities (Capital Market) segment. The
RETDEBT Market facility on the NEAT system of Capital Market Segment is used for
entering transactions in RDM session. The trading holidays and market timings of the RDM
segment are the same as the Equities segment

31

Trading Parameters:
The trading parameters for RDM segment are as below:

Trading in Retail Debt Market is permitted under Rolling Settlement, where in each trading
day is considered as a trading period and trades executed during the day are settled based on
the net obligations for the day. Settlement is on a T+2 bases. National Securities Clearing
Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed in
Retail Debt Market.
Negotiated Dealing System
The first step towards electronic bond trading in India was the introduction of the RBIs
Negotiated Dealing System in February 2002.

NDS, interlay, facilitates screen based

negotiated dealing for secondary market transactions in government securities and money
market instruments, online reporting of transactions in the instruments available on the NDS
and dissemination of trade information to the market. Government Securities
(Including T-bills), call money, notice/term money, repos in eligible securities are available
for negotiated dealing through NDS among the members. NDS members concluding deals, in
the telephone market in instruments available on NDS, are required to report the deal on NDS
system within 15 minutes of concluding the deal. NDS interfaces with CCIL for settlement of
government securities transactions for both outright and repo trades done/reported by NDS
members. Other instruments viz, call money, notice/term money, commercial paper and
certificate of deposits settle as per existing settlement procedure.
With the objective of creating a broad-based and transparent market in government securities
and thereby enhancing liquidity in the system, the NDS was designed to provide:

32

 Electronic bidding in primary market auctions (T-Bills, dated securities, state government
securities) by members,
Electronic bidding for OMO of RBI including repo auctions under LAF, Screen based
negotiated dealing system for secondary market operations,
Reporting of deals in government securities done among NDS members outside the system
(over telephone or using brokers of exchanges) for settlement,
Dissemination of trade information to NDS members, Countrywide access of NDS through
INFINET,
Electronic connectivity for settlement of trades in secondary market both for outright and
repos either through CCIL or directly through RBI, and Creation and maintenance of basic
data of instruments and members.
The functional scope of the NDS relating to trading includes:
giving/receiving a Quote,
placing a call and negotiation (with or without a reference to the quote),
entering the deals successfully negotiated,
Setting up preferred counterparty list and exposure limits to the counterparties,
dissemination of on-line market information such as the last traded prices of securities,
volume of transactions, yield curve and information on live quotes, interface with Securities
Settlement System for facilitating settlement of deals done in government securities and
treasury bills.
Facility for reporting on trades executed through the exchanges for information
dissemination and settlement in addition to deals done through NDS.
The system is designed to maintain anonymity of buyers and sellers from the market but only
the vital information of a transaction viz., ISIN of the security, Nome cloture, amount (face
value), price/rate and/ or indicative yield, in case applicable, are disseminated to the market,
through Market and Trade Watch.
The benefits of NDS include:
Transparency of trades in money and government securities market,
Electronic connectivity with securities settlement systems, thus, eliminating submission of
physical SGL form,
Settlement through electronic SGL transfer,
Elimination of errors and discrepancies and delay inherent in manual processing system, and
Electronic audit trail for better monitoring and control.

33

NDS-OM
NDS was intended to be used principally for bidding in the primary auctions of G-secs
conducted by RBI, and for trading and reporting of secondary market transactions. However,
because of several technical problems and system inefficiencies, NDS was being used as a
reporting platform for secondary market transactions and not as a dealing system. For actual
transactions, its role was limited to placing bids in primary market auctions. Much of
secondary market in the bond market continued to be broker intermediated. It was therefore,
decided to introduce a screen-based (i.e. electronic) anonymous order matching system, and
integrated with NDS. This system (NDSOM) has become operational with effect from August
1, 2005.
NDS-OM is an electronic, screen based, anonymous order driven trading system introduced
by RBI as part of the existing NDS system to facilitate electronic dealing in government
securities. It is accessible to members through RBIs INFINET Network. The system
facilitates price discovery, liquidity, increased operational efficiency and transparency. The
NDS-OM System supports trading in all Central Government Dated Securities and State
Government securities in T+1 settlement type. Since August 1, 2006 the system was
enhanced to facilitate trading in Treasury Bills and When Issued transaction in a security
authorized for issuance but not as yet actually issued. All WI transactions are on an if
basis, to be settled if and when the actual security is issued. Further, RBI has permitted the
execution of intraday short sale transaction and the covering of the short position in
government securities can be done both on and outside the NDS-OM platform i.e. through
telephone market. The order system is purely order driven with all bids/offers being matched
based on price/time priority for securities traded on price terms and yield/time priority for
securities traded on yield, ensuring transparency and fairness to all users. This ensures a level
playing field for all participants. The trader gets the best bid/offer in the system. It then tries
to match the sale orders with the purchase orders available on the system. When a match
occurs, the trade is confirmed. The counterparties are not aware of each others identitieshence the anonymous nature of the system. While initially only banks and primary dealers
could trade on it, NDS-OM has been gradually expanded to cover other institutional players
like insurance companies, mutual funds, etc. Further, NDS-OM has been extended to cover
all entities required by law or regulation to invest in Government securities such as deposit
taking NBFCs, Provident Funds, Pension Funds, Mutual Funds, Insurance Companies,
Cooperative Banks, Regional Rural Banks, Trusts, etc. The NDS-OM has several advantages
over the erstwhile telephone based market. It is faster, transparent, and cheaper and provides
34

benefits to its users like straight through processing, audits trails for transactions. Straight
through processing (STP) of transactions means that, for participants using CCILs clearing
and settlement system, once a deal has been struck on NDSOM, no further human
intervention is necessary right up to settlement, thus eliminating possibilities human errors.
The trades agreed on this system flow directly to CCIL for settlement.
Wholesale Debt Market comprising of investors like Banks, financial institutions, RBI,
insurance companies, Mutual funds, corporate and FIIs. The Commercial Banks and the
Financial Institutions are the most prominent participants in the Wholesale Debt Market in
India.
There are normally two types of transactions either an outright sale/purchase OR a Repo
trade. Globally debt markets are dominated by Government securities, which dominate close
to 50-75% of the trading volumes in all markets. Instruments issued by Central government
in India account for close to 90% of the trading volumes while those issues by State
governments account for 3-4% of the trading volumes.

35

MARKET STRUCTURE

36

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.
In order to understand the entirety of the debt market we have looked at it through a
framework based on its main elements. The market is best understood by understanding these
elements and their mutual interaction. These elements are as follows:
Instruments - the instruments that are being traded in the debt market.
Issuers - entity which issue these instruments
Investors - entities which invest in these instruments or trade in these instruments

37

SIZE OF DEBT MARKET

Worldwide debt markets are three to four times larger than equity markets. However, the
debt market in India is very small in comparison to the equity market. This is because the
domestic debt market has been deregulated and liberalized only recently and is at a relatively
nascent stage of development. The debt market in India is comprised of two main segments,
the Government securities market and the corporate securities market. Government securities
form the major part of the debt market-accounting for about 90-95% in terms of outstanding
issues, market capitalization and trading value. In the last few years there has been significant
growth in the Government securities market.
In terms of size, the Indian debt market is the third largest in Asia after Japan and Korea. It,
however, fairs poorly when compared to other economies like the US and the Euro area. The
Indian debt market also lags behind in terms of the size of the corporate debt market the
aggregate trading volumes of Government securities in the secondary market have grown
significantly from 1998-99 to 2008-09.
In terms of size, the Indian debt market is the third largest in Asia after Japan and Korea. It,
however, fairs poorly when compared to other economies like the US and the Euro area. The
Indian debt market also lags behind in terms of the size of the corporate debt market. The
share of corporate debt in the total debt issued had in fact declined.

38

DEBT INSTRUMENTS
A paper or electronic obligation that enables the issuing party to raise funds by promising to
repay a lender in accordance with terms of a contract. Types of debt instruments include
notes, bonds, certificates, mortgages, leases or other agreements between a lender and a
borrower.
Debt instruments are a way for markets and participants to easily transfer the ownership
of debt obligations from one party to another. Debt obligation transferability increases
liquidity and gives creditors a means of trading debt obligations on the market. Without debt
instruments acting as a means to facilitate trading, debt is an obligation from one party to
another. When a debt instrument is used as a medium to facilitate debt trading, debt
obligations can be moved from one party to another quickly and efficiently.

39

Treasury Bills: Treasury bills are short term money market instruments issued by the RBI at
the behest of the Government of India and thus are actually a class of Government Securities.
Presently T-Bills are issued in maturity periods of 91 days, 182 days and 364 days. They are
issued for raising funds to meet short fall in revenue collection i.e. to meet revenue
expenditure of the government. It is purely a finance bill as it does not arise out of any trade
transaction.
Until 1988, the only kind of Treasury bill that was available was the 91-day bill, issued on
tap; at a fixed rate of 4.5% (the rates on these bills remained unchanged at 4.5% since 1974!).
182-day T-bills were introduced in 1987, and the auction process for T-bills was started. 364
day T-bill was introduced in April 1992, and in July 1997, the 14-day T-bill was also
introduced. RBI had suspended the issue of 182-day T- bills from April 1992, and revived
their issuance since May 1999. RBI did away with 14-day and 182-day Treasury
Bills from May 2001. It was decided in consultation with the Central Government to reintroduce, 182 day TBs from April 2005. All T-bills are now sold through an auction process
according to a fixed auction calendar, announced by the RBI. Ad hoc treasury bills, which
enabled the automatic monetization of central government budget deficits, have been
eliminated in 1997. All T-bill issuances now represent market borrowings of the central
Government.
Commercial paper: Commercial Paper (CP) is an unsecured money market instrument
issued in the form of a promissory note. CP, as a privately placed instrument, was introduced
in India in 1990 with a view to enabling highly rated corporate borrowers to diversify their
sources of short-term borrowings and to provide an additional instrument to investors.
Subsequently, primary dealers, satellite dealers 3 and all-India financial institutions were also
permitted to issue CP to enable them to meet their short-term funding requirements for their
operations. Guidelines for issue of CP are presently governed by various directives issued by
the Reserve Bank of India, as amended from time to time.
Government Securities: It is the Reserve Bank of India that issues Government Securities or
G-Secs on behalf of the Government of India. These securities have a maturity period of 1 to
30 years. G-Secs offer fixed interest rate, where interests are payable semi-annually. For
shorter term, there are Treasury Bills or T-Bills, which are issued by the RBI for 91 days, 182
days and 364 days.
40

Corporate Bonds: These bonds come from PSUs and private corporations and are offered
for an extensive range of tenures up to 15 years. There are also some perpetual bonds.
Comparing to G-Secs, corporate bonds carry higher risks, which depend upon the
corporation, the industry where the corporation is currently operating, the current market
conditions, and the rating of the corporation. However, these bonds also give higher returns
than the G-Secs.

Long-term debt instruments: These instruments have a maturity period exceeding 1year.
The main instruments are Government of India dated securities (GOISEC), State Government
securities (state loans), Public Sector Undertaking bonds (PSU bonds) and corporate
bonds/debenture. Majority of these instruments are coupon bearing i.e. interest payments are
payable at pre specified dates.
Government of India dated securities (GOISECs): Issued by the RBI on behalf of the
Central Government, they form a part of the borrowing program approved by Parliament in
the Finance Bill each year (Union Budget). They have a maturity period ranging from 1 year
to 30 years. GOISECs are issued through the auction route with the RBI pre specifying an
approximate amount of dated securities that it intends to issue through the year. But unlike TBills, there is no pre set schedule for the auction dates. The RBI also issues products other
than plain vanilla bonds at times, such as floating rate bonds, inflation-linked bonds and zero
coupon bonds.
State Government Securities (state loans): Although these are issued by the State
Governments, the RBI organizes the process of selling these securities. The entire process, 17
rights from selling to auction allotment is akin to that for GOISECs. They also form a part of
the SLR requirements and interest payment and other modalities are analogous to GOISECs.
Although there is no Central Government guarantee on these loans, they are believed to be
exceedingly secure. One important point is that the coupon rates on state loans are slightly
higher than those of GOISECs, probably denoting their sub-sovereign status.
Public Sector Undertaking Bonds (PSU Bonds): These are long-term debt instruments
issued generally through private placement. The Ministry of Finance has granted certain

41

PSUs, the right to issue tax-free bonds. This was done to lower the interest cost for those
PSUs who could not afford to pay market determined interest rates.
Bonds of Public Financial Institutions (PFIs): Financial Institutions are also allowed to
issue bonds, through two ways - through public issues for retail investors and trusts and
secondly through private placements to large institutional investors.
Corporate debentures: These are long-term debt instruments issued by private companies
and have maturities ranging from 1 to 10 years. Debentures are generally less liquid as
compared to PSU bonds.
Certificate of Deposits: Certificate of Deposits (CDs) was introduced in India in 1989. They
are essentially securitized short term time deposits issued by banks and all- India Financial
Institutions during the period of tight liquidity at relatively higher discount rates as compared
to term deposits. Certificates of Deposits (CDs) are short-term borrowings by banks. CDs
differ from term deposit because they involve the creation of paper, and hence have the
facility for transfer and multiple ownerships before maturity. CD rates are usually higher than
the term deposit rates, due to the low transactions costs. Banks use the CDs for borrowing
during a credit pick-up, to the extent of shortage in incremental deposits. Most CDs are held
until maturity, and there is limited secondary market activity. Certificates of Deposit (CDs) is
a negotiable money market instrument and issued in dematerialized form or as a Usance
Promissory Note, for funds deposited at a bank or other eligible financial institution for a
specified time 88 period. Guidelines for issue of CDs are presently governed by various
directives issued by the Reserve Bank of India.

42

WORKING OF DEBT MARKET

The current operational and legal framework for managing public debt. It describes the
various categories of public debt and explains how the RBI and Ministry of Finance manage
debt and coordinate with one another. It then details how the primary and secondary markets
in government securities operate. Finally, it traces the legal underpinnings of public debt
management, as well as of primary and secondary market operations.
1.

Categories of debt

Under current budgetary practice, there are three categories of Union government liability
that constitute public debt - internal, external and other liabilities.
Internal debt is classied into (1) market loans, (2) other long and medium-term borrowing
and (3) short-term borrowing and is shown in the receipt budget of the Union government. It
includes market loans, special securities issued to the Reserve Bank of India (RBI),
compensation and other bonds, treasury bills (including 14-day treasury bills issued to States
only), commercial banks and other parties, as well as non-negotiable and non-interest bearing
rupee securities issued to international nancial institutions.
External debt represents loans received from foreign governments and multilateral
institutions. The Union Government does not borrow directly from international capital
markets. Its foreign currency borrowing takes place from multilateral agencies and bilateral
sources, and is a part of official development assistance (ODA). At present, the Government
of India does not borrow in the international capital markets. However, as noted by the
Report on Ministry of Finance for the 21st Century (Kelkar Report), this is a partial picture
and does not account for proxy foreign exchange borrowing, in the form of contingent
liabilities. Foreign exchange borrowing by Para-a statal agency is substantially inuenced by
the Union Government. For example, the State Bank of India (SBI), which is majority owned
by the Union Government and the RBI, borrows in foreign currency through instruments such
as Resurgent India Bonds, India Millennium Deposits and Millennium India Bonds (MIB).
The Union Government and RBI restrict how SBI can use these funds, and the Union
Government provides exchange rate guarantees for this borrowing. Government-owned banks
have raised substantial funds through this route for many years now; 1.6 billion USD was
raised using the India Development Bond in 1991, 4.2 billion USD using the Resurgent

43

India Bond in 1998 and 5.3 billion USD using the Millennium India Deposit in 2000,
(MoF, 2004).
The other liabilities category, not a part of public debt, includes other interest-bearing
obligations of the government, such as post office savings deposits, deposits under small
savings schemes, loans raised through post office cash certicates, provident funds and
certain other deposits.
2.

Operational framework

In thinking about the operational framework, it is useful to use the vocabulary of the Front
Office, Middle Office and Back Office. The Front Office negotiates all new loans. The
Middle Office measures and monitors all loans and conducts policy formulation. The Back
Office looks after auditing, accounting and data consolidation (EDMU, 2006).
A) Domestic Debt
Within the RBI, the Internal Debt Management Department formulates, in consultation with
the Ministry of Finance, a core calendar for primary issuance of dated securities and treasury
bills, and suggests the size and timing of issuance and conducts auctions, keeping in account
the governments needs, market conditions, and preferences of various segments. The RBI
charges the Central and State Governments fees for issuing and managing securities. Primary
and secondary market mechanisms are discussed in more detail later in this chapter.
Any person including rms, companies, corporate bodies, institutions, State Governments,
provident funds and Trusts, can invest in government securities. NRIs, Overseas Corporate
Bodies predominantly owned by NRIs and Foreign Institutional Investors registered with
SEBI and approved by the RBI are also eligible to invest in government securities, subject to
the Foreign Exchange Management Act, 1999. 1
B) External Debt
As regards external debt, the Fund-Bank Division, the External Commercial Borrowing
(ECB) Division, ADB Division, EEC Division, Japan Division in the Ministry of Finance and
RBI (IMF Loans) perform front office functions. The External Debt Management Unit
performs the role of the Middle Office, and the Office of the Controller of Aid Accounts and
Audit acts as the Back Office.

44

C) Cash Management
Cash management in India is a collaborative effort of the Reserve Bank of India (RBI) and
the Budget Division, Ministry of Finance. The RBI acts as the banker to the Government and
in this process maintains the Consolidated Fund of India. It also participates actively in the
cash forecasting process, which is carried out via negotiations between the Budget Division
and the RBI. The Monitoring Group on Cash and Debt Management coordinates this process
in its meetings. The RBI uses the Ways and Means Advances, which are short-term (three
month) loans to States to smooth temporary mis-matches in revenues and expenditures.
D) Contingent Liabilities
Government guarantees are approved by the Ministry of Finance, Department of Economic
Affairs (Budget Division). Once a guarantee is approved by Ministry of Finance, it is
executed and monitored by the Administrative Ministry concerned. The concerned Ministry is
also required to annually report the status of the guarantee in this regard, until the guarantee
falls due or expires.
E) Gaps in the present arrangement
A unied database about all onshore and offshore liabilities of the government (including
contingent liabilities) is absent in the present system. Further, no single arm of government is
charged with the function of analyzing such an integrated database and working towards
identifying mechanisms through which the long-term cost of borrowing of the government is
minimized.
3.

Coordination between RBI and MoF

The Monitoring Group on Cash and Debt Management of the Government of India generally
meets twice a year or as necessary to make decisions regarding the borrowing programme of
the Government of India. This formal mechanism is accompanied by regular discussions
between the Budget Division and the RBI.
The Technical Advisory Committee on Money and Government Securities Market advises the
RBI on development and regulation of the government securities market. This committee
comprises nancial sector professionals, representatives of market associations such as the
Primary Dealers Association of India, the Fixed Income Money Markets and Derivatives

45

Association of India, as well as representatives from mutual funds, academia, and the
Government.
4.

Issuance and trading of securities

This section discusses the functioning of the primary and secondary markets in government
securities. If a private entity issued bonds, the various agencies involved in issuing and
trading would, broadly speaking, be the regulator, the investment bank, the registrar and
transfer agent, the stock exchange, the clearing corporation and the depository
When the Central Government or a State Government issues securities, the RBI performs
almost the entire range of these functions. The Clearing Corporation of India acts as a central
counter-party in government securities transactions. The RBI and CCILs roles in primary and
secondary markets are detailed below.
A) Primary issuance of dated securities
The Reserve Bank of India issues Central and State Government securities through an auction
mechanism. The auctions of government securities are open to individuals, institutions,
pension funds, provident funds, NRIs, Overseas Corporate Bodies (OCBs) and foreign
institutional investors. Individuals and small investors such as provident and pension funds
and corporations can also participate in auctions on a non-competitive basis in certain specic
issues of dated government securities and in Treasury bill auctions. Non-competitive bidding
has been allowed since January 2002 and, in the case of dated securities, a small percentage
of up to 5 percent is allocated for allotment to non-competitive bidders at weighted average
cut-off rates. Bids are received through banks and primary dealers. Calendar: The RBI
formulates an issuance calendar in consultation with the Budget Divisions of MoF, which is
announced before the auctions. The calendar does not cover issuance of Treasury Bills or
dated securities under the MSS scheme. Loan notication: As per the borrowing requirement
in the calendar, the government issues a Public Notication that species the amount it
wishes to borrow in dated securities. In the case of money market or MSS auctions, the RBI
directly issues the press release. Auction press release: The RBI issues a press release that
gives the details of the auction - the amount involved and the maturity and tenor of the notes.
This is circulated to all commercial banks and primary dealers, and also posted on the RBI
exclusively for the trading of government securities and treasury bills. The NDS facilitates
electronic bidding in auctions, and offers straight through settlement, since it connects with
46

the Public Debt Offices and the accounts of the banks with the RBI. Banks, primary dealers
and other nancial institutions including mutual funds can negotiate deals in government
securities through this electronic mode on a real-time basis and report all trades to the system
for settlement. NDS Participation is restricted to members of INFINet, a closed user group
network. Members of INFINet hold a Subsidiary General Ledger and/or a current account
with the RBI. Subsidiary General Ledger or SGL is a facility that the RBI provides for large
banks and nancial institutions. This allows the holding of government securities in
electronic or book form with the RBI.
Bidding: As per the schedule in the press release, the bidding process is carried out both on
the Negotiated Dealing System (NDS) and via sealed bid tenders dropped in the auction box
at the Mumbai office of the RBI This takes place for both competitive and non-competitive
bids. Primary dealers underwrite auctions of dated securities
Auction results: The RBI announces the allottees of the auctions at the date and time
indicated in the press release.
Clearance and Settlement: Transactions are settled at the RBI.
Monitoring: The CAS then monitors the interest payments and maturity dates for issued
securities/Treasury Bills.
Secondary market in government securities:
The secondary market for government securities is split across a variety of trading platforms the RBIs internal NDS, NSE and BSE. However, the majority of trading is concentrated in
the NDS. The RBI also encourages members of the NDS to inform NDS of any secondary
trades they undertake on other platforms. Settlement is carried out through the RBI. The
CCIL provides settlement guarantee for these trades. Once trades are received by CCIL, it
validates counterparties and their exposure limits for the particular trade. Valid trades are then
settled under a DVP (III) system. The net funds statement is sent to the RBI Public Debt
Office along with the record of settlement. Based on the information sent by CCIL, the PDO
debits the requisite counter-partys SGL account and credits the CCILs SGL account. The
funds settlement is carried out by the RBI-DAD, a cell under the Central Accounts Section
(CAS) in Nagpur.

47

The RBI disseminates information via its website regarding the nature and volume of
secondary trades in securities, in order to encourage better pricing.
There is also a retail debt market for government securities, traded on the Retail Debt Market
(RDM) segments of the NSE, BSE and OTCEI. However, market transactions in this segment
are an extremely small proportion of total trading volume.
5. Legal framework
A) Constitutional Provisions
a. Power to legislate on public debt
Under the Constitution, Union Government debt is a Union subject, while State
Government debt is a State subject, i.e. the Centre cannot legislate how State Governments
should manage State borrowing. Article 246(1) of the Constitution read with Entries 35 and
37 of List I provide that Parliament has exclusive power to make laws regarding the public
debt of India and foreign loans. Article 246(3) of the Constitution read with Entry 43 of List
II provides that State legislatures have exclusive power to make laws regarding the public
debt of the States.
b. Executive powers to borrow and give guarantees
However, the Constitution limits the sources from which State Governments can borrow, and
gives the Centre power under certain circumstances to inuence whether the State
Government can borrow from sources other than the Centre. Therefore, the Constitution
implicitly empowers the Centre to place limits on the amount and sources of State
Government borrowing. Article 292 and 293 dene the executive borrowing powers of the
Centre and the States. Article 292 provides that the Central Government can borrow upon the
security of the Consolidated Fund of India within such limits as Parliament may x. Under
Article 293, State Governments can borrow money on the security of the Consolidated Fund
of the State within such limits, if any, as the State legislature may x. States can only borrow
domestically, whether from the Centre or from other sources. However, if a State has any
loans outstanding from the Centre, or for which the Centre is a guarantor, it must obtain the
Centres consent before borrowing from any other source. As a consequence, in effect, almost
all States today need Union consent before they can borrow funds.

48

No separate law has been enacted under Article 292 to regulate Central Government
borrowing. However, the Fiscal Responsibility and Budget Management (FRBM) Act,
2003 and FRBM Rules, 2004 lay down a framework for scal management. The FRBM Act
aims to ensure inter-generational equity in scal management and long-term macro-economic
stability. This requires sufficient revenue surpluses, reducing the scal decit, removing scal
impediments in the effective conduct of monetary policy and prudential debt management
consistent with scal sustainability through limits on Central Government borrowings, debt
and decits, and greater transparency in scal operations.
Simultaneously, the Central Government shall not borrow from the RBI in the form of
subscription to the primary issues by the RBI except under special circumstances. The Act
also attempts to check contingent liabilities by restricting guarantees to 0.5 percent of GDP
during any nancial year.
The FRBM Act, 2003 prohibits participation of RBI in the primary Government securities
market with effect from April 1, 2006, except under special circumstances.
The FRBM Rules, 2004 specify the annual targets for reduction of scal and revenue decits,
annual targets for assuming contingent liabilities in the form of guarantees and the
assumption of additional liabilities as a percentage of GDP.
The Rules do the following
Restrict assumption of additional liabilities (including external debt at current exchange rate)
in excess of 9% of GDP for 2004-05 and require that this limit be progressively reduced by at
least one percentage point of GDP in each subsequent year.
Require a reduction of the revenue decit by an amount equivalent to 0.5 per cent or more of
the GDP in each nancial year, beginning with 2004-05.
Require a reduction of the scal decit by an amount equivalent of 0.3 per cent or more of
the GDP in each nancial year, beginning with 2004-05.
Restrict issuance of guarantees in excess of 0.5 per cent of GDP in any nancial year,
beginning with 2004-05.
c. Borrowing secured against the Consolidated Fund Central and State government borrowing
is constitutionally secured against the Consolidated Funds of India (CFI) and of State
49

Governments respectively. Article 112(3)(c) provides that the expenditure in respect of debt
charges for which the Government of India is liable, including interest, sinking fund charges
and redemption charges and other expenditure relating to the raising of loans and the service
and redemption of debt shall be charged on the Consolidated Fund of India. Article 202(3)
(c) makes the parallel provision for States, and provides that a States cost of borrowing is
charged on the Consolidated Fund of the State.
d. Annual nancial statement and appropriations process Under Article 112, the Central
Government is required to submit an annual nancial statement before both Houses of
Parliament each year, showing estimated receipts and expenditures for that year. The
estimates of expenditure in the annual nancial statement fall into two categories: (1) sums
required to meet expenditure that the Constitution provides is to be charged upon the CFI and
(2) sums required to meet other expenditure proposed by the Central Government.
Under Article 113(1), estimated expenditure charged on the Consolidated Fund of
India under the rst category is not submitted to the vote of the Parliament, but nothing in
Article 113 prevents either house of Parliament from discussing those estimates. Under
Article 113(2), the Lok Sabha shall have the power to vote on other expenditure, i.e. the
second category of proposed expenditure in the annual nancial statement.
Once Parliament sanctions grants based on the annual nancial statement, an Appropriations
Bill is introduced to provide for the appropriation out of the CFI of all monies required to
meet these grants and any expenditure charged on the CFI.
B) Legislation on debt management
The Reserve Bank of India is legally obliged to manage Central Government debt. It agrees
to manage State Government debt through a formal agreement. Under Section 20 of the
Reserve Bank of India (RBI) Act 1934, the Reserve Bank is obliged to manage the Central
Governments public debt. Section 21 of the RBI Act 1934, provides that the Central
Government shall entrust debt management to the RBI. Section 21A of the RBI Act 1934
provides that a State Government may agree to let the RBI manage that States debt. Thus,
the RBI Act respects the Constitutional allocation of State debt to the State List: it does not
mandate how State Governments should manage their debt, but gives them the option of
asking the RBI to do this. Under Section 17(11) of the RBI Act, the RBI is empowered to act

50

as an agent of, inter alia, the Central Government and State Governments, in managing public
debt and issuing and managing bonds and debentures.
C) Legal underpinnings of securities issuance
Investment banking function: As discussed above, the RBI Act 1934 vests the RBI with the
investment banking function for the Central and State governments; it obligates and
empowers the Bank to manage the Centres public debt and empowers it to manage States
public debt. While this broad power and obligation to manage public debt is embedded in
primary legislation, detailed functions and operations connected with issuance and trading
are, in general, not spelled out in the RBI Act 1934. Such functions are largely regulated by
the Government Securities Act, 2006 and rules and regulations framed there under, and
through other notications and circulars issued by the Government or the RBI.
RTA Function: The RBI acts as the Registrar and Transfer Agent (RTA) for government
securities. This function is not covered directly by the RBI Act 1934. The GSA 2006 denes a
bond ledger account subsidiary general ledger account and a constituents subsidiary ledger
account However the GSA 2006 does not explicitly lay down the structure of the primary
dealer system, or require primary dealers to hold a bond ledger account loan SGL account.
Under section 2(c) of the GSA 2006, a bond ledger account is an account with the RBI or
with an agent - a scheduled bank or any other person specied as an agent in which
government securities are held in a dematerialised form at the credit of the holder. Under
section 2(d), a constituents subsidiary general ledger account is dened as a general ledger
account opened and maintained with the RBI by an agent on behalf of the constituents of the
agent. Section 4(1) of the GSA 2006 provides: a subsidiary general ledger account including
a constituents subsidiary general ledger account and a bond ledger account may be opened
and maintained by the Bank subject to such conditions and restrictions as maybe specied
and in such form and on payment of such fee as may be prescribed [emphasis added].
This provision allows, but does not require, the creation of an SGL; thus the GSA2006 does
not lock the RBI or any other public authority into the present arrangement. The RBI has the
power to prescribe the manner and form in which government securities can be transferred
under the GSA 2006, by regulations and with prior approval of the Central Government.
Primary and secondary market trading: The RBI Act 1934 and the GSA 2006 do not prescribe
how to conduct primary and secondary trading in government securities.
51

Instructions to primary dealers are laid down in the RBI guidelines and circulars, the most
recent of which are Master Circular on Operational Guidelines to Primary Dealers in
Government Securities Market dated 1 July 2008, and the Master Circular on Capital
Adequacy Standards and Risk Management for standalone Primary Dealers dated 1 July
2008. Terms and conditions for issue of government securities are laid down in a General
Notication by the Central Government dated 6 May 2002. The General Notication
prescribes, inter alia, who is eligible to invest in government securities, types of securities,
types of auctions, mode of payment, and form in which securities may be held. The General
Notication may be supplemented by Specic Notications issued from time to time which
address specic features of a particular security issue.
Clearance and Settlement: The clearance and settlement mechanism discussed earlier is not
prescribed by primary legislation. Under the Payment and Settlement Systems Act, 2007, the
RBI regulates payment systems in India. However, the Act does not apply to stock exchanges
or clearing corporations of the stock exchanges. Thus, when government securities are traded
on the NSE or the BSE, the payment and settlement systems of these stock exchanges are not
covered by the Act.
Depository function: The depository function is covered in primary legislation. Section 17(9)
of the RBI Act 1934 authorizes the RBI to have the custody of monies, securities and other
articles of value, and the collection of the proceeds, whether principal, interest or dividends,
of any such securities. However, section 17(9) is somewhat ambiguous because it does not
specify whether the RBI has this authority as a principal, as an agent of the Centre and States,
or as both principal and agent .In addition, nothing in section 17(9) prohibits the RBI from
contracting with an external depository, nor does section 17(9) positively require that the
depository for government securities must be internal to the RBI.
The RBIs depository arrangements for government securities are not regulated by the
Depositories Act 1996. The NSEs and BSEs depository arrangements for government
securities are regulated by the Depositories Act, 1996. However, section 31 of the GSA 2006
provides that nothing in the Depositories Act 1996 shall apply to government securities
covered by the GSA 2006, unless an agreement to the contrary is executed between a
depository under the Depositories Act 1996, and the Government or the RBI.
Regulatory functions: The RBI regulates trading in government securities, under section 45W
of the RBI Act 1934, with the caveat that RBI cannot issue directions on the procedure for
52

execution or settlement of the trades on stock exchanges recognized by the Central

Government under the SCRA 1956

53

CREDIT RATING
A credit rating evaluates the credit worthiness of a debtor, especially a business (company) or
a government. It is an evaluation made by a credit rating agency of the debtor's ability to pay
back the debt and the likelihood of default.
Credit ratings are determined by credit ratings agencies. The credit rating represents the credit
rating agency's evaluation of qualitative and quantitative information for a company or
government; including non-public information obtained by the credit rating agencies analysts.
Credit ratings are not based on mathematical formulas. Instead, credit rating agencies use
their judgment and experience in determining what public and private information should be
considered in giving a rating to a particular company or government. The credit rating is used
by individuals and entities that purchase the bonds issued by companies and governments to
determine the likelihood that the government will pay its bond obligations.
A poor credit rating indicates a credit rating agency's opinion that the company or
government has a high risk of defaulting, based on the agency's analysis of the entity's history
and analysis of long term economic prospects.
CREDIT RATING AGENCIES
The largest credit rating agencies (which tend to operate worldwide) are Dun &
Bradstreet, Moody's, Standard & Poor's and Fitch Ratings.
Other agencies include A. M. Best (U.S.), Baycorp Advantage (Australia), Egan-Jones Rating
Company (U.S.),

Global

Credit

Ratings

Co.

(South

Africa),Levin

and

Goldstein(Zambia),Augusto & Co(Nigeria),Japan Credit Rating Agency, Ltd. (Japan) Muros

Ratings (Russia alternative rating agency), Rapid Ratings International (U.S.). And Credit
Rating Information and Services Limited (Bangladesh)

54

55

PARTICIPANTS
Debt markets are pre-dominantly wholesale markets, with dominant institutional investor
participation. The investors in the debt markets concentrate in banks, financial institutions,
mutual funds, provident funds, insurance companies and corporate. Many of these
participants are also issuers of debt instruments. The smaller number of large players has
resulted in the debt markets being fairly concentrated, and evolving into a wholesale
negotiated dealings market. Most debt issues are privately placed or auctioned to the
participants. Secondary market dealings are mostly done on telephone, through negotiations.
In some segments such as the government securities market, market makers in the form of
primary dealers have emerged, who enable a broader holding of treasury securities. Debt
funds of the mutual fund industry, comprising of liquid funds, bond funds and gilt funds,
represent a recent mode of intermediation of retail investments into the debt markets, apart
from banks, insurance, provident funds and financial institutions, who have traditionally been
major intermediaries of retail funds into debt market products.
The market participants in the debt market are:
1. Central Governments, raising money through bond issuances, to fund budgetary deficits
and other short and long term funding requirements.
2. Reserve Bank of India, as investment banker to the government, raises funds for the
government through bond and t-bill issues, and also participates in the market through openmarket operations, in the course of conduct of monetary policy. The RBI regulates the bank
rates and repo rates and uses these rates as tools of its monetary policy. Changes in These
benchmark rates directly impact debt markets and all participants in the market.
3. Primary dealers, who are market intermediaries appointed by the Reserve Bank of India
who underwrite and make market in government securities, and have access to the call
markets and repo markets for funds.
4. State Governments, municipalities and local bodies, which issue securities in the debt
markets to fund their developmental projects, as well as to finance their budgetary deficits.
5. Public sector units are large issuers of debt securities, for raising funds to meet the long
term and working capital needs. These corporations are also investors in bonds issued in the
debt markets.
6. Corporate treasuries issue short and long term paper to meet the financial requirements of
the corporate sector. They are also investors in debt securities issued in the market.
56

7. Public sector financial institutions regularly access debt markets with bonds for funding
their financing requirements and working capital needs. They also invest in bonds issued by
other entities in the debt markets.
8. Banks are the largest investors in the debt markets, particularly the Treasury bond and bill
markets. They have a statutory requirement to hold a certain percentage of their deposits
(currently the mandatory requirement is 25% of deposits) in approved securities (all
government bonds qualify) to satisfy the statutory liquidity requirements. Banks are very
large participants in the call money and overnight markets. They are arrangers of commercial
paper issues of corporate. They are also active in the inter-bank term markets and repo
markets for their short term funding requirements. Banks also issue CDs and bonds in the
debt markets.
9. Mutual funds have emerged as another important player in the debt markets, owing
primarily to the growing number of bond funds that have mobilized significant amounts from
the investors. Most mutual funds also have specialized bond funds such as gilt funds and
liquid funds. Mutual funds are not permitted to borrow funds, except for very short-term
liquidity requirements. Therefore, they participate in the debt markets pre-dominantly as
investors, and trade on their portfolios quite regularly.
10. Foreign Institutional Investors are permitted to invest in Dated Government Securities
and Treasury Bills within certain specified limits.
11. Provident funds are large investors in the bond markets, as the prudential regulations
governing the deployment of the funds they mobilize, mandate investments pre-dominantly in
treasury and PSU bonds. They are, however, not very active traders in their portfolio, as they
are not permitted to sell their holdings, unless they have a funding requirement that cannot be
met through regular accruals and contributions.
12. Charitable Institutions, Trusts and Societies are also large investors in the debt markets.
They are, however, governed by their rules and byelaws with respect to the kind of bonds
they can buy and the manner in which they can trade on their debt portfolios. The matrix of
issuers, investors, instruments in the debt market and their maturities are presented in Table
2.2.

57

58

REGULATORS
The Securities Contracts Regulation Act (SCRA) defines the regulatory role of various
regulators in the securities market. Accordingly, with its powers to regulate the money and
Government securities market, the RBI regulates the money market segment of the debt
products (CPs, CDs) and the Government securities market. The non Government bond
market is regulated by the SEBI. The SEBI also regulates the stock exchanges and hence the
regulatory overlap in regulating transactions in Government securities on stock exchanges
have to be dealt with by both the regulators (RBI and SEBI) through mutual cooperation. In
any case, High Level Co-ordination Committee on Financial and Capital Markets
(HLCCFCM), constituted in 1999 with the Governor of the RBI as Chairman, and the Chiefs
of the securities market and insurance regulators, and the Secretary of the Finance Ministry as
the members, is addressing regulatory gaps and overlaps.

59

IMPACT OF DEBT MARKET ON ECONOMY

The impact of the debt market on the economy is as follows:
1.
2.
3.
4.

Opportunity for investors to diversify their investment portfolio.

Higher liquidity and control over credit.
Better corporate governance.
Improved transparency because of stringent disclosure norms and auditing

requirements.
5. Less risk compared to the equity markets, encouraging low-risk investments. This
leads to inflow of funds in the economy.
6. Increased funds for implementation of government development plans. The
government can raise funds at lower costs by issuing government securities.
7. Implementation of a monetary policy.
8. Reduced role of banks and political intervention in use of funds, as banks have to
follow norms laid down by the central bank.
For a developing economy like India, debt markets are crucial sources of capital funds. The
debt market in India is amongst the largest in Asia. It includes government securities, public
sector undertakings, other government bodies, financial institutions, banks and companies. In
2005, the market size was close to $ 325 billion.

FACTORS INFLUENCING DEBT MARKET

60

After reviewing functioning of debt market in India, the following issues have been identified
as some of the major aspects affecting the market.
a) Poor Quality Paper
Quality of paper refers to regular payment of coupon and repayment of principal at the right
time. Companies that do not default on these two counts are said to be issuing high quality
paper. High quality paper issued in the market does not create problems / issues for investors,
regulators and issuers. The question of private placement vs. public issue and institutional
investors vs. retail investor are of less significance and almost no consequence in the market,
if the quality of
The paper is good. It is the poor quality paper with a possibility of non-payment of coupon
and
Principal that poses threat to the development of the market and hence stringent regulatory
norms are warranted.
Imposition of additional regulatory provisions, though has its opportunity cost, therefore, it is
essential to strike a balance between regulatory protection and disclosure based regulation.
Further, in an emerging market / developing market the incidence of industrial sickness is
relatively high. This high industrial sickness generally translates into default of companies
and their obligations. The bond paper issued by companies turns worthless and creates
problems in the minds of investors. Since most retail investors, who invest in bonds, hold for
maturity and also hold their investment in a fewer number of companies, any default will
wipe out their savings and security for the post retirement / old age requirements. Therefore,
defaults in fixed income securities market attract more attention of the public and the
regulators.
b) Inadequate liquidity
Secondary Market for Corporate Debt lacks liquidity in India. Hardly few trades take place,
that too, in a limited number of issues. There is a chicken and egg problem. Poor liquidity is
attributable to inadequate number of good papers and lack of sufficient investor base in terms
of quantity as well as diversity. We can address the liquidity issue in the following ways:
1) By developing bond manager;
2) By enlarging number of investors;
3) By introducing good quality paper.

61

The third factor is exogenous and the second will take long time. Therefore, what is feasible
and achievable in the near term is the development of bond manager so that liquidity issue
can be addressed and to some extent the quality of paper also.
c) Investor base
In many markets the number of investors in fixed income securities market runs into
thousands and their variety include mutual funds, insurance companies, pension funds,
endowments, private banking institutions, banks and retail investors. In India, we have
primarily mutual funds investing in bond funds and their investment requirements are one
sided, if money starts coming in all mutual funds will get in large quantities and if it starts
going out it will go in huge quantities thus creating storms in the market. Insurance funds and
pension funds are the long term investors. Any short term shocks can be absorbed by these
long term players. Insurance companies in India till recently were limited in number and they
were investing to hold till maturity. Individual investors generally hold for maturity. Now that
we have more private sector and joint sector players, their presence in the primary as well as
in the secondary market can be felt in the time to come. Pension funds are not there today.
Banks do invest in the primary market and their activity in the secondary market is almost nil
d) Regulatory arbitrage (additional costs on listed companies)
Companies operating in India can be broadly divided into two categories on the basis of
regulatory jurisdiction: Listed and Unlisted. All companies are, by and large, administered by
the Companies Act, 1956 and the regulatory administration is carried out by DCA, Ministry
of Finance. Listed companies are overseen by SEBI through Listing Agreement of exchanges.
Listed companies are required to follow elaborate corporate governance principles,
accounting and disclosure standards, continuous disclosure standards and hence incur
additional costs. Unlisted companies, thus, enjoy regulatory arbitrage over listed companies.
There is a perception that listed companies seek delisting owing to perceived regulatory
arbitrage.
e) Debt Versus equity: Cost and risks
By design and necessity debt has finite life sometimes, very short whereas equity is said to
have perpetual life. Therefore, debt paper is offered and reoffered quite frequently by
companies. In falling interest rate scenario, as has been the case in India for the past few
years, corporate tend to borrow for shortest possible period thus restoring to repeated issue
costs and interest rate risks. High regulatory and compliance costs add to cost of resources.

62

Therefore, corporate might invent new methods of raising capital. Either way, the corporate
debt market will be affected adversely.
f) Incomplete access to information
One of the most important issues is lack of sufficient, timely and reliable information on
bonds and on bond markets to the investors. Information on bond issue, size, coupon, latest
credit rating, trade statistics are sparsely available. If the investors have access to the relevant
information more frequently then it may be possible for them to assess the quality of the
paper and take decisions. In addition, there is no one place in India where one can have all the
data pertaining to corporate debt issues. No one knows exactly how much debt is outstanding
on any given date and different agencies have incoherent estimates for the same. Tables 1 and
2 amply demonstrate this point. Annual public issue amount averages around Rs. 40,000
crore for the past 3 years. If the entire 5 year period is considered roughly Rs. 170,000 crore
was raised through public issue. However, the amount of debt outstanding for trading at NSE
excluding government securities and treasury bills comes to roughly Rs. 100,000 crore. There
is a wide gap between publicly issued amount and that which is admitted for trading even if
one considers average maturity period of five years. Generally bonds have longer maturity.
Hence, any regulatory action either becomes ineffective or misdirected leading to unintended
results target. Therefore, there is an urgent need to launch a survey and prepare a
comprehensive database and bring in transparency. Transparency ensures confidence which
in turn ensures liquidity. Sudden shocks can be mitigated.
g) Interest rate structure
Very skewed interest rate structure exists in India. Corporate with AAA rating offer lower
coupon than sovereign rate offered on certain instruments such as public provident fund,
National Saving Certificates. Individual investors, therefore, have almost nil or no interest in
coupon debt market, both primaries as well as in secondary, unless they are accompanied by
some fiscal concessions resulting in net higher return compared to above cited instruments.

63

BONDS
Bond is a debt security, in which the authorized issuer owes the holders a debt and, depending
on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the
principal at a later date, termed maturity. A bond is a formal contract to repay borrowed
money with interest at fixed intervals (ex semiannual, annual, and sometimes monthly).
Bonds are commonly referred to as fixed-income securities and are one of the three main
asset classes, along with stocks and cash equivalents. Two features of a bond - credit
quality and duration - are the principal determinants of a bond's interest rate. Bond maturities
range from a 90-day Treasury bill to a 30-year government bond. Corporate and municipals
are typically in the three to 10-year range.
Bonds provide the borrower with external funds to finance long-term investments, or, in the
case of government bonds, to finance current expenditure. Bonds and stocks are both
securities, but the major difference between the two is that (capital) stockholders have an
equity stake in the company (i.e., they are owners), whereas bondholders have a creditor
stake in the company (i.e., they are lenders). Another difference is that bonds usually have a

64

defined term, or maturity, after which the bond is redeemed, whereas stocks may be
outstanding indefinitely.

BOND MARKET
The bond market primarily includes government-issued securities and corporate debt
securities, and facilitates the transfer of capital from savers to the issuers or organizations
requiring capital for government projects, business expansions and ongoing operations.
The bond market (also known as the credit, or fixed income market) is a financial market
where participants can issue new debt, known as the primary market, or buy and sell debt
securities, known as the Secondary market, usually in the form of bonds. The primary goal of
the bond market is to provide a mechanism for long term funding of public and private
expenditures. Traditionally, the bond market was largely dominated by the United States, but
today the US is about 44% of the market

[1]

. As of 2009, the size of the worldwide bond

market (total debt outstanding) is an estimated $82.2 trillion, [2] of which the size of the
outstanding U.S. bond market debt was $31.2 trillion according to Bank for International
Settlements (BIS), or alternatively $35.2 trillion as of Q2 2011 according to Securities
Industry and Financial Markets Association (SIFMA).[2]
Nearly all of the $822 billion average daily trading volume in the U.S. bond market[3] takes
place between broker-dealers and large institutions in a decentralized, over-the-counter
(OTC) market. However, a small number of bonds, primarily corporate, are listed on
exchanges.
References to the "bond market" usually refer to the government bond market, because of its
size, liquidity, relative lack of credit risk and, therefore, sensitivity to interest rates. Because
of the inverse relationship between bond valuation and interest rates, the bond market is often
used to indicate changes in interest rates or the shape of the yield curve. The yield curve is the
measure of "cost of funding".

65

BOND MARKET PARTICIPANTS

Bond market participants are similar to participants in most financial markets and are
essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often both.
Participants include:

Institutional investors

Governments

Traders

Individuals

Because of the specificity of individual bond issues, and the lack of liquidity in many smaller
issues, the majority of outstanding bonds are held by institutions like pension funds, banks
and mutual funds. In the United States, approximately 10% of the market is currently held by
private individuals.

66

TYPES OF BONDS
Government Bonds
In general, fixed-income securities are classified according to the length of time before
maturity. These are the three main categories:
Bills - debt securities maturing in less than one year.
Notes - debt securities maturing in one to 10 years
Bonds - debt securities maturing in more than 10 years
Marketable securities from the U.S. government - known collectively as Treasuries - follow
this guideline and are issued as Treasury bonds, Treasury notes and Treasury bills (T-bills).
Technically speaking, T-bills aren't bonds because of their short maturity. (You can read more
about T-bills in our Money Market tutorial.) All debt issued by Uncle Sam is regarded as
extremely safe, as is the debt of any stable country. The debt of many developing countries,
however, does carry substantial risk. Like companies, countries can default on payments.
Municipal Bonds
Municipal bonds, known as "munis", are the next progression in terms of risk. Cities don't go
bankrupt that often, but it can happen. The major advantage to munis is that the returns are
free from federal tax. Furthermore, local governments will sometimes make their debt nontaxable for residents, thus making some municipal bonds completely tax free. Because of
these tax savings, the yield on a muni is usually lower than that of a taxable bond. Depending
on your personal situation, a muni can be a great investment on an after-tax basis.
Corporate Bonds
A company can issue bonds just as it can issue stock. Large corporations have a lot of
flexibility as to how much debt they can issue: the limit is whatever the market will bear.
Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years,
67

and long term is over 12 years.

Corporate bonds are characterized by higher yields because there is a higher risk of a
company defaulting than a government. The upside is that they can also be the most
rewarding fixed-income investments because of the risk the investor must take on. The
company's credit quality is very important: the higher the quality, the lower the interest rate
the investor receives.
Other variations on corporate bonds include convertible bonds, which the holder can convert
into stock, and callable bonds, which allow the company to redeem an issue prior to maturity.

Zero-Coupon Bonds
This is a type of bond that makes no coupon payments but instead is issued at a considerable
discount to par value. For example, let's say a zero-coupon bond with a $1,000 par value and
10 years to maturity is trading at $600; you'd be paying $600 today for a bond that will be
worth $1,000 in 10 years.
Classification on the basis of Variability of Coupon
Zero Coupon Bonds
Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity,
the principal/face value is repaid to the holders. No interest (coupon) is paid to the holders
and hence, there are no cash inflows in zero coupon bonds. The difference between issue
price (discounted price) and redeemable price (face value) itself acts as interest to holders.
The issue price of Zero Coupon Bonds is inversely related to their maturity period, i.e. longer
the maturity period lesser would be the issue price and vice-versa. These types of bonds are
also known as Deep Discount Bonds.
Treasury Strips
Treasury strips are more popular in the United States and not yet available in India. Also
known as Separate Trading of Registered Interest and Principal Securities, government dealer
firms in the United States buy coupon paying treasury bonds and use these cash flows to
further create zero coupon bonds. Dealer firms then sell these zero coupon bonds, each one
having a different maturity period, in the secondary market.
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Floating Rate Bonds

In some bonds, fixed coupon rate to be provided to the holders is not specified. Instead, the
coupon rate keeps fluctuating from time to time, with reference to a benchmark rate. Such
types of bonds are referred to as Floating Rate Bonds.
For better understanding let us consider an example of one such bond from IDBI in 1997.
The maturity period of this floating rate bond from IDBI was 5 years. The coupon for this
bond used to be reset half-yearly on a 50 basis point mark-up, with reference to the 10 year
yield on Central Government securities (as the benchmark). This means that if the benchmark
rate was set at X %, then coupon for IDBIs floating rate bond was set at (X +
0.50) %.
Coupon rate in some of these bonds also have floors and caps. For example, this feature was
present in the same case of IDBIs floating rate bond wherein there was a floor of 13.50%
(which ensured that bond holders received a minimum of 13.50% irrespective of the
benchmark rate). On the other hand, a cap (or a ceiling) feature signifies the maximum
coupon that the bonds issuer will pay (irrespective of the benchmark rate). These bonds are
also known as Range Notes.
More frequently used in the housing loan markets where coupon rates are reset at longer time
intervals (after one year or more); these are well known as Variable Rate Bonds and
Adjustable Rate Bonds. Coupon rates of some bonds may even move in an opposite direction
to benchmark rates. These bonds are known as Inverse Floaters and are common in developed
markets.
Classification on the Basis of Variability of Maturity
Callable Bonds
the issuer of a callable bond has the right (but not the obligation) to change the tenor of a
bond (call option). The issuer may redeem a bond fully or partly before the actual maturity
date. These options are present in the bond from the time of original bond issue and are
known as embedded options. A call option is either a European option or an American option.
Under a European option, the issuer can exercise the call option on a bond only on the
specified date, whereas under an American option, option can be exercised anytime before
the specified date.
This embedded option helps issuer to reduce the costs when interest rates are falling, and
when the interest rates are rising it is helpful for the holders.
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Puttable Bonds
the holder of a puttable bond has the right (but not an obligation) to seek redemption (sell)
from the issuer at any time before the maturity date. The holder may exercise put option in
part or in full. In riding interest rate scenario, the bond holder may sell a bond with low
coupon rate and switch over to a bond that offers higher coupon rate. Consequently, the issuer
will have to resell these bonds at lower prices to investors. Therefore, an increase in the
interest rates poses additional risk to the issuer of bonds with put option (which are redeemed
at par) as he will have to lower the re-issue price of the bond to attract investors.
Convertible Bonds
the holder of a convertible bond has the option to convert the bond into equity (in the same
value as of the bond) of the issuing firm (borrowing firm) on pre-specified terms. This results
in an automatic redemption of the bond before the maturity date. The conversion ratio
(number of equity of shares in lieu of a convertible bond) and the conversion price
(determined at the time of conversion) are pre-specified at the time of bonds issue.
Convertible bonds may be fully or partly convertible. For the part of the convertible bond
which is redeemed, the investor receives equity shares and the non-converted part remains as
a bond.
Classification on the basis of Principal Repayment
Amortizing Bonds
Amortizing Bonds are those types of bonds in which the borrower (issuer) repays the
principal along with the coupon over the life of the bond. The amortizing schedule
(repayment of principal) is prepared in such a manner that whole of the principle is repaid by
the maturity date of the bond and the last payment is done on the maturity date. For example auto loans, home loans, consumer loans, etc.
Bonds with Sinking Fund Provisions
Bonds with Sinking Fund Provisions have a provision as per which the issuer is required to
retire some amount of outstanding bonds every year. The issuer has following options for
doing so:
By buying from the market
By creating a separate fund which calls the bonds on behalf of the issuer

70

Since the outstanding bonds in the market are continuously retired by the issuer every year by
creating a separate fund (more commonly used option), these types of bonds are named as
bonds with sinking fund provisions. These bonds also allow the borrowers to repay the
principal over the bonds life.

RISK OF INVESTING IN BONDS

Interest rate risk: The bond trading prices are inversely related to the interest rates. When
interest rates rise, bond prices decline. If you need to sell you bond in a high interest rate
environment, you may get less than you paid for it. The risk from fluctuations in interest rate
declines the closer the instrument is to maturity.

Credit risk: If the issuer faces a financial crunch or bankruptcy, it may default on payments
towards the instrument.
Liquidity risk: If the coupon rate is lower than prevailing interest rates in the market, then an
investor may find it difficult to sell the instrument before maturity. Debt instruments are
generally more liquid during the initial period after they are issued.
Call risk or reinvestment risk: For a bond with a call option, the issuer may redeem the
instrument prior to maturity as per the predetermined dates and prices for such a trade. Issuers
normally redeem such bonds when the interest rates are falling, and as a result investors have
to reinvest their funds at a lower rate.
71

Default in relation to bond markets

Failure of a bond issuer to pay principal or interest as per the predetermined schedule is
termed as default. A default can also occur if the issuer fails to meet/comply with the
obligations related to reporting requirements, etc.
In case of a bankruptcy, bond holders, being creditors, have the first right to the assets of the
issuer when receiving a payout by way of liquidation. The kind of bond held also determines
an investors status during bankruptcy.
Secured bonds are instruments which are backed by a specific collateral (or asset) of the
issuer, If the issuer defaults, a secured bond investor has the first claim to the said collateral.
Unsecured bonds do not have a claim to any specific collateral from the issuer. Unsecured
bonds normally offer a higher coupon rate due to a higher risk of investment.

72

BOND PRICNG

1. Par Amount
The nominal dollar amount assigned
to
a security by
the issuer.
For
an equity
security, par value is usually a very small amount that bears no relationship to its market
price, except for preferred stock, in which case par value is used to
calculate dividend payments. For a debt security, par value is the amount repaid to
the investor when the bond matures (usually, corporate bonds have a par value of
$1000, municipal bonds $5000, and federal bonds $10,000). In the secondary market,
a bond's price fluctuates with interest rates. If interest rates are higher than the coupon rate on
a bond, the bond will be sold below par value (at a "discount"). If interest rates have fallen,
the price will be sold above par value. Also called face value or par
A bond selling at par has a coupon rate such that the bond is worth an amount equivalent to
its original issue value or its value upon redemption at maturity. This amount is typically
$1000 per bond.
Par value stock has no relation to market value and, as a concept, is somewhat archaic. The
par value of a share of stock is the value stated in the corporate charter below which shares of
that class cannot be sold upon initial offering; the issuing company promises not to issue
further shares below par value, so investors can be confident that no one else will receive a
more favorable issue price. Thus, par value is the nominal value of a security which is
determined by the issuing company to be its minimum price. This was far more important in
unregulated equity markets than in the regulated markets that exist today.
Par value also has accounting purposes. It allows the company to put a de minims value for
the stock on the company's financial statement.
73

Many common stocks issued today do not have par values; those that do (usually only in
jurisdictions where par values are required by law) have extremely low par values (often the
smallest unit of currency in circulation), for example a penny par value on a stock issued
at USD$25/share. Most states do not allow a company to issue stock below par value.
Even in jurisdictions that permit the issue of stock with no par value, the par value of a stock
may affect its tax treatment. For example, Delaware permits the issue of stock either with or
without a par value, but by choosing to assign a par value, a corporation may significantly
reduce its franchise tax liability.
No-par stocks have "no par value" printed on their certificates. Instead of par value, some
U.S. states allow no-par stocks to have a stated value, set by the board of directors of the
corporation, which serves the same purpose as par value in setting the minimum legal capital
that the corporation must have after paying any dividends or buying back its stock.
Also, par value still matters for a callable common stock: the call price is usually either par
value or a small fixed percentage over par value.
In the United States, it is legal for a corporation to issue "watered" shares below par value.
However, the purchasers of "watered" shares incur an accounting liability to the corporation
for the difference between the par value and the price they paid. Today, in many jurisdictions,
par values are no longer required for common stocks.
2. Maturity

The maturity dates is the specific day, month, and year that the bond issuer is obligated to pay
back the principal to the bondholder. There are rare examples of extendable bonds that give
the issuer or bondholder the option to extend the maturity date of the bond.

74

In the bond market, the maturity of a bond is expressed as the number of years remaining
until the bonds maturity date. For example, a 30-year bond that was issued ten years ago
would be referred to as a 20-year bond.
When bonds are issued, there is a direct correlation between the maturity date and the coupon
rate of the bond. The longer the length of time to maturity, the higher the coupon rate will
be. There are a number of reasons for this correlation; one of them is the time value of
money. The time value of money stipulates that an individual would rather receive money
now than at some time in the future due to the potential earnings capacity of the money.
Another reason for this is that the longer the time period, the more uncertainty is involved
with holding the bond. There is always a chance that the price of a bond can decline, or an
adverse event can befall the issuer of the bond that will jeopardize their ability to pay the
interest and/or principal. Normally, this correlation also holds true for bonds trading in
the secondary market, but there are rare occasion when it does not (we will discuss those
occasions in later lessons).
2. Bond Pricing and Yield
As marketable debt instruments, bonds can be traded and their price can fluctuate over time.
Bond prices are quoted as a percentage of paramount. For example, a bond price of 99
indicates a price of 99% of par, which would be $990 for a par amount of $1,000. A bond
trading at 101 3/8 is 101.375% of par or $1013.75 (every 1/8 th of a point is worth $1.25 for
every $1,000 in face amount). Bonds priced above par (such as 102 ) are referred to as
trading at a premium, while bonds below par are at a discount. Bonds trading at 100 are
always quoted as trading at par.
An entity that is offering bonds in the primary or new issue market, it sets the coupon rate to
reflect the coupon rate of issues that are similar in maturity, credit quality, etc. During the
initial underwriting or offering period, the bonds should trade close to par, but when the
offering period ends, the price can freely fluctuate on the secondary market. We will examine
what factors influence bond prices in detail in future lessons but they include:

The general level of interest rates;

The expected rate of inflation;

The economic outlook;

The issuers credit rating;

The supply of new debt issues; and

The demand for bonds versus alternative investments.

While we have stated that the coupon rate remains constant for fixed rate bonds, the market
yield will fluctuate with the price of the bond. If a bond has a coupon rate of 7 % and the
market yield for equivalent bond is 7 %, then the price of the bond would be par. But, if
some event caused the market yield on equivalent bonds to rise to 8%, the coupon yield of the
75

bond at 7 % is not as attractive to potential buyers who can get a bond with the higher
yield. The price of the less desirable, lower yielding bond would drop in price until its
market yield was also 8%. This is a very important concept: When market yields increase,
bond prices decrease; when market yields decrease, bond prices increase. That is to say that
there is an inverse relationship between changes market yield and changes in bond prices.
When a bond is purchased at a price other than par, the interest payment is no longer the
single factor that determines the rate of return on the investment. If a bond is purchased at
90, the investor pays $900 for the bond, but will receive $1,000 at maturity. In addition to
receiving the interest payments over the life of the bond, the investor will also earn a $100
profit at maturity. Conversely, bonds that are purchased at a premium will cause the investor
to experience a loss at maturity. The measure of a bonds return that takes this principal gain
or loss at maturity is the bonds yield to maturity. The market yield that we have been
referring to is the bonds yield to maturity. Yield to maturity is the measurement of the
present value of a bonds future cash flows (coupon payments and any principal gain or loss
at maturity) based on the current market price.
We could go through the mathematics of calculating yield to maturity and how to determine
what the price change of a bond would be for a given change in interest rates, but it is much
easier to just use bond calculators, like those found here. For those that are curious enough to
want to explore the mathematics, you can find it here.
Another yield measurement that bond investors use is a bonds current yield. The current
yield is determined by simply dividing the annual coupon payment by the market value of the
bond. A $1,000 par bond trading at 96 would have a market value of $960. If the bond had a
stated coupon rate of 7 % it would pay $75 annually: 75/960= .078125, so the current yield
would be 7.8125%. The current yield of a bond trading at a discount will always be higher
than the coupon rate, while the current yield of a premium bond will always be less than the
coupon rate. This also holds true for yield to maturity. Because yield to maturity takes into
account the time value of money, and current yield does not, it is a much better measure of a
bonds true return.

76

REFORMS IN BOND MARKET IN INDIA

The system of auction introduced to sell government securities.

The system of Delivery Versus Payment System (DvP) by Reserve Bank of India to
nullify the risk of settlement in securities and assure the smooth functioning of

securities Delivery and Payment.

The computerization of SGL.
The launch of innovative products such as capital indexed bonds and zero coupon

bonds to attract more and more investors from the wider spectrum of the populace.
Sophistication of markets for bonds such as inflation indexed bonds.
The development of more and more primary dealers as the creator of government of

India bond markets.

The establishment of the powerful regulatory system called the trade for trade system
by the reserve bank of India which stated that all deals are to be settled with bonds

and funds.
A new segment called the wholesale debt market was established at the NSE to report
the trading volume of the government of India bond market.

VALUATION OF BONDS
77

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. In case of a plain vanilla bond, which we will first see,
before understanding the variations, the cash flows are pre-defined. The cash flows expected
from a bond, which is not expected to default are primarily made up of (i) coupon payments
and (ii) redemption of principal. 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 13.1). 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 semiannually, 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 comparable 12% rate).
Therefore, the value of the bond can be stated in general terms as:

Where P0 is the value of the bond

c1, c2 cn are cash flows expected from the bond, over n periods
r is the required rate at which we shall discount the cash flows.
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, 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
78

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.
Value of a 11.75% bond with 8 years to redemption at par

TIME PATH OF A BOND

Consider a 12.5% Central Government bond maturing on March 23, 2004, selling at a
required yield of 9.7% on February 5, 2001 for Rs. 106.89. If the required yield does not
change, there would still be a change in its value and as this bond moves towards maturity,
the value will converge to the redemption value of Rs. 100.
Let us put forth the generalizations that we know from the bond value equation, all of which
arise from the inverse relationship between required yield and the value of the bond:
a) If the required yield on a bond is equal to its coupon, the bond will sell at par.
b) The price of a bond will be higher than the redemption value, if the required yield is lower
than the coupon rate. This is because coupons earned at a higher rate are being discounted at
a lower rate. We may also understand the premium in the price of the bond, as arising from
79

higher demand for a bond with coupons that are higher than the prevalent market rates. Such
a bond which sells at a price higher than the redemption value is called a premium bond.
c) The price of a bond will be lower than the redemption value, if the required yield is higher
than the coupon rate. This is because coupons earned at a lower rate are being discounted at a
higher rate. These bonds sell at a discount because buyers have the option of seeking higher
rate bonds when required rates go up, rather than buy into a lower coupon bond. Such a bond
is called a discount bond. Value of a bond will change over time, even if required rates do not
change. This is an important property of bond values.
Time path of 7.40% 2012 Bond

VALUING A BOND AT ANY POINT ON THE TIME SCALE

In the simple example where we applied the principles of discounting, we discounted the cash
flows of the bond, on the date of issue of the bond. If we valued the bond, say on the first
coupon date, we would consider all the cash flows from that time point until maturity of the
bond. Such valuation is a simple exercise because; we need to discount cash flows for a time
period that culminates into a cash flow date. The valuation exercise can consider rounded
semiannual periods (the n in the equation). In reality, we need to be able to value a bond on
any date from the date of its issue (this date is called the valuation date or settlement date for
the bond). We should be able to discount the expected cash flows to the valuation date,
80

exactly measuring the fractional period of time on the time scale. Therefore the n in the
bond equation should be equal to the actual distance, which is seldom a round number.
Computing this distance for the purpose of valuing a bond depends on the day count
convention in the bond markets. In order to value a bond accurately we need to know the
actual dates on which coupons will be paid, the number of days between two coupon periods
and the distance of the actual valuation date from the previous and the next coupon. All of
this depends on the market convention used, for counting the days on the time line, which is
also called the day count convention. There are 5 popular day count conventions:
a. 30/360: This convention considers each month, including February, as having 30 days and
the year as consisting of 360 days. There are 2 variations to this convention: US NASD
convention and the European 30/360 convention. The 30/360 convention is used in the
Treasury bond markets in many countries. Indian treasury markets use the European 30/360
day count convention.
b. Actual/360: This convention counts the actual number of days in a month, but uses 360 as
the number of days in the year.
c. Actual/actual: This convention uses the actual number of days in the month and the actual
number of days in the year, 366, for a leap year.
d. Actual/365: This convention uses the actual number of days in a month and365 days as the
days in the year.
For example consider the period January 2, 2001 to June 30, 2001. The number of days in
this period and the period in terms of years can vary depending on the day count convention,
as can be seen
Days in the period Jan 2 June 30, 2001

If we have to value a bond on any date other than the coupon date, we have to use the
appropriate day count convention to measure the n in the bond valuation equation. In the
general form, we did not care about the actual date of maturity of the bond, since we
81

measured time periods as rounded half-years. For real-life bond valuation, we have to know
the settlement date, as well as the actual date of maturity, so that, using the appropriate day
count convention, we can discount the cash flows for the actual time distance that is involved.
Coupons and Coupon days
In order to find the expected future cash flows from a bond, the dates on which these cash
flows are expected and the distances from the settlement dates, we can use the coupon
functions in Excel. The following are the coupon functions that are commonly used:
a) Coupnum: number of coupons payable between the settlement date and the maturity date.
b) Coupdays: number of days in the coupon period, containing the settlement date
c) Coupdaybs: number of days from beginning of the coupon period to the settlement date
d) Coupdaysnc: number of days from the settlement date to the next coupon date
In all these cases, we need to specify the settlement date, maturity date, frequency of coupon
payments per annum and the day count convention (also called basis). We can use the
yearfrac unction to convert the number of days into fractional years.

Table provides the data using the coupon functions of Excel, for an illustrative sample of 4
treasury bonds, using the 30/360 day count convention.
Coupon days for settlement date February 5, 2001

In order to value a bond, on a settlement date that is not a coupon date, we have to re-cast the
bond valuation equation

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Where c1, c2... Cn are expected cash flows from the bond. Given the redemption value,
coupon rate and frequency of coupons, we can compute these cash flows.
dnc is the number of days to the next coupon dicp is the days in the coupon period Since the
first cash flow c1, is only dnc/dicp periods away from the settlement date, we discount it only
for that period. For the subsequent cash flows, we can generalize the period for which
discounting is to be done, as [(n-1) + dnc/dicp]. We can use the price function in Excel, in
order to use equation in actual valuation of a bond. Alternatively, we can use the coupon
functions to find out the values in equation and value the bond using the PV function.
The value of the same bond, by merely varying the day count convention (change the basis in
Excel to 1, 2 and 3) can vary to Rs. 99.0136, Rs. 99.0143 ands. 99.0134 Respectively. Using
Excel, readers can check the impact of changes in the day count convention and the
frequency of coupon payments on the value of the bond.
ACCRUED INTEREST
The discounting of expected future cash flows to the present provides a valuation for the
bond, which denotes the price at which a bond can be bought or sold, provided buyer and
seller agree on the price based on such value (whether they will do so depends on their view
of the required rate among other things). We will proceed on the assumption that the required
yield represents the market and that there would be buyers and sellers at this fair value. If
a transaction takes place at the value determined by the bond equation, the buyer pays for all
the future cash flows occurring after the date of settlement, discounted until the settlement
date, in return for receiving all those cash flows.
However, if the settlement occurs at a date, which is not a coupon date, as can mostly be the
case, the transaction takes place on a date that falls between two coupon dates. This would
mean that the seller has held the bond for a period beginning from the previous coupon, to the
settlement date and is eligible to receive a part of the next coupon, in proportion to his
holding period. The seller on the other hand, holds the bond only for the period beginning the
settlement date, but receives the next coupon entirely, having bought the bond.

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Therefore in the bond markets, interest on a bond is not accounted on the coupon date, but is
accrued on an everyday basis. On every transaction in the markets, the buyer has to pay the
seller, a part of the coupon he would receive later, to compensate the seller for holding the
bond for the fraction of the coupon period. This cash flow that is paid to the seller is called
accrued interest and computed as follows:

Where dflc represents days from the last coupon and dicp represents the days in the coupon
period and is the coupon payment. We know that both these values depend on the day count
convention and can be found with the help of the coupon functions in Excel.
If the price of the bond includes accrued interest, it is called as the dirty price or full price of
the bond. Price that excludes accrued interest is called clean price. In most markets the
convention is to quote the clean price, though the buyers always pay the seller the clean price
and the accrued interest that is the dirty price. It is important to remember that the price
function in Excel provides the clean price of the bond.
Accrued Interest on Settlement Date February 5, 2001

YIELD
The returns to an investor in bond are made up of three components: coupon, interest from reinvestment 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.
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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:
Current Yield = 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.
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 a yield measure,
which is known 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. For example, if we find that an 11.99% 2009 bond is being issued at a
price of Rs. 108, (for the sake of simplicity we will begin with the valuation on a cash flow
date), we can state that,

This equation only states the well known bond valuation principle that the value of a bond
will have to be equal to the discounted value of the expected future cash flows, which are the
85

18 semi-annual coupons of Rs. 5.995 each and the redemption of the principal of Rs. 100, at
the end of the 9th year. That value of r which solves this equation is the YTM of the bond. We
can find the value of r in the above equation using the IRR function in Excel
The value of r that solves the above equation can be found to be 5.29%, which is the semiannual rate. The YTM of the bond is 10.58%. However, as we have already noted in the
section on valuation, we should be able to compute price and yield for a bond, at any given
point of time. We therefore have to be able to compute the yield by plotting the cash flows
accurately on the time line (using the appropriate day count convention) and calculate YTM,
given the price at any point on the time line. We have to adopt a procedure very similar to the
one we used for bond valuation11 and we can use the yield function in Excel to compute the
YTM for a bond. Yield to maturity represents the yield on the bond, provided the bond is held
to maturity and the intermittent coupons are re-invested at the same YTM rate. In other
words, when we compute YTM as the rate that discounts all the cash flows from the bond, at
the same YTM rate, what we are assuming in effect is that each of these cash flows can be reinvested at the YTM rate for the period until maturity. 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 13.6. 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.
The yield function in Excel will compute the yield of a bond, given the following:
Settlement: the date on which the yield is sought to be computed
Maturity: the date on which the bond matures
Rate: the rate at which coupon is paid
Price: the market price of the bond
Redemption: the redemption value of the bond
Frequency: number of coupons per year
Basis: Day count convention to be used (represented by numbers 0-4)
On providing these inputs, Excel computes the cash flows from the coupon rate and
redemption values, the time as the distance between settlement date and each of the cash
86

flows, given the day count convention specified in the basis and find by trial and error, the
rate that equates the future the cash flows to the price on the settlement date. Use the function
as = yield (settlement, maturity, rate, price, redemption, frequency, basis)
For example, in order to value the 11.75% 2006 bond, maturing on April 16, 2006, on
February 2, 2001, using the day count convention of 30/360, at price of Rs. 106.84, we shall
state the following:
= yield (02/02/2001, 16/04/2006, 0.1175, 106.84, 100, 2, 4)
Excel will return a yield of 10.0229%, which is the YTM of the bond.

REALISED YIELD
The actual yield realized by the investor in a bond, over a given holding period, is called
realized yield. Realized yield represents the horizon return to the investor, from all the three
components of bond return, namely, coupon, return from re-investment of coupon and capital
gain/loss from selling the bond at the end of the holding period. The realized yield to the
investor is the rate which equates cash flows from all these three sources, to the initial cash
outflow. Realized yield is also called total return from a bond. Depending upon the
reinvestment rates available to the investor and the yields which prevail at the end of the
holding period, the investors realized yield from holding a bond can vary. For example,
consider the 12.5% 2004 bond. The realized yield on a 1-year horizon based on a set of
assumptions about re-investment rates and YTM at the end of the holding period, are as
Follows:

The total return to the investor is attributable to all the three sources of income and depends
on the re-investment rate and the sale price. An increase in interest rates will enhance the
87

reinvestment income of the investor, while reducing the capital gains; a decrease in interest
rates will generate capital gains, while reducing the re-investment income of the investor. The
investment horizon will also impact the percentage composition of each of these components
to the total return of the investor. Holding the bond over a longer time will enhance coupon
component of the return and reinvestment, if rates are increasing. However, the capital gains
will drop, due to a fall in yield, as well as due to the time path effect, leading to the bond
tending to redemption value, as it nears maturity.
Realized yield or total return therefore provides the investor the tool to analyze impact of
interest rates and holding period, on the actual returns earned from a bond.
YIELDPRICE RELATIONSHIPS OF BONDS
The 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 of Bonds

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.
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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 in Figure 13.1, that CG2013 has the steepest slope, while 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 lower coupons.
In the bond markets therefore, we are interested in two key questions: What is the yield at
which reinvestment and valuation happens and how the change in this yield impacts the value
of the bonds held.

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DEBENTURE
A Debenture is a debt security issued by a company (called the Issuer), which offers to pay
interest in lieu of the money borrowed for a certain period. In essence it represents a loan
taken by the issuer who pays an agreed rate of interest during the lifetime of the instrument
and

repays

the

principal

normally,

unless

otherwise

agreed,

on

maturity.

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
Debentures enable investors to reap the dual benefits of adequate security and good returns.
Unlike other fixed income instruments such as Fixed Deposits, Bank Deposits they can be
transferred from one party to another by using transfer from. Debentures are normally issued
in physical form. However, corporate/PSUs have started issuing debentures in Demat form.
Generally, debentures are less liquid as compared to PSU bonds and their liquidity is
inversely proportional to the residual maturity. Debentures can be secured or unsecured.

90

Debentures can be of following types:

Redeemable and Irredeemable Debentures
Redeemable debentures are those which can be redeemed or paid back at the end of a
specified period mentioned on the debentures or within a specified period at the option of the
company by giving notice to the debenture holders or by instalments as per terms of issue.
Irredeemable debentures are those which are repayable at any time by the company during its
existence. No date of redemption is specified. The debenture holders cannot claim their
redemption. However, they are due for redemption if the company fails to pay interest on
such debentures or on winding up of the company. They are also called perpetual debentures.
Secured and Unsecured Debentures
Secured or mortgaged debentures carry either a fixed charge on the particular asset of the
company or floating charge on all the assets of the company. Unsecured debentures, on the
other hand, have no such charge on the assets of the company. They are also known as simple
or naked debentures.
Registered and Bearer Debentures
Registered debentures are registered with the company. Name, address and particulars of
holdings of every debenture holders are recorded on the debenture certificate and in the books
of the company. At the time of transfer, a regular transfer deed duly stamped and properly
executed is required. Interest is paid only to the registered debenture holders. Bearers
debentures on the other hand, are transferred by more delivery without any notice to the
company. Company keeps no record for such debentures. Debentures-coupons are attached
with the debentures-certificate and interest can be claimed by the coupon-holder.
Convertible and Non-convertible Debentures
Convertible debentures are those which can be converted by the holders of such debentures
into equity shares or preference shares, cannot be converted into shares. Now, a company can
also issue partially convertible debentures under which only a part of the debenture amount
can be converted into equity shares.

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MONEY MARKET
It is a market to issue and trade securities with short term maturity or quasi-money
instruments. Instruments like treasury bills, certificates of deposits, commercial papers, bills
of exchange etc are traded in the money market. The money market offers an alternative to
these higher-risk investments.
The money market is better known as a place for large institutions and government to manage
their short-term cash needs. However, individual investors have access to the market through
a variety of different securities. In this tutorial, we'll cover various types of money market
securities and how they can work in your portfolio.
The money market is a subsection of the fixed income market. We generally think of the term
fixed income as being synonymous to bonds. In reality, a bond is just one type of fixed
income security. The difference between the money market and the bond market is that the
money market specializes in very short-term debt securities (debt that matures in less than
one year). Money market investments are also called cash investments because of their short
maturities.
Money market securities are essentially IOUs issued by governments, financial institutions
and large corporations. These instruments are very liquid and considered extraordinarily safe.
Because they are extremely conservative, money market securities offer significantly lower
returns than most other securities.
One of the main differences between the money market and the stock market is that most
money market securities trade in very high denominations. This limits access for the
individual investor. Furthermore, the money market is a dealer market, which means that
firms buy and sell securities in their own accounts, at their own risk. Compare this to the
stock market where a broker receives commission to acts as an agent, while the investor takes
the risk of holding the stock. Another characteristic of a dealer market is the lack of a central
trading floor or exchange. Deals are transacted over the phone or through electronic systems.
The easiest way for us to gain access to the money market is with a money market mutual
funds, or sometimes through a money market bank account. These accounts and funds pool
together the assets of thousands of investors in order to buy the money market securities on
their behalf. However, some money market instruments, like Treasury bills, may be
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purchased directly. Failing that, they can be acquired through other large financial institutions
with direct access to these markets.
There are several different instruments in the money market, offering different returns and
different risks. In the following sections, we'll take a look at the major money market
instruments.
(T-bills) are the most marketable money market security. Their popularity is mainly due to
their simplicity. Essentially, T-bills are a way for the U.S. government to raise money from
the public. In this tutorial, we are referring to T-bills issued by the U.S. government, but
many other governments issue T-bills in a similar fashion.
T-bills are short-term securities that mature in one year or less from their issue date. They are
issued with three-month, six-month and one-year maturities. T-bills are purchased for a price
that is less than their par (face) value; when they mature, the government pays the holder the
full par value. Effectively, your interest is the difference between the purchase price of the
security and what you get at maturity. For example, if you bought a 90-day T-bill at $9,800
and held it until maturity, you would earn $200 on your investment. This differs from coupon
bonds, which pay interest semi-annually.
Treasury bills (as well as notes and bonds) are issued through a competitive bidding process
at auctions. If you want to buy a T-bill, you submit a bid that is prepared either noncompetitively or competitively. In non-competitive bidding, you'll receive the full amount of
the security you want at the return determined at the auction. With competitive bidding, you
have to specify the return that you would like to receive. If the return you specify is too high,
you might not receive any securities, or just a portion of what you bid for.
The biggest reasons that T-Bills are so popular are that they are one of the few money market
instruments that are affordable to the individual investors. T-bills are usually issued in
denominations of $1,000, $5,000, $10,000, $25,000, $50,000, $100,000 and $1 million. Other
positives are that T-bills (and all Treasuries) are considered to be the safest investments in the
world because the U.S. government backs them. In fact, they are considered risk-free.
Furthermore, they are exempt from state and local taxes.
The only downside to T-bills is that you won't get a great return because Treasuries are
exceptionally safe. Corporate bonds, certificates of deposit and money market funds will
93

often give higher rates of interest. What's more, you might not get back all of your investment
if you cash out before the maturity date.
A certificate of deposit (CD) is a time deposit with a bank. CDs are generally issued by
commercial banks but they can be bought through brokerages. They bear a specific maturity
date (from three months to five years), a specified interest rate, and can be issued in any
denomination, much like bonds. Like all time deposits, the funds may not be withdrawn on
demand like those in a checking account.
CDs offer a slightly higher yield than T-Bills because of the slightly higher default risk for a
bank but, overall, the likelihood that a large bank will go broke is pretty slim. Of course, the
amount of interest you earn depends on a number of other factors such as the current interest
rate environment, how much money you invest, the length of time and the particular bank
you choose. While nearly every bank offers CDs, the rates are rarely competitive, so it's
important to shop around.
A fundamental concept to understand when buying a CD is the difference between annual
percentage yield (APY) and annual percentage rate (APR). APY is the total amount of
interest you earn in one year, taking compound interest into account. APR is simply the stated
interest you earn in one year, without taking compounding into account.
The difference results from when interest is paid. The more frequently interest is calculated,
the greater the yield will be. When an investment pays interest annually, its rate and yield are
the same. But when interest is paid more frequently, the yield gets higher. For example, say
you purchase a one-year, $1,000 CD that pays 5% semi-annually. After six months, you'll
receive an interest payment of $25 ($1,000 x 5 % x .5 years). Here's where the magic of
compounding starts. The $25 payment starts earning interest of its own, which over the next
six months amounts to $ 0.625 ($25 x 5% x .5 years). As a result, the rate on the CD is 5%,
but its yield is 5.06. It may not sound like a lot, but compounding ads up over time.
The main advantage of CDs is their relative safety and the ability to know your return ahead
of time. You'll generally earn more than in a savings account, and you won't be at the mercy
of the stock market. Plus, in the U.S. the Federal Deposit Insurance Corporation guarantees
your investment up to $100,000.

94

Despite the benefits, there are two main disadvantages to CDs. First of all, the returns are
paltry compared to many other investments. Furthermore, your money is tied up for the
length of the CD and you won't be able to get it out without paying a harsh penalty.
For many corporations, borrowing short-term money from banks is often a laborious and
annoying task. The desire to avoid banks as much as possible has led to the widespread
popularity of commercial paper.
Commercial paper is an unsecured, short-term loan issued by a corporation, typically for
financing accounts receivable and inventories. It is usually issued at a discount, reflecting
current market interest rates. Maturities on commercial paper are usually no longer than nine
months, with maturities of between one and two months being the average.
For the most part, commercial paper is a very safe investment because the financial situation
of a company can easily be predicted over a few months. Furthermore, typically only
companies with high credit ratings and credit worthiness issue commercial paper. Over the
past 40 years, there have only been a handful of cases where corporations have defaulted on
their commercial paper repayment.
Commercial paper is usually issued in denominations of $100,000 or more. Therefore,
smaller investors can only invest in commercial paper indirectly through money market
funds.
A bankers' acceptance (BA) is a short-term credit investment created by a non-financial firm
and guaranteed by a bank to make payment. Acceptances are traded at discounts from face
value in the secondary market.
For corporations, a BA acts as a negotiable time draft for financing imports, exports or other
transactions in goods. This is especially useful when the creditworthiness of a foreign trade
partner is unknown.
Acceptances sell at a discount from the face value:
Face Value of Banker's Acceptance
Minus 2% Per Annum Commission for One Year
Amount Received by Exporter in One Year

$1,000,000
-$20,000
$980,000

One advantage of a banker's acceptance is that it does not need to be held until maturity, and

95

can be sold off in the secondary markets where investors and institutions constantly trade
BAs.
Contrary to the name, Eurodollars have very little to do with the euro or European countries.
Eurodollars are U.S.-dollar denominated deposits at banks outside of the United States. This
market evolved in Europe (specifically London), hence the name, but Eurodollars can be held
anywhere outside the United States.
The Eurodollar market is relatively free of regulation; therefore, banks can operate on
narrower margins than their counterparts in the United States. As a result, the Eurodollar
market has expanded largely as a way of circumventing regulatory costs.
The average Eurodollar deposit is very large (in the millions) and has a maturity of less than
six months. A variation on the Eurodollar time deposit is the Eurodollar certificate of deposit.
A Eurodollar CD is basically the same as a domestic CD, except that it's the liability of a nonU.S. bank. Because Eurodollar CDs are typically less liquid, they tend to offer higher yields.
The Eurodollar market is obviously out of reach for all but the largest institutions. The only
way for individuals to invest in this market is indirectly through a money market fund.
Repo is short for repurchase agreement. Those who deal in government securities use repos
as a form of overnight borrowing. A dealer or other holder of government securities (usually
T-bills) sells the securities to a lender and agrees to repurchase them at an agreed future date
at an agreed price. They are usually very short-term, from overnight to 30 days or more. This
short-term maturity and government backing means repos provide lenders with extremely
low risk.
Repos are popular because they can virtually eliminate credit problems. Unfortunately, a
number of significant losses over the years from fraudulent dealers suggest that lenders in this
market have not always checked their collateralization closely enough.
There are also variations on standard repos:

Reverse Repo - The reverse repo is the complete opposite of a repo. In this case, a
dealer buys government securities from an investor and then sells them back at a later
date for a higher price
96

Term Repo - exactly the same as a repo except the term of the loan is greater

The money market specializes in debt securities that mature in less than one year.

Money market securities are very liquid, and are considered very safe. As a result,
they offer a lower return than other securities.

The easiest way for individuals to gain access to the money market is through
a money market mutual fund.

T-bills are short-term government securities that mature in one year or less from their
issue date.

T-bills are considered to be one of the safest investments - they don't provide a great
return.

A certificate of deposit (CD) is a time deposit with a bank.

Annual percentage yield (APY) takes into account compound interest, annual
percentage rate (APR) does not.

CDs are safe, but the returns aren't great, and your money is tied up for the length of
the CD.

Commercial paper is an unsecured, short-term loan issued by a corporation. Returns

are higher than T-bills because of the higher default risk.

Bankers acceptances (BA) are negotiable time draft for financing transactions in
goods.

BAs are used frequently in international trade and are generally only available to
individuals through money market funds.

Eurodollars are U.S. dollar-denominated deposit at banks outside of the United States.

The average Eurodollar deposit is very large. The only way for individuals to invest in
this market is indirectly through a money market fund.

Repurchase agreements (repos) are a form of overnight borrowing backed by

government securities.

97

REPO MARKET IN INDIA: SOME RECENT ISSUES

Repos being short term money market instruments are necessarily being used for
smoothening volatility in money market rates by central banks through injection of short term
liquidity into the market as well as absorbing excess liquidity from the system. Regulation of
the repo market thus becomes a direct responsibility of RBI. Accordingly, RBI has been
concerned with use of repo as an instrument by banks or non-bank entities and issues relating
to type of eligible instruments for undertaking repo, eligibility of participants to undertake
such transactions etc. and it has been issuing instructions in this regard in consultation with
the Central Government. After evidence of abuse in the repo market during the period leading
to the securities scam of 1992, RBI had banned repos from the markets. It is only in the
recent past that these restrictions have been removed, and after the acceptance of the report of
the technical sub-groups recommendations, RBI has initiated efforts for creating an active
market for repos. It was decided to adopt the international usage of the term Repo and
Reverse Repo under LAF operations. Thus, when RBI absorbs liquidity it is termed as
Reverse Repo and the RBI injecting liquidity is the repo operation. Since forward trading in
securities was generally prohibited in India, repos were permitted under regulated conditions
in terms of participants and instruments. Reforms in this market have encompassed both
institutions and instruments. Both banks and non-banks were allowed in the market. All
government securities and PSU bonds were eligible for repos till April 1988. Between April
1988 and mid June 1992, only inter-bank repos were allowed in all government securities.
Double ready forward transactions were part of the repos market throughout the period.
Subsequent to the irregularities in securities transactions that surfaced in April 1992, repos
were banned in all securities, except Treasury Bills, while double ready forward transactions
were prohibited altogether. Repos were permitted only among banks and PDs. In order to
reactivate the repos market, the Reserve Bank gradually extended repos facility to all Central
Government dated securities, Treasury Bills and State Government securities. It is mandatory
98

to actually hold the securities in the portfolio before undertaking repo operations. In order to
activate the repo market and promote transparency, the Reserve Bank introduced regulatory
safeguards such as delivery versus payment system during 1995-96. The Reserve Bank
allowed all non-bank entities maintaining subsidiary general ledger (SGL) account to
participate in this money market segment. Furthermore, NBFCs, mutual funds, housing
finance companies and insurance companies not holding SGL accounts were allowed by the
Reserve Bank to undertake repo transactions from March 2003 through their gilt accounts
maintained with custodians. With the increasing use of repos in the wake of phased exit of
Non-banks from the call money market, the Reserve Bank issued comprehensive uniform
accounting guidelines as well as documentation policy in March 2003. Moreover, the DVP III
mode of settlement in government securities (which involves settlement of securities and
funds on a net basis) in April 2004 facilitated the introduction of rollover of repo transactions
in government securities and provided flexibility to market participants in managing their
collaterals.
The operationalisation of the Negotiated Dealing System (NDS) and the Clearing
Corporation of India Ltd. (CCIL) combined with the prudential limits on borrowing and
lending in the call/notice market for banks also helped in the development of market repos.

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INDIAN CORPORATE DEBT MARKET CURRENT STATUS

India has been distinctly lagging behind other emerging economies in developing its longterm debt market (LTDM), be it corporate or municipal bonds. The equity market has been
more active, developed and at the centre of media and investor attention. Traditionally, larger
corporate have used bank finance, equity markets and external borrowings to finance their
needs. Small and medium enterprises face significant challenges in raising funds for growth.
Comparison with other countries
In India, the proportion of bank loans to GDP is approximately 36%, while that of corporate
debt to GDP is only 4% or so. In contrast, corporate bond outstanding is 70% of GDP in
USA, 147% in Germany, 41% in Japan, & 49% in South Korea. The size of the Indian
corporate debt market is very small in comparison to both developed markets, as well as
some of the major emerging market economies. For a sample of eight Indian corporate that
featured in Forbes 2000, corporate bonds account for only 21% of total long term financing.
In contrast, corporate bonds account for nearly 80% of total long term debt financing by
corporate in the four developed economies of USA, Germany, Japan and South Korea 1. In
these countries, the share of corporate bonds is close to 87% for corporate graded above BBB
and 66% for the rest. Corresponding figures in major emerging economies such as South
Africa, Brazil, China and Singapore, are 57% and 33% for corporate rated above BBB and
those rated at BBB or below respectively.
Drawing on the cross sectional experience of G7 countries since the 1970s, it is estimated that
the overall capitalization of the Indian debt market (including public-sector debt) could grow
nearly four-fold over the next decade. This would bring it from roughly USD 400 billion, or
around 45% of GDP, in 2006, to USD 1.5 trillion, or about 55% of GDP, by 2016. This
growth, if not crowded out by public sector debt, could result in increased access to debt
markets for Indian corporate.

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Comparison with the G-Sec Market and Equity Market

In India the long-term debt market largely consists of government securities. The market for
corporate debt papers in India primarily trades in short term instruments such as commercial
papers and certificate of deposits issued by Banks and long term instruments such as
debentures, bonds, zero coupon bonds, step up bonds etc. In 2011, the outstanding issue size
of Government securities (Central and State) was close to Rs. 29 lakh crores (USD 644.31
billion) with a secondary market turnover of around Rs. 53 lakh crores (USD 1.18 trillion). In
contrast, the outstanding issue size of corporate bonds was close to Rs. 9 lakh crores (USD
200 billion). Moreover, the turnover in corporate debt in 2011 was roughly Rs. 6 lakh crores
(USD 133 billion) whereas in 2011, the Indian equity market turnover was roughly Rs. 47
lakh crores (USD 1.04 trillion.)

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Some challenges in the Indian market

The total corporate bond issuance in India is highly fragmented because bulk of the debt
raised is through private placements. Small and medium-size enterprises are unable to access
the debt markets. Furthermore, trading is concentrated in a few securities, with the top five to
ten traded issues accounting for the bulk of total turnover. The secondary market is also
minuscule, accounting for only 0.03% of the total trading.
Development of the domestic corporate debt market in India is constrained by a number of
factors viz: low issuance leading to illiquidity in the secondary market, narrow investor base,
high costs of issuance, lack of transparency in trades and so on. The market suffers from
deficiencies in products, participants and institutional framework.
All this is despite the fact that India is fairly well placed insofar as pre-requisites for the
development of the corporate debt market are concerned. There is a reasonably welldeveloped government securities market, which generally precedes the development of the
market for corporate debt securities. Another emerging economy, South Africa for instance,
witnessed nearly a decade long public sector debt market reform before the market for
corporate debt securities began to develop. The major stock exchanges in India have trading
platforms for transactions in debt securities. Infrastructure also exists for clearing and
settlement in the form of the Clearing Corporation of India Limited (CCIL). Finally, the
presence of multiple rating agencies meets the requirement of an assessment framework for
bond quality.
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In the subsequent blogs in this series, our objective is to analyze the evolution of and
developments in the Indian corporate debt market over the last couple of decades, identify the
challenges and also discuss possible recommendations to further improve and deepen this
critical area of the Indian financial system.

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BIBLIOGRAPHY

Investopedia.com
Investorwoeds.com
Scibd.com
Bseindia.com

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