Gilt-edged securities in India by G-7 Sec-C.pdf

8/10/2019 Gilt-edged securities in India by G-7 Sec-C.pdf

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Gilt-edged Securities in India

SUSHMAN DAS (22) CHINTAMANENI SATYA BHUSAN(35)MOIZ AKHTAR MIR(81)SWOYAN SATYENDU (92)

MOHD NAUMAN KHALID (182)

MONEY AND FINANCIAL MARKETS PROJECTECONOMICS HONOURS SEMESTER V - GROUP 7

SHRI RAM COLLEGE OF COMMERCEOCTOBER 2014


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Table of Contents

1.Acknowledgements.....................................................................................................5

2.Introduction.................................................................................................................6

3. Gilt-edged Securities: Features of Government Securities and type of GovernmentSecuritiesBy Sushman Das ..........................................................................................7

3.1)Instrument Development in Government Securities Market...............................9

3.2) Types of government Securities.........................................................................10

3.3)Dated Instruments...............................................................................................12

3.4)Forms of Central and State Government Securities...........................................14

3.5)Participants in Gilt-edged Securities Market......................................................15

3.6)Denomination of Government Securities...........................................................15

3.7)Prices & Yields...................................................................................................15

4. Auctions of Government Securities,Procedure for Application & Payment of InterestbyMoiz Akhtar Mir...........................................................................................................17

4.1)Auction of Government Securities ....................................................................17

4.2)How are the Government Securities issued? .....................................................18

4.3)Different types of auctions used for issue of securities ....................................18

4.4)Design of Government Securities Auction in India ..........................................22

4.5)Procedure for Application to purchase Government Securities .......................23

4.6)Payment of Interest in Government Securities .................................................23


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5.Minimum Subscription,Importance of Investing in Government Securities & Gilt Funds inIndiaby Md.Nauman Khalid.............................................................................................24

5.1)Minimum Subscription ...........................................................................................24

5.2)Importance of Investing in Government Securities Market....................................25

5.3)Gilt Funds:What are they? ..................................................................................26

5.4)Gilt Switching.........................................................................................................32

5.5)Gilt Funds in India ..................................................................................................32

5.6)Government Secuirites Market : Analysis & Assessment.......................................34

6. Developments in Government Securities Market in India by Chintamaneni SatyaBhushan.............................................................................................................................38

6.1)Policy Developments...............................................................................................39

6.1.1)Develoments in Primary Markets .....................................................................40

6.1.2)Reforms in Secondary Markets ........................................................................45

6.1.3)Developments in Market Infrastructure ...........................................................46

6.2)Developments at a Glance ......................................................................................48

7. Gilt-edged Securities in other countries : A Case Study of UKby Swoyan Satyendu..50

7.1)Gilt-edged Securities in other countries:A Case Study of UK ...............................50

7.2)A Brief History of British Gilt-edged Securities ....................................................51

7.3)Types of UK-GILT Securities..................................................................................52

7.4)Present Status of UK-Gilts Market..........................................................................58

8.Conclusion......................................................................................................................59


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1. ACKNOWLEDGEMENTS

We take this opportunity to express our profound gratitude and deep regards to our

guide Dr. Ritu Ranjan, for his exemplary guidance, monitoring and constant

encouragement throughout the course of this project. The blessing, help andguidance given by him time to time shall carry us a long way in the journey of life on

which we are about to embark.

He has shown the attitude and the substance of a genius. He continually andpersuasively conveyed a spirit of adventure in regard to research and an excitementin regard of teaching. Without his supervision this project would not have beenpossible.

Individual commitment to a group effort - that is what makes a team work. We are

also thankful to our team mates for their dedication and commitment towards theproject, where we all exchanged our own interesting ideas, thoughts and made it

possible to complete the project with all accurate information. All the team mateswere equally competent and co-operating thus making the preparation of this reporthassle-free and highly productive.

Last but not the least, to the tireless efforts of all researchers and economists who

work exceptionally hard to produce excellent study material for undergraduates likeus to benefit from their labour expand our knowledge about pertinent matters aboutthe country.

Getting deep insights into the importance of the Government Securities Market inIndia to realize national aspirations and to keep pace with the changing times hasbeen a tremendous journey for us.

Sushman DasChintamaneni Satya Bhushan

Moiz Akhtar MirSwoyan Satyendu

Mohd Nauman Khalid


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2. Introduction

The government securities market is at the core of financial markets in most countries. It deals withtradable debt instruments issued by the Government for meeting its financing requirements. Thedevelopment of the primary segment of this market enables the managers of public debt to raise

resources from the market in a cost effective manner with due recognition to associated risks. A vibrantsecondary segment of the government securities market helps in the effective operation of monetary

policy through application of indirect instruments such as open market operations, for whichgovernment securities act as collateral. The government securities market is also regarded as the

backbone of fixed income securities markets as it provides the benchmark yield and imparts liquidity toother financial markets. The existence of an efficient government securities market is seen as anessential precursor, in particular, for development of the corporate debt market. Furthermore, thegovernment securities market acts as a channel for integration of various segments of the domesticfinancial market and helps in establishing inter-linkages between the domestic and external financialmarkets.

Recognising the need for a well developed government securities market, the Reserve Bank, incoordination with the Government, initiated a series of measures from the early 1990s to deregulate themarket of administered price and quantity controls. Consequently, the government securities market haswitnessed significant transformation in various dimensions,viz.,market-based price discovery, wideningof investor base, introduction of new instruments, establishment of primary dealers, and electronictrading and settlement infrastructure. This,in turn, has enabled the Reserve Bank to perform its functionsin tandem with the evolving economic and financial conditions.

The government debt policy today emphasizes maintaining stable, sustainable,prudent, andmarket-oriented active debt management and broadening the investor base to develop a competitivemarket. The importance and role of the gilt-edged market has undergone a great change in the last

decade. The volume and timing of official debt sales has become a matter of public concern as monetarygrowth has come to be seen as a central aspect of economic management.Recent events like RBIsdecision to sell $2.3 billion in government debt through the unpopular 'multiple pricing' method in July2014 rather than through the more popular uniform pricing method have attracted criticism whilemeasures like introduction of inflation-indexed bonds have attracted applauds. Understanding of theinfluence of financial markets and of the importance of monetary growth has increasingly become morecrucial in the post-crisis world.

Major participants in the Government securities market historically have been large institutionalinvestors.However,with the various measures for development, the market has also witnessed the entryof smaller entities such as co-operative banks, small pension and other funds etc. These entities are

mandated to invest in Government securities through respective regulations.The Reserve Bank of Indiahas also taken several initiatives to bring awareness about the Government securities market amongsmall investors. These include workshops on the basic concepts relating to fixed income securities/

bonds like Government securities, existing trading and investment practices, the related regulatoryaspects and the guidelines.

Through this paper,we seek to analyze the vibrant Government securities market in India and its role asan instrument of participatory growth for citizens in the country.


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3. Gilt-edged Securities: Features of Government Securities andtypes of Government Securities

Government securities are tradeable debt-instruments issued by the government for meeting financialrequirements.The gilt-edged market refers to the market for Government and semi-Governmentsecurities,backed by the Government of India.Gilt-edged securities are bonds issued by certain nationalgovernments. The term is of British origin, and originally referred to the debt securities issued by theBank of England, which had a gilt (or gilded) edge. Hence, they are known as gilt-edged securities, orgilts for short. Today the term is used in the United Kingdom as well as some Commonwealth nations,such as South Africa and India.Colloquially, the term "gilt-edged" is sometimes used to denotehigh-grade securities, consequently carrying low yields, as opposed to relatively riskier, belowinvestment-grade securities.

The term gild-edged means of best quality. Government securities do not suffer from risk of defaultand are highly liquid as they can be easily sold in the market at their current price.The open marketoperations of the Reserve Bank of India are also conducted in such securities. The term "gilt account" is

also a term used by the Reserve Bank of India to refer to a constituent account maintained by a custodianbank for maintenance and servicing of dematerialized government securities owned by a retail customer.

Major participants in the Government securities market historically have been large institutionalinvestors. With the various measures for development, the market has also witnessed the entry of smallerentities such as co-operative banks, small pension and other funds etc. These entities are mandated toinvest in Government securities through respective regulations. However, some of these new entrantshave often found it difficult to understand and appreciate various aspects of the Government securitiesmarket. The Reserve Bank of India has, therefore, taken several initiatives to bring awareness about theGovernment securities market among small investors. These include workshops on the basic conceptsrelating to fixed income securities/ bonds like Government securities, existing trading and investment

practices, the related regulatory aspects and the guidelines.

Government securities are short term (usually called treasury bills, with original maturities of less thanone year) or long term (usually called Government bonds or dated securities with original maturity ofone year or more). In India, the Central Government issues both, treasury bills and bonds or datedsecurities while the State Governments issue only bonds or dated securities, which are called the StateDevelopment Loans (SDLs). Government securities carry practically no risk of default and, hence, arecalled risk-free gilt-edged instruments. Government of India also issues savings instruments (SavingsBonds, National Saving Certificates (NSCs), etc.) or special securities (oil bonds, Food Corporation ofIndia bonds, fertiliser bonds, power bonds, etc.). They are, usually not fully tradable and are, therefore,not eligible to be SLR securities.


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Pic : A Government of India Security Certificate


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3.1. Instrument Development in Government Securities Market:

The profile of government securities differs across countries in terms of (i) maturity; (ii) ways of fixingcoupon and principal payment; (iii) methods of coupon and principal settlement; and (iv) investororientation. An analysis of evolution of various instruments in the government bond markets shows that

normally countries in the nascent stage of development of government bond markets preferred toconcentrate exclusively on simple and standardised instruments. Over the years, they moved towards amix of conventional and, more advanced and complex instruments. The instrument development has

become increasingly more sensitive to various risks associated with trading in government bonds.

Most of the government securities markets in developed countries are characterised by instruments withtenors ranging from short to long-term. For instance, the US treasuries market primarily offers two typesof conventional government bonds, viz.,treasury notes (maturing between two and 10 years) and bonds(with maturity of 10 years or above) with a semi-annual coupon or interest payment. The 10-yearDiversification of available instruments encourages participation of varied investors, as differentcategories of investors require different kinds of instruments to meet their specific needs.

While banks require government securities for their asset liability management in addition tomaintaining the prescribed SLR, insurance companies and provident funds require long-terminvestments to match their liabilities. Prior to the reforms initiated in the early 1990s, most of thegovernment bonds were in the form of plain vanilla fixed coupon securities. Since 1994, the ReserveBank has been developing a range of instruments to cater to the diversified requirements and hedgingneeds of investors. These include zero coupon bonds, capital indexed bonds, floating rate bonds and

bonds with call and put options.


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3.2. Types of Government Securities:

State Development Loans:

State Governments also raise loans from the market. SDLs are dated securities issued through an auction

similar to the auctions conducted for dated securities issued by the Central Government (see question 3below). Interest is serviced at half-yearly intervals and the principal is repaid on the maturity date. Likedated securities issued by the Central Government, SDLs issued by the State Governments qualify forSLR. They are also eligible as collaterals for borrowing through market repo as well as borrowing byeligible entities from the RBI under the Liquidity Adjustment Facility (LAF).

Dated Instruments:These are generally fixed maturity and fixed coupon securities usually carrying semi-annualcoupon.These are called Dated Securities because these are identified by their date of maturity and thecoupon. Eg: 11.03% is a Central Government security maturing in 2012,which carries a coupon of

11.3% payable half-yearly.Dated Instruments include Fixed Rate Bonds,Floating Rate Bonds,ZeroCoupon Bonds,Capital-Indexed Bonds,bonds with Call/Put Options,special securities to Oil PSUs/FCIsand new Instruments like STRIPS.

Cash Management Bills:

Government of India, in consultation with the Reserve Bank of India, has decided to issue a newshort-term instrument, known as Cash Management Bills (CMBs), to meet the temporary mismatches inthe cash flow of the Government. The CMBs are issued for maturities less than 91 days.They are issuedat a discount and redeemed at face value at maturity. The tenure, notified amount and date of issue of theCMBs depends upon the temporary cash requirement of the Government. The announcement of theirauction is made by Reserve Bank of India through a Press Release which will be issued one day prior to

the date of auction. The settlement of the auction is on T+1 basis.These instruments are tradable andqualify for ready forward facility.First set of CMBs were issued on May 12, 2010.

Treasury Bills:

Treasury Bills(T-Bills)offer short-term investment opportunities,generally upto one year.At present,theGovernment of India issues 3 types of Treasury Bills through auctions,namely,91-day,182-day and364-day.There are no treasury bills issued by State Governments.Treasury bills are available for aminimum amount of Rs.25,000 and in multiples of Rs.25,000.Treasury bills are issued at a discount andredeemed at par.While 91-day T-bills are auctioned every week on Wenesdays,182-day and 364-dayT-Bills are auctioned every alternate week on Wednesdays.The RBI announces the exact dates ofauction,the amount to be auctioned and payment dates by issuing press releases prior to every

auction.Payment by allottees at the auction is required to be made by debit to their custodians currentaccount.Banks,Primary Dealers,State Governments,Provident Funds,Financial Institutions,InsuranceCompanies,NBFCs,FIIs(as per prescribed norms),NRIs and OCBs can invest in T-Bills.


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Government

Securities

StateDevelopment

Loans

DatedInstruments

Fixed RateBonds

Floating RateBonds

Zero CouponBonds

Capital-IndexedBonds

Bonds withCall/PutOptions

SpecialSecurities to

Oil-PSUs,FCI

New

Instruments likeSTRIPS

CashManagement

Bills

Treasury Bills


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3.3. Dated Instruments:

1) Zero-Coupon Bonds: Zero Coupon Bonds (ZCBs) were introduced on January 17, 1994. ZCBs,which do not have regular interest (coupon) payments like traditional bonds, are sold at a discount and

redeemed at par on final maturity. The ZCBs were beneficial, both to the Government because of thedeferred payment of interest and to the investors because of the lucrative yield and absence ofreinvestment risk.There were four issuances of ZCBs between 1994 and 1996

2)Partly-paid Stock:Par tly paid stock was introduced on November 14, 1994 whereby payment forthe Government stock was made in four equal monthly instalments. Designed for institutions withregular flow of investible resources requiring regular investment avenues, this instrument attractedgood market response and was actively traded. There was, however, only one more issue of partly

paid stock on June 24, 1996.

3) Floating-rate Bonds: Floating Rate Bonds (FRBs) were first issued on September 29, 1995 but

were discontinued after the first issuance due to lack of market enthusiasm.They were reintroduced onNovember 21, 2001 on demand from market par ticipants, with some modification in the structure.There were 10 issuances of the FRBs till October 9, 2004. Although there was initially anoverwhelming market response to these issuances, FRBs were discontinued due to the waning marketinterest reflected in the partial devolvement in the last two auctions on the Reserve Bank and PDs.Erosion in the market interest for FRBs at that time was, inter alia, due to strong credit pick-up andlow secondary market liquidity in FRBs. In the secondary market, liquidity in FRBs, is low due to (i)low trading interest of market participants in FRBs as such instruments, by design, are hedginginstruments and offer limited scope for trading gains;(ii) no reissuance of FRBs on account ofcomplexities associated with pricing; (iii) preference of commercial banks to place these bonds underheld to maturity (HTM) category, reducing the availability of bonds for trading; and (iv) complex

pricing method which deterred market participants from undertaking outright transactions in FRBs.

4)Capital Indexed Bonds: These are bonds, the principal of which is linked to an accepted index ofinflation with a view to protecting the holder from inflation. A capital indexed bond, with the principalhedged against inflation, was issued in December 1997. These bonds matured in 2002. Thegovernment is currently working on a fresh issuance of Inflation Indexed Bonds wherein payment of

both, the coupon and the principal on the bonds, will be linked to an Inflation Index (Wholesale PriceIndex). In the proposed structure, the principal will be indexed and the coupon will be calculated onthe indexed principal. In order to provide the holders protection against actual inflation, the final WPIwill be used for indexation.

5)Bonds with Call/ Put Options: Bonds can also be issued with features of optionality wherein theissuer can have the option to buy-back (call option) or the investor can have the option to sell the bond(put option) to the issuer during the currency of the bond. 6.72%GS2012 was issued on July 18, 2002for a maturity of 10 years maturing on July 18, 2012. The optionality on the bond could be exercisedafter completion of five years tenure from the date of issuance on any coupon date falling thereafter.The Government has the right to buyback the bond (call option) at par value (equal to the face value)while the investor has the right to sell the bond (put option) to the Government at par value at the timeof any of the half-yearly coupon dates starting from July 18, 2007.


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6)New Instruments like STRIPS: Steps are being taken to introduce new types of instruments likeSTRIPS (Separate Trading of Registered Interest and Principal of Securities). Accordingly, guidelinesfor stripping and reconstitution of Government securities have been issued. STRIPS are instrumentswherein each cash flow of the fixed coupon security is converted into a separate tradable ZeroCoupon Bond and traded. For example, when Rs.100 of the 8.24%GS2018 is stripped, each cash flow

of coupon (Rs.4.12 each half year) will become coupon STRIP and the principal payment (Rs.100 atmaturity) will become a principal STRIP. These cash flows are traded separately as independentsecurities in the secondary market. STRIPS in Government securities will ensure availability ofsovereign zero coupon bonds, which will facilitate the development of a market determined zerocoupon yield curve (ZCYC). STRIPS will also provide institutional investors with an additionalinstrument for their asset- liability management. Further, as STRIPS have zero reinvestment risk,

being zero coupon bonds, they can be attractive to retail/non-institutional investors. The process ofstripping/reconstitution of Government securities is carried out at RBI, Public Debt Office (PDO) inthe PDO-NDS (Negotiated Dealing System) at the option of the holder at any time from the date ofissuance of a Government security till its maturity. All dated Government securities, other thanfloating rate bonds, having coupon payment dates on 2nd January and 2nd July, irrespective of the

year of maturity are eligible for Stripping/Reconstitution. Eligible Government securities held in theSubsidiary General Leger (SGL)/Constituent Subsidiary General Ledger (CSGL) accounts maintainedat the PDO, RBI, Mumbai. Physical securities shall not be eligible for stripping/reconstitution.Minimum amount of securities that needs to be submitted for stripping/reconstitution will be Rs. 1crore (Face Value) and multiples thereof.


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3.4. Forms of Central and State Government Securities

These securities can be issued in three forms:1. Inscribed stock or stock certificate

2. Promissory note3. Bearer Bond

Bearer bonds are generally not issued in India and stock certificates are not popular with investors. Mostgovernment securities are in the form of a promissory note. Of course, promissory notes of a loan can beconverted into stock certificates of any other loan and vice versa.

Stock certificates have some benefits over promissory notes, such as, (i) the name of the holder of stockcertificate is registered in the books of Public Debt Office (PDO) and hence these are safer, (ii) these aresent to the applicant directly by registered post by the PDO, (iii) the half-yearly interest is directlyremitted to the holder by an interest warrant drawn at par on any treasury or State Bank of India branch

specified by the holder or is remitted by money order, if the holder so desires, and (iv) it can be sold bysinging the transfer for on the reserve of the certificate. Despite these advantages stock certificates arenot popular because their lack of quick transferability and negotiability, these cannot be transferred byendorsement. The procedure for their transfer is relatively more complex.


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3.5. Participants in Gilt-edged Securities Market:

Participants in government securities market belong to the following categories:

1.Central and State governments. Their holdings represent inter-government transfer of resources.

2.Banking Sector, comprising commercial banks and co-operative banks.

3.Insurance companies including both Life Insurance Corporation and general insurance companies.

4.Provident funds, both statutory and non-statutory

5.Other institutions including special financial institutions, joint stock companies, local authorities,

trusts, individuals and non-residents.

3.6. Denomination of Government Securities:

1.In case of Central Government Securities,the minimum is Rs.10,000 and trading takes place inmultiples of Rs.5 crores.

2.In case of State Government Securities,the minimum is Rs.1,000 and trading takes place inmultiples of Rs.1-5 crores.

3.Government Bonds-the minimum is Rs.5000 and trading takes place in its multiples.

3.7. Prices and Yields

Three types of prices are prevalent in gilt-edged securities market:

RBI prices. These are prices for deals with RBI. These are not cash prices. RBI publishes a price listfrom time to time for securities dealt in by it. These prices are so aligned that the yield on thesesecurities for the remaining maturity period is the same as on the bonds of similar maturity which arecurrently issued.

Prices prevailing in the secondary market at which deals take place between different operators.

Artificial or loaded prices fixed by the brokers for producing deals in securities. For helping banks toshow higher book profits the dealers buy depreciated securities at an inflated price above the market

price and sell the same amount of some other security to the bank again at inflated price so as toneutralize its loss on purchase. Such artificial prices distort computation of yield on securities.


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4.1. Auction of Government Securities

The Government of India issues debt securities to finance the Public Debt. Reserve Bank of Indiaconducts the auctions of the Government securities such as auctions of Treasury Bills and fixed couponearning dated securities, floating rate bonds, capital index bonds by following a pre-announced

half-yearly calendar. Dated securities are issued by either conducting yield-based auctions for issue ofnew securities wherein coupon rates emerge on the basis of competitive bidding, or price-based auctionsfor re-issue of existing securities. With the reform process initiated in the 1990s, auctioning governmentsecurities evolved out since the first auction of dated security was conducted on June 03, 1992.

Auction is a price building process driven by a competitive bidding process, wherein the seller receives acollective assessment of prospective empirical data on bidders behavior when different units of goodsget allocated at accepted bid prices. The importance of periodic empirical evaluation of bidding behaviorhelps reset the assumptions that go behind designing auctions, specially the traditionally evolved outcomplex designs like those of Treasury security auctions. As underlying raw bid price distributionsgovern a priori the bidders demand and information about quantum and price, an empirical

understanding of the bid data in the form of panel data analysis of locally differentiated form of a varietyof the empirical frequency distributions, concentration analysis of bids as also evidences of localizedmean reverting bell shaped (near-normal) pricing behavior, provide valuable insights about overall

performance of the auction design.

The major participants in these auctions in India are the banks, insurance companies, mutual funds andprimary dealers. Banks and insurance companies participate actively in the auctions to meet theirstatutory requirements while primary dealers participate in the auction for market making and

positioning the securities for further sale in the secondary market. Auction data reveal the competitivebehaviour of various investor-groups in terms of success ratios, bid shading, total amount of bondsdemanded, bid amount distribution as against respective bid prices, dispersion as well as concentration

of bids around multi-modal bids that could be expected within a heterogeneous cluster of bidders. Panelempirical analysis for a similar set of auctions would elucidate the bidding pattern and help evaluate theoverall efficiency of the auctioning process.


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4.2. How are the Government Securities issued?

Government securities are issued through auctions conducted by the RBI. Auctions are conducted on theelectronic platform called the Public Debt Office Negotiated Dealing System (PDO-NDS).Commercial banks, scheduled urban cooperative banks, Primary Dealers, insurance companies and

provident funds, who maintain funds account (current account) and securities accounts (SGL account)with RBI, are members of this electronic platform. All members of PDO-NDS can place their bids in theauction through this electronic platform. All non-NDS members including non-scheduled urbanco-operative banks can participate in the primary auction through scheduled commercial banks orPrimary Dealers. For this purpose, the urban co-operative banks need to open a securities account with a

bank / Primary Dealer such an account is called a Gilt Account. A Gilt Account is a dematerializedaccount maintained by a scheduled commercial bank or Primary Dealer for its constituent (e.g., anon-scheduled urban co-operative bank).The RBI, in consultation with the Government of India, issues an indicative half-yearly auction calendarwhich contains information about the amount of borrowing, the tenor of security and the likely periodduring which auctions will be held. A Notification and a Press Communique giving exact particulars of

the securities, viz., name, amount, and type of issue and procedure of auction are issued by theGovernment of India about a week prior to the actual date of auction. RBI places the notification and aPress Release on its website (www.rbi.org.in) and also issues an advertisement in leading English andHindi newspapers. Information about auctions is also available with the select branches of public and

private sector banks and the Primary Dealers.

4.3. Different types of auctions used for issue of securities:

Prior to introduction of auctions as the method of issuance, the interest rates were administratively fixed

by the Government. With the introduction of auctions, the rate of interest (coupon rate) gets fixedthrough a market based price discovery process.

An auction may either be yield based or price based.i. Yield Based Auction: A yield based auction is generally conducted when a new Government securityis issued. Investors bid in yield terms up to two decimal places (for example, 7.85 per cent, 7.87 per cent,etc.). Bids are arranged in ascending order and the cut-off yield is arrived at the yield corresponding tothe notified amount of the auction. The cut-off yield is taken as the coupon rate for the security.Successful bidders are those who have bid at or below the cut-off yield. Bids which are higher than thecut-off yield are rejected. An illustrative example of the yield based auction is given below:


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ii. Price Based Auction: A price based auction is conducted when the Government of India re-issuessecurities already issued earlier. Bidders quote in terms of price per Rs.100 of face value of the security(e.g., Rs.101.02, Rs.100.95, Rs.99.80, etc., per Rs.100/-). Bids are arranged in descending order and thesuccessful bidders are those who have bid at or above the cut-off price. Bids which are below the cut-off

price are rejected. An illustrative example of price based auction is given below:


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Depending upon the method of allocation to successful bidders, auction could be classified as UniformPrice based and Multiple Price based. In a Uniform Price auction, all the successful bidders arerequired to pay for the allotted quantity of securities at the same rate, i.e., at the auction cut-off rate,

irrespective of the rate quoted by them. On the other hand, in a Multiple Price auction, the successfulbidders are required to pay for the allotted quantity of securities at the respective price / yield at whichthey have bid. In the example under (ii) above, if the auction was Uniform Price based, all bidders wouldget allotment at the cut-off price, i.e., Rs.100.20. On the other hand, if the auction was Multiple Price

based, each bidder would get the allotment at the price he/ she has bid, i.e., bidder 1 at Rs.100.31, bidder2 at Rs.100.26 and so on.

An investor may bid in an auction under either of the following categories:


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i. Competitive Bidding: In a competitive bidding, an investor bids at a specific price / yield and isallotted securities if the price / yield quoted is within the cut-off price / yield. Competitive bids are made

by well informed investors such as banks, financial institutions, primary dealers, mutual funds, andinsurance companies. The minimum bid amount is Rs.10, 000 and in multiples of Rs.10, 000 thereafter.Multiple bidding is also allowed, i.e., an investor may put in several bids at various price/ yield levels.

ii. Non-Competitive Bidding: With a view to providing retail investors an opportunity to participate inthe auction process, the scheme of non-competitive bidding in dated securities was introduced in January2002. Non-competitive bidding is open to individuals, HUFs, RRBs, co-operative banks, firms,companies, corporate bodies, institutions, provident funds, and trusts. Under the scheme, eligibleinvestors apply for a certain amount of securities in an auction without mentioning a specific price /yield. Such bidders are allotted securities at the weighted average price / yield of the auction. In theillustration given under (ii) above, the notified amount being Rs.1000 crore, the amount reserved fornoncompetitive bidding will be Rs.50 crore (5% of the notified amount). Noncompetitive bidders will beallotted at the weighted average price which is Rs.100.26 in the given illustration. The participants innon-competitive bidding are, however, required to hold a gilt account with a bank or PD. Regional Rural

Banks and co-operative banks which hold SGL and Current Account with the RBI can, also, participateunder the scheme of non-competitive bidding without holding a gilt account.

In every auction of dated securities, a maximum of 5 per cent of the notified amount is reserved fornon-competitive bids. In the case of auction for Treasury Bills, the amount accepted for non-competitive

bids is over and above the notified amount and there is no limit placed. However, non-competitivebidding in Treasury Bills is available only to State Governments and other select entities and is notavailable to the co-operative banks. Only one bid is allowed to be submitted by an investor eitherthrough a bank or Primary Dealer. For bidding under the scheme, an investor has to fill in anundertaking and send it along with the application for allotment of securities through a bank or aPrimary Dealer. The minimum amount and the maximum amount for a single bid is Rs. 10, 000 and Rs.2 crore respectively in the case of an auction of dated securities. A bank or a Primary Dealer can chargean investor up to maximum of 6 paise per Rs.100 of application money as commission for renderingtheir services. In case the total applications received for non-competitive bids exceed the ceiling of 5 percent of the notified amount of the auction for dated securities, the bidders are allotted securities on a

pro-rata basis.


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4.4. Design of Government Securities Auction in India

The auction procedure followed by RBI is the commonly used multiple-price sealed-bidauction. Thebidders electronically submit sealed competitive bids specifying the price they are willing to pay for aparticular amount of debt security. For dated securities auctions, investors belonging to eligible

categories may also submit non-competitive bids up to a ceiling of Rs.2 crore without specifying price.These bids are accepted at the average price of bids accepted in the auction. The total amount ofnon-competitive bids is subtracted from the total issue-size for allocation to competitive bids. An initialceiling of 5 per cent of issue size is kept on the total non-competitive amount but the ceiling limit israrely touched. Once all the bids are received during the bidding time, RBI allocates the competitive

bids starting from highest price bid and moving down until entire amount is allocated. In a multipleprice-auction, each successful bidder pays the price stated in his bid. In case of uniform price auctions,all successful bidders pay the same price that is cut-off price at which the market clears the issue. Themethod of auction is announced well in advance in the issue announcement notification.

In India, the banks and insurance companies are required to invest in government securities as per

statutory reserve requirements. Main auction bidding strategy of the banks and the insurance companiesis to price their bids in such a way that it is beneficial to them than buying from secondary market tomeet their growing reserve requirement. Their buying demand in secondary market may increase the

price in secondary market. Therefore, these bidders being long-term investor have to price their bidsbased on their own values of the security in longer time horizon as against the bidding strategy of otherbidders like the primary dealers who acquire securities in auction mainly to sale later in the secondarymarket and thus their bid pricing would have valuation of shorter-term. The intermediaries like the

primary dealers would like to earn quick profit by acquiring securities in the primary auctions andselling in the secondary market.On the other hand, primary dealers have the obligation of underwriting the auction issue and get theincentive in the form of underwriting commission. Thus, the primary dealers would have of different bid

pricing strategy. Moreover, on account of size (capacity) constraint, the bidding strategy of the primarydealers would be different than the banks and insurance companies. The primary dealers are smallerentities as compared to banks and insurance companies, which have higher financial capacities.

India follows the by and large universally adopted auction method with most of the auctions beingmulti-price (or discriminatory price) auctions. Uniform price auctions were also undertaken in the past(RBI Annual Report, 2002-03). Countries that follow regularly similar auction designs include the UK,Italy, Canada, Germany and Sweden (KeloharjuMet al,2005).Even though the traditional Treasury procedures have theoretical drawbacks, it is difficult to prescribethe best way to auction government securities. The Treasury is obliged to provide easy entry into the

auctions, broadening, where possible, the ownership of the public debt; and it must adhere closely to acrowded schedule of borrowing. While the Treasury may not always get the top revenue amounts for theissuances, the prevailing auction system help the conduct of monetary policy and ensure a deep andactive secondary market in government obligations.


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4.5. Procedure for Application to purchase GovernmentSecurities

Offers for the purchase of Government Securities are submitted by interested persons in the form of anapplication (including electronic form) as specified by the Reserve Bank of India from time to time.Foreign Institutional Investors, Non-Resident Indians and Overseas Corporate bodies predominantlyowned by NRIs, however, submit their applications through the designated banks which have beenauthorized by the Reserve Bank of India to act as a banker to FIIs or authorized to deal in ForeignExchange as the case may be. Applications duly filled in are then submitted to the office of ReserveBank of India or any other institution notified for the purpose, before the close of banking hours on thespecified date/s. Interested persons submitting applications for purchase of Government Securities arethen bound by the terms and conditions as indicated in the specified form of application.

4.6. Payment of Interest on Government Securities

Interest on Government Securities is paid at the Public Debt Offices of the Reserve Bank of India atAhmedabad, Bangalore, Bhubaneswar, Kolkata, Chennai, Guwahati, Hyderabad, Jaipur, Kanpur,Mumbai, Nagpur, New Delhi, Patna and Thiruvananthapuram, or any other Office of the Reserve Bankof India notified for this purpose from time to time, or at branches of State Bank of India and Associate

banks conducting Government business or at any Treasury or Sub Treasury served by the Public DebtOffice where there is no Office of the Reserve Bank of India or branch of State Bank of India or itsassociates except the States of Jammu & Kashmir and Sikkim. Interest on securities held in Bond LedgerAccount with any of the Offices of the Reserve Bank of India/Agency as specified by the Reserve Bankof India in this behalf, is paid at such Office/Agency.

Interest is paid after rounding off the amount to the nearest whole rupee. For this purpose, amount ofinterest less than fifty paise is ignored and fifty paise or more is rounded off to the next rupee.


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5.1. Minimum Subscription

Section 69 of the Companies Act, 1956 specifies that no allotment shall be made of any share capital ofa company, offered to the public for subscription, unless the amount stated in the prospectus as theminimum amount has been subscribed. As per Schedule II to the Companies Act, 1956, the issuer is

required to make a declaration about refund of the issue, if minimum subscription of 90% of the issuesize is not received.

However, for public issue of non-convertible debentures (NCDs), no such requirement is specified underCompanies Act, 1956. Further, as per Regulation 12 of SEBI (Issue and Listing of Debt Securities)Regulations, 2008 (SEBI ILDS Regulations), the issuer may decide the amount of minimumsubscription, which it seeks to raise from public through issue of NCDs and disclose the same in theoffer document.

Companies Act, 2013 and (draft) Rules made there under also do not specify the quantum of minimumsubscription needed in case of public issues (both for equity and debt), but only requires disclosure of

the same in the offer document.

In view of the above, it has been decided that the minimum subscription for public issue of debtsecurities shall be specified as 75% of the base issue size for both NBFCs and Non NBFC issuers.Further, if the issuer does not receive minimum subscription of its base issue size (75%), then the entireapplication monies shall be refunded within 12 days from the date of the closure of the issue. In theevent, there is a delay, by the issuer in making the aforesaid refund, then the issuer shall refund thesubscription amount along with interest at the rate of 15% per annum for the delayed period.

However, the issuers issuing tax-free bonds, as specified by CBDT, shall be exempted from the aboveproposed minimum subscription limit.


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5.2. Why Should One Invest in Govt. Securities?

Government securities are issued by RBI on behalf of Government of India and state governments inIndia. Government securities have always been considered as an investment option which is suitableonly for banks, financial institutions and corporate. However, the fact remains that these securities are

one of the best options for investment for common investors as well. Unfortunately retail investors havenot shown interest in these securities due to lack of information and understanding about process ofinvestment in government securities. However, things seem to be changing gradually. Both regulator i.e.RBI and banks are pitching these products as an attractive option for retail investors as well. Retailinvestors can invest in government securities both through primary market as well as secondary marketroute. RBI allows retail investors to offer their bids in auction of government securities throughnon-competitive bidding. On the other hand, banks have started providing option to invest in thesesecurities with IDBI Bank being the first bank to provide an online option for investment in governmentsecurities.

There are many positives of investing in government securities. Though there are various reasons for

investing in government securities, five most obvious reasons are as follows:

Government Securities are risk free:Government securities have always been an ideal example of riskfree security. Though this is being widely debated in wake of what is going on in Greece and otherEuropean countries, the fact remains that government securities in Indian context are risk free. Forinvestors looking for risk free investment, government securities are best option.

Government Securities offer decent yield for longer duration: Currently government securities offeryield ranging from 8.5% to 9%. The 8.83% Government Bond maturity in 2041 is having an yield ofclose of 8.6% while GOI FRB 2020 offers an yield of 9.35% currently. These returns are as good as the

bank deposits; however unlike bank deposits these deposits are available for longer duration. Today an

investor can block his money for 30 years in a government security while in bank deposits themaximization duration is 10 years. If you are assured for 8.5% yield for 30 years while investing ingovernment securities, it is indeed a good return for long term.

Government Securities offer prospect of capital gains: There is an inverse relationship betweenbond price and interest rate. It is believed that rate of interest in India has already peaked. Thegovernment bonds are offering decent yield currently for very long period of time. If an investor parksmoney in these bonds now, there is a prospect of good returns as and when interest rate falls. The priceof these bonds will go up when interest rate falls and the investment can exist from his investment in

bonds by booking good capital gains.

Government Securities have good liquidity:Government securities can be bought and sold like equityproducts on NDS-OM (Negotiated Dealing System- Order Matching) platform of CCIL. The liquidity inthese securities is good as banks and financial institutions regularly participate in this market. As retailinvestors, trading can be done through a SGL member of RBI. Many banks and primary dealers providethis facility of trading in government security.


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Government Securities help diversify portfolio: Last but not the least with addition of governmentsecurity in portfolio, the portfolio gets well diversified and the risk gets mitigated because governmentsecurities are considered as risk free.

5.3. GILT Funds

Simply put, gilt funds are mutual funds that predominantly invest in government securities (G-Secs).Unlike conventional debt funds that invest in debt instruments across the board, gilt funds target just agiven category of debt instruments i.e. G-Secs. The latter are securities issued by the Reserve Bank ofIndia (RBI) on behalf of the Government of India. Being sovereign paper, they do not expose investorsto credit risk. Since the market for G-Secs (as is the case with most debt instruments) is largelydominated by institutional investors, gilt funds offer retail investors a convenient means to invest inG-Secs. Depending on their investment horizon, investors can choose between short-term and long-termgilt funds.

5.3.1. Advantages of GILT Funds:

Less Credit Risk: As they are backed by govt. there is almost no credit risk.

Tax Benefits: Investors should note that not only are these returns higher than those offered bytraditional investment avenues like bank fixed deposits, but they are also more efficient in terms of tax

benefits. GILT funds are given the same treatment as debt funds and thus are eligible for the benfits ofindexation on capital appreciation.

Open to retail investors: Only institutional investors can invest in G-sec market but GILT fundsprovide retail investors a low cost way to invest in G-sec, which otherwise was open only to largeplayers.

Easiness: Just like stocks and bonds, govt securities are traded in both the primary and the secondarymarket. This means that as a small individual investor it is possible to do the buying selling and tradingof securities yourself.

Diversification: Investment in Gilt funds provides for effective diversification.

5.3.2. Disadvantage of GILT Funds:

Interest rate risk: If the interest rate increases the price of Gsec fal which is a big risk to the investor.

Not Liquid: Investors have to keep in mind that git funds are not as liquid as other debt funds as G-secsare not actively traded Moreover, if there is a sudden redemption pressure, fund houses will have noother means but resort to a distress sale. Also, investors must avoid those gilt funds that have a smallcorpus becaise these funds are not able to perform well in case of sudden volatiity in interest rates and if


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there is a sudden redemption pressure. Underlying securities are illiquid as they are not frequently traded.So if the fund manager opts for distress sell, to relieve redemption pressure, the fund may suffer loss.

Mostly ldeal for short term investment: Makes ideal short-term investment as most of the funds tendto be volatie over longer investment time frame and equity scores over gilt in the long term.

Complicatlons: The paperwork and intricacies of these transactions can be very complicated. however,so gilt funds provide the benefit of pooling money with other investors and having larger buyers takecare of the transaction logistics.

5.3.3. Trends:

The most noticeable tends in the gilt market in recent years have been:

10 Year Bond Yield in percentage


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0

10

2030

40

50

6070

80

90

1980-81 1990-91 1996-97 2000-01 2004.05 2006-07

(BE)

Centre States TotalTrends in Govt Debt to GDP Ratio

0.0

20.0

40.0

60.0

80.0

100.0

1950-51 1980-81 1990-91 2000-01 2006-07

(BE)

Domestic Liabilities External Liabilities

Trend in External Borrowings


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5.3.4. Why are gilt funds in the news?

First, lets understand the relationship between bond prices and the interest rates. The two are inverselyrelated. Hence a fall in interest rates, leads to a rise in bond prices. In racent times, the RBI hasundertaren a series of rate cuts to infuse liquidity into the system. The falling interest rates havetranslated into an appreciation in prices of long-term bond; and G-secs alike. Expectedy, funds that are

invested in such secuities have benefited.

Average maturity:

Mostly, the average maturity and duration of such funds is on the higher side. Average maturity indicatesthe tenor of a portfolio and duration measures how sensitive the price of a fixed income security is inrelation to change in interest rates. While the investment objective does not define the average maturity,typicaly it ranges from a low two-year to as high as 15 years in some cases. The maturity of gilts isdefined by the DMO is as follows: short 0-7 years, medium 7-15 years and long 15 years+. Gilts with amaturity of less than three years are also referred to as ultra short, whie the new gilts issued since 2005with a maturity of 50 years have been referred to as ultra long.

Advisability of investment duration:In case of bonds, if interest rates rise, bond prices fall and vice-versa. Let's say there is a 10-year bondissue in Apri 2012 with an annual coupon of 8% and face value of Rs.100. If interest rates were to belowered in the next couple of months, subsequent bond issues of 10-year tenor are likely to have a lowercoupon rate. Now, this wil increase the demand for the former 8% corpon bond, which now has aresidual mattrity of around 9 years: hence, the price would increase.

Also, the longer the duration, the higher would be the impact on prices due to change in interest rates.This happens simply because higher duration means the matuity date of the bond or portfolio of bondsis farther away (from any new bond issuances today) and hence, the advantage of the relatively higherirterest rate is more. In the above example, if the residual maturity of the 8% coupon bond was only oneyear, the advantage of a comparatively higher coupon will be for another year, Iimiting the price rise.Keep in mind though that this is also true in case the reverse happens. So if interest rates rise, bond

prices will fall and the impactor extent of damage will be greater where a fund has a high duration. Inthe past, gift funds have seen negative returns in rising rate environment.

How are these investments taxed?

Simiar to any other Debt Fund, Dividends are Tax Free in the hands of the investor. Units if held for aperiod of one year & above are eligble for indexation benefits as per the current tax ruling. lf you sell theunit in less than a year, the retuns are added to your income and taxed according to the slab you fallunder (short-term capital gains tax). If you sell it after a year long-term capital gains tax is applied. Itshould be noted that these are debt funds and not subject to the securities transaction tax.

How investing in GILT Fund is a better investment than investing in Fixed Deposits?

FD is for an investor with low risk appetite and who wants a stable fixed return. In a gilt fund one couldgenerate higher than FD returns but there is an element of risk due to movement in interest rates in themarket. Redemption from a GILT fund after a certain period (in our case one month) would not attractany exit load thus the investor has the option of redeeming the money without any additional charges


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unlike an FD where there could be a penalty for premature withdrawal. FD as per current income taxrules is sutject to a tax as per the applicable income tax bracket. However any gains from a gilt fund isconsidered as capital gains and hence taxed at a lower rate. Investment in an FD does involve an elementof credit risk as one relies on the ability of the bank to repay the FD as per schedule.

What major events affect the gilt funds performance in a big way?

I. RBI monetary poicyII. Supply / Maturity of government debtIII. Inflation & Inflationary expectationsIV. Economic growth outlookV. Deposit Growth/Credit growthVI. Global bond yields

When do these investments perform well?

Gilt funds give good returns when other asset classes like equity are not doing well but to investsuccessfuly in gilt funds, it is essertial to watch the economic indicators that can predict the decrease ininerest rates. Some essential factors leading to interest rate reduction are peaking of inflation, reductionin IIP (Index of Industrial Production), slow GDP growth and likelihood of reduction in corporateearnings. At the same time you must also consider your capacity to take risk, goals and funds trackrecord you are investing in. Investors would do well to keep an eye on indicators that can be precursorsto a fall in interest rates. A slowdown in GDP growth, rising inflation, a decline in IIP (Index ofIndustrial Production) and expectations of a fall in corporate earnings, to name a few. Broady speaking,a situation when inerest rates have peaked and a downturn seems imminent, would be an opportune timeto invest in gilt funds. Of course, investors must understand that to make the most of their gilt fundinvestments, being invested for the long haul (to cover an interest rate cycle) is important.

Are gilt funds really risk free?

While a gilt fund is sometimes thought of as being free of any risk, this is not strictly the case. Many ofthese types of funds are structured to include investments that carry a variable or floating rate of interest.This means that if the average interest rate should fall, the amount of returns generated for the fund may

be less than anticipated. From this perspective, the investor in a gilt fund does carry the risk of possiblymaking less from the investment than originaly projected. Depending on how severe the shift in interestrates happen to be, this could mean the investor would do better to withdraw and invest in a differenttype of mutual fund.

Increasingly, gilt funds are being promoted by fund houses and investment advisors, by emphasising ontheir risk free nature. That isnt entirely correct. We have already discussed how the underlyinginstruments i.e. G-Secs do not expose investors to any credit risk. However, that doesnt make gilt funds,risk free investment avenues in the conventional sense. Unlike small savings schemes wherein investorsenjoy both safety of capital and assured returns, gilt funds are not equipped to offer assured returns.For instance, investments in gilt funds are vulnerable to interest rate risks. When interest rates rise,

prices of govemment securities fall; this in turn has an adverse impact on the performance of gilt funds.Typicaly, higher the fund's average maturity, more it is prone to volatility.


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A security is termed as liquid, if it can be easily bought and sold. It can be broady stated that higher theliquidity, lower is the risk. A gilt fund can be invested in a G-Sec paper which isnt actively traded i.e. itis illiquid. Now consider a scenario wherein to meet redemption pressure, the fund manager is forced tomake a distress sale i.e. incur a loss. This in turn will adversely affect the fund's performance.

One strong benefit of a gilt fund that does limit volatility is that the investments acquired for the fundtend to be covered with some type of investment insurance. What this means is that even ifcircumstances occur that preclude the delivery of any type of retum from the fund, investors are highlylikely to at least recoup the original contribution. Since trade laws and regulations vary from one nationto the next, it is important to review the terms and conditions associated with a particular gilt fund andfind out exactly what type of protections are in place before choosing to participate in the fund.

What should investors do?

The question is - should investors consider investing in gilt funds? That would ideally depend on their

risk appetite, investment objective and existing portfolio, among a host of other factors. An investmentavenue that is apt for one investor could be grossly unsuitable for another. Therefore, investors would dowell to consult their investment advisors/financial planners to determine the suitabiity of gilt funds intheir portfolios. Price change in long duration bonds result in sharp moves in net asset value. Of course,if you hold the fund for the stated average maturity, you are likely to eam the yield on the securities andyou will not lose money, but that can mean remaining invested for as long as 10 years. Some gilt fundshave an exit load extending up to a year. If you are looking for accrual income from fixed income, suchfunds are not for you.

Thus, the factors an investor considers in selecthg the 'Best Gilt Fund' are:1. Expense ratio2. Loadcharges and load period3. Past Performance (though not an indicator for future performance)4. Fund size (at times a very large fund wodd be a disadvantage in case of extreme volatility)


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5.4. Gilt-Edged Switching

It is the selling and repurchasing of certain high grade stocks or bonds to captue profits. Gilt-edgedswitching involves gilt edged security, which can be highgrade stodr or bond issued by a financialystable company such as the Blue Chp companies or by certain governmems. They are considered to be

low-risk investments because they are backed by strong, established entities. Gilt edged secuities aregeneraly inversely Iirked to interest rates, and therefore experience price fluctuations.

Git-edged switching is utiized by governments like those of the United Kingdom, South Africa andIreland. An example of a Gilt-edged switching is selling one bond in favor of another one.Higher-yielding bonds may increase the potential for profit. Gilt edged switdiing may also involveselling one bond at a discount in order to purchase a more favorably yielding investment.

5.5. GILT Funds in INDIA

The first gilt fund in India was set up in December 1998. The Reserve Bank of India is the governingbody of al gilt funds ever since. The gilt funds provide to the investors the safety of investments made ingovernment securities and better returns than direct investments in these securities through investing in avariety of government securities yielding varying rate of returns. Gilt funds, however, do run the risk.Govemment securities mean and include central government dated securities, state governmentsecurities and treasury bills.

Reserve Bank and the Government Securities Market Legal Framework

Reserve Banks operations in the government securities market are governed by Sections 20, 21 and 21Aof the Reserve Bank of India Act, 1934. Under these provisions, the Reserve Bank is entrusted with thefunction of management of public debt and issue of new loans of the Union Government and the StateGovernments. The legal framework for Reserve Banks conduct of open market operations is providedunder Section 17(8) of the Reserve Bank of India Act, 1934, under which the Reserve Bank is authorisedto purchase and sell securities of the Union Government or a State Government of any maturity and thesecurity of a local authority specified by the Central Government on the recommendations of the CentralBoard of the Reserve Bank. Central Government securities are used by the Reserve Bank for its openmarket operations and liquidity adjustment facility (LAF). Effective April 3, 2007, the StateDevelopment Loans were also permitted as eligible securities for LAF operations. The new ChapterIII-D of the Reserve Bank of India (Amendment) Act, 2006 has empowered the Reserve Bank todetermine policy relating to interest rate products and regulate the agencies dealing, inter alia, insecurities.

The Reserve Bank derives its regulatory power over the government securities market from Section 16of the Securities Contract (Regulation) Act (SCRA), 1956, amended in March 2000, under which theGovernment has delegated the powers exercisable by it to the Reserve Bank. The Reserve Bank is, thus,authorised to regulate dealings in government securities, money market securities, gold related securitiesand securities derived from these securities as also ready forward contracts in debt securities.


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3. Funds Insist faculty: The gilt funds are given the facility of tansfer of funds from one center toanother under the Remittance Facility Scheme of the Reserve Bark. The gilt funds are alsogiven the facility of clearing of cheques arising out of government securities transactions,tendered at the Resenre Bank counters.

4. Access to call market: Gilt funds can access the call money marketas lenders.

5. Ready forwards: The Reserve Bank of India will also recommend to the Government of Indiato permit the gilt funds to undertake ready forward transactions in Government securitiesmarket.

5.6. GOVERNMENT SECURITIES MARKET IN INDIA: ANALYSISAND ASSESSMENT

An assessment of the impact of the measures taken to develop the government securities market sincethe early 1990s reveals significant growth of the market in terms of both size and liquidity. Theoutstanding stock of government securities has increased significantly, both in absolute terms and inrelation to GDP, in tandem with the growing financing requirement of the Government. Significantchanges in the primary market have also been observed in terms of wider participation and better pricediscovery. The system of PDs has emerged as an important element, both in the primary and secondarysegments of the government securities market.

Magnitude of Government Securities

With the phasing out of ad hoc Treasury Bills and earmarking of small saving collections for the States,the Central Government has been financing its deficit largely through market borrowings. Accordingly,the share of market borrowings in financing Central Governments gross fiscal deficit increased toaround 70 per cent in 2005-06 from around 18 per cent in 1990-91. The share of market borrowings infinancing the gross fiscal deficit of the State Governments, however, showed a modest increase onaccount of availability of other sources of financing such as small savings. As a result, market

borrowings financed around 46 per cent of combined gross fiscal deficit of the Centre and States in2005-06 as compared with around 20 per cent in 1990-91. Accordingly, the outstanding stock of both theCentral and State Governments securities has increased significantly over the years. Implementation ofthe MSS from 2004-05 has also contributed to the growth of outstanding government securities in recentyears .


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Table 5.6: Weighted Average Interest Rate on

Government Securities

(Per cent)

Year Centre States

1 2 3

1990-91 11.4 11.5

1991-92 11.8 11.8

1992-93 12.5 13.0

1993-94 12.6 13.5

1994-95 11.9 12.5

1995-96 13.8 14.0

1996-97 13.7 13.8

1997-98 12.0 12.8

1998-99 11.9 12.4

1999-00 11.8 11.9

2000-01 11.0 11.0

2001-02 9.4 9.2

2002-03 7.3 7.5

2003-04 5.7 6.1

2004-05 6.1 6.4

2005-06 7.3 7.6


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6. DEVELOPMENTS IN GOVERNMENT SECURITIES MARKET ININDIA

The evolution of the government securities market in India has been in line with the developmentsin other countries. Slow development of the market in the 1970s and the 1980s was shaped by the need

to meet the growing financing requirements of the Government. This essentially resulted in financialrepression as progressively higher statutory requirements were stipulated, mandating banks to invest ingovernment securities at administered interest rates. Although this captive financing provided low costresources to the Government, it impeded the development of the market and distorted the interest ratestructure. Furthermore, such arrangements, along with automatic monetisation of Government deficits,hampered the conduct of monetary policy.Recognising the need for a well developed governmentsecurities market, the Reserve Bank, in coordination with the Government, initiated a series of measuresfrom the early 1990s to deregulate the market of administered price and quantity controls. Consequently,the government securities market has witnessed significant transformation in various dimensions, viz.,market-based price discovery, widening of investor base, introduction of new instruments, establishmentof primary dealers, and electronic trading and settlement infrastructure. This, in turn, has enabled the

Reserve Bank to perform its functions in tandem with the evolving economic and financial conditions.

Wide ranging reforms in the government securities market were largely undertaken in response to thechanging economic environment. Increased borrowing requirements of the Government, stemming fromhigh fiscal deficits, had to be met in a cost effective manner without distorting the financial system. Theunderlying perspective of the reform process was, therefore, to raise government debt at market relatedrates through an appropriate management of market borrowing. There was also a need to develop a

benchmark for other fixed income instruments for the purposes of their pricing and valuation. An activesecondary market for government securities was also needed for operating monetary policy throughindirect instruments such as open market operations and repos. Reforms, therefore, focussed on thedevelopment of appropriate market infrastructure, elongation of maturity profile, increasing the width

and depth of the market, improving risk management practices and increasing transparency.

Governments issue securities with maturities ranging from less than a year to a very long-term stretchingup to 50 years. Typically, short-term maturities up to one year, viz., Treasury Bills, form a part of themoney market and facilitate the Government's cash management operations, while bonds with maturitiesmore than a year facilitate its medium to long-term financing requirements.

As stipulated under the Fiscal Responsibility and Budget Management Act, 2003, the Reserve Bank haswithdrawn from participating in the primary market for government securities from April 1, 2006. Theincreasing move towards fuller capital account convertibility as recommended by the Committee onFuller Capital Account Convertibility (FCAC) (Chairman: Shri S.S. Tarapore) would necessitate

measures that promote greater integration of the domestic financial markets with global markets. Thedeepening of the government securities market is, therefore, essential not only for transmission of policysignals but also for developing the derivatives market which would meet future challenges thrown up byfurther liberalisation of the capital account. Moreover, an environment of freer capital flows will alsonecessitate widening of the government securities market with further persification of the investor base.


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6.1. POLICY DEVELOPMENTS

The development of the government securities market in India in the pre-reform period was mainlyconstrained, like in most developing countries, by almost unlimited automatic monetisation of theCentral Government budget deficits, captive investors (predominantly banks and insurance companies)

and administered coupon rates on government securities at artificially low levels. As a result, thesecondary market for government securities was almost nonexistent. This impinged on the pricediscovery process, which is crucial for the development of any market. Since interest rates were keptlow in order to ensure low cost of Government borrowing, real rates of return remained negative forseveral years. Artificially low yields on government securities affected the interest rate structure in thesystem. In order to compensate for low yield on government securities, banks charged higher interestrates to the commercial sector.

Higher interest rates for the private commercial sector not only adversely impacted investment activityand economic growth, but also affected the financial health of the banking system as bad debts mountedover time. Low economic growth resulted in lower revenues for the Government, both tax and non-tax,

necessitating higher borrowing. This was largely met through the mechanism ofad hoc Treasury Billsissued by the Government to the Reserve Bank and the progressive increase in SLR, as a result of whichthe government securities market remained dormant. Driven by the compulsions of automaticmonetisation, which resulted in expansion of monetary base, the Reserve Bank had to progressivelyraise the cash reserve ratio (CRR) of banks for monetary management. In the face of large government

borrowings and the need to restore the health of the financial system, the Reserve Bank, in consultationwith the Government, initiated reforms in the government securities market as a part of financial sectorreforms in the early 1990s. These reforms were broadly aimed at removing the imperfections in themarket and creating enabling conditions for its development.


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6.1.1. Developments in Primary Markets

In the primary market, a price discovery mechanism was activated by introducing an auction system.Efforts were also made to broaden the investor base and promote voluntary subscriptions in governmentsecurities. To provide a wider menu, new instruments were introduced from time to time to suit the

investor requirements.

Issuance Procedures

In the initial phase of reforms, the focus was on migration from the administered interest rate regime to amarket oriented price discovery mechanism. Accordingly, a system of auctions was introduced in 1992for Central Government securities whereby the amount is notified but the coupon rate is auctiondetermined. Tap issuances, for which the coupon rate was pre-determined but the amount was notnotified, were also conducted from time to time up to 2000.Since the inception of the auction system,

multiple price auction system has been used for dated securities. The uniform price auction format,followed for the issuance of 91-day Treasury Bills from November 1998, was extended to auctions ofCentral Government dated securities on a selective basis from 2001. While both methods of pricing areused, multiple price auction is the most frequently used selling technique for issuance of dated securities.The uniform pricing technique is used when there is market uncertainty. It is also used for issuing newinstruments, such as floating rate bonds and bonds with embedded options, as well as bonds with longtenor as in such cases the market does not have a reference rate.

Auctions of government securities between 1992-93 and 1998-99 were conducted solely on the basis ofyield (coupon). In order to consolidate outstanding loans for ensuring sufficient volumes and liquidity inany one issue, price-based auctions were introduced in May 1999, whereby new loans are raised throughre-issuances of existing securities with predetermined coupons. This helps the price discovery of asecurity already in existence in the market. Yield-based auctions are, thus, employed in respect of newissuances, and price-based auctions in respect of reissue of existing securities.Apart from allotmentthrough auction, a system of non-competitive bidding was introduced in January 2002 to encourageretail investors who do not have sufficient expertise in such bidding. The Reserve Bank also participatedon a non-competitive basis in the government securities auctions up to April 1, 2006 to primarily take upsome part of the issues in the case they were not fully subscribed.

Unlike Central Governments market borrowings, a predominant share of State Governments marketborrowings was conducted by way of tap issues up to 2005-06. The traditional tranche method (underwhich government securities were issued with a pre-determined coupon and notified amounts for eachState) was employed between 1991-92 and 1997-98. Beginning 1998-99, a combination of the auction

method and tap method has been employed. The State Governments could opt for auction routebetween 5 to 35 per cent of the allocated market borrowings (subsequently raised to 50 per cent). Theumbrella tap tranche method was introduced during 2001-02 to avoid the risk of under-subscription ofany issue of the State Governments. Under this method, after receiving the concurrence of the StateGovernments, the Reserve Bank announces the name of the States participating in the tap, the aggregatetargeted amount to be raised and the coupon rate which is fixed uniformly for all the States. The targetedamount in respect of individual States is not separately announced. Up to December 2002, the tap was


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normally kept open till the targeted amount was received for each State. This resulted in keeping the tapopen for more than two days in respect of a few States. As this procedure subjected the States toreputational risk, which varied with the number of days taken to close the tap, it was decided in January2003 to close the tap at the end of the second day even if the targeted amount is not mobilised. Thenames of the States whose issues are not fully subscribed as well as the amount of under-subscription are

not disclosed.

Mandated Investments in Government Securities

Banks are the largest investors in government securities. In terms of the SLR provisions of the BankingRegulation Act, 1949, banks are required to maintain a minimum of 25 per cent of their net demand andtime liabilities (NDTL) in liquid assets such as cash, gold and unencumbered government securities orother approved securities as Statutory Liquidity Ratio (SLR). The minimum SLR stipulation forscheduled urban co-operative banks (UCBs) is the same as for scheduled commercial banks (SCBs)from April 1, 2003. However, for non-scheduled UCBs, the minimum SLR requirement is 15 per centfor banks with NDTL of over Rs.25 crore and 10 per cent for the remaining non-scheduled UCBs. Theminimum SLR stipulation for regional rural banks (RRBs) is the same as for SCBs. From April 1, 2003,the coverage under the SLR has also been made akin to SCBs. All deposits with sponsor banks, whichwere earlier considered as part of the SLR, were to be converted into approved securities on maturity inorder to be reckoned for the SLR purpose. Recently, the Banking Regulation Amendment Act, 2007 hasremoved the floor limit of 25 per cent for SLR for scheduled banks.

The second largest category of investors in the government securities market is the insurance companies.According to the stipulations of the Insurance Regulation and Development Authority of India (IRDA),all companies carrying out the business of life insurance should invest a minimum of 25 per cent of theircontrolled funds in government securities. Similarly, companies carrying on general insurance businessare required to invest 30 per cent of their total assets in government securities and other guaranteedsecurities, of which not less than 20 per cent should be in Central Government securities. For pensionand general annuity business, the IRDA stipulates that 20 per cent of their assets should be invested ingovernment securities.

The non-Government provident funds, superannuation funds and gratuity funds are required by theCentral Government from January 24, 2005 to invest 40 per cent of their incremental accretions inCentral and State government securities and/or units of gilt funds regulated by the Securities andExchange Board of India (SEBI) and any other negotiable securities fully and unconditionallyguaranteed by the Central/State Governments. The exposure of a trust to any individual gilt fund,however, should not exceed five per cent of its total portfolio at any point of time.

Non-banking financial companies (NBFCs) accepting public deposits are required to maintain 15 per

cent of such outstanding deposits in liquid assets, of which not less than 10 per cent should bemaintained in approved securities, including government securities and government guaranteed bonds.Investment in government securities should be in dematerialised form, which can be maintained inConstituents Subsidiary General Ledger (CSGL) Account of a SCB/Stock Holding Corporation of IndiaLimited (SHCIL). In order to increase the security and liquidity of their deposits, residuary non-bankingcompanies (RNBCs), are required to invest not less than 95 per cent of their aggregate liability todepositors (ALD) as outstanding on December 31, 2005 and entire incremental deposits over this levelin directed investments, which include government securities, rated and listed securities and debt


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for auction. In view of their statutory obligations, RRBs, UCBs and NBFCs can also apply under thisScheme within the ceiling of Rs.2 crore.

To ensure higher retail participation, it is important to improve liquidity in the secondary market.Towards this end, the Reserve Bank has been encouraging PDs to offer two-way quotes to retail

investors and become members of the stock exchanges. Screen-based order driven trading in stockexchanges was also introduced in January 2003 to encourage retail participation in the governmentsecurities market.

Instruments

Persification of available instruments encourages participation of varied investors, as different categoriesof investors require different kinds of instruments to meet their specific needs. While banks requiregovernment securities for their asset liability management in addition to maintaining the prescribed SLR,insurance companies and provident funds require long-term investments to match their liabilities. Priorto the reforms initiated in the early 1990s, most of the government bonds were in the form of plainvanilla fixed coupon securities. Since 1994, the Reserve Bank has been developing a range ofinstruments to cater to the persified requirements and hedging needs of investors. These include zerocoupon bonds, capital indexed bonds, floating rate bonds and bonds with call and put options

Zero Coupon Bonds (ZCBs) were introduced on January 17, 1994. ZCBs, which do not have regularinterest (coupon) payments like traditional bonds, are sold at a discount and redeemed at par on finalmaturity. The ZCBs were beneficial, both to the Government because of the deferred payment of interestand to the investors because of the lucrative yield and absence of reinvestment risk. There were fourissuances of ZCBs between 1994 and 1996.

Floating Rate Bonds (FRBs) were first issued on September 29, 1995 but were discontinued after thefirst issuance due to lack of market enthusiasm. They were reintroduced on November 21, 2001 on

demand from market participants, with some modification in the structure. There were 10 issuances ofthe FRBs till October 9, 2004. Although there was initially an overwhelming market response to theseissuances, FRBs were discontinued due to the waning market interest reflected in the partialdevolvement in the last two auctions on the Reserve Bank and PDs. Erosion in the market interest forFRBs at that time was, inter alia, due to strong credit pick-up and low secondary market liquidity inFRBs. In the secondary market, liquidity in FRBs, is low due to (i) low trading interest of market

participants in FRBs as such instruments, by design, are hedging instruments and offer limited scope fortrading gains; (ii) no reissuance of FRBs on account of complexities associated with pricing; (iii)

preference of commercial banks to place these bonds under held to maturity (HTM) category, reducingthe availability of bonds for trading; and (iv) complex pricing method which deterred market

participants from undertaking outright transactions in FRBs.

A capital indexed bond (CIB) was issued on December 29, 1997 with a maturity of 5 years. The bondprovided for inflation hedging for the principal, while the coupons of the bond were not protectedagainst inflation. The issue of this bond met with lacklustre response, both in the primary and thesecondary markets due to the limited hedging against inflation. Therefore, there were no subsequentissuances. An attempt is being made to reintroduce these bonds and towards this end, a discussion paperwas also widely circulated in May 2004. The proposed modified structure of the CIB would be in linewith the internationally popular structure, which offers inflation linked returns on both the coupons and


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principal repayments at maturity. The coupon rate for the bonds would be specified in real terms. Thisrate would be applied to the inflation-adjusted principal to calculate the periodic semi-annual coupon

payments. The principal repayment at maturity would be the infl

Gilt-edged securities in India by G-7 Sec-C.pdf

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