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Money, Forex and Bond Markets

II. Bond Markets

Dr HK Pradhan
XLRI Jamshedpur

Debt Securities
Debt securities are a class of interest rate sensitive instruments, wherein
borrowings being made in return for a predetermined stream of cash flows,
paid on a fixed schedule.
The defining feature is that there are well-defined rules governing when
there will be a payout to the holder of the security
Predetermined cash flows such as Coupons, Par value(no other asset class assures this)
With cashflows predetermined, these securities are subject to various
risks(defaults, inflation)
Cash flows promised to the holders of securities represent contractual
obligations of the respective issuers
Holders of debt securities are creditors, and the issuer is the borrower
(Governments, Corporate, Municipalities, SPVs )
Contractual obligations differ across issuers, setting rules for cashflows

Importance of Fixed Income Securities Markets

Fixed income securities offer an assured rate of return to the

Government bond yields serve as benchmark returns in the
Government bond yields signal monetary policy
Corporate bond yields signals credit risk behavior
Debt markets signal long run prospects of the economy

Debt Markets.

Classification of Debt Securities
By Issuers
Central Government, State Governments, Municipal Corporations, PSUs, PFIs,
By Instruments
T Bills, Government Securities, SDLs, Municipal Bonds, Corporate bonds,
FRBs, Inflation Indexed, Convertibles, ABSs
By Interest rates
Fixed rate issues, Floating rate issues, Zero coupons, inflation indexed bonds
By Maturity
money market instruments (T Bills, CPs), Bonds (with 2 or more years tenor)
By Optionality, Structured Obligations
Calls, Puts & Convertibles, ABS, CDS
By Tax features
Taxable, non-taxable bonds
Sectoral/Special bonds
PUSs, Bank bonds, Infra, oil, special purpose bonds
By Derivatives
FRAs, IRFs, OIS, IRFs, Options, Caps and Floors, STRIPS

Savings of Households
Household prefer bank deposits, savings schemes, and to an
extent debt instruments
Specific debt instruments are available for retail
investors (tax free bonds, infrastructure bonds, inflation
indexed bonds)

Savings of Households

Central Government primarily uses debt markets to finance
fiscal deficit
Other sub-sovereign entities extensively use debt markets for
financing & investments
(state and local governments, state sponsored SPVs,
municipal corporations)
Corporate raise money thro debt instruments
(CPs, debentures, bonds)

Treasury Bills(91, 182 and 364 days)

Instruments of short-term borrowings of government, smoothens
cash management operations, and for monetary policy purposes.
Issued at a discount through auction by RBI and redeemed at par
All issuance of T-Bills run online on PDO-NDS system
Serves as a benchmark for money markets
Repo transactions permitted in all T-Bills

Government Bonds
Maturities extended upto 40 years (coupon bonds, FRBs, Zero, IIBs, tax free, special
bonds, etc)
Banks/FIs hold government securities in their portfolio for prudential reasons
Government securities can be used as collateral to raise liquidity in the repo/CBLO
market/short sale
Yields on government securities serve important purposes
G Sec yields represent indicators of risk free rates
Government securities yields serve as benchmark yields for rest of the sector
Used for derivative pricing

State Government Securities

Until 1998-99 the states issued securities at pre-announced
coupon rates and prices and were issued by the Reserve
Bank through common tranches.
Since 1999, an option has been given to the states to raise
their borrowings by way of competitive auctions
RBI manages state borrowing programmes using combined
Sub-sovereign issuances, carries implicit guarantees

State Sponsored Institutions

State sponsored institutions include state level

financial institutions, state sponsored special
purpose vehicles (SPVs), and statutory boards
such as Water Supply and Sewerage Boards.
The instruments are usually known in India as
structured obligations(SO)

Municipal bonds(ULBs)

Trends towards decentralization and urbanization

have necessitated borrowings by municipal
Municipal bonds have a number of interesting features.
There are two basic types:
General Obligation Bonds: The governments
taxation authority backs the bond.
Revenue bonds revenue from a specific project is
used to pay the bonds down
Tax-free bonds

Municipal Bonds
Municipal issues are in the nature of revenue bonds, with fixed
interest rate, with government guarantee, maturity 7-15 years,
are in the form of Structured Obligations(SO)

Municipal Bonds With AMC as an Intermediary


Principal Munici pal

Interest Bonds

AMC Guarantee by


+ ULBs
Interest Loan/Bonds

Project Cash
Fl ows

Escrow Debt Reserve Fund

Corporate Securities
CPs/CDs, Corporate bonds, Corporate bonds with embedded options,
Perpetual bonds, Securitized Papers (Asset Backed Securities, Mortgage
Backed Securities), equity linked debentures
SEBI issues guidelines for corporate debt issuance and also for their listing
on stock exchanges.
Privately placed debt paper of banks, institutions and corporates requires an
investment grade credit rating
Relatively less liquid when compared with G-sec market
Trading takes place typically through OTC market/ Telephone market
Credit ratings determine Spreads/ pricing of debt instruments
Spread as per ratings over the relevant benchmark rates
Ratings and rating migration depend on the state of the economy
The Insolvency and Bankruptcy Code passed by the Parliament protects
creditors rights in insolvency resolution

Investors or the buy side institutions

Banks hold government securities for their statutory investment
Mutual Funds hold significant portion of debt portfolios
Insurance companies, provident funds & pension funds invest in
debt related instruments
Primary Dealers are a set of specialized intermediaries actively
trade and invest in debt market
Reserve Bank of India operates monetary policy using
government securities and T-bills
FIIs invest in debt markets, government & corporate bonds

Primary Dealers
Primary Dealers are those banks & securities firms that are
approved to transact directly with the Reserve Bank in auctions.
Advantage of primary dealer system is that the Reserve Bank will
be in a position to conduct its auctions efficiently with a small
number of well capitalized institutions.
Primary dealers are expected to
Participate in auctions
Underwrite Auction
Act as "Market Makers
RBI provides liquidity support
PDs have access to the RBIs open market operations
PDs are permitted to borrow and lend in the money market

Primary Dealers

FII in Indian Bond Markets

Foreign Institutional Investor
FIIs are entities incorporated or established outside India .It Includes
asset management companies, Pension funds , mutual funds , investment
trust as nominee companies incorporated/institutional Portfolio
Manager, endowment funds, charitable trust and societies .
Regulation and investment limit .
FII are registered with SEBI.
FIIs investment limit in government securities including T-bills is
USD 25 Billion and in corporate bond is US dollar 51 Billion
Factors affecting FII investment are rupee movement ,policy reforms,
investment regulation, interest rate ,liquidity and macro economic

Government Debt Operations
G-SECs issued by the Order of the President of India
thro the Ministry of Finance(Department of Economic
Affairs: Budget Division)
RBI manages the entire government debt operations at its
Both the initial sale of securities and subsequent transfers
are handled by the RBI
Settlement thro a computerized book-entry system called the
SGL and constituents SGL Accounts
Settlement System is Delivery versus payment (DvP)/RTGS
with T+0, T+1 as the conditions of deals

Demand and Supply of G Secs

Cash management (pattern of taxes/Government
expenditures are front loaded, whereas tax collections gather
towards year-end
Long Term Securities
Budget financing
Short Term Securities
Treasury Bills, Cash Management bills
Moderating variables
OMOs, Repos/Reverse Repos, Cash Management Bills

Sovereign Liabilities & Public Debt
Sovereign Liabilities = Public Debt + Other Liabilities
Other Liabilities = Small savings, provident funds, special deposits,
reserve funds of departmental commercial undertakings, etc
Public debt = Internal Debt + External Debt
Internal debt
Market Borrowings
Dated Securities
Treasury Bills,
Special Securities (UTI, Oil companies, Nationalized banks, etc)
Compensation and other bonds
Nonnegotiable, non-interest bearing rupee securities issued to international
financial institutions
External Debt
Bilateral official


State Government Debt

Public debt = Internal Debt (No External Debt)
Internal debt
Market Borrowings
Dated Securities (State Development Loans)
Loans from the Centre
Securities Issued to NSSF
External Assistance to States used to be Routed
Through Centre Now back to back


Debt Management framework
Constitution of India
Art 292 (Centre) and 293 (States)
Limit on Public Debt ( Parliament)
Secured against the Consolidated Fund
Section 20/21
RBI Sole Manager of Public Debt
Of Centre - By Statute
Of States By Agreement
Public Debt Act 1944 replaced with GS
Act 2006
Issue and Servicing of Debt


RBI's role as Debt Manager

Union Budget
Formulation of borrowing program
Objectives of debt management
Lower cost
Minimal roll over risk


Government Financing Options
BorrowingRequirements (inlocalcurrency) FinancingItems(inlocalcurrency)
Revenues(T) 60,000 DomesticBorrowing(60%)24,000
Expenditures(G)80,000 Treasurybills
Generalgovernmentexpenditures(GE)70,000 Ways&Meansadvances
BudgetDeficit(TG=BD)20,000 Domesticloans
Totalnetborrowingrequirement(TG)20,000 Retailinstruments
TotalRedemption(TR) 20,000
Shorttermdebt5,000 ExternalBorrowing(40%)16,000
Longtermdebt15,000 Grants
Grossborrowingrequirements(TR+BD)40,000 Bondfinance

Methods of Government Debt
Governments use several methods to sell securities such as
On-Tap issuance,
Retail issuance
Auction based issuing techniques are most common form
Half-yearly issuance calendars
Cash shortfalls are part of liquidity management

Government Debt Issuance

Primary Issuance
Auction method(primary dealers)
Maturity bunching & roll over
Passive Consolidation ( reissuances/ reopening)
Liability Management/Restructuring
Buyback, switch/swap, secondary market purchase

Primary Issuance Framework



Institutional Arrangements
Government of India (through the Public Debt Act of 1944, replaced with GS
Act, 2006) empowers RBI to regulate primary issuance of debt securities,
issuance and redemption; Lien/Pledge /Hypothecation, STRIPS
SEBI regulates primary issuance of debt securities other than government
Primary Issuance
Primary dealership
Direct, Broker driven (OTC markets generally predominate)
Anonymous Order Driven
Clearing & Settlement

Negotiated Dealing System (NDS)
NDS of RBI provides an electronic platform for negotiating trades in
government securities.
NDS Order Matching (NDS-OM)
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
WDM Segment of NSE Trading System
BSE and NSE to have in place for bond trading
NSEs Wholesale Debt Market (WDM) segment offers a fully automated
screen based trading platform through the NEAT (National Exchange for
Automated Trading) system

Bond Trading Screen NDS OM

Debt market serves as important
conduits for monetary policy
Key route for monetary policy applications
Management of liquidity in the financial markets
Statutory liquidity requirements for banks and financial
institutions are met using government securities markets
Debt markets signal long run prospects of the economy
Signals inflationary expectations, in term structure of interest
Links money markets and foreign exchange markets

Yield Curve
Provides the long run anchor of the economy
Inflationary expectations and long run interest
The shape and shift in the YC impacts the trading
behaviour in the bond market
Indian YC are seen significant gyrations in recent

Shape & Shifts of the Yield Curve


RBI, Annual Report 2017, page 61

Indian bond market is illiquid
Traded prices are not available for all bonds
Corporate bonds are extremely illiquid
Marked-to-Market valuation of bond portfolios becomes
The mutual fund industry and insurance companies (for their
ULIPs portfolio) follow a daily mark-to-market valuation
Banks mark-to-market their portfolio on a monthly basis

Secondary Bond Markets
Banks typically hold a substantial portion for bonds,
effectively to maturity, to a smaller extent for short term
trading purpose
Large portion of HTM portfolio as against the trading
Contractual saving institutions mainly focus on long term
bonds, buy-hold investors in general
Captive nature of holdings create market distortions in
yield and illiquidity (Pension funds, mutual funds,
insurance companies)
Price discovery processes must be as efficient as possible
such that true market prices that accurately reflect
conditions in the economy

Illiquidity is primarily due to buy-hold nature of
Cost of illiquidity: This leads to lower price realization of
an asset
Value of an illiquid asset would be lower to the extent of
the present value of expected future transaction costs
There are other elements of costs associated with trading
an asset
Bid-ask spread of an asset
Price impact while trading an asset
Opportunity costs associated with the waiting to trade

Government Securities - Market Liquidity Indicators(8/9/2017)
Liquid Securities
1A Bid Ask Spread Spread Spread (`) Spread (bps) Spread
(Ratio) Range (`)
Aug-17 0.02% 0.0252 0.4067 0.19-0.0025
Jul-17 0.02% 0.0210 0.3343 0.0905-
Semi-Liquid Securities
1B Bid Ask Spread Spread Spread (`) Spread (bps) Spread
(Ratio) Range (`)
Aug-17 0.12% 0.1280 2.1694 1.44-0.01
Jul-17 0.18% 0.1997 3.6725 1.7-0.01
Illiquid Securities (Orderbook was available
for only a few days)
1C Bid Ask Spread Spread Spread (`) Spread (bps) Spread
(Ratio) Range (`)
Aug-17 0.52% 0.6167 7.9817 1.75-0.03
Jul-17 0.29% 0.3312 12.6707 1.5-0.02
Daily Average Deals
2 Average No. of Trades G-Sec SDLs T-Bills Total
Aug-17 2985 63 55 3103
Jul-17 4142 69 57 4267
3 Average Orderbook Size No. of Order Value (` Traded Value (` Trades
Orders Cr.) Cr.)
Aug-17 5465 112915 34800 3103
30.82% 56.78%
Jul-17 6949 136684 46892 4267
34.31% 61.41%
4 Impact Cost (%) Offer Bid Average
Aug-17 0.0227 0.0222 0.0224
Jul-17 0.0191 0.0204 0.0198
5A Turnover Ratio - G-Sec SDLs
Components T-Bills Special
Aug-17 1.64% 0.25% 1.88% 0.00%
Jul-17 2.26% 0.29% 1.62% 0.03%
5B Turnover Ratio Market Outright Repo

Repo, CLBO(collateralized borrowing and lending
Floating Rate Bonds
When Issued Markets
Inflation Index Bonds
Short sales
FRAs, Swaps, Overnight index swaps
Interest Rate Futures(IRF)
Currency futures
Credit Default Swaps(CDS)



Market follows FIMMDA valuation methods for
interest rate benchmarks
FEDAI provided forex benchmarks
Independent benchmark company (FBIL)
provides MIBOR & FC Rupee Option volatility
MIFOR, CD and CP based curves yet to be
RBIs Reference Rate - polling window of one
FIMMDA-CRISIL Corporate bond spreads


Thank You