INDIAN DEBT MARKETS

OVERVIEW
An introduction to the debt markets
Market Participants
Short term Instruments
Long term Instruments
 Introduction
 The Government securities market has witnessed
significant changes during the past decade.
 Introduction of an electronic screen based trading
system, dematerialized holding, straight through
processing, establishment of CCIL as the Central
Counterparty for guaranteed settlement, new
instruments and changes in the legal environment
are some of the major aspects that have contributed
to the rapid development of the market.
 Introduction
 Major participants in the Government securities
market historically have been large institutional
investors. With the various measures for
development, the market has also witnessed the
entry of 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.
 What are Financial Markets?
A market is where buyers and sellers meet to
exchange goods, services, money, or anything of
value.
 In a financial market, the buyers are investors or
lenders: the sellers are issuers or borrowers. An
investor/lender can be a government, an individual,
company or any entity that has surplus funds.
 An issuer/borrower is an entity that has a need for
capital. Each investor and issuer is active in a market
that meets its needs.
 Needs are based on many factors, including a time
horizon (short/long term), cost/return preference
and type of capital (debt or equity).
 What is a Security
 Securityis a generic term that refers to a debt or
equity IOU issued by a borrower or issuer.
 Debt security or bond – an IOU promising periodic
payments of interest and/or principal from a claim
on the issuer's earnings.
 Equity or stock – an IOU promising a share in the
ownership and profits of the issuer.
 Types of Financial Markets

 Thereare two general classifications of financial

markets:

 Money markets
 Capital markets
 Types of Financial Markets
 Money Markets : Money markets trade short-
term, marketable, liquid, low-risk debt securities.
These securities are often called "cash equivalents"
because of their safety and liquidity. The liquidity
of a market refers to the ease with which an
investor can sell securities and receive cash.
 A market with many active investors and few
ownership regulations usually is a liquid market; a
market with relatively few investors, only a few
securities, and many regulations concerning security
ownership is probably less liquid.
 Types of Financial Markets
 Capital Markets: Capital markets trade in longer-
term, more risky securities. There are three general
subsets of capital markets- bond (or debt) markets,
equity markets and derivatives markets.
 Debt markets specialize in the buying and selling
of debt securities.
 Types of Financial Markets

To illustrate how debt markets look, we will

analyze a short example:

Suppose a Company A needs new equipment for its

operations. Most companies try to match assets and
liabilities according to maturity (time left before the
item is no longer useful).
Company A expects the new equipment to have a
useful life of about 10 years and, therefore, after
consulting with its financial advisors, they decide to
issue 10-year bonds to pay for the equipment.
 Types of Financial Markets

Company A will consult with its investment

bankers to find out what types of bonds investors
are buying and to decide what interest rate the
bonds will pay. The object is to make them
attractive to investors, yet cost-efficient for
Company A.
Financial Markets
 Market Participants
 Central Government raising money through bond
issuances, to fund budgetary deficits and other short
and long term funding requirements.
 Reserve Bank of India as investment banker to
the government, raises funds for the government
through bond and T-bill issues and also participates
in the market through open-market operations, in
the course of conduct of monetary policy. The
RBI regulates the bank rates and repo rates and uses
these rates as tools of its monetary policy. Changes
in these benchmark rates directly impact debt
markets and all participants in the market.
 Market Participants
 Primary Dealers are market intermediaries
appointed by RBI 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 issue securities in the debt markets to fund
their developmental projects, as well as to finance
their budgetary deficits.
 Public Sector Units are large issuers of debt
securities, for raising funds to meet the long term
and working capital needs. These corporations are
also investors in bonds issued in the debt markets.
 Market Participants
 Corporate Treasuries issue short and long term
paper to meet the financial requirements of the
corporate sector. They are also investors in debt
securities issued in the debt market.
 Public Sector Financial Institutions regularly
access debt markets with bonds for funding their
financing requirements and working capital needs.
They also invest in bonds issued by other entities in
the debt markets.
 Market Participants
 Banks are the largest investors in the debt markets,
particularly the treasury bond and bill markets.
 Banks have a statutory requirement to hold a certain
percentage of their deposits (currently 21.50%) in
approved securities (all govt. bonds qualify) to satisfy
statutory liquidity requirements.
 Banks are very large participants in the call money and
overnight markets. They are also arrangers of
commercial paper issues of corporates.
 Banks are active in the inter-bank term markets and
repo markets for their short term funding
requirements. Banks also issue CDs and Bonds in the
debt markets.
 Market Participants
 Mutual Funds have emerged as another important
player in the debt markets, owing primarily to the
growing number of bond funds that have
mobilized significant amounts from the investors.
Most mutual funds also have specialized bond
funds such as gilt funds and liquid funds.
 Mutual Funds are not permitted to borrow funds,
except for very short-term liquidity requirements.
Therefore, they participate in the debt markets pre-
dominantly as investors, and trade on their
portfolios quite regularly.
 Market Participants
 Foreign Institutional Investors FIIs can invest
upto US $ 30 billion in Government Securities and
upto US $ 15 billion in Corporate Debt.
 Provident Funds are large investors in the bond
markets, as the prudential regulations governing the
deployment of the funds they mobilize, mandate
investments pre-dominantly in treasury and PSU
bonds. They are, however, not very active traders in
their portfolio, as they are not permitted to sell their
holdings, unless they have a funding requirement
that cannot be met through regular accruals and
contributions.
 Market Participants
 Charitable Institutions, Trusts and Societies are
also large investors in the debt markets. They are,
however, governed by their rules and byelaws with
respect to the kind of bonds they can buy and the
manner in which they can trade on their debt
portfolios.
Participants and Instruments
 SHORT-TERM INSTRUMENTS
 Call/Notice Money (1-14 days)
 Term Money – FDs (upto 1 year)
 Repo (1-14 days)
 Collateral Borrowing and Lending Obligation
(CBLO) (1 day to 3 months)
 Treasury Bills (91 days, 182 and 364 days)
 Fixed deposit
 Certificates of Deposits (upto 1 year)
 Commercial Paper (upto 1 year)
 Bills Rediscounting schemes (upto 6 months)
 CALL/NOTICE MONEY
 It is an important segment of the Indian money
market. Banks and Primary Dealers borrow and
lend funds to each other on unsecured basis.
 If the period is more than 1 day and up to 14 days
it is called “notice money” and if it is 15-days to
1- year, it is called is called “term money”.
 Settlement is done directly between the participants
through current accounts maintained with the RBI.
 In general the call money rate is also referred to as
the overnight MIBOR.
 CASH MANAGEMENT BILLS (CMBS)
 GOI in consultation with RBI, has decided to
issue a new short-term instrument, known as
CMBs, to meet the temporary mismatches in the
cash flow of the Government.
 CMBs have the generic character of T-bills but are
issued for maturities less than 91 days. Like T-bills,
they are also issued at a discount and redeemed at
face value at maturity.
 The tenure, notified amount and date of issue of
the CMBs depends upon the temporary cash
requirement of the Government.
 CASH MANAGEMENT BILLS (CMBS)
 The announcement of their auction is made by RBI
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. The
non-competitive bidding scheme has not been
extended to the CMBs.
 CMBs are tradable and qualify for ready forward
facility and an investment in CMBs is an eligible
investment in Government securities by banks for
SLR purpose under Section 24 of the Banking
Regulation Act, 1949.
 REPO AND REVERSE REPO
 Repurchase agreements are contracts for the sale
and future repurchase of a financial asset, most
often sovereign securities.
 On the termination date, the seller repurchases the
asset at the price agreed at inception of the repo.
 The difference between the sale and repurchase
prices represents interest for the use of the funds.
 A repo is essentially a short term interest bearing
loan against collateral.
 A repo transaction for the borrower is a “reverse
repo” transaction for the lender.
 REPO AND REVERSE REPO
 Repo Rate
 It is the rate at which banks borrow from RBI.
 It is currently at 6.75 %.

 Reverse Repo
 It is the rate at which RBI borrows from banks.
 It is currently at 5.75 %.
 COLLATERALIZED BORROWING AND LENDING
OBLIGATION (CBLO)
 As an alternative to the call money market, CCIL
has developed CBLO, a money market instrument
recognized by RBI.
 It is an instrument which is issued at a discount and
in electronic book entry form, for initial maturities
ranging from one day to one year.
 CBLO rates are generally comparable to market
repo rates, both being secured transactions.
 TREASURY BILLS
 Promissory notes of the central government and
therefore qualify as being free of credit risks.
 Issued to meet short term funding requirements of
the government account with Reserve Bank.
 Sale is by auction. Any individual, corporate, bank,
primary dealer or other entity is free to buy T-Bill.
 Denominations of 91, 182 and 364 days.
 COMMERCIAL PAPER
 Promissory notes issued by the corporate sector for
raising short term funds and is sold at a discount to face
value.
 Maturity can range between a minimum of 7 days and a
maximum of 1 year.
 CPs are required to be rated and the minimum rating
eligibility is P2.
 Every CP issue has an Issuing and Paying Agent (IPA),
which has to be a scheduled bank.
 Stamp duty is payable on CP issues, depending on the
maturity and who the initial buyer is.
 CERTIFICATE OF DEPOSIT
 Itis similar to CPs except that the issuer is a bank.
 The minimum amount of a CD can be Rs. 1 lakh
and maturity will range between 7 days and 1 year.
 Financial Institutions can issue CDs only for
maturities between 1 and 3 years.
 BILL REDISCOUNTING SCHEME
 The RBI introduced the Bills Market Scheme (BMS)
in 1952 which was later modified into the New Bills
Market Scheme (NBMS).
 Under this scheme commercial banks can
rediscount the bills which were originally discounted
by them with approved institutions (viz.,
Commercial Banks, Development Financial
Institutions, Mutual Funds, Primary Dealers etc.)
 CRR AND SLR
 CRR is the amount of funds that the banks have to
keep with RBI. If RBI decides to increase this %,
the available amount with the banks comes down.
 RBI increases the CRR to drain out the excessive
money from the banks. It is currently at 4.00 %.
 A SLR is the percentage of net time and demand
liabilities banks have to invest in government bonds
and other approved securities.
 It is currently at 21.50 %. RBI is empowered to
increase the ratio up to 40 %.
 DERIVED INSTRUMENTS
Pass Through Certificates
 They are fixed-income securities that represent an
undivided interest in a pool of federally insured
mortgages put together by the Government
National Mortgage Association.
 Mortgage-backed certificates are the most common
type of pass-through, where homeowners' payments
pass from the original bank through a government
agency or investment bank to investors.
 HEDGING TOOLS
Interest Rate Swaps
 A swap is defined as “a financial transaction in
which two counterparties agree to exchange streams
of payments, or cash flows, overtime” on the basis
agreed at the inception of the contract.
 Interest payment streams of differing character, on
an agreed, or notional, principal, are periodically
exchanged.
 HEDGING TOOLS
Interest Rate Options (IRO)
 Its an agreement between two parties in which one
grants the other, the right to buy (call option) or sell
(put option) an asset under specified conditions
(price, time) and assumes the obligation to buy/sell.
 The party who has the right, but not the obligation,
is the buyer of the option, and pays a fee, or
premium, to the writer or seller of the option.
 The asset could be a currency, bond, interest rate,
share, commodity or a futures contract.
 No IRO in the INR market at present.
 LONG-TERM INSTRUMENTS
 Government of India dated securities (G-SECS)
 Inflation Linked Bonds
 Zero Coupon Bonds
 State Government Securities (State Loans)
 Public Sector Undertaking Bonds (PSU Bonds)
 Corporate Debentures
 Bonds of Public Financial Institutions (PFIs)
 G-SECS
Government of India dated securities (G-SECs)
 G-SECs are issued by RBI on behalf of the Indian
Government. They form a part of the borrowing
program approved by Parliament in the Finance Bill
each year (Union Budget).
 They have maturity ranging from 1 year to 30 years.
 G-SECs are issued through the auction route. The
RBI pre specifies an approximate amount of dated
securities that it intends to issue through the year.
 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 hesitant to invest in longer dated
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.
 ZERO COUPON BONDS
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 construed as long
duration T-Bills or as bonds with cumulative interest
payment.
 STATE DEVELOPMENT LOANS
State Government Securities (State Loans)
 These are issued by the respective state
governments 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. State Government issue such securities to fund
their developmental projects and finance their
budgetary deficits.
 PUBLIC SECTOR UNDERTAKING BONDS
(PSU BONDS)
 These are long term debt instruments issued by
(PSUs). The term usually denotes bonds issued by
the central PSUs (i.e. PSUs funded by and under the
administrative control of the GOI).
 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.
 They have maturities ranging between 5-10 years
and they are issued in denominations (face value) of
Rs.1,000 each.
 PUBLIC SECTOR UNDERTAKING BONDS
(PSU BONDS)
 Most of these issues are made on a private
placement basis to a targeted investor base at market
determined interest rates.
 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).
BONDS OF PUBLIC FINANCIAL INSTITUTIONS
(PFIs)
 Apart from Public Sector Undertakings, Public
Financial Institutions (PFIs)are also allowed to issue
bonds, that too in much higher quantum.
 PFIs issue bonds in two ways - through public
issues targeted at retail investors and trusts and
through private placements to 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 G-SECs in value of issuance.
 CORPORATE DEBENTURES
 Corporate debentures are long term debt
instruments issued by private sector companies.
 They are issued in denominations as low as Rs.1,000
and have maturities ranging between one and ten
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.
 CORPORATE DEBENTURES
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.
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