Debt Markets in India
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Transcript of Debt Markets in India
The Debt Market in India Executive Summary
Executive Summary
I have selected this topic totally from knowledge point of view. I wanted to
know about the market, which is the largest of all the financial markets as far
as volume is considered. I wanted to gain knowledge about various securities,
their trading, their prices and rate of return, etc.
This report provides information about debt market and its categories viz,
Government Securities
Corporate Debt/Bonds
PSU Bonds
It also brings out the role played by debt market in the Indian economy. It
talks about the benefits of investing in fixed income securities in terms of risk
and guaranteed returns.
After that it explains Money Markets and in that call money markets,
information about the wholesale and retail debt market and the role of NSE
and BSE in the wholesale debt market.
The yield of the bond is of much significance in determining the value of a
particular bond. Therefore, how the yield is determined is explained with the
help of yield curve and with the help of that price determination mechanism
is also explained.
It gives a brief description about various instruments, both short-term and
long-term, in wholesale and retail debt market. These include CP, CD, and T-
Bills (short-term) and GOI Sec, State loan and PSU Bonds (long-term). It also
gives information about their tradability and liquidity in the debt market.
Information about the issuers of debt instruments is provided. The
following are the categories of issuers in debt markets:
Government of India and other sovereign bodies
Banks and Development Financial Institutions
PSUs
Private sector companies
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The Debt Market in India Executive Summary
Government or quasi government owned non-corporate entities
Investors are the most important class in debt market after all they are
the ones on which the debt markets thrive. The major participation is by the
large investors whereas retail investors don’t participate much in debt
markets. Information about these large investors is provided in brief.
After that, details about the regulators of the debt markets and the credit
rating of various debt instruments are given.
Also the impact of Union Budget 2004 on debt market is explained. After
that, a few points to be considered before investing in any debt instrument
are given. Before concluding the report I have given my perspective on the
problems faced by retail investors and made recommendations for the same.
An FAQ section precedes the conclusion of the project report.
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The Debt Market in India Introduction
Introduction
Debt market as the name suggests is where debt instruments are traded.
The most distinguishing feature of these instruments is that the return is
fixed, that is they are as close to being risk free as possible, if not totally risk
free.
There is no single location or exchange where debt market participants
interact for common business. Participants talk to each other, over telephone,
conclude deals, and send confirmations by Fax, Mail etc. with back office
doing the settlement of trades. In the sense, the wholesale debt market is a
virtual market. The daily transaction volume of all the debt instruments
traded would be about Rs.4000 - 5000 crores per day. In India, NSE has its
separate segment, which allows online trades in the listed debt securities
through its member brokers. Also BSE has introduced Debt Market Segment.
What is Debt Instrument?
A tradable form of loan is normally termed as a Debt Instrument. They are
usually obligations of issuer of such instrument as regards certain future cash
flow representing Interest & Principal, which the issuer would pay to the legal
owner of the Instrument. This arrangement can be converted in the form of
an instrument wherein the loans can be made tradable by converting it into
instruments of smaller units with a pro rate allocation of principal and
interest. So the basic features of any debt instrument are as follows:
Face value of the instrument is the value that is written on the debt
certificate.
Issue price, is the value at which the security is issued. It might be at
par or at a premium or discount.
Coupon, the interest rates payable on the instrument.
Terms and conditions like repayment period, pattern and mode of
repayment
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The Debt Market in India Introduction
Debt Instruments are of various types. The distinguishing factors of the
Debt Instruments are as follows: -
Issuer class
Coupon bearing / Discounted
Interest Terms
Repayment Terms (Including Call / put etc.)
Security / Collateral / Guarantee
Introduction to Fixed Income Instruments
Fixed Income securities are one of the most innovative and dynamic
instruments evolved in the financial system ever since the inception of
money. Based as they are on the concept of interest and time-value of
money, Fixed Income securities personify the essence of innovation and
transformation, which have fuelled the explosive growth of the financial
markets over the past few centuries.
Fixed Income securities offer one of the most attractive investment
opportunities with regard to safety of investments, adequate liquidity, and
flexibility in structuring a portfolio, easier monitoring, long-term reliability and
decent returns. They are an essential component of any portfolio of financial
and real assets, whether in form of pure interest bearing bonds, innovative
and varied type of debt instruments or asset-backed mortgages and
securitised instruments.
Fixed Income Markets - Powering the World
The Fixed Income securities market was the earliest of all the securities
markets in the world and has been the forerunner in the emergence of the
financial markets as the engine of economic growth across the globe. The
Fixed Income Securities Market, also known as the Debt Market or Bond
Market, is easily the largest of all the financial markets in the world today.
The size of the world Bond markets last year was around US $ 35 trillion,
which is nearly equivalent to the total GDP of all the countries in the world.
The Debt Markets have therefore a very prominent role to play in the efficient
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The Debt Market in India Introduction
functioning of the world financial system and in catalysing the economic
growth of nations across the globe.
Indian Debt Markets - Pillars of the Indian Economy
The Debt Markets therefore play a very critical 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 corporates. The
Indian Debt Markets with an outstanding issue size of close to Rs.14640
Billion (or Rs. 14,64,000 Crores) and a secondary market turnover of around
Rs.28500 Billion (in the year - 2005) is the largest of the Indian financial
markets.
The key role of the debt markets in the Indian Economy stems from the
following reasons:
Efficient mobilization and allocation of resources in the economy
Financing the development activities of the Government
Transmitting signals for implementation of the monetary policy
Facilitating liquidity management in tune with overall short term and
long-term objectives.
Since the Government Securities are issued to meet the short term and
long term financial needs of the government, they are not only used as
instruments for raising debt, but have emerged as key instruments for
internal debt management, monetary management and short term liquidity
management.
The returns earned on the government securities are normally taken as
the benchmark rates of returns and are referred to as the risk free return in
financial theory. The Risk Free rates obtained from the G-sec rates are often
used to price the other non-govt. securities in the financial markets.
Benefits of an efficient Debt Market to the financial system and the economy
3
The Debt Market in India Introduction
Reduction in the borrowing cost of the Government and enable
mobilization of resources at a reasonable cost.
Provide greater funding avenues to public sector and private sector
projects and reduce the pressure on institutional financing.
Enhanced mobilization of resources by unlocking illiquid retail
investments like gold.
Development of heterogeneity of market participants
Assist in development of a reliable yield curve and the term structure
of interest rates.
Advantages of investing in fixed income securities
Fixed Income securities offer a predictable stream of payments by way of
interest and repayment of principal at the maturity of the instrument. The
debt securities are issued by the eligible entities against the moneys
borrowed by them from the investors in these instruments. Therefore, most
debt securities carry a fixed charge on the assets of the entity and generally
enjoy a reasonable degree of safety by way of the security of the fixed and/or
movable assets of the company.
The investors benefit by investing in fixed income securities as they
preserve and increase their invested capital and also ensure the
receipt of regular interest income.
The investors can even neutralize the default risk on their investments
by investing in Govt. securities, which are normally referred to as risk-
free investments due to the sovereign guarantee on these instruments.
The prices of Debt securities display a lower average volatility as
compared to the prices of other financial securities and ensure the
greater safety of accompanying investments.
Debt securities enable wide-based and efficient portfolio diversification
and thus assist in portfolio risk-mitigation.
Different types of risks with regard to debt securities
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The Debt Market in India Introduction
Even though debt markets are considered to be risk-free investments,
they are not totally risk-free. The following are the risks associated with debt
securities:
Default Risk: This can be defined as the risk that an issuer of a bond
may be unable to make timely payment of interest or principal on a
debt security or to otherwise comply with the provisions of a bond
agreement and is also referred to as credit risk.
Event Risk: Event risk reflects the bond issuer’s activities such as
restructurings, mergers and acquisitions, and leveraged buyouts to
boost shareholder value. Events such as these can dramatically
increase a company’s debt burden resulting in a deterioration of its
credit risk profile and a decline in bond value.
Interest Rate Risk: This can be defined as the risk emerging from an
adverse change in the interest rate prevalent in the market so as to
affect the yield on the existing instruments. A good case would be an
upswing in the prevailing interest rate scenario leading to a situation
where the investors' money is locked at lower rates whereas if he had
waited and invested in the changed interest rate scenario, he would
have earned more.
Reinvestment Rate Risk: can be defined as the probability of a fall in
the interest rate resulting in a lack of options to invest the interest
received at regular intervals at higher rates at comparable rates in the
market.
The following are the risks associated with trading in debt securities:
Counter Party Risk: is the normal risk associated with any
transaction and refers to the failure or inability of the opposite party to
the contract to deliver either the promised security or the sale-value at
the time of settlement.
Price Risk: refers to the possibility of not being able to receive the
expected price on any order due to an adverse movement in the
prices.
Development of Debt Markets
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The Debt Market in India Introduction
Development of debt markets has recently become a major pre-
occupation of the regulators. A host of reforms undertaken in the recent past
has resulted in a marked change in the nature of instruments offered, a wider
investor base and in progressive movement towards market determined
interest rates but still lots needs to be done in terms of market design and
liquidity.
The following reforms have been affected for the development of the
Indian debt markets:
Notifying the amounts in respect of all treasury bills and excluding non-
competitive bids outside the notified amount to provide certainty to
the amounts acceptable from competitive bidders.
Permitting FIIs with equity funds to invest in government dated
securities and treasury bills, both in the primary and the secondary
markets.
Allowing NSDL, SHCIL and NSCCL to open SGL accounts with RBI in
order to facilitate custodial and depository services for FIIs in
government dated securities.
Development of the primary dealers and the satellite dealers, with an
impetus to widen and deepen government securities market and
retailing government securities.
Accepting private placement of government securities by RBI and
offloading them in the market when conditions are favourable with a
view to maintain stable interest rates.
Allowing banks to freely buy and sell government securities on an
outright basis and retail them to non-bank clients without any
restriction on the period between the sale and purchase.
Abolishing stamp duty on transfer of debt instruments in a depository
to modernize and deepen the debt market.
Different forms of government security auction processes of dated
securities, resulting in more efficient pricing.
Mandating trades in corporate debt securities to be executed on the
basis of price and order matching mechanism of the stock exchanges
as in equities.
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The Debt Market in India Introduction
Notifying regulations for regulating the Credit Rating Agencies (CRAs),
and
Progressive opening up of the short-term corporate markets, by
liberalizing the Commercial Papers market.
These regulatory measures taken to widen the investor base and move
towards market determined interest rates have given a new lease of life to
the Indian debt markets. Introduction of primary dealers, news instruments
like 14 & 28 Treasury bills and encouraging retail participation have
popularised the government securities market. The corporate debt markets
have provided an attractive route to the corporates to raise funds through
private placement. Dematerialization of debt and online trading would
certainly improve the liquidity. The arrival of insurance and pension funds to
the debt market would boost the market.
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The Debt Market in India Structure of Debt Market
Structure of Debt Market
The debt market in India comprises basically three segments, viz.,
Government Securities Market, which is oldest and most dominant; PSU
Bonds Market, which is basically a development since late 'eighties; and
Corporate Securities Market, which is growing fast after liberalisation,
especially in the last two years. The major focus in the development of debt
markets has been the Government Securities Market for three reasons. First,
it constitutes the principal segment of our debt market. Second, as a market
for sovereign paper, it has a role in setting benchmarks in the financial
markets as a whole. Third, it is critical in bringing about an effective and
reliable transmission channel for the use of indirect instruments of monetary
control.
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 market 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 a set of 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.
Participants in the Debt Markets
The market participants in the debt market are:
Central Government, raising money through bond issuance, to fund
budgetary deficits.
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The Debt Market in India Structure of Debt Market
Reserve Bank of India, an investment banker to the government, raises
funds for the government. 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.
Primary Dealers, who are market intermediaries 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.
State Governments, Municipalities and local bodies, which issue
securities in the debt markets to fund their development projects, as
well as to finance their budgetary deficits.
Public sector units are large issuers of debt securities, for meeting their
fund requirements.
Corporate Sector issue short and long term paper to meet the financial
requirements.
Banks, Mutual funds, Insurance companies, Provident funds, Trusts,
Corporate treasuries, Foreign Investors (FIIs) are the large investors in
the bond market.
Categories in Debt Market
Primary Debt Market
Government Securities Market (G-Secs)
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) at the end of March 2005 were
around Rs. 14610 billion. The G-Secs market plays a vital role in the Indian
economy as it provides the benchmark for determining the level of interest
9
Government Securities Market
PSU Bonds Market
Corporate Securities Market
The Debt Market in India Structure of Debt Market
rates in the country through the yields on the government securities which
are referred to as the risk-free rate of return in any economy.
Advantages of investing in Government Securities (G-Secs) – The Zero
Default Risk of the G-Secs offer one of the best reasons for investments in G-
Secs so that it enjoys the greatest amount of security possible. The other
advantages of investing in G- Secs are:
Greater safety and lower volatility as compared to other financial
instruments.
Variations possible in the structure of instruments like Index linked
Bonds
Higher leverage available in case of borrowings against G-Secs.
No TDS on interest payments
Tax exemption for interest earned on G-Secs. up to Rs.3000/- over
and above the limit of Rs.12000/- under Section 80L
Greater diversification opportunities
Adequate trading opportunities with continuing volatility expected
in interest rates the world over.
The issuance process of G-Secs – G-Secs are issued by RBI in either a
yield-based (participants bid for the coupon payable) or price-based
(participants bid a price for a bond with a fixed coupon) auction basis. The
Auction can be either a Multiple price (participants get allotments at their
quoted prices/yields) Auction or a Uniform price (all participants get
allotments at the same price). RBI has recently announced a non-competitive
bidding facility for retail investors in G-Secs through which non-competitive
bids will be allowed up to 5 percent of the notified amount in the specified
auctions of dated securities.
Public Sector Undertaking (PSU) Bonds Market
These are Medium or long-term debt instruments issued by Public Sector
Undertakings (PSUs). The term usually denotes bonds issued by the central
PSUs (i.e. PSUs funded by and under the administrative control of the
Government of India). Most of the PSU Bonds are sold on Private Placement
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The Debt Market in India Structure of Debt Market
Basis to the targeted investors at Market Determined Interest Rates. Often
investment bankers are roped in as arrangers to this issue. Most of the PSU
Bonds are transferable and endorsement at delivery and are issued in the
form of Usance Promissory Note.
In case of tax-free bonds, normally such bonds accompany post dated
interest cheque / warrants.
Corporate Securities Market
Floating rates of interest, of course, will be advantageous in times of falling
interest rates. As the interest rates in the economy fell, corporates that raised
funds at exorbitant rates five years ago are now caught between the devil
and the deep sea. If they repay loans prematurely by mobilizing funds at the
prevailing rates, the FIs will slap them with penalty. If they do not, they
cannot manage their bottom lines when interest outgo is high. Since those
who raised loans at floating rates are now better off, this route is being
preferred. The present trend is to raise funds at rates below PLR through
private placements to banks. But the risk involved is that RBI may, at any
time, issue guidelines making private placements equivalent to loans. As one
cannot predict the movements of interest rates, the universal mantra is to
have a mix of different kinds of instruments to hedge the risks.
Issue process – The process of issue of corporate securities involves the
following steps:
Board meeting and Approval for issue at the AGM.
Credit Rating of the Issue.
Appointment of Debenture trustee for the creation of securities.
Appointment of the Advisors and Merchant Bankers for the issue
management.
Finalisation of the initial terms of the issue.
Preparation of the offer document for the public issue and the
information memorandum for private placement.
SEBI approval of offer document for public issue.
Listing arrangement with stock exchanges.
Offer the issue to prospective investors and /or book building
11
The Debt Market in India Structure of Debt Market
Acceptance of the application money
Allotment of the issue
Issue of letter of allotment/certificate /depository confirmation
Collect final amount /refund excess application money.
Secondary Debt Market
Segments in the secondary debt market – The segments in the
secondary debt market based on the characteristics of the investors and the
structure of the market are:
Wholesale Debt Market
Here the investors are mostly Banks, Financial Institutions, the RBI, Primary
Dealers, Insurance companies, MFs, Corporates and FIIs.
Retail Debt Market
This involves participation by individual investors, provident funds, pension
funds, private trusts, NBFCs and other legal entities in addition to the
wholesale investor classes.
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The Debt Market in India Money Market
Money Market
What is the Money Market?
The Money Market is basically concerned with the issue and trading of
securities with short-term maturities or quasi-money instruments. The
Instruments traded in the money market are Treasury Bills, Certificates of
Deposits (CDs), Commercial Paper (CPs), Bills of Exchange and other such
instruments of short-term maturities (i.e. not exceeding 1 year with regard to
the original maturity). The banks that lend and borrow money on a short-term
basis in the market form the inter bank call money market.
The rate of lending and borrowing, the interest rate depends on demand
and supply of money in the market. When money is scarce in the market,
quite obviously, the rate moves up and vice versa. The supply of money also
tells on the yields of other instruments.
The money market apart from facilitating flows of short-term funds also
reflects the implementation of monetary policy by the Central bank through
Open Market Operation (OMO). In OMOs, the Reserve Bank of India controls
the money supply in various ways.
When the market is flooded with money, the RBI might suck the excess
money by selling treasury bills. Similarly, when the economy suffers from
dearth of money, RBI infuses money by way of buying treasury bills.
Apart from OMOs, the Central Bank regulates money supply by using tools
such as Cash Reserve Ratio (CRR), bank rate and Statutory Liquidity Ratio
(SLR). CRR determines the amount of cash that the banks are required to
maintain with the RBI. SLR determines the liquid funds banks are required to
maintain with the Central Bank in the form of cash or government securities.
Bank rate is the interest rates at which the Central bank lends funds to other
banks.
13
III
The Debt Market in India Money Market
While OMOs are used to manage the temporary liquidity in the system,
the regulating tools are used to guide the long-term trend of money supply in
the economy. When CRR is hiked, money flows from the system to the RBI,
thus arresting money supply within the system. Similar is the effect of SLR
changes. The Bank rate sends a signal of interest rates to the economy.
When the bank rate is lower it means that banks can borrow from the Central
bank at a lower rate, thus enabling them to lend at a lower rate.
Call Money Market
The call money market is an integral part of the Indian Money Market,
where the day-to-day surplus funds (mostly of banks) are traded. The loans
are of short-term duration varying from 1 to 14 days. The money that is lent
for one day in this market is known as "Call Money", and if it exceeds one day
(but less than 15 days) it is referred to as "Notice Money". Term Money refers
to Money lent for 15 days or more in the InterBank Market. Banks borrow in
this money market for the following purpose:
To fill the gaps or temporary mismatches in funds
To meet the CRR & SLR mandatory requirements as stipulated by the
Central bank
To meet sudden demand for funds arising out of large outflows.
Thus call money usually serves the role of equilibrating the short-term
liquidity position of banks.
Call Money Market Participants:
Those who can both borrow as well as lend in the market – RBI, Banks,
PDs
Those who can only lend - financial institutions - LIC, UTI, GIC, IDBI,
NABARD, ICICI and mutual funds etc.
Reserve Bank of India has framed a time schedule to phase out the
second category out of Call Money Market and make Call Money market as
exclusive market for Bank/s & PD/s.
14
The Debt Market in India Money Market
What are Money Market Instruments?
By convention, the term "Money Market" refers to the market for short-
term requirement and deployment of funds. Money market instruments are
those instruments, which have a maturity period of less than one year. The
most active part of the money market is the market for overnight call and
term money between banks and institutions and repo transactions. Call
Money / Repo are very short-term Money Market products. The below
mentioned instruments are normally termed as money market instruments:
Certificate of Deposit (CD)
Commercial Paper (C.P)
Inter Bank Participation Certificates
Inter Bank term Money
Treasury Bills
Bill Rediscounting
Call/ Notice/ Term Money
15
The Debt Market in India Wholesale Debt Market
Wholesale Debt Market
There is no single location or exchange where debt market participants
interact for common business. Participants talk to each other, conclude deals,
send confirmations etc. on the telephone, with clerical staff doing the running
around for settling trades. In that sense, the wholesale debt market is a
virtual market. The daily transaction volume of all the traded instruments
would be about Rs5bn per day excluding call money and repos. Its
participants include Banks, Financial Institutions, the RBI, Primary Dealers,
Insurance companies, Provident Funds, MFs, Corporates and FIIs.
In order to understand the entirety of the wholesale 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 i.e. the instruments that are being traded in the debt
market.
Issuers i.e. entities which issue these instruments.
Investors i.e. entities which invest in these instruments or trade in
these instruments.
Interventionists or Regulators i.e. the regulators and the regulations
governing the market.
Each of these is discussed in depth later on as separate chapters.
Types of Trades
There are usually two types of trades in the wholesale debt market:
An outright sale or purchase and
A Repo trade.
16
IV
The Debt Market in India Wholesale Debt Market
An outright sale or purchase means that one participant buy or sells the
securities to the other. An outright Buy or sell transaction is a one where
there is no intended reversal of the trade at the point of execution of the
trade. The Buy or sell transaction is an independent trade and is in no way
connected with any other trade at the same or a later point of time.
A Ready Forward Trade (which is normally referred to as a Repo trade or a
Repurchase Agreement) is a transaction where the said trade is intended to
be reversed at a later point of time at a rate, which will include the interest
component for the period between the two opposite legs of the transactions.
So in such a transaction, one participant sells securities to other with an
agreement to purchase them back at a later date. The trade is called a Repo
transaction from the point of view of the seller and it is called a Reverse Repo
transaction from point of view of the buyer.
Repos therefore facilitate creation of liquidity by permitting the seller to
avail of a specific sum of money (the value of the repo trade) for a certain
period in lieu of payment of interest by way of the difference between the two
prices of the two trades.
Repos and reverse repos are commonly used in the money markets as
instruments of short-term liquidity management and can also be termed as a
collateralised lending and borrowing mechanism. Banks and Financial
Institutions usually enter into reverse repo transactions to manage their
reserve requirements or to manage liquidity.
Turnover
The trading volume on the WDM segment has been growing rapidly. The
trading volume (face value) increased from Rs. 6,781 crores during 1994-95
(June-March) to Rs. 4,75,523 crores during 2005-06. The average daily
trading volume increased from Rs. 30 crores to Rs.1,755 crores during the
same period. However, the financial year 2005-06 period has recorded a
substantial decline compared to the financial year 2004-05. The highest
recorded WDM trading volume of Rs. 13,912 crores was registered on August
17
The Debt Market in India Wholesale Debt Market
25, 2003. The business growth of the WDM segment is presented in Table 1
and Chart 1.
Table 1 – Business Growth of WDM Segment
Chart 1 – Business Growth of WDM Segment
18
Source: NSE Fact Sheet 2006
Source: NSE Fact Sheet 2006
The Debt Market in India Wholesale Debt Market
The transactions in dated government securities account for a substantial
share of transactions on the WDM segment. The details of transactions in
government securities and treasury bills, outright as well as repo transactions
are presented in Table 2. The WDM's SGL Outright Transactions as a
percentage to the NDS reporting system Outright transactions was 63.67% in
2005-06.
Table 2 – WDM Transactions in Government Securities
The security-wise and participant-wise distribution of WDM trades is
presented in Table 3. It is observed that the market is dominated by dated
government securities (including state development loan), which accounted
for 72.67% of WDM trades during 2005-06. Among the market participants,
the dominance of the domestic banks reduced this year to 28.07% from
29.89% in 2004-05.
19
Source: NSE Fact Sheet 2006
The Debt Market in India Wholesale Debt Market
Table 3 – Security-wise & Participation-wise Distribution of WDM
Trades
Market Capitalisation
Market capitalisation of the WDM segment has witnessed a constant
increase indicating an increase in the number of securities available for
trading on this segment. Total market capitalisation of the securities available
for trading on WDM segment stood at Rs. 15,67,574 crores as on March 31,
2006. Central Government securities accounted for the largest share of the
market capitalisation with 67.61%. The details of market capitalisation of
WDM securities are presented in Table 4.
Table 4 – Market Capitalisation of WDM Securities
20
Source: NSE Fact Sheet 2006
Source: NSE Fact Sheet 2006
The Debt Market in India Wholesale Debt Market
Role of the Exchanges in the Wholesale Debt market
Exchanges offer order-driven screen based trading facilities for Govt.
securities. The trading activity on the systems is however restricted with
most trades today being put through in the broker offices and reported to the
Exchange through their electronic systems.
Constituent SGL Account
A Constituent Subsidiary General Ledger Account (CSGL) is a service
provided by Reserve Bank of India through Primary Dealers and Banks to
those entities who are not allowed to hold direct SGL Accounts with it. This
account provides for holding of Central/State Government Securities and
Treasury bills in book entry/dematerialized form. Individuals are also allowed
to hold a Constituent SGL Account.
Settlement in the Wholesale Debt Market
The settlement for the various trades is finally carried out through the SGL
of the RBI except for transfers between the holders of Constituent SGL A/c’s
in a particular Bank or Institution like intra-a/c transfers of securities held at
the Banks.
As far as the Broker Intermediated transactions are concerned, the
settlement responsibility for the trades in the Wholesale market is primarily
on the clients i.e. the market participants and the broker has no role to play
in the same. The member only has to report the settlement details to the
Exchange for monitoring purposes. The Exchange reports the trades to RBI
regularly and monitors the settlement of these trades.
21
The Debt Market in India Yield Curve
Retail Debt Market
The transaction sizes in the wholesale debt market are so large that
individual investors can’t participate in it. So there is a separate market
called the retail debt market for individual investors. But the retail investors
don’t have much of a choice as far as investment in the debt market is
concerned. Following are some of the instruments in the retail debt market:
Public issues of debt by corporates : The corporates make public
issues of the debt they want to raise from the market. The individual
investors can invest in these issues. These issues also include the
issues made by the FIs to raise money from the public.
Deposits of banks : Maximum amounts of retail savings in India go in
to the deposits of banks. Banks accept deposits from the public and
pay interest on them. These deposits are secure and liquid but they
don’t carry attractive yields.
Mutual Funds : Since the retail investors can’t participate in the
wholesale debt market, it can invest in this market via mutual funds.
The mutual funds accumulate individual savings from the investors and
invest them in these markets. The best example of such type of MFs is
a money market mutual fund.
Insurance companies and provident funds : Just like mutual funds,
these also mobilize individual savings and invest them in wholesale
debt market and other attractive investment avenues.
Fixed deposits of companies : This presents a very attractive
investment avenue with reasonable yields but here the risk of default
is very high. The recent NBFC episode is a case in point, where a lot of
NBFCs took money from people and vanished. One should look at the
financial performance of that particular company and the previous
history of deposits and their repayments before investing in such
deposits.
22
V
The Debt Market in India Yield Curve
Investment/saving products: It must be noted that there are few
tradable instruments available for investment by retail investors. Most
of the available products are different kinds of schemes that are
largely illiquid. The different investment products available for retail
participation are listed below:
Products from banks
Fixed/term deposits
Recurring deposits
Savings deposits
Small savings schemes of government
Public Provident Fund (PPF) scheme
Tax free Relief Bonds
Small savings schemes from Department of Posts
National Savings Scheme (NSS)
National Savings Certificates (NSC)
Postal fixed deposits
Indira Vikas Patra
Kisan Vikas Patra
Savings oriented life insurance schemes
Company fixed deposits
Bonds of development financial institutions
Debentures of private sector companies
Debentures of infrastructure companies
Debentures of state government backed entities
Unit Trust of India
Guaranteed return monthly income schemes
Income/bond funds
Other Mutual funds
Broad Trends in Retail Debt Market
Traditionally, fixed deposits of companies used to be the biggest avenue
for retail investors. Within this category, it was the deposits of finance
23
The Debt Market in India Yield Curve
companies (NBFCs), which were most popular with investors and mobilizers
alike – with investors because of the higher interest rates offered (typically 1-
2% higher and additional incentives like gold coin etc.) and with mobilizers
because of the high commissions. In South India, nidhi companies, benefit
and chit funds were quite popular due to the high returns offered.
The last 3 years have been times of dramatic disorder in the retail debt
market. The key events relate to defaults by many of the issuers especially
the finance companies and the benefit companies. Prominent default cases
include the CRB group of companies, Lloyds Finance, and most recently the
Kuber group of companies. The market was also rocked by the US 64 problem
when for a brief period of time investors were scared and withdrawing money
from the scheme.
The reasons for default by manufacturing companies are related to the
overall decline in profitability due to increased competition, dumping of
imports, sharp fall in commodity prices and general slowdown in the
economy.
The reasons for defaults in finance companies are related to their
investments. Most NBFCs had invested in real estate (either directly or
builder financing), stock market, promoter funding and other illiquid
investments. In addition, they had invested in 100% depreciation leases
(often fictitious sale and leaseback transactions) to obtain tax shields. They
witnessed widespread defaults in their lending portfolio, huge losses in
investment portfolio and often were disallowed tax shields by the income tax
authorities. In the wake of credit problems, the RBI came down heavily on
these companies and investors stopped investing in their FD’s, which further
aggravated their liquidity crisis. Ironically, the loss of business and the losses
they faced resulted in their so-called tax shield being irrelevant.
All these resulted in a huge flight to safety. This can be seen from the
increase in popularity of institutional bond issues (i.e. ICICI "Safety Bonds"
and IDBI "Flexi Bonds") and the sharp increase in the collection of
Government sponsored small savings schemes and postal schemes (In FY 99,
small savings collections were about Rs320bn as against about Rs91bn 5
years ago). While it is difficult to obtain data to support the feeling that
24
The Debt Market in India Yield Curve
nationalized banks have also received larger amounts of money, empirical
experience on the ground does point towards that trend.
Despite the US 64 problem and the consequent loss of image suffered by
UTI, it continued to collect large quantum of funds from retail investors. Many
retail investors thought that the UTI was the lesser evil especially after the
Finance minister and a host of government officials came out openly in
support of UTI.
Apart from UTI, private sector mutual funds also witnessed substantial
increase in collections, although from low bases.
Listing
All Government securities and Treasury bills are deemed to be listed on
the Exchange automatically, as and when they are issued.
Initially, 85 central government securities would be traded in the retail
debt market segment. The Exchange will introduce additional securities for
trading from time to time. Other securities like state government securities,
T-Bills etc. would be added in subsequent phases.
Security Details
Every security will be identified with a unique symbol and series. The
nomenclature (classification) of the symbol will be as follows:
First 4 characters - Coupon Rate (without the decimal point)
Next character - Month of Maturity (A - Jan, B - Feb, C - Mar, etc.)
Next 2 characters - Year of Maturity (03 - 2003, 04 - 2004, etc.)
In cases where more than one security has the same characteristic,
then the last character shall have an additional character descriptor,
viz. A/B etc.
Example:
Security Name Maturity date Symbol
GOI Loan 5.75% 2003 12-May-2003 0575E03
25
The Debt Market in India Yield Curve
GOI Loan 6.65% 2009 05-Apr-2009 0665D09
GOILoan11.50% 2011 05-Aug-2011 1150H11
All government securities will be traded under the series GC
Face Value of all the securities is 100
Permitted Lot size of all the securities is 10
Trading in the Retail Debt Market
Trading in the Retail Debt Market takes place in the same manner in which
the trading takes place in the equities (Capital Market) segment. The
RETDEBT Market facility on the NEAT (National Exchange for Automated
Trading) system of Capital Market Segment is used for entering transactions
in RDM session.
Members eligible for trading in RDM segment
Trading Members who are registered members of NSE in the Capital
Market segment and Wholesale Debt Market segment are allowed to trade in
Retail Debt Market (RDM) subject to fulfilling the capital adequacy norms.
Trading Members with membership in Wholesale Debt Market segment only,
can participate in RDM on submission of a letter in the prescribed format.
Market Timings and Market Holidays
Trading in RDM segment takes place on all days of the week, except
Saturdays and Sundays and holidays declared by the Exchange in advance
(The holidays on the RDM segment shall be the same as those on the Equities
segment). The market timings of the RDM segment are the same as the
Equities segment, viz.:
Normal Market Open: 09:55 hours
Normal Market Close: 15:30 hours
Trading System
26
The Debt Market in India Yield Curve
Trading in RDM takes place on the 'National Exchange for Automated
Trading' (NEAT) system, a fully automated screen based trading system,
which adopts the principle of an order driven market. The RETDEBT Market
facility on the NEAT system of Capital Market Segment is used for entering
transactions in RDM session.
The future scenario for the Retail Debt Market in India
The Retail Debt Market is set to grow tremendously in India with the
broadening of the market participation and the availability of a wide range of
debt securities for retail trading through the Exchanges. The following are the
trends, which will impact the Retail Debt Market in India in the near future:
Expansion of the Retail Trading platform to enable trading in a wide
range of government and non-government debt securities.
Introduction of new instruments like securitised paper etc.
Development of the secondary market in Corporate Debt
Introduction of Interest Rate Derivatives based on a wide range of
underlying in the Indian Debt and Money Markets.
Development of the Secondary Repo Markets.
27
The Debt Market in India Yield Curve
Yield Curve
Coupon rate of the Security
The Coupon rate is simply the interest rate that every debenture/Bond
carries on its face value and is fixed at the time of issuance. For example, a
12% p.a coupon rate on a bond/debenture of Rs 100 implies that the investor
will receive Rs 12 p.a. The coupon can be payable monthly, quarterly, half-
yearly, or annually or cumulative on redemption. Thus, a coupon rate is the
periodic interest rate that the issuer agrees to pay to the owners of the
security till maturity.
Coupon
The annual amount of the interest payment made to the holders of the
government security is called the coupon. The coupon is determined by
multiplying the coupon rate by the par value of the government securities.
Accrued Interest
Accrued Interest is the amount of interest accrued since the last coupon
payment; the G-Sec buyer must include the value of accrued interest while
pricing the securities. In government securities Accrued Interest is calculated
on a 30-day month/360 day year basis and the coupon payment is semi-
annual.
To calculate AI we need three pieces of information:
The number of days in the AI period
The number of days in the coupon period and
The amount of the coupon payment
28
VI
The Debt Market in India Yield Curve
Dirty Price
Dirty Price of a security is the agreed upon price i.e. buy price plus
accrued interest.
Clean Price
Clean Price of a security is the agreed upon price i.e. buy price without
accrued interest.
Valuation of Government Securities
The valuation process involves following steps.
Estimating the expected cash flows
Determining the appropriate interest rate or interest rates that should
be used to discount the cash flows and
Calculating the present value of the expected cash flows
The sum of the present values for a security’s expected cash flows is the
value of the security.
Premium
A security whose value is greater than its maturity value is said to be
trading at a premium to maturity value.
Discount
A security whose value is less than its maturity value is said to be trading
at a discount to maturity value.
Relationship between discount rate and coupon rate:
Discount rate less than the coupon rate implies that the security is
traded at a premium.
Discount rate greater than the coupon rate implies that the security is
traded at a discount.
29
The Debt Market in India Yield Curve
Discount rate equal to the coupon rate implies that the security is
traded at a par.
Maturity date for Security
Securities are issued for a fixed period of time at the end of which the
principal amount borrowed is repaid to the investors. The date on which the
term ends and proceeds are paid out is known as the Maturity date. It is
specified on the face of the instrument. In respect of Demat Debt instrument
due date is known from ISIN Number of the security.
Yield
Yield refers to the percentage rate of return paid on a stock in the form of
dividends, or the effective rate of interest paid on a bond or note. There are
many different kinds of yields depending on the investment scenario and the
characteristics of the investment.
Yield To maturity (YTM)
The yield or the return on the instrument held till its maturity is known as
the Yield-to-maturity (YTM). It basically measures the total income earned by
the investor over the entire life of the Security. This total income consists of
the following:
Coupon income: The fixed rate of return that accrues from the
instrument
Interest-on-interest at the coupon rate: Compound interest earned on
the coupon income
Capital gains/losses: The profit or loss arising on account of the
difference between the price paid for the security and the proceeds
received on redemption/maturity
Yield to Maturity (YTM) is the most popular measure of yield in the Debt
Markets and is the percentage rate of return paid on a bond, note or other
fixed income security if you buy and hold the security till its maturity date.
30
The Debt Market in India Yield Curve
The yield on the government securities is influenced by various factors
such as level of money supply in the economy, inflation, future interest rate
expectations, borrowing program of the government & the monetary policy
followed by the government.
Price determination in the debt markets
The price of a bond in the markets is determined by the forces of demand
and supply, as is the case in any market. The price of a bond in the
marketplace also depends on a number of other factors and will fluctuate
according to changes in
Economic conditions
General money market conditions including the state of money supply
in the economy
Interest rates prevalent in the market and the rates of new issues
Future Interest Rate Expectations
Credit quality of the issuer
There is however, a theoretical groundwork to the determination of the
price of the bond in the market based on the measure of the yield of the
security.
31
4.50%
4.80%
5.10%
5.40%
5.70%
6.00%
6.30%
6.60%
6.90%
7.20%
7.50%
7.80%
1 2 3 5 7 10 12 15 18 21 29 30
Tenor (yrs)
Yie
ld T
o M
atu
rity
The Debt Market in India Yield Curve
Relationship between yields and price
Yields and Bond Prices are inversely related. So a rise in price will
decrease the yield and a fall in the bond price will increase the yield.
There will be an immediate and mostly predictable effect on the prices of
bonds with every change in the level of interest rates. (The predictability here
however refers to the direction of the price change rather than the quantum
of the change)
When the prevailing interest rates in the market rise, the prices of
outstanding bonds will fall to equate the yield of older bonds into line with
higher-interest new issues. This will happen, as there will be very few takers
for the lower coupon bonds resulting in a fall in their prices. The prices would
fall to an extent where the same yield is obtained on the older bonds as is
available for the newer bonds.
When the prevailing interest rates in the market fall, there is an opposite
effect. The prices of outstanding bonds will rise, until the yield of older bonds
is low enough to match the lower interest rate on the new bond issues.
These fluctuations ensure that the value of a bond will never be the same
throughout the life of the bond and is likely to be higher or lower than its
original face value depending on the market interest rate, the time to
maturity (or call as the case may be) and the coupon rate on the bond.
Yield Curve
The relationship between time and yield on a homogenous risk class of
securities is called the Yield Curve. The relationship represents the time value
of money - showing that people would demand a positive rate of return on
the money they are willing to part today for a payback into the future. It also
shows that a Rupee payable in the future is worth less today because of the
relationship between time and money. A yield curve can be positive, neutral
or flat. A positive yield curve, which is most natural, is when the slope of the
curve is positive, i.e. the yield at the longer end is higher than that at the
shorter end of the time axis. This results, as people demand higher
compensation for parting their money for a longer time into the future. A
32
The Debt Market in India Yield Curve
neutral yield curve is that which has a zero slope, i.e. is flat across time. This
occurs when people are willing to accept more or less the same returns
across maturities. The negative yield curve (also called an inverted yield
curve) is one of which the slope is negative, i.e. the long-term yield is lower
than the short-term yield.
Diagram- Yield Curve
Factors affecting yield curve
The Monetary Policy
Suppose the Reserve Bank feels that there is too much liquidity in the
financial system and there is a threat that inflation may rise. In such a
scenario, the Reserve Bank will adopt a tight monetary policy. It therefore,
sells government bonds (and collects money), reducing the money
availability in the system. In case the central bank wants to ease the
monetary policy, it buys back the bonds, in effect infusing liquidity in the
economy.
The central bank can therefore, effectively control the short-term interest
rates and the lower end of the yield curve. When the market expects the
central bank to cut rates, the short-term instruments become expensive as
33
The Debt Market in India Yield Curve
they continue to offer higher interest or coupon rates. Consequently, the yield
declines; adjusting to the lower interest rate environment. On the contrary,
when the expectations are that the central bank will increase interest rates,
the price of the debt instruments fall causing the yield to increase.
The central bank’s decision to cut interest rates or to increase it also
depends on the economic scenario in the country. The central bank has to
keep in mind two objectives- to promote economic growth and to keep
inflation under control. If the growth prospects of the economy are good, then
investment activity will be buoyant, resulting in demand for money (to fund
expansion).
However, unchecked investment activity could lead to a heating up of the
economy, giving rise to inflationary pressures. In such a scenario, the central
bank needs to adjust the fast rise in demand to the slower growth in supply.
The central bank does this by increasing the cost of money. When the cost of
money is high, both investment and consumption demand suffer.
Economic Growth
Economic growth and its prospects affect the yield curve. This is because
the monetary policy is largely influenced by the health of the economy.
The growth prospects of the economy affect the allocation of capital. If
there are little or no growth prospects, the demand for capital will be slow-
moving.
Banks would be saddled with surplus funds, which would probably be
diverted to the debt markets. Also, in a slowing economy, banks themselves
might not be comfortable giving loans to the industry for fear of accumulating
bad debts.
Consequently, the investment avenue that guarantees almost risk-free
returns is the G-secs and T-bills. This drives up demand for debt instruments.
Higher demand results in price of debt instruments being marked up,
implying that yields decline.
On the other hand, when the growth prospects for the economy become
brighter the demand for these instruments weakens.
34
The Debt Market in India Yield Curve
Fiscal Policy
The fiscal policy controls the government’s earnings and spending. If a
government spends more than it earns it will incur a fiscal deficit. A higher
fiscal deficit increases the risk of default by a government.
Therefore, the interest rates in these countries are higher. Rising budget
deficits cause the yield curve to be steep while falling budget deficits tend to
flatten the curve.
India Inc’s balance sheet
However, in case a fiscal situation of a country looks precarious, the short-
term interest rates will tend to be much higher than long-term interest rates.
The long-term interest rates will be relatively lower on hopes that the
situation improves in the future.
But if the fiscal deficit continues to rise then interest rates in the long-term
will be higher because the government will continue to borrow to meet its
fiscal deficit, increasing the demand for money. The markets as a result
would demand higher interest rates causing the prices for instruments to
decline.
Inflation
Inflation affects both the long-term and the short-term yields. If the inflation
is around 7 percent and the long-term yield is about 11 percent, the real rate
of return is just 4 percent. Therefore, if inflation rises, the real rate of return
would decline causing the price of the instrument to head south and thereby
increasing the yield.
35
The Debt Market in India Instruments
Instruments
When a nation has capital, it can utilize it in two ways: either consume the
capital i.e. spend it on things that will not give any further benefit or invest
the capital into capacity building that will help the economy to grow.
Sustainable economic growth is dependent on the level of investment
activity. Therefore, industries and the government need money to grow.
Household is one of the supply avenues. And the job of financial markets is to
channelize this money into the industrial sector. Though deposits in banks are
the safest form of investments, in a scenario where the interest rates are
decreased by the central bank, the investor is the loser.
However, if the same investor would hold a bond that had fixed returns,
the bond would become valuable in a scenario where interest rates declined.
The retail investor in India did not have much of a choice. Either he was at
the mercy of the banks for deposits or at the mercy of the securities and the
real estate market. Equities and real estates are risky. The numerous scams
have time and again highlighted the so-called credibility of the equities
market in the country. Also, due to the inherent uncertainty in returns, these
markets did not suit the risk appetite of many investors. Therefore the need
of the hour was to have a market in which the price discovery was far more
realistic, market determined and more in favour of the investor. Also,
important was liquidity. The answer to this was debt markets, where
instruments with fixed returns could be traded.
Traditionally when a borrower takes a loan from a lender, he enters into
an agreement with the lender specifying when he would repay the loan and
what return (interest) he would provide the lender for providing the loan. This
entire structure can be converted into a form wherein the loan can be made
tradable by converting it into smaller units with pro rata allocation of interest
and principal. This tradable form of the loan is termed as a debt instrument.
Therefore, debt instruments are basically obligations undertaken by the
issuer of the instrument as regards certain future cash flows representing
36
VII
The Debt Market in India Instruments
interest and principal, which the issuer would pay to the legal owner of the
instrument. Debt instruments are of various types. The key terms that
distinguish one debt instrument from another are as follows:
Issuer of the instrument
Face value of the instrument
Interest rate
Repayment terms (and therefore maturity period/tenor)
Security or collateral provided by the issuer
Different kinds of debt instruments and their key terms and characteristics
are discussed below.
Money Market Instruments
By convention, the term "money market" refers to the market for short-
term requirement and deployment of funds. Money market instruments are
those instruments, which have a maturity period of less than one year. The
most active part of the money market is the market for overnight and term
money between banks and institutions (called call money) and the market for
repo transactions. The former is in the form of loans and the latter are sale
and buy back agreements – both are obviously not traded. The main traded
instruments are commercial papers (CPs), certificates of deposit (CDs) and
treasury bills (T-Bills). All of these are discounted instruments i.e. they are
issued at a discount to their maturity value and the difference between the
issuing price and the maturity/face value is the implicit interest. These are
also completely unsecured instruments. One of the important features of
money market instruments is their high liquidity and tradability. A key reason
for this is that these instruments are transferred by endorsement and
delivery and there is no stamp duty or any other transfer fee levied when the
instrument changes hands. Another important feature is that there is no tax
deducted at source from the interest component. A brief description of these
instruments is as follows:
Commercial paper (CP)
These are issued by corporate entities in denominations of Rs2.5mn and
usually have a maturity of 90 days. CPs can also be issued for maturity
37
The Debt Market in India Instruments
periods of 180 days and one year but the most active market is for 90 day
CPs.
Two key regulations govern the issuance of CPs-firstly, CPs have to be
compulsorily rated by a recognized credit rating agency and only those
companies can issue CPs which have a short term rating of at least P1.
Secondly, funds raised through CPs do not represent fresh borrowings for the
corporate issuer but merely substitute a part of the banking limits available
to it. Hence, a company issues CPs almost always to save on interest costs
i.e. it will issue CPs only when the environment is such that CP issuance will
be at rates lower than the rate at which it borrows money from its banking
consortium.
Certificates of deposit (CD)
These are issued by banks in denominations of Rs0.5mn and have
maturity ranging from 30 days to 3 years. Banks are allowed to issue CDs
with a maturity of less than one year while financial institutions are allowed
to issue CDs with a maturity of at least one year. Usually, this means 366 day
CDs. The market is most active for the one-year maturity bracket, while
longer dated securities are not much in demand. One of the main reasons for
an active market in CDs is that their issuance does not attract reserve
requirements since they are obligations issued by a bank.
Treasury Bills (T-Bills)
These are issued by the Reserve Bank of India on behalf of the
Government of India and are thus actually a class of Government Securities.
At present, T-Bills are issued in maturity of 14 days, 91 days and 364 days.
The RBI has announced its intention to start issuing 182 day T-Bills shortly.
The minimum denomination can be as low as Rs100, but in practice most of
the bids are large bids from institutional investors who are allotted T-Bills in
dematerialised form. RBI holds auctions for 14 and 364 day T-Bills on a
fortnightly basis and for 91 day T-Bills on a weekly basis. There is a notified
value of bills available for the auction of 91 day T-Bills that is announced 2
days prior to the auction. There is no specified amount for the auction of 14
38
The Debt Market in India Instruments
and 364 day T-Bills. The result is that at any given point of time, it is possible
to buy T-Bills to tailor one’s investment requirements.
Potential investors have to put in competitive bids at the specified times.
These bids are on a price/interest rate basis. The auction is conducted on a
French auction basis i.e. all bidders above the cut off at the interest rate/price
which they bid while the bidders at the clearing/cut off price/rate get pro rata
allotment at the cut off price/rate. The cut off is determined by the RBI
depending on the amount being auctioned, the bidding pattern etc. By and
large, the cut off is market determined although sometimes the RBI utilizes
its discretion and decides on a cut off level, which results in a partially
successful auction with the balance amount devolving on it. This is done by
the RBI to check undue volatility in the interest rates.
Non-competitive bids are also allowed in auctions (only from specified
entities like State Governments and their undertakings and statutory bodies)
wherein the bidder is allotted T-Bills at the cut off price.
Apart from the above money market instruments, certain other short-term
instruments are also in vogue with investors. These include short-term
corporate debentures, Bills of exchange and promissory notes.
Like CPs, short-term debentures are issued by corporate entities.
However, unlike CPs, they represent additional funding for the corporate i.e.
the funds borrowed by issuing short term debentures are over and above the
funds available to the corporate from its consortium bankers. Normally,
debenture issuance attracts stamp duty; but issuers get around this by
issuing only a letter of allotment (LOA) with the promise of issuing a formal
debenture later – however the debenture is never issued and the LOA itself is
redeemed on maturity. These LOAs are freely tradable but transfers attract
stamp duty.
Bills of exchange are promissory notes issued for commercial transactions
involving exchange of goods and services. These bills form a part of a
company’s banking limits and are discounted by the banks. Banks in turn
rediscount bills with each other.
Long-Term Debt Instruments
39
The Debt Market in India Instruments
By convention, these are instruments having a maturity exceeding one
year. The main instruments are Government of India dated securities
(GOISEC), State Government securities (state loans), public sector bonds
(PSU bonds), corporate debentures etc.
Most of these are coupon bearing instruments i.e. interest payments
(called coupons) are payable at pre specified dates called "coupon dates". At
any given point of time, any such instrument has a certain amount of accrued
interest with it i.e. interest, which has accrued (but is not due) calculated at
the "coupon rate" from the date of the last coupon payment e.g. if 30 days
have elapsed from the last coupon payment of a 14% coupon debenture with
a face value of Rs 100, the accrued interest will be
Whenever coupon-bearing securities are traded, by convention, they are
traded at a base price with the accrued interest separate – in other words,
the total price would be equal to the summation of the base price and the
accrued interest.
A brief description of these instruments is as follows:
Government of India dated securities (GOISECs)
Like treasury bills, GOISECs are issued by the Reserve Bank of India on
behalf of the Government of India. These form a part of the borrowing
program approved by Parliament in the Finance Bill each year (Union
Budget). They are issued in dematerialised form but can be issued in
denominations as low as Rs 100 in physical certificate form. They have
maturity ranging from 1 year to 30 years. Very long dated securities i.e.
those having maturity exceeding 20 years were in vogue in the seventies and
the eighties while in the early nineties, most of the securities issued have
been in the 5-10 year maturity bucket. Very recently, securities of 15 and 20
years maturity have been issued.
Like T-Bills, GOISECs are most commonly issued in dematerialised form in
the "SGL" account although it can be issued in physical certificate form on
specific request. Tradability of physical securities is very limited. The SGL
40
100*0.14*30/365 = 1.15
The Debt Market in India Instruments
passbook contains a record of the holdings of the investor. The RBI acts as a
clearing agent for GOISEC transactions by being the custodian and operator
of the SGL account. GOISECs are transferable by endorsement and delivery
for physical certificates. Transactions of securities held in SGL form are
effected through SGL transfer notes. Transfer of GOISECs does not attract
stamp duty or transfer fee. Also no tax is deductible at source on the coupon
payments made on GOISECs.
Like T-Bills, GOISECs are issued through the auction route. The RBI pre
specifies an approximate amount of dated securities that it intends to issue
through the year. However, it has broad flexibility in exceeding or being
under that figure. Unlike T-Bills, it does not have a pre set timetable for the
auction dates and exercises its judgement on the timing of each issuance, the
duration of instruments being issued as well as the quantum of issuance.
Sometimes the RBI specifies the coupon rate of the security proposed to
be issued and the prospective investors bid for a particular issuance yield.
The difference between the coupon rate and the yield is adjusted in the issue
price of the security. On other occasions, the RBI just specifies the maturity of
the proposed security and prospective investors bid for the coupon rate itself.
In either case, just as in T-Bills, the auction is conducted on a French auction
basis. Also, the RBI has wide freedom in deciding the cut off rate for each
auction and can end up with unsold securities, which devolve on it.
Apart from the auction program, the RBI also sells securities in its Open
Market Operations (OMO), which it has acquired in devolvement or
sometimes directly through private placements. Similarly, it also buys
securities in open market operations if it feels fit. Earlier, the RBI used to
issue straight coupon bonds i.e. bonds with a stated coupon payable
periodically. In the last few years, the RBI has been innovative and new types
of instruments have also been issued. These include
Inflation linked bonds – These are bonds for which the coupon
payment in a particular period is linked to the inflation rate at that
time – the base coupon rate is fixed with the inflation rate
(consumer price index-CPI) being added to it to arrive at the total
coupon rate. Investors are often unwilling to invest in longer dated
41
The Debt Market in India Instruments
securities due to uncertainty of future interest rates. The idea
behind these bonds is to make them attractive to investors by
removing the uncertainty of future inflation rates, thereby
maintaining the real value of their invested capital.
Floating Rate Bonds (FRBs) – They come with a coupon floater,
which is usually a margin over and above a benchmark rate. E.g.,
the Floating Bond may be nomenclature/denominated as +1.25%
FRB YYYY (the maturity year). +1.25% coupon will be over and
above a benchmark rate, where the benchmark rate may be a six-
month average of the implicit cut-off yields of 364-day Treasury bill
auctions. If this average works out 9.50% p.a, then the coupon will
be established at 9.50% + 1.25% i.e., 10.75%p.a. Normally FRBs
(floaters) also bear a floor and cap on interest rates. Interest so
determined is intimated in advance before such coupon payment,
which is normally, Semi-Annual.
Zero coupon bonds – These are bonds for which there is no
coupon payment. They are issued at a discount to face value with
the discount providing the implicit interest payment. In effect, these
can be interpreted as long duration T – Bills or as bonds with
cumulative interest payment.
State Government Securities (state loans)
The respective state governments issue these but the RBI coordinates the
actual process of selling these securities. Each state is allowed to issue
securities up to a certain limit each year. The planning commission in
consultation with the respective state governments determines this limit.
While there is no central government guarantee on these loans, they are
deemed to be extremely safe. This is because the RBI debits the overdraft
accounts of the respective states held with it for payment of interest and
principal. Generally, the coupon rates on state loans are marginally higher
than those of GOISECs issued at the same time.
The procedure for selling of state loans, the auction process and allotment
procedure is similar to that for GOISEC. They also qualify for SLR status and
interest payment and other modalities are similar to GOISECs. They are also
42
The Debt Market in India Instruments
issued in dematerialised form and no stamp duty is payable on transfer. The
procedure for transfer is similar to GOISECs. In general, state loans are much
less liquid than GOISECs.
Public Sector Undertaking Bonds (PSU Bonds)
These are long-term debt instruments issued by Public Sector
Undertakings (PSUs). The term usually denotes bonds issued by the central
PSUs (i.e. PSUs funded by and under the administrative control of the
Government of India). The issuance of these bonds began in a big way in the
late eighties when the central government stopped/reduced funding to PSUs
through the general budget. Typically, they have maturities ranging between
5-10 years and they are issued in denominations (face value) of Rs.1000
each. Most of these issues are made on a private placement basis to a
targeted investor base at market determined interest rates. Often,
investment bankers are roped in as arrangers for these issues.
These PSU bonds are transferable by endorsement and delivery and no
tax is deductible at source on the interest coupons payable to the investor
(TDS exempt). In addition, from time to time, the Ministry of Finance has
granted certain PSUs, an approval to issue limited quantum of tax-free bonds
i.e. bonds for which the payment of interest is tax exempt in the hands of the
investor. This feature was introduced with the purpose of lowering the
interest cost for PSUs which were engaged in businesses which could not
afford to pay market determined rates of interest eg. Konkan Railway
Corporation was allowed to issue substantial quantum of tax free bonds. Thus
we have taxable coupon PSU bonds and tax free coupon PSU bonds.
Bonds of Public Financial Institutions (PFIs)
Apart from public sector undertakings, Financial Institutions are also
allowed to issue bonds, that too in much higher quantum. They issue bonds in
2 ways – through public issues targeted at retail investors and trusts and also
through private placements to large institutional investors. Usually, transfers
of the former type of bonds are exempt from stamp duty while only part of
the bonds issued privately have this facility. On an incremental basis, bonds
of PFIs are second only to GOISECs in value of issuance.
43
The Debt Market in India Instruments
Retail bond issues of PFI bonds have become a big rage with investors in
the last three years. PFIs have also been offering bonds with different
features to meet differing needs of investors. Eg. monthly return bonds
(which pay monthly coupons), cumulative interest bonds, step up coupon
bonds, etc.
Corporate Debentures
These are long-term debt instruments issued by private sector companies.
These are issued in denominations as low as Rs. 1000 and have maturities
ranging between 1 and 10 years. Long maturity debentures are rarely issued,
as investors are not comfortable with such maturities. Generally, debentures
are less liquid as compared to PSU bonds and the liquidity is inversely
proportional to the residual maturity.
A key feature that distinguishes debentures from bonds is the stamp duty
payment. Debenture stamp duty is a state subject and the quantum of
incidence varies from state to state. There are two kinds of stamp duties
levied on debentures, viz. issuance and transfer. Issuance stamp duty is paid
in the state where the principal mortgage deed is registered. Over the years,
issuance stamp duties have been coming down and are reasonably uniform.
Stamp duty on transfer is paid to the state in which the registered office of
the company is located. Transfer stamp duty remains high in many states
and is probably the biggest deterrent for trading in debentures resulting in
lack of liquidity. Debentures are divided into different categories on the basis
of:
Convertibility of the instrument
Security
Debentures can be classified on the basis of convertibility into:
Non-Convertible Debentures (NCD): These instruments retain
the debt character and cannot be converted in to equity shares
Partly Convertible Debentures (PCD): A part of these
instruments are converted into Equity shares in the future at notice
of the issuer. The issuer decides the ratio for conversion. This is
normally decided at the time of subscription.
44
The Debt Market in India Instruments
Fully convertible Debentures (FCD): These are fully convertible
into Equity shares at the issuer's notice. Upon conversion the
investors enjoy the same status as ordinary shareholders of the
company.
Optionally Convertible Debentures (OCD): The investor has the
option to either convert these debentures into shares at price
decided by the issuer/agreed upon at the time of issue.
On basis of Security, debentures are classified into:
Secured Debentures: These instruments are secured by a charge
on the fixed assets of the issuer company. So if the issuer fails on
payment of either the principal or interest amount, his assets can
be sold to repay the liability to the investors.
Unsecured Debentures: These instruments are unsecured in the
sense that if the issuer defaults on payment of the interest or
principal amount, the investor has to be along with other unsecured
creditors of the company.
Secured Redeemable Debenture: Secured refers to the security
given by the issuer for the loan transaction represented by the
debenture. This is usually in the form of a first mortgage or charge
on the fixed assets of the company on a pari passu basis with other
first charge holders like financial institutions. Sometimes, the
charge can also be a second charge instead of a first charge. A
trustee specifically appointed for the purpose creates the charge on
behalf of the entire pool of debenture holders. Typically, financial
institutions and banks are trustees and their job is to create and
maintain the security. Redemption refers to the process whereby
the debenture is extinguished on payment of all the obligations due
to the holder after the repayment of the last instalment of the
principal amount of the debenture.
Sometimes investors get confused and think that the above-mentioned
type of debenture is secured by a guarantee of the trustee financial
institution. The presence of the name of a reputed financial institution as a
trustee confuses them.
45
The Debt Market in India Instruments
Difference between a bond and a debenture:
Generally speaking, long-term debt securities issued by the Government
of India or any of the State Government's undertakings owned by them or by
development financial institutions are called bonds. Instruments issued by
other entities are called debentures. The difference between the two is
actually a function of where they are registered and pay stamp duty and how
they trade. Issuance stamp duty on bonds is a central subject and a bond is
transferable by endorsement and delivery without payment of any transfer
stamp duty. The stamp duty on debentures is a state subject and has to be
paid both on issuance and transfer. On issuance it is linked to finance
creation, while on transfer, it is levied in accordance with the laws of the
state in which the registered office of the company in question is located.
Unlike a bond, a debenture transfer has to be effected through a transfer
deed.
Pass Through Certificates (PTCs)
Pass through certificate is an instrument with cash flows derived from the
cash flow of another underlying instrument or loan. Most commonly, they
have been issued by foreign banks like Citibank on the basis of their car loan
or mortgage/housing loan portfolio. The issuer is a special purpose vehicle
which just receives money from a multitude of (may be several hundreds or
thousands) underlying loans and passes the money to the holders of the
PTCs. This process is called securitization. Legally speaking PTCs are
promissory notes and therefore tradable freely with no stamp duty payable
on transfer. Most PTCs have 2-3 year maturity because the issuance stamp
duty rate of 0.75% makes shorter duration PTCs unviable.
46
The Debt Market in India Issuers
Issuers
Issuers of debt instruments can be classified into five broad categories.
These are as follows:
Government of India and other sovereign bodies
The largest volumes of instruments issued and traded in the debt market
fall in this category. Issuers within this category include the Government of
India, various State Governments and some statutory bodies. Instruments
issued by the Central Government carry the highest credit rating because of
the ability of the Government to tax and repay its obligations.
As mentioned earlier, government of India issues T-Bills and GOISECs of
varying maturities, while state government’s issue state loans. Apart from
these, the government also issues instruments, which are tailor-made for
retail investors. These include tax-free relief bonds, Indira Vikas Patra, Kisan
Vikas Patra, etc.
Banks and Development Financial Institutions (DFI)
Instruments issued by DFIs and banks carry the highest credit ratings
amongst non-government issuers primarily because of their linkage with the
Government. There is also a perception that the Government will not allow
important DFIs and banks to fail or default on their obligations. Prominent DFI
issuers include ICICI, IDBI, IFCI, IRBI, as well as some state level DFIs like
SICOM, GIIC, etc. ICICI and IDBI have been the most aggressive issuers.
Virtually all banks raise CDs, while prominent bond issuers have been SBI,
47
Government of India and other sovereign bodies
Banks and Development Financial Institutions
Public Sector Undertakings
Private sector companies
Government or quasi government owned non-corporate entities
VIII
The Debt Market in India Issuers
Bank of Baroda, Bank of India etc. Most banks have floated issues last year in
order to raise capital to meet their capital adequacy requirements.
DFIs issue 1-3 year CDs as well as longer maturity bonds. Banks mainly
issue short term CDs and they have also issued bonds from time to time
(although infrequently). For DFIs, bonds used to originally account for a very
small part of their overall resource raising; but the picture has changed
dramatically in the past 5 years as Government has discontinued other
cheaper avenues of funds to them. For new private sector banks and foreign
banks, which do not have access to a large branch network, CDs constitute
an extremely important part of overall resource raising.
DFIs are the second largest issuer of debt instruments after the
Government and sovereign bodies. The total value of outstanding bonds and
CDs issued by DFIs is estimated at Rs.1 trillion while the total outstanding
value of CDs and bonds issued by scheduled commercial banks is estimated
at Rs.60 bn. The incremental gross issuance of bonds by DFIs and banks is
estimated at Rs.320 bn, while the gross and net annual issuance of CDs is
estimated at Rs.120 bn and Rs.60 bn respectively.
DFIs raise bonds through public issues targeted at retail investors and
trusts. These retail issues account for about 20% of total funds raised. Private
placement of bonds with institutional investors is the main mechanism for
raising money. Privately placed bonds can be issued at any time to any
investor with the only restriction being the ceiling defined by the
shareholders of the PFI. Since these private placements happen throughout
the year, they are called on-tap bond issues.
Public Sector Undertakings (PSUs)
PSUs issue PSU bonds, which enjoy special concessions. These
concessions are indirect i.e. these PSU bonds are approved securities for
investment by various trusts, provident funds etc. The prominent PSU issuers
include Mahanagar Telephone Nigam Ltd. (MTNL), National Thermal Power
Corporation (NTPC), Indian Railway Finance Corporation (IRFC), Konkan
Railway Corporation (KRC), Neyveli Lignite Corporation (NLC), Steel Authority
of India (SAIL), National Hydel Power Corporation (NHPC), HUDCO, Coal India,
48
The Debt Market in India Issuers
Rashtriya Ispat Nigam Ltd (RINL) etc. IRFC is the fund raising arm of the
Indian railways while MTNL raises funds for itself as well as for the
Department of Telecom. In addition to PSU bonds, PSUs issue CPs like any
other corporate.
The total value of PSU bonds outstanding as at March 31, 1999 is
estimated at Rs.500 bn with MTNL, NTPC, IRFC and SAIL being the largest
issuers. The overall issuance of PSU bonds was very high in the late eighties
and early nineties when they were the biggest issuers after the Government
of India and other sovereign bodies. However the total issuance has declined
considerably in the last 3 - 4 years.
Private sector companies
Private sector companies issue commercial papers (CPs) and short and
long-term debentures. The total value of outstanding debentures issued by
private sector corporates is estimated at Rs.500 bn. There were large issues
of debentures by private sector companies in the early and mid nineties.
Capital investment in the private sector was booming on the back of a strong
capital market and private sector companies were raising loans by way of
debentures (among other means) in order to meet their overall fund
requirements. Sometimes, debentures were issued together with equity
issues in the form of partly convertible debentures. Since then three
developments have taken place. Firstly, there was overall decline in the
investment spending by the private corporate sector leading to decline in
demand for raising money in all forms including this one. On the other hand,
the demand for top quality debentures – i.e. debentures issued by top rated
companies – has increased substantially due to general flight to quality.
Thirdly, banks have been allowed to invest in private sector debentures,
which is an indirect way of giving term loans to these companies. Banks have
begun debenture investment in a big way and demand for debentures by
banks and newer investors like mutual funds have been high. These opposing
forces have resulted in a market that is stagnant at about Rs.100 bn per year.
Most of the debentures issued by the private sector are privately placed with
institutional investors. It is not feasible for a typical company to have a public
49
The Debt Market in India Issuers
issue of debentures because the cost of making a public issue is very high for
amounts less than Rs.5 bn.
Government owned or quasi government non-corporate
entities
This is a new class of issuers, which has emerged in the last 3 years. The
origin of these issuers lies in the inability of state governments to execute
large infrastructure projects through budgetary allocations. Consequently,
these state governments have created Special Purpose Vehicles (SPVs) for
executing these projects. These SPVs issue bonds/debentures. Typical
maturity of the instruments ranges from 3-7 years. The first prominent
issuance of this type was made in 1993 - that of Sardar Sarovar Narmada
Nigam Ltd., a vehicle created by the Government of Gujarat to execute the
Sardar Sarovar project. Since then, Krishna Bhagya Jala Nigam (KBJNL),
Maharashtra Krishna Valley Development Corporation (MKVDC), Maharashtra
State Road Development Corporation (MSRDC), etc. have come with larger
and larger issues for funding such ambitious infrastructure projects.
The credit rating of these debentures takes into account the implicit and
sometimes explicit support of the State Government and the ratings issued
are called SO rating (called Supplemental Obligation rating). In effect, it is an
indirect rating of the state government in question. Most of these issues are
public issues and the size of each issue is fairly large - ranging from Rs.5 bn
to Rs.15 bn per issue. But the actual subscribers are largely institutional.
There is a widespread belief that the state government behind the issuance
would not be willing to face the wrath of a large number of retail investors
and therefore would not let the issuer default. Hence, these issues are
perceived to be safe. The total value of outstanding debentures from this
class of issuers is estimated at Rs.150 bn. Many private developers have
come forward to sponsor infrastructure projects. We expect similar issues
from such private sector infrastructure developers in the years to come.
50
The Debt Market in India Investors
Investors
While understanding the behaviour of institutional investors, one will have
to appreciate the very fundamental point that in most cases debt market is a
market of compulsion as against the equity market which is a market of
choice. Many institutional investors have no choice but to invest in specific
debt instruments by virtue of their constitution or due to the regulations,
which govern their functioning, or by their orientation as to whom they
represent.
We have classified institutional investors operating in the Indian debt
market in the following main categories:
While banks, corporate treasuries, mutual funds and some FIIs can and do
invest in other kinds of securities like equities; provident funds, insurance
companies and trusts almost exclusively invest in various debt instruments.
Banks
Collectively, all the banks put together are the largest investors in the
debt market. They invest in all instruments ranging from T-Bills, CPs and CDs
to GOISECs, private sector debentures etc. By regulation, a bank has to invest
25% of its total deposits in GOISECs or other approved securities. This
percentage figure (25%) is called the Statutory Liquidity Ratio (SLR) and
these eligible securities are called SLR securities. These securities are the
ones, which are supposed to be extremely safe and carry minimal risk
51
Banks
Insurance companies
Provident funds
Mutual funds
Trusts
Corporate treasuries
Foreign Investors (FIIs)
IX
The Debt Market in India Investors
weightage. GOISECs used to carry zero risk weightage till very recently,
which has now been changed to 5%.
The SLR regulation makes the banks the largest investors in the market
for Government of India securities. In reality most banks have exposure to
Government of India securities much higher than the minimum 25%
stipulated by regulation. This is because of the prevailing recessionary
environment wherein many industrial and commercial borrowers have been
performing poorly and have been unable to meet their repayment obligations
on time. In such an environment, investing in GOISECs represents a sure fire
way of avoiding Non-Performing Assets (NPAs). Similarly, investment in bonds
and CDs of DFIs is another safe investment in the present environment.
Banks would be amongst the largest investors in DFI bonds.
Banks lend to corporate sector directly by way of loans and advances and
also invest in debentures issued by the private corporate sector and in PSU
bonds. A few years ago, the total ceiling for investment by banks in corporate
debentures, shares and other securities was fixed at 5% of the incremental
deposits of the previous year. This regulation has since been changed. Banks
can now invest 5% of the incremental deposits of the previous year in shares
of private sector while there is no ceiling for debentures. Banks’ investment
in private sector investment has grown manifold due to this relaxation.
Banks also keep on investing in CDs and CPs - but that is more as a way of
managing their liquidity on a day-to-day basis. By and large, bank treasuries
are not very active. In most cases, banks just buy and hold the investments,
which they make and not trade too much on them. Things have been
changing in recent times with some of the more aggressive banks churning
over part of their portfolio and having a more active treasury.
Insurance companies
The second largest category of investors in the debt market are the
insurance companies which have aggregate outstanding investments of
Rs.1250 bn and gross annual incremental investments of Rs.250 bn. By
regulation, LIC has to allocate 60% of its annual incremental investments to
GOISECs, while the GIC and its 4 subsidiaries (New India Assurance, Oriental
52
The Debt Market in India Investors
Insurance, United India Insurance and National Insurance) are supposed to
allocate 40% of their annual incremental investments in GOISECs. LIC is
allowed to invest up to a maximum of 15% of its incremental investments in
private sector debentures and shares while GIC and it subsidiaries are
allowed to invest up to a maximum of 25% of their incremental investments
in private sector shares and debentures. Hence, collectively, the insurance
companies are one of the largest investors in GOISEC’s. Of their annual
incremental investments of Rs.250 bn, not less than Rs.150 bn would be in
GOISECs.
Provident funds
Provident funds are estimated to have a total corpus of Rs.800 bn. The
total incremental investment by provident funds every year is approximately
Rs.150 bn, which makes them the third largest investors in the debt market.
Again by virtue of regulation, provident funds are supposed to invest a
minimum of 25% of their incremental accretions each year in GOISECs, 15%
in state government securities, 40% in PSU bonds, etc. with a maximum of
10% in rated private sector debentures. Investment guidelines for provident
funds are being progressively liberalized and investment in private sector
debentures is one step in this direction.
Most of the provident funds are very safety oriented and tend to give
much more weightage to investment in government securities although they
have been considerable investors in PSU bonds as well as state government
backed issues like SSNL, MSRDC, etc. The largest provident fund is the one
managed by the State Bank of India on behalf of the Central Provident Fund
Commissioner. This has an estimated corpus of Rs.400 bn and fresh annual
investments of Rs.70 bn. This Provident fund has taken a policy decision not
to invest in private sector debentures although recent regulation allows it to
do so.
By their very orientation as well as by regulation, provident funds are buy
and hold investors and almost never trade on their investments.
53
The Debt Market in India Investors
Mutual funds
Mutual funds represent an extremely important category of investors.
World over, they have almost surpassed banks as the largest direct collector
of primary savings from retail investors and therefore as investors in the
wholesale debt market.
Mutual funds include the Unit Trust of India, the mutual funds set up by
nationalized banks and insurance companies like the SBI Mutual Fund, the
GIC Mutual Fund, the LIC Mutual Fund, etc. as well as the new private sector
mutual funds set up by corporates and overseas mutual fund companies. Of
these, the largest is the Unit Trust of India, which has almost 85% of the
market share of the mutual fund business and a total corpus of about Rs.700
bn. The total corpus of all the mutual funds put together is about Rs.850 bn
while the annual gross incremental investments are in the range of around
Rs.150 bn.
While all mutual funds including the Unit Trust of India invest in GOISECs
in a big way, they are collectively one of the largest investors in PSU bonds
and private sector corporate debentures. Private sector mutual funds like
Birla, Prudential ICICI, etc. have emerged as major investors in the
debentures issued by top rated private sector companies. Short-term
debentures are a favourite of mutual funds. This has resulted in a scenario
where the yield on some of the top quality private sector corporates is at a
very low differential compared to risk free sovereign instruments and bonds
of financial institutions.
Most mutual funds trade at least 30-40% of their portfolio with the
exception of UTI, which does very little trading.
Trusts
Trusts include religious and charitable trusts as well as statutory trusts
formed by the government and quasi government bodies. The largest trusts
in India are the port trusts, which have been constituted under the Major Port
Trust Act. These include the Bombay Port Trust, Madras Port Trust, Calcutta
Port Trust, Cochin Port Trust etc. The aggregate corpus of the Port Trusts is
54
The Debt Market in India Investors
estimated at Rs.80 bn, while their annual investments would be about Rs.20
bn of that amount.
Religious trusts and Charitable trusts range from the very small ones to
large ones like Tirupati Devasthanam, Mata Amritanandmayi, Ramkrishna
Mission, etc. Other trusts include hospital trusts like Jaslok, Bombay Hospital
etc, armed forces trusts like Army Wives Welfare Association, Air Force
Officers Association and many other general trusts like the Rajiv Gandhi
Foundation, Birla Science Foundation etc.
There are very few instruments in which trusts are allowed to invest. Most
of the trusts invest in CDs of banks and bonds of financial institutions and
units of Unit Trust of India. The total aggregate corpus of all trusts is
estimated at Rs.250 bn while the total incremental investment would be
approximately Rs.40 bn per annum.
Corporate Treasuries
Corporate treasuries have become prominent investors only in the last
few years. Treasuries could be either those of the public sector units or
private sector companies or any other government bodies or agencies.
The treasuries of PSUs as well as the governmental bodies are heavily
regulated in the instruments they can invest in. These regulations were put in
place by the administrative ministries as a reaction to the Harshad Mehta
scam. These treasuries are allowed to invest in papers issued by DFIs and
banks as well as GOISECs of various maturities. However, the orientation of
the investments is mostly in short-term instruments or sometimes in
extremely liquid long-term instruments, which can be sold immediately in the
markets. Some have been investing in preference shares issued by DFIs.
In complete contrast to public sector treasuries, those in the private sector
are very adventurous, fleet footed and savvy. They invest in CDs of banks
and CPs of other private sector companies, GOISECs as well as debentures of
other private sector companies. Of late, preference shares of DFIs and open-
ended mutual funds have also become popular with these treasuries. Some of
the savvier treasuries have also been investing in badla financing which gives
much superior returns as compared to any other security although with
55
The Debt Market in India Investors
higher risk perception. Another favourite is the inter-corporate deposit (ICD),
which is also non tradable like badla financing. The big private sector
treasuries are those belonging to the Birla companies, Reliance group,
Gujarat Ambuja, Bajaj Auto, Parle Products, etc.
Foreign Institutional Investors
India does not allow capital account convertibility either to overseas
investors or to domestic residents. Registered FIIs are an exception to this
rule. More than 300 FIIs invest in Indian equities, while the number of FIIs
investing in Indian domestic debt is less than 20.
FIIs have to be specifically and separately approved by SEBI for equity and
debt. Each debt FII is allocated a limit every year up to which it can invest in
Indian debt securities. It can do so without asking for any permission from
anyone. They are also free to disinvest any of their holdings, at any point of
time, without asking for any permission from anyone.
The total aggregate limit or ceiling of investments by debt FIIs is US$
1.5bn. As on date, the aggregate investments are less than US$100mn. Most
of the debt FIIs are extremely quick traders. They invest wherever they can
make a quick buck. They are unlikely to invest in Indian debt at a time when
the currency risk is high and the expected gains from price appreciation in
Indian debt paper are not very high. FII investment limit in debt market raised
to $1.75 billion in Union Budget 2004.
56
The Debt Market in India Regulators
Regulators
Reserve Bank of India (RBI)
The Reserve Bank of India is the main regulator for the debt market. Apart
from its role as a regulator, it has to simultaneously fulfil several other
important objectives, viz. managing the borrowing program of the
Government of India, controlling inflation, ensure adequate credit at
reasonable costs to various sectors of the economy, managing the foreign
exchange reserves of the country and ensuring a stable currency
environment. This shows the importance of RBI’s role as a fundraiser for the
Government of India.
Inevitably, there are occasions when one of RBI’s objectives clashes with
another one and the bank is forced to choose between trying to fulfil two
different objectives. It makes this choice depending on the exigencies of the
situation. eg. in the wake of the Asian crisis, maintaining currency stability
was a more important objective than keeping interest rates low.
Consequently, the RBI chose to ignore latter objective for some time. Such a
perspective of the issues confronting the RBI is extremely important for
understanding and forecasting events in the debt market.
RBI controls the issuance of new banking licenses to either foreign banks
or to new private sector banks. It controls the manner in which various
scheduled banks raise money from depositors. Further, it controls the
deployment of money through its policies on CRR, SLR, priority sector
lending, export refinancing, guidelines on investment assets, etc. E.g. its
policy on the cash reserve ratio and the statutory liquidity ratio determines
the extent to which banks money is locked away and the extent to which
money is available for lending/investment. Incremental changes in these
ratios can result in substantial change in the liquidity scenario and hence the
short term interest rates. The Reserve bank also regulates the market
57
X
The Debt Market in India Regulators
through the control of the investment policy followed by banks. As an
example, RBI has recently allowed banks to invest in debentures of private
sector companies. This was earlier controlled by a limit and therefore in
earlier days, banks were unable to invest in debentures to a worthwhile
extent. Similarly, the limit for investment in shares has been enlarged
substantially making banks active investors in shares after decades. For the
non-banking financial companies (NBFCs), the RBI determines the extent to
which these companies can be leveraged and the extent to which they can
raise deposits from public depositors. Simultaneously it controls the asset
portfolio through changes in liquidity ratios, etc.
The next major area under the control of the RBI is the interest rate policy.
Earlier, it used to strictly control interest rates through a directed system of
interest rates. Each type of lending activity was supposed to be carried out at
a pre-specified interest rate. This system has changed over the years and RBI
has moved slowly towards a regime of market-determined controls. It now
seeks to control interest rate policy through various benchmarks and portrays
changes in these benchmarks as signals of its intent. These benchmarks
include the cut off interest rate of the various auctions for government
securities and T-Bills, the bank rate, the repo rates, and the rates on
refinance provided to banks, CRR etc. It also gives signals through the open
market operations that it carries out. eg. if it wants to signal a rise in interest
rate for a particular maturity, it would sell securities with similar maturities at
a yield higher than the prevailing market yield.
As mentioned earlier, in pursuit of its objective of ensuring a stable
currency environment, RBI temporarily abandoned its easy money policy,
when it had to defend the rupee against speculative forces in the worst days
of the Asian crisis. It reversed a long run trend of lowering of CRR and
increased the short term interest rates in such a way that speculators found it
difficult to speculate, reducing the volatility in the foreign exchange market.
On the reverse side, RBI has been buying dollars in times of heavy dollar
inflows to keep the rupee from appreciating against the dollar and hurting the
prospects of Indian exports.
58
The Debt Market in India Regulators
SEBI
Another regulator for the debt market is the Securities and Exchange
Board of India (SEBI). SEBI gets involved whenever there is any entity raising
money from Indian individual investors through public issues. It regulates the
manner in which such moneys are raised and tries to ensure a fair play for
the retail investor. It forces the issuer to make the retail investor aware of the
risks inherent in the investment. SEBI is also a regulator for the entire family
of mutual funds, which are becoming an increasingly important player in the
debt market. SEBI regulates the entry of new mutual funds in the industry. It
also regulates the instruments in which mutual funds can invest. SEBI also
regulates the investments of debt FIIs.
Others
Apart from the two main regulators, the RBI and SEBI, there are several
other regulators specific for different classes of investors, eg. The Central
Provision Fund Commissioner and the Ministry of Labour regulate the
Provident Funds. The religious and charitable trusts are regulated by some of
the State governments of the states in which the trusts are located. The
Ministry of Surface Transport regulates Port Trusts. The Ministry of Human
Resource Development of the Government of India regulates some religious
trusts.
59
The Debt Market in India Credit Rating of Instruments
Credit Rating of Instruments
Credit rating is the process of assigning standard scores, which summarize
the probability of the issuer being able to meet its repayment obligations for
a particular debt instrument in a timely manner. Credit rating is integral to
debt markets as it helps market participants to arrive at quick estimates and
opinions about various instruments. In this manner it facilitates trading in
debt and money market instruments, especially in instruments other than
Government of India Securities.
Rating is usually assigned to a specific instrument rather than the
company as a whole. In the Indian context, the rating is done at the instance
of the issuer, which pays rating fees for this service. If it is unsatisfied with
the rating assigned to its proposed instrument, it is at liberty not to disclose
the rating given to it. There are 4 rating agencies in India. These are as
follows:
CRISIL - The oldest rating agency was originally promoted by ICICI.
Standard & Poor, the global leader in ratings, has recently taken a
small 10% stake in CRISIL.
ICRA - Promoted by IFCI. Moody’s, the other global rating major, has
recently taken a small 11% stake in ICRA.
CARE - Promoted by IDBI.
Duff and Phelps - Co-promoted by Duff and Phelps, the world’s 4th
largest rating agency.
CRISIL is believed to have about 42% market share followed by ICRA with
about 36%, CARE with 18% and Duff and Phelps with 4%.
Grading system
Each of the rating agencies has different codes for expressing rating for
different instruments; however, the number of grades and sub-grades is
similar. eg. for long-term debentures/bonds and fixed deposits, CRISIL has 4
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XI
The Debt Market in India Credit Rating of Instruments
main grades and a host of sub grades. In decreasing order of quality, these
are AAA, AA+, AA, AA-, A+, A, A-, BBBB, BBB+, BB+, BB, BB-, B+, B, B-, C and
D. ICRA, CARE and Duff and Phelps have similar grading systems.
Credit rating is a dynamic concept and all the rating companies are
constantly reviewing the companies rated by them with a view to changing
(either upgrading or downgrading) the rating. They also have a system
whereby they keep ratings for particular companies on "rating watch" in case
of major events, which may lead to change in rating in the near future.
Ratings are made public through periodic newsletters issued by rating
companies, which also explain briefly the rationale for particular ratings. In
addition, they issue press releases to all major newspapers and wire services
about rating events on a regular basis.
Factors involved in credit rating
Credit rating depends on several factors, some of which are
tangible/numerical and some of which are judgmental and intangible. Some
of these factors are listed below:
Overall fundamentals and earnings capacity of the company and
volatility of the same
Overall macro economic and business/industry environment
Liquidity position of the company (as distinguished from profits)
Requirement of funds to meet irrevocable commitments
Financial flexibility of the company to raise funds from outside sources
to meet temporary financial needs
Guarantee/support from financially strong external bodies
Level of existing leverage (borrowings) and financial risk
As mentioned earlier, ratings are assigned to instruments and not to
companies and two different ratings may be assigned to two different
instruments of the same company. eg. a company may be in a fundamentally
weak business and may have a poor rating assigned for 5 year debentures
while its liquidity position may be good, leading to the highest possible rating
for a 3 month commercial paper. Very few companies may be assigned the
highest rating for a long term 5 or 7 year instrument. eg. CRISIL has only 20
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The Debt Market in India Credit Rating of Instruments
companies rated as AAA for long term instruments and these companies
include unquestionable blue chips like Videsh Sanchar Nigam, Bajaj Auto,
Bharat Petroleum, Nestle India apart from institutions like ICICI, IDBI, HDFC
and SBI.
Derived ratings and structured obligations
Sometimes, debt instruments are so structured that in case the issuer is
unable to meet repayment obligations, another entity steps in to fulfil these
obligations. Sometimes there is a documented, concrete mechanism for
recourse to the third party, while on other occasions, the arrangement is
loose. On such occasions, the debt instrument in question is said to be "credit
enhanced" by a "structured obligation" and the rating assigned to the
instrument factors in the additional safety mechanism. The extent of
enhancement is a function of the rating of the "enhancer", the nature of the
arrangement etc and usually there is a suffix to the rating which expresses
symbolically that the rating is enhanced. e.g. A bond backed by the
guarantee of the Government of India may be rated AAA (SO) with the SO
standing for structured obligation.
Limitations of credit rating - rating downgrades
Rating agencies all across the world have often been accused of not being
able to predict future problems. In part, the problem lies in the rating process
itself, which relies heavily on past numerical data and standard ratios with
relatively lower usage of judgment and understanding of the underlying
business or the country economics. Data does not always capture all aspects
of the situation especially in the complex financial world of today. An
excellent example of the meaningless over reliance on numbers is the poor
country rating given to India. Major rating agencies site one of the reasons for
this as the low ratio India’s exports to foreign currency indebtedness. This
completely ignores two issues – firstly, India gets a very high quantum of
foreign currency earnings through remittances from Indians working abroad
and also services exports in the form of software exports, which are not
counted as "merchandise" exports. These two flows along with other
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The Debt Market in India Credit Rating of Instruments
"invisible" earnings accounted for almost US$ 11 bn in FY 99. Secondly, since
India has tight control on foreign currency transactions, there is very little
error possible in the foreign currency-borrowing figure. As against this, for a
country like Korea, the figure for foreign currency borrowing increased by
US$ 50 bn after the exchange crisis began. This was on account of hidden
forward liabilities through swaps and other derivative products.
In general, Indian rating agencies have lost some amount of their
credibility in the last two years due to their inability to predict defaults in
many companies, which they had rated quite highly. Sometimes, some of the
agencies had an investment grade rating in place when the company in
question had already defaulted to some of the fixed deposit holders. Further,
rating agencies resorted to mass downgrading of 50-100 companies as a
reaction to public criticism, which further eroded their credibility. The major
reasons for these downgrades are as follows:
Corporate earnings fell very sharply due to persistent recessionary
conditions prevailing in the economy. Many of the corporates are in
commodity sectors where fluctuations in selling prices of products can be
very sharp - leading to complete erosion of profitability. This problem was
compounded by the Asian crisis, which led to increased competition from
cheap imports in many product categories.
Rating agencies substantially overestimated financial flexibility of
corporates especially from traditional corporate houses. Much of the financial
flexibility was implicit on raising money from new issues from the capital
market, which has been impossible in the last 3 years.
In the case of finance companies, widespread defaults and tightening of
regulations made it virtually impossible for them to raise money in any form.
These finance companies had been in the habit of investing in longer term,
illiquid assets by borrowing shorter term fixed deposits. When the flow of
credit stopped, they faced liquidity problems. These were further
compounded by defaults by some of the companies to which they had lent
money.
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The Debt Market in India Credit Rating of Instruments
The experience is no different from the international scenario where
reputed and highly experienced rating agencies like Standard & Poor (S&P)
and Moody’s were unable to predict the Asian crisis and had to face the
embarrassment of seeing the credit rating of South Korea as a country go
from A+ to BB+ in a short span of 3 months.
By and large, the rating is a very good estimate of the actual
creditworthiness of the company; however, it is not able to predict extreme
situations such as the ones described above, which are unlikely to have been
predicted by most investors in any case. Investors should realize that a credit
rating is not sacrosanct and that one has to do one’s own due diligence and
investigation before investing in any instrument. They should use the rating
as a reference and a base point for their own effort. One good way of doing
this is examining the behaviour of the stock price in case the stock is listed.
As a collective, the market is far smarter at predicting problems than any
credit rating agency. Witness the sharp erosion in stock prices of companies
much before their credit ratings were downgraded. Witness also the fact that
foreign currency bonds from Indian issuers trade at yields lower than
countries, which have been rated higher by rating agencies.
64
The Debt Market in India Judicious Investment
Judicious Investment
The main points to be kept in mind by the investor while investing in the
Debt Markets:
Coupon (or the discount implied by the price as in the case of zero
coupon bonds) and the frequency of interest payments. The securities
can also be chosen in such a manner so that the interest payments
coincide with any requirements of funds at that point of time.
Timing of Cash Flows - In case the interest and redemption
proceeds, at one single point or at different points of time, are planned
to be used for meeting certain planned expenses in the future.
Information about the Issuer and the Credit Rating – It is
essential to obtain enough information about the background, the
business operations, the financial position, the use of the funds being
collected and the future projections to satisfy oneself of the suitability
of the investment. As per the regulations in force in the capital
markets, it is essential for any corporate debt security to obtain a
credit rating from any of the major credit rating agencies. A proper
analysis of the background and the financials of the issuer of any non-
govt. debt instrument and especially the credit rating would lend
greater safety to your investments.
Other Terms of particular Issue – It is also advisable to check on
certain terms of the issue like the use of the issue proceeds, the
monitoring agency, the formation of trustees, the secured or
unsecured nature of the bonds, the assets underlying the security and
the credit-worthiness of the organization.
Most of the said information can be available from the prospectus of the
said issue (and any required and relevant details can also be obtained on
demand from the lead manager of the issue)
Obtain all the relevant knowledge on the debt security like the coupon,
maturity, interest payments, Yield To Maturity (at the particular price
65
XII
The Debt Market in India Judicious Investment
at which the trade is intended to be carried out) and the Duration of
the Instrument.
Check the Yield To Maturity (YTM) of the debt security with the YTMs of
other comparable debt securities of the same class and features.
Remember that the Yield and the Price are inversely related. So, you
will be able to obtain a higher yield at a lower price.
It is desirable to check on the liquidity of any corporate debt
instrument before investing in it so as to ensure the availability of
satisfactory exit options.
The Debt Markets are suited for investors who seek decent returns
over a longer time horizon with periodic cash flows.
The investor should be well aware of the set of risks associated with the
Debt Markets like the default risk (non-receipt or delay in receipt of interest
or principal), price risk, interest rate risk (risk of rates moving adversely after
investment), settlement risk (or risk of non-delivery of securities and funds in
the secondary market) and the re-investment risk (interest payments
fetching a lower return when re-invested).
Investors in the Debt Markets should follow a process of judicious
investing after a careful study of the economic and money market condition,
various instruments available for investment, the desired returns and its
compatibility with existing investment opportunities, alternative modes
available for investments and the relevant transaction costs.
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The Debt Market in India Frequently Asked Questions
Frequently Asked Questions
Can a retail investor buy Government of India Securities, State
Government Bonds or treasury bills?. If so what is the mechanism for
doing the same? Are these securities available on the Bombay Stock
Exchange or National Stock Exchange and can they be bought
through BSE/NSE brokers?
Theoretically, a retail investor can buy Government of India Securities,
State Government securities and Treasury Bills. The minimum amount for
participation in securities auctions is Rs10000 but these securities can be
made available in denominations of Rs100. However, there are enormous
practical difficulties in buying these. The main problems are as follows:
These securities are usually traded in large lots – at least Rs5mn with the
average transaction size being at least 10 times higher
These securities are usually traded in the dematerialized form through the
SGL accounts maintained by the Reserve Bank of India. An individual cannot
open an individual SGL account but has to get a constituent or subsidiary
account opened with a bank. This process is tedious and costly and most
banks may not entertain individuals
Sometimes, these securities are also available in the form of physical
certificates in the secondary market. Even here, the transaction size would be
higher – in the range of Rs0.5mn and the prices quoted for these are
extremely unattractive.
Securities bought in physical certificate form are extremely illiquid and an
investor may have to hold it till redemption. Alternatively, he may be offered
a very bad price for it.
All the above suggest that buying and selling of such securities on the
secondary market is almost impossible. They are listed on the BSE/NSE but
do not actually trade there in any significant manner. The debt market is
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The Debt Market in India Frequently Asked Questions
actually a telephone market where transactions get verbally concluded on
the phone but are then "routed" or "consummated" on the NSE just to fulfil
the internal requirements of many institutions. Hence, BSE/NSE brokers may
not be able to help an investor in buying these securities.
The best way to buy these is directly from the RBI in the periodic auctions
held by it. There is a special counter at the RBI where an investor can submit
a bid in an auction or in an Open Market Operation. Here also, individual
investors have to present RBI with Demand Drafts.
Are fixed deposits issued from various private sector companies
completely safe? Are they guaranteed buy the Government of India
or any other government body?
On the contrary, company fixed deposits are completely unsecured. Unlike
bank fixed deposits which are guaranteed by the Deposit Insurance and
Guarantee Corporation (DICGIC) up to Rs100,000 per account, the repayment
of company fixed deposits is completely dependent on the company issuing
them. There have been widespread defaults and delays in the last three
years especially in finance company fixed deposits.
How risky is it to invest in company fixed deposits? How can an
investor understand the risk involved with a particular company and
avoid it? Would you recommend an investor to invest money in FDs?
To the extent that deposits are completely unsecured, it is definitely risky.
But rather than being general, one has to look at the specific company in
question before taking a decision. We are not at all against the idea of risk
taking especially if a particular individual can afford to take it – but taking
risks should be in a calculated and sensible manner. It does not make any
sense whatsoever to invest in a riskier FD for 2% higher interest rate. The
potential reward is just not worth it. For risk takers, the stock market has a
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The Debt Market in India Frequently Asked Questions
much superior risk-reward pay off. A successful pay off in the stock market
can be 50% not 2%.
All investors should remember the old adage - " Anything which looks too
good to be true usually is".
A few years ago, some of the finance companies were offering very high
rates of interest. Further, brokers who were marketing these deposits also
offered on the spot cash incentives and other attractions like gold coins etc.
Prudent investors should have thought about the ultimate end use of their
funds – which activities were these companies engaged in that they were
able to afford high rates of interest and the freebies - because there are very
few businesses in the world which could be profitable after offering such high
interest rates.
The last person to look for advice in fixed deposit investing is the FD
broker. Assuming that he or she belongs to a professional organization which
is not out to cheat you and make a quick commission, investors should
remember that typical brokers may not be well informed about the risks of
investing in a particular company.
Is it possible for a retail investor to buy debentures of private sector
companies? If so, what is the avenue for buying this?
Retail investors can buy debentures of private sector companies. This is
possible in 2 ways. Firstly, by subscribing to new issues and secondly in
secondary market transactions on stock exchanges.
Up to the early nineties, large private sector companies made public
issues of debentures. Now, such issues have virtually stopped except for the
bond issues being made by Financial Institutions like ICICI and IDBI and issues
being made by state government sponsored agencies like Maharashtra State
Road Development Corporation.
The secondary market for debentures and bonds is not very active but it
exists. Everyday debentures get traded on the BSE/NSE albeit in small
quantities. However, bonds of Financial Institutions are becoming more and
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The Debt Market in India Frequently Asked Questions
more liquid and available on the stock exchanges. This is probably because of
the sheer base of investor population and the massive efforts being made by
these institutions in making their bonds liquid in the secondary market.
Are the safety bonds and flexibonds issued by financial institutions
really safe? Does the Government of India or any other government
body guarantee them?
"Nothing is really certain in this world except death and taxes". While the
Government of India has not directly guaranteed the safety/flexi bonds of
financial institutions, these bonds are very safe. Doubts of their safety have
arisen only in the last few years after the stock prices of these companies
have fallen substantially reflecting the uncertainty of non performing
assets/loans made by these institutions to the corporate world. These
institutions have a fair amount of equity capital, which is at a much higher
risk than the public borrowings made by them.
Moreover, it is unlikely that these institutions, or for that matter
nationalized banks, which are also facing similar problems, will be allowed to
fail. These institutions are one of the key pillars of the financial system and
their problems are in effect the problems of the corporate sector in general.
In the past, whenever problems have arisen, the Government has stepped in
to bail out the concerned entity. Indian Bank is a good example and so is the
recent case involving US 64.
What is a difference between a bond and a debenture?
Generally speaking, long term debt securities issued by the Government
of India or any of the State Government’s or undertakings owned by them or
by development financial institutions are called bonds. Instruments issued by
other entities are called debentures. The difference between the two is
actually a function of where they are registered and pay stamp duty and how
they trade. Issuance stamp duty on bonds is a central subject and a bond is
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The Debt Market in India Frequently Asked Questions
transferable by endorsement and delivery without payment of any transfer
stamp duty. The stamp duty on debentures is a state subject and has to be
paid both on issuance and transfer. On issuance it is linked to mortgage
creation, while on transfer, it is levied in accordance with the laws of the
state in which the registered office of the company in question is located.
Unlike a bond, a debenture transfer has to be effected through a transfer
deed.
What is exactly meant by the term secured redeemable debenture?
Secured refers to the security given by the issuer for the loan transaction
represented by the debenture. This is usually in the form of a first mortgage
or charge on the fixed assets of the company on a pari passu basis with other
first charge holders like financial institutions. Sometimes, the charge can also
be a second charge instead of a first charge. The charge is created on behalf
of the entire pool of debenture holders by a trustee specifically appointed for
the purpose. Typically, financial institutions and banks are trustees and their
job is to create and maintain the security.
Redemption refers to the process whereby the debenture is extinguished
on payment of all the obligations due to the holder after the repayment of the
last installment of the principal amount of the debenture.
Sometimes investors get confused and think that the above mentioned
type of debenture is secured by a guarantee of the trustee financial
institution. They get confused by the presence of the name of a reputed
financial institution as a trustee.
If debentures carry a fixed interest rate why do prices of debentures
fluctuate like shares? Why are debentures available at prices other
than face value?
The price of a debenture is inversely proportional to changes in interest
rates. Let us take the example of a blue chip company issuing a debenture or
a bond which carries a fixed interest rate say 10% per annum payable
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The Debt Market in India Frequently Asked Questions
annually. This implies that for every debenture of Rs100 face value, the
holder gets Rs10 per year as interest. If the interest rate environment
undergoes a change and the overall interest rates for all securities comes
down by say 2%, then new debentures would be issued by the same
company at the new rate of 8%. If so, the older debenture is quite valuable
because the company is obliged to pay the holders a higher interest rate.
Consequently, the price of the debenture goes up. The price is likely to go up
to such an extent that the annual interest of Rs10 gives the same yield as the
new 8% debenture – crudely put it will be 10*100/8 = 125. The real
calculation is much more complicated than this simple example but this
example can give an idea about the general direction of the price.
Conversely, if the interest rates go up, the price of the debentures will fall
below face value to reflect the new yields.
The sensitivity of a particular debt instrument to a change in interest rates
is directly proportional to the "duration" of the instrument, which is broadly
linked to the residual maturity of the instrument. Thus a longer maturity
instrument will rise or fall more than a shorter maturity instrument.
There are other situations when the prices can fluctuate eg If the said blue
chip company no longer remains blue chip, and its credit quality falls due to
its business problems, then the market expectations of the interest rate from
the company will increase – thus resulting in a fall in the debenture price.
However, in most real life cases, the price fluctuations in debentures will
be much less than price fluctuations in other asset classes like shares.
What factors determine interest rates? Are they fixed by anyone?
When we talk of interest rates, there are different types of interest rates –
rates that banks offer to their depositors, rates that they lend to their
borrowers, rate at which the Government borrows in the bond market, rates
offered to small investors in small savings schemes like NSC/NSS, rates at
which companies issue fixed deposits etc Ten years ago, almost all interest
rates in India were rigidly administered or directed by the Reserve Bank of
India and there was nothing anyone could do about it. This controlled interest
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The Debt Market in India Frequently Asked Questions
rate regime has been progressively loosened in the last 5 years and now
most of the interest rates in the economy are freely determined by market
sources. The RBI ensures that there is a free and fair market and that things
do not go out of hand. Also the overall direction of rates is definitely a
function of the policies followed by RBI.
Many investors, especially older persons who were used to a controlled
interest rate regime, find it difficult to adjust to the new dispensation.
However, investors have to constantly keep track of changes affecting the
interest rate environment and we will endeavor to help them in
understanding these.
The factors which govern the interest rates are mostly economy related
and are commonly referred to as macroeconomic. Some of these factors are
as follows:
Demand for money – When the economy is booming, the demand
for money is high, because all industries need money to finance larger
working capital and fixed capital investments. At such times, they are
not bothered excessively about the interest rates because their
businesses are booming and they are able to pass on the higher costs to
their consumers. On the other hand, in recessionary times, when the
demand for money is low, everyone is averse to borrowing money at
higher rates and rates tend to come down
Government borrowings– The largest borrower in the debt
market is the Government, which borrows money in the form of GOI
Securities issued by the RBI. Excessive amounts of these borrowings
raise the level of interest in the economy. The important point is that
since the Government borrowing is said to be risk free, all interest rates
are benchmarked on that basis and this pushes up all interest rates in
the economy. Many international bodies like the World Bank believe that
this is the biggest problem of the Indian economy and one of the factors
that makes industries uncompetitive. Going one step deeper,
government borrowings are a reflection of inability of the Government to
live within its means i.e. expenditure more than income. Technically, this
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The Debt Market in India Frequently Asked Questions
is reflected in the indicator, fiscal deficit as a percentage of national
income, which each finance minister talks about at budget time.
Supply of money – When the government is running large
amounts of deficit financing, the "printing" of notes leads to excess
supply of money in the economy. Similarly, when the country receives a
large amount of inflows from overseas, there is excess supply of money.
On the other hand foreign exchange leaving the country leads to a
shortage of money supply. The supply of money is reflected in the
Money Supply figure or M3, which is released by the RBI every week.
Excess leads to decline in level of interest rates while shortage leads to
an increase.
Inflation rate – Normally, a higher inflation rate leads to a high
interest rate. This is very much true about developed countries but less
so about India. In India, the main determinant of inflation is the price of
primary articles like food and vegetables.
Are interest rates influenced by any authority like the RBI or by the
Government? Why have interest rates in India fluctuated so widely in
the last 5 years?
The RBI and the Government change policies frequently in order to fulfill
various national objectives and these policy changes have a bearing on some
or all of the variables mentioned in the answer to question 11. Such changes
lead to changes in the level of interest rates.
A chronology of events in the last 5 years, which affected interest rates, is
given below.
In 1994, money supply was increasing at a very fast pace due to large
amount of foreign currency inflows caused by Foreign Institutional
Investors (FIIs) investing in India in a major way. This caused a very
sharp reduction in the interest rates.
The inflation rate was very high and the RBI took steps to reduce the
money supply in order to fight it. This sharp reduction in money supply
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The Debt Market in India Frequently Asked Questions
at a time when the economy was booming (7% GDP growth rate) caused
an acute shortage of funds leading to a very sharp rise in interest rates.
The recession that followed led to a drastic decrease in the demand for
money and this lowered the interest rates.
In 1998, there was a fear of foreign exchange crisis sparked by the
crisis in the Asian region. In order to prevent a runaway depreciation of
the rupee, the RBI imposed certain controls, reduced money supply and
engineered a rise in interest rates so that it would be difficult for the
rupee to depreciate sharply.
Again when the threat against the rupee receded, it reversed its
policies leading to a decline in interest rates once again.
Is it possible for the Reserve Bank of India to control inflation?
Inflation is caused by many factors, many of which are inter linked to each
other. In developed economies, inflation is generally a function of the
demand and supply of money. A booming economy generates high demand
for money causing a rise in inflation while a recessionary economy has a low
demand for money leading to low inflation. However, this simple equation
need not be necessarily true as can be seen by the current happenings in the
United States. The US economy is in a continuous boom phase but has one of
the lowest ever inflation rates. One of the key reasons is that prices of
commodities and manufactured goods have slumped due to general global
over capacity and the Asian crisis.
In the Indian context, many experts believe that inflation is cost pushed
and not demand pulled. Administered costs like transportation, electricity etc
constantly going up and they have to be passed on. Secondly, inflation is
linked to the cost of food and vegetables, which keeps going up due to the
rising support prices announced by the Government to keep farmers happy.
There are also sharp price surges in specific food items due to shortage as we
saw in onions in 1998.
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The Debt Market in India Frequently Asked Questions
In this context, it appears extremely difficult for the RBI to keep control
over inflation.
Which debt instruments/schemes available for retail investors earn
tax free interest?
Tax-free Relief Bonds
Voluntary Provident Fund
Public Provident Fund
US 64 (which is not an interest bearing scheme in true sense)
Long term postal deposit schemes
Each investor can invest in certain instruments, the interest on which is
exempt from tax up to a limit of Rs12000 per annum, under the section 80L
of the Income Tax Act. These instruments are as follows:
All kinds of bank deposits
All small savings schemes excluding National Savings Scheme
Bonds of Development Financial Institutions.
All kinds of postal deposits
Government of India and State Government Securities
Kisan Vikas Patra
Indira Vikas Patra
For a more detailed idea about the tax implications of retail instruments
please refer to the special section on tax implications in each scheme profile.
While mutual funds are not interest bearing instruments, income mutual
funds are almost similar since they invest only in interest bearing
instruments.
Which are the largest brokers of fixed deposits?
Integrated Finance Enterprises
Kotak Securities
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The Debt Market in India Frequently Asked Questions
JM Share & Stock Brokers
Bajaj Capital
Karvy Securities
Birla Global Finance
Are all nationalized banks safe from the point of view of investment?
All the nationalized banks are owned fully or substantially by the
Government of India. Together with the State Bank of India and its
subsidiaries, they have more than 25000 branches spread across the length
and breadth of the country. They would be having more than 100 million
deposit accounts.
Given this background, it is extremely unlikely that the Government will
allow any nationalized bank to fail. The implications of such a failure can be
explosive. Its past actions when it bailed out troubled banks like the New
Bank of India and the Indian Bank and injected capital in the entire banking
system to improve the capital adequacy of all banks can be taken as signals
in this regard. Its handling of the US 64 crisis is also a pointer.
This is not unusual in other parts of the world as well. The US Government
handled an almost trillion dollar bailout of its savings and loan associations
(S&Ls) in the late eighties. It also bailed out banks, which were overexposed
to Latin America through the Brady bond mechanism.
In addition to the support of the Government, deposits up to Rs100,000
per account are completely insured by the Deposit Insurance and Guarantee
Corporation (DICGC). This has however never been tested in practice.
In conclusion, nationalized banks are as safe as anything you can get. If
some people feel uncomfortable about investing in banks, which are believed
to be relatively deeper in trouble, we provide below a list of such banks
United Commercial bank (UCO Bank)
Allahabad Bank
United Bank of India (UBI)
Bank of Maharashtra
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The Debt Market in India Frequently Asked Questions
Indian Bank
Indian Overseas Bank
However, we would advise investors to be cautious about investing in
small and less known cooperative banks where the extra interest earned may
not be worth the additional risk.
Why is the trading volume in the debt market significantly lower as
compared to the amount of outstanding securities issued?
Most of the investors in the debt market are of the buy and hold profile
especially the provident funds, insurance companies etc. Bank treasuries are
also quite inactive with only some small part of the portfolio being
traded/churned. Secondly, the debt market is a market where it is difficult for
speculators to operate because buyers have to pay for 100% of what they
have bought and there is no concept of intra-settlement squaring up. As
against this, in equity markets, investors just pay for their net positions at the
end of each settlement and the actual delivery trades settled are less than
10% of the total volume.
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The Debt Market in India Conclusion
Conclusion
Increasing Retail Participation with the help of Mutual
Funds
The prospects for the debt markets seem to be bright as volumes are
increasing every day with comparatively less volatility than the equity
markets. For the long-term development of the debt funds, mutual funds
have to now compete with the commercial banks. There will be a tough race
between both for the retail investors’ savings and the surplus funds with the
corporates. This is just the beginning for the mutual funds. As far as
attracting retail investments are concerned debt funds have only scratched
the surface. There is a vast potential in the debt funds to attract and hold
retail investors. Currently only institutions, banks and corporates are large
players in this market. The exposure to the retail investor is significantly low
due to lack of awareness. An informed investor will understand that fund
managers make better decisions for both, long-term and short-term plans.
The key to the development of the mutual fund industry is the education of
investors towards the various aspects of risk, return and diversification. Even
today bank deposits are perceived as the risk-free whereas these are mostly
totally unsecured deposits. Once the concept of risk and diversification is
embodied, one has to look at avenues of optimising returns through reduced
risk. That is where; mutual funds offer the best avenues for deployment.
The debt funds also need to upgrade their servicing standards to the level
of international banks. They have to further diversify their portfolio and
introduce electronic transfer of funds. They must also introduce lower
denominations of units in debt schemes so that more and more retail
investors are attracted to the debt fund schemes.
Investors with adequate appetite for safety, liquidity and tax benefits
would do well to invest in debt funds. With the pace for reforms in the mutual
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The Debt Market in India Conclusion
funds sector all set to increase by leaps and bounds the investors can look
forward to a wider and safer choice of investment avenues.
Policy changes in the Debt market
Over a long period of time the market has undergone a lot of
transformation due to the various measures taken by the government. Now,
debt instruments are traded on exchanges on screen-based terminals, private
placements of debt instruments are frequently seen. In spite of all the
positive changes that have so far taken place, there is still a long way to go
for the markets. The participation of the small investors is low; investor-
confidence in corporate debt is not what it should be, there are claims that
the government is maintaining low interest rates for its own benefit, stamp
duties are strangling some segments to death, financial institutions dominate
the market and the list goes on.
At the same time, it should also be said that the situation is undergoing a
steady change. Debt instruments traded in dematerialised form are exempt
from stamp duties, regulations relating to credit rating agencies have been
tightened and the need for Internet based trading has been realized. Also the
Securities Transaction Tax (STT) levied on the equities market in not levied
on the debt market. All these changes, together with those on the anvil, like
activating mechanisms for retailing of government securities and starting of
operations of the clearing corporation of India are likely to bring about a
welcome change in the prospects of the debt markets.
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The Debt Market in India Bibliography
Bibliography
Book Referred:
Debt Markets New Horizons – A. Suryanarayana
Websites Referred:
www.nseindia.com
www.bseindia.com
www.indiainfoline.com
www.fimmda.org
www.debtonnet.com
www.valuenotes.com
www.investorwords.com
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