Debt Markets in India

The Debt Market in India Executive Summary

Executive Summary

I have selected this topic totally from knowledge point of view. I wanted to

know about the market, which is the largest of all the financial markets as far

as volume is considered. I wanted to gain knowledge about various securities,

their trading, their prices and rate of return, etc.

This report provides information about debt market and its categories viz,

Government Securities

Corporate Debt/Bonds

PSU Bonds

It also brings out the role played by debt market in the Indian economy. It

talks about the benefits of investing in fixed income securities in terms of risk

and guaranteed returns.

After that it explains Money Markets and in that call money markets,

information about the wholesale and retail debt market and the role of NSE

and BSE in the wholesale debt market.

The yield of the bond is of much significance in determining the value of a

particular bond. Therefore, how the yield is determined is explained with the

help of yield curve and with the help of that price determination mechanism

is also explained.

It gives a brief description about various instruments, both short-term and

long-term, in wholesale and retail debt market. These include CP, CD, and T-

Bills (short-term) and GOI Sec, State loan and PSU Bonds (long-term). It also

gives information about their tradability and liquidity in the debt market.

Information about the issuers of debt instruments is provided. The

following are the categories of issuers in debt markets:

Government of India and other sovereign bodies

Banks and Development Financial Institutions

PSUs

Private sector companies

i

The Debt Market in India Executive Summary

Government or quasi government owned non-corporate entities

Investors are the most important class in debt market after all they are

the ones on which the debt markets thrive. The major participation is by the

large investors whereas retail investors don’t participate much in debt

markets. Information about these large investors is provided in brief.

After that, details about the regulators of the debt markets and the credit

rating of various debt instruments are given.

Also the impact of Union Budget 2004 on debt market is explained. After

that, a few points to be considered before investing in any debt instrument

are given. Before concluding the report I have given my perspective on the

problems faced by retail investors and made recommendations for the same.

An FAQ section precedes the conclusion of the project report.

ii

The Debt Market in India Introduction

Introduction

Debt market as the name suggests is where debt instruments are traded.

The most distinguishing feature of these instruments is that the return is

fixed, that is they are as close to being risk free as possible, if not totally risk

free.

There is no single location or exchange where debt market participants

interact for common business. Participants talk to each other, over telephone,

conclude deals, and send confirmations by Fax, Mail etc. with back office

doing the settlement of trades. In the sense, the wholesale debt market is a

virtual market. The daily transaction volume of all the debt instruments

traded would be about Rs.4000 - 5000 crores per day. In India, NSE has its

separate segment, which allows online trades in the listed debt securities

through its member brokers. Also BSE has introduced Debt Market Segment.

What is Debt Instrument?

A tradable form of loan is normally termed as a Debt Instrument. They are

usually obligations of issuer of such instrument as regards certain future cash

flow representing Interest & Principal, which the issuer would pay to the legal

owner of the Instrument. This arrangement can be converted in the form of

an instrument wherein the loans can be made tradable by converting it into

instruments of smaller units with a pro rate allocation of principal and

interest. So the basic features of any debt instrument are as follows:

Face value of the instrument is the value that is written on the debt

certificate.

Issue price, is the value at which the security is issued. It might be at

par or at a premium or discount.

Coupon, the interest rates payable on the instrument.

Terms and conditions like repayment period, pattern and mode of

repayment

1

I


Debt Instruments are of various types. The distinguishing factors of the

Debt Instruments are as follows: -

Issuer class

Coupon bearing / Discounted

Interest Terms

Repayment Terms (Including Call / put etc.)

Security / Collateral / Guarantee

Introduction to Fixed Income Instruments

Fixed Income securities are one of the most innovative and dynamic

instruments evolved in the financial system ever since the inception of

money. Based as they are on the concept of interest and time-value of

money, Fixed Income securities personify the essence of innovation and

transformation, which have fuelled the explosive growth of the financial

markets over the past few centuries.

Fixed Income securities offer one of the most attractive investment

opportunities with regard to safety of investments, adequate liquidity, and

flexibility in structuring a portfolio, easier monitoring, long-term reliability and

decent returns. They are an essential component of any portfolio of financial

and real assets, whether in form of pure interest bearing bonds, innovative

and varied type of debt instruments or asset-backed mortgages and

securitised instruments.

Fixed Income Markets - Powering the World

The Fixed Income securities market was the earliest of all the securities

markets in the world and has been the forerunner in the emergence of the

financial markets as the engine of economic growth across the globe. The

Fixed Income Securities Market, also known as the Debt Market or Bond

Market, is easily the largest of all the financial markets in the world today.

The size of the world Bond markets last year was around US $ 35 trillion,

which is nearly equivalent to the total GDP of all the countries in the world.

The Debt Markets have therefore a very prominent role to play in the efficient

2


functioning of the world financial system and in catalysing the economic

growth of nations across the globe.

Indian Debt Markets - Pillars of the Indian Economy

The Debt Markets therefore play a very critical role in any modern

economy. And more so in the case of developing countries like India which

need to employ a large amount of capital and resources for achieving the

desired degree of industrial and financial growth. The Indian Debt Markets

are today one of the largest in Asia and includes securities issued by the

Government (Central & State Governments), public sector undertakings,

other government bodies, financial institutions, banks and corporates. The

Indian Debt Markets with an outstanding issue size of close to Rs.14640

Billion (or Rs. 14,64,000 Crores) and a secondary market turnover of around

Rs.28500 Billion (in the year - 2005) is the largest of the Indian financial

markets.

The key role of the debt markets in the Indian Economy stems from the

following reasons:

Efficient mobilization and allocation of resources in the economy

Financing the development activities of the Government

Transmitting signals for implementation of the monetary policy

Facilitating liquidity management in tune with overall short term and

long-term objectives.

Since the Government Securities are issued to meet the short term and

long term financial needs of the government, they are not only used as

instruments for raising debt, but have emerged as key instruments for

internal debt management, monetary management and short term liquidity

management.

The returns earned on the government securities are normally taken as

the benchmark rates of returns and are referred to as the risk free return in

financial theory. The Risk Free rates obtained from the G-sec rates are often

used to price the other non-govt. securities in the financial markets.

Benefits of an efficient Debt Market to the financial system and the economy

3


Reduction in the borrowing cost of the Government and enable

mobilization of resources at a reasonable cost.

Provide greater funding avenues to public sector and private sector

projects and reduce the pressure on institutional financing.

Enhanced mobilization of resources by unlocking illiquid retail

investments like gold.

Development of heterogeneity of market participants

Assist in development of a reliable yield curve and the term structure

of interest rates.

Advantages of investing in fixed income securities

Fixed Income securities offer a predictable stream of payments by way of

interest and repayment of principal at the maturity of the instrument. The

debt securities are issued by the eligible entities against the moneys

borrowed by them from the investors in these instruments. Therefore, most

debt securities carry a fixed charge on the assets of the entity and generally

enjoy a reasonable degree of safety by way of the security of the fixed and/or

movable assets of the company.

The investors benefit by investing in fixed income securities as they

preserve and increase their invested capital and also ensure the

receipt of regular interest income.

The investors can even neutralize the default risk on their investments

by investing in Govt. securities, which are normally referred to as risk-

free investments due to the sovereign guarantee on these instruments.

The prices of Debt securities display a lower average volatility as

compared to the prices of other financial securities and ensure the

greater safety of accompanying investments.

Debt securities enable wide-based and efficient portfolio diversification

and thus assist in portfolio risk-mitigation.

Different types of risks with regard to debt securities

4


Even though debt markets are considered to be risk-free investments,

they are not totally risk-free. The following are the risks associated with debt

securities:

Default Risk: This can be defined as the risk that an issuer of a bond

may be unable to make timely payment of interest or principal on a

debt security or to otherwise comply with the provisions of a bond

agreement and is also referred to as credit risk.

Event Risk: Event risk reflects the bond issuer’s activities such as

restructurings, mergers and acquisitions, and leveraged buyouts to

boost shareholder value. Events such as these can dramatically

increase a company’s debt burden resulting in a deterioration of its

credit risk profile and a decline in bond value.

Interest Rate Risk: This can be defined as the risk emerging from an

adverse change in the interest rate prevalent in the market so as to

affect the yield on the existing instruments. A good case would be an

upswing in the prevailing interest rate scenario leading to a situation

where the investors' money is locked at lower rates whereas if he had

waited and invested in the changed interest rate scenario, he would

have earned more.

Reinvestment Rate Risk: can be defined as the probability of a fall in

the interest rate resulting in a lack of options to invest the interest

received at regular intervals at higher rates at comparable rates in the

market.

The following are the risks associated with trading in debt securities:

Counter Party Risk: is the normal risk associated with any

transaction and refers to the failure or inability of the opposite party to

the contract to deliver either the promised security or the sale-value at

the time of settlement.

Price Risk: refers to the possibility of not being able to receive the

expected price on any order due to an adverse movement in the

prices.

Development of Debt Markets

5


Development of debt markets has recently become a major pre-

occupation of the regulators. A host of reforms undertaken in the recent past

has resulted in a marked change in the nature of instruments offered, a wider

investor base and in progressive movement towards market determined

interest rates but still lots needs to be done in terms of market design and

liquidity.

The following reforms have been affected for the development of the

Indian debt markets:

Notifying the amounts in respect of all treasury bills and excluding non-

competitive bids outside the notified amount to provide certainty to

the amounts acceptable from competitive bidders.

Permitting FIIs with equity funds to invest in government dated

securities and treasury bills, both in the primary and the secondary

markets.

Allowing NSDL, SHCIL and NSCCL to open SGL accounts with RBI in

order to facilitate custodial and depository services for FIIs in

government dated securities.

Development of the primary dealers and the satellite dealers, with an

impetus to widen and deepen government securities market and

retailing government securities.

Accepting private placement of government securities by RBI and

offloading them in the market when conditions are favourable with a

view to maintain stable interest rates.

Allowing banks to freely buy and sell government securities on an

outright basis and retail them to non-bank clients without any

restriction on the period between the sale and purchase.

Abolishing stamp duty on transfer of debt instruments in a depository

to modernize and deepen the debt market.

Different forms of government security auction processes of dated

securities, resulting in more efficient pricing.

Mandating trades in corporate debt securities to be executed on the

basis of price and order matching mechanism of the stock exchanges

as in equities.

6


Notifying regulations for regulating the Credit Rating Agencies (CRAs),

and

Progressive opening up of the short-term corporate markets, by

liberalizing the Commercial Papers market.

These regulatory measures taken to widen the investor base and move

towards market determined interest rates have given a new lease of life to

the Indian debt markets. Introduction of primary dealers, news instruments

like 14 & 28 Treasury bills and encouraging retail participation have

popularised the government securities market. The corporate debt markets

have provided an attractive route to the corporates to raise funds through

private placement. Dematerialization of debt and online trading would

certainly improve the liquidity. The arrival of insurance and pension funds to

the debt market would boost the market.

7

The Debt Market in India Structure of Debt Market

Structure of Debt Market

The debt market in India comprises basically three segments, viz.,

Government Securities Market, which is oldest and most dominant; PSU

Bonds Market, which is basically a development since late 'eighties; and

Corporate Securities Market, which is growing fast after liberalisation,

especially in the last two years. The major focus in the development of debt

markets has been the Government Securities Market for three reasons. First,

it constitutes the principal segment of our debt market. Second, as a market

for sovereign paper, it has a role in setting benchmarks in the financial

markets as a whole. Third, it is critical in bringing about an effective and

reliable transmission channel for the use of indirect instruments of monetary

control.

The market for Government securities comprises the centre, state and

state-sponsored securities. In the recent past, local bodies such as

municipalities have also begun to tap the debt market for funds. The PSU

bonds are generally treated as surrogates of sovereign paper, sometimes due

to explicit guarantee and often due to the comfort of public ownership. Some

of the PSU bonds are tax free, while most bonds including government

securities are not tax-free. The RBI also issues a set of tax -free bonds, called

the 6.5% RBI Relief bonds, which is a popular category of tax-free bonds in

the market. Corporate bond markets comprise of commercial paper and

bonds. These bonds typically are structured to suit the requirements of

investors and the issuing corporate.

Participants in the Debt Markets

The market participants in the debt market are:

Central Government, raising money through bond issuance, to fund

budgetary deficits.

8

II


Reserve Bank of India, an investment banker to the government, raises

funds for the government. The RBI regulates the bank rates and repo

rates and uses these rates as tools of its monetary policy. Changes in

these benchmark rates directly impact debt markets and all

participants in the market.

Primary Dealers, who are market intermediaries by the Reserve Bank

of India who underwrite and make market in government securities,

and have access to the call markets and repo markets for funds.

State Governments, Municipalities and local bodies, which issue

securities in the debt markets to fund their development projects, as

well as to finance their budgetary deficits.

Public sector units are large issuers of debt securities, for meeting their

fund requirements.

Corporate Sector issue short and long term paper to meet the financial

requirements.

Banks, Mutual funds, Insurance companies, Provident funds, Trusts,

Corporate treasuries, Foreign Investors (FIIs) are the large investors in

the bond market.

Categories in Debt Market

Primary Debt Market

Government Securities Market (G-Secs)

The Government Securities (G-Secs) market is the oldest and the largest

component of the Indian Debt Market in terms of market capitalization,

outstanding securities and trading volumes. The outstanding volumes of

Government Securities (Central & State) at the end of March 2005 were

around Rs. 14610 billion. The G-Secs market plays a vital role in the Indian

economy as it provides the benchmark for determining the level of interest

9

Government Securities Market

PSU Bonds Market

Corporate Securities Market


rates in the country through the yields on the government securities which

are referred to as the risk-free rate of return in any economy.

Advantages of investing in Government Securities (G-Secs) – The Zero

Default Risk of the G-Secs offer one of the best reasons for investments in G-

Secs so that it enjoys the greatest amount of security possible. The other

advantages of investing in G- Secs are:

Greater safety and lower volatility as compared to other financial

instruments.

Variations possible in the structure of instruments like Index linked

Bonds

Higher leverage available in case of borrowings against G-Secs.

No TDS on interest payments

Tax exemption for interest earned on G-Secs. up to Rs.3000/- over

and above the limit of Rs.12000/- under Section 80L

Greater diversification opportunities

Adequate trading opportunities with continuing volatility expected

in interest rates the world over.

The issuance process of G-Secs – G-Secs are issued by RBI in either a

yield-based (participants bid for the coupon payable) or price-based

(participants bid a price for a bond with a fixed coupon) auction basis. The

Auction can be either a Multiple price (participants get allotments at their

quoted prices/yields) Auction or a Uniform price (all participants get

allotments at the same price). RBI has recently announced a non-competitive

bidding facility for retail investors in G-Secs through which non-competitive

bids will be allowed up to 5 percent of the notified amount in the specified

auctions of dated securities.

Public Sector Undertaking (PSU) Bonds Market

These are Medium or long-term debt instruments issued by Public Sector

Undertakings (PSUs). The term usually denotes bonds issued by the central

PSUs (i.e. PSUs funded by and under the administrative control of the

Government of India). Most of the PSU Bonds are sold on Private Placement

10


Basis to the targeted investors at Market Determined Interest Rates. Often

investment bankers are roped in as arrangers to this issue. Most of the PSU

Bonds are transferable and endorsement at delivery and are issued in the

form of Usance Promissory Note.

In case of tax-free bonds, normally such bonds accompany post dated

interest cheque / warrants.

Corporate Securities Market

Floating rates of interest, of course, will be advantageous in times of falling

interest rates. As the interest rates in the economy fell, corporates that raised

funds at exorbitant rates five years ago are now caught between the devil

and the deep sea. If they repay loans prematurely by mobilizing funds at the

prevailing rates, the FIs will slap them with penalty. If they do not, they

cannot manage their bottom lines when interest outgo is high. Since those

who raised loans at floating rates are now better off, this route is being

preferred. The present trend is to raise funds at rates below PLR through

private placements to banks. But the risk involved is that RBI may, at any

time, issue guidelines making private placements equivalent to loans. As one

cannot predict the movements of interest rates, the universal mantra is to

have a mix of different kinds of instruments to hedge the risks.

Issue process – The process of issue of corporate securities involves the

following steps:

Board meeting and Approval for issue at the AGM.

Credit Rating of the Issue.

Appointment of Debenture trustee for the creation of securities.

Appointment of the Advisors and Merchant Bankers for the issue

management.

Finalisation of the initial terms of the issue.

Preparation of the offer document for the public issue and the

information memorandum for private placement.

SEBI approval of offer document for public issue.

Listing arrangement with stock exchanges.

Offer the issue to prospective investors and /or book building

11


Acceptance of the application money

Allotment of the issue

Issue of letter of allotment/certificate /depository confirmation

Collect final amount /refund excess application money.

Secondary Debt Market

Segments in the secondary debt market – The segments in the

secondary debt market based on the characteristics of the investors and the

structure of the market are:

Wholesale Debt Market

Here the investors are mostly Banks, Financial Institutions, the RBI, Primary

Dealers, Insurance companies, MFs, Corporates and FIIs.

Retail Debt Market

This involves participation by individual investors, provident funds, pension

funds, private trusts, NBFCs and other legal entities in addition to the

wholesale investor classes.

12

The Debt Market in India Money Market

Money Market

What is the Money Market?

The Money Market is basically concerned with the issue and trading of

securities with short-term maturities or quasi-money instruments. The

Instruments traded in the money market are Treasury Bills, Certificates of

Deposits (CDs), Commercial Paper (CPs), Bills of Exchange and other such

instruments of short-term maturities (i.e. not exceeding 1 year with regard to

the original maturity). The banks that lend and borrow money on a short-term

basis in the market form the inter bank call money market.

The rate of lending and borrowing, the interest rate depends on demand

and supply of money in the market. When money is scarce in the market,

quite obviously, the rate moves up and vice versa. The supply of money also

tells on the yields of other instruments.

The money market apart from facilitating flows of short-term funds also

reflects the implementation of monetary policy by the Central bank through

Open Market Operation (OMO). In OMOs, the Reserve Bank of India controls

the money supply in various ways.

When the market is flooded with money, the RBI might suck the excess

money by selling treasury bills. Similarly, when the economy suffers from

dearth of money, RBI infuses money by way of buying treasury bills.

Apart from OMOs, the Central Bank regulates money supply by using tools

such as Cash Reserve Ratio (CRR), bank rate and Statutory Liquidity Ratio

(SLR). CRR determines the amount of cash that the banks are required to

maintain with the RBI. SLR determines the liquid funds banks are required to

maintain with the Central Bank in the form of cash or government securities.

Bank rate is the interest rates at which the Central bank lends funds to other

banks.

13

III


While OMOs are used to manage the temporary liquidity in the system,

the regulating tools are used to guide the long-term trend of money supply in

the economy. When CRR is hiked, money flows from the system to the RBI,

thus arresting money supply within the system. Similar is the effect of SLR

changes. The Bank rate sends a signal of interest rates to the economy.

When the bank rate is lower it means that banks can borrow from the Central

bank at a lower rate, thus enabling them to lend at a lower rate.

Call Money Market

The call money market is an integral part of the Indian Money Market,

where the day-to-day surplus funds (mostly of banks) are traded. The loans

are of short-term duration varying from 1 to 14 days. The money that is lent

for one day in this market is known as "Call Money", and if it exceeds one day

(but less than 15 days) it is referred to as "Notice Money". Term Money refers

to Money lent for 15 days or more in the InterBank Market. Banks borrow in

this money market for the following purpose:

To fill the gaps or temporary mismatches in funds

To meet the CRR & SLR mandatory requirements as stipulated by the

Central bank

To meet sudden demand for funds arising out of large outflows.

Thus call money usually serves the role of equilibrating the short-term

liquidity position of banks.

Call Money Market Participants:

Those who can both borrow as well as lend in the market – RBI, Banks,

PDs

Those who can only lend - financial institutions - LIC, UTI, GIC, IDBI,

NABARD, ICICI and mutual funds etc.

Reserve Bank of India has framed a time schedule to phase out the

second category out of Call Money Market and make Call Money market as

exclusive market for Bank/s & PD/s.

14


What are Money Market Instruments?

By convention, the term "Money Market" refers to the market for short-

term requirement and deployment of funds. Money market instruments are

those instruments, which have a maturity period of less than one year. The

most active part of the money market is the market for overnight call and

term money between banks and institutions and repo transactions. Call

Money / Repo are very short-term Money Market products. The below

mentioned instruments are normally termed as money market instruments:

Certificate of Deposit (CD)

Commercial Paper (C.P)

Inter Bank Participation Certificates

Inter Bank term Money

Treasury Bills

Bill Rediscounting

Call/ Notice/ Term Money

15

The Debt Market in India Wholesale Debt Market

Wholesale Debt Market

There is no single location or exchange where debt market participants

interact for common business. Participants talk to each other, conclude deals,

send confirmations etc. on the telephone, with clerical staff doing the running

around for settling trades. In that sense, the wholesale debt market is a

virtual market. The daily transaction volume of all the traded instruments

would be about Rs5bn per day excluding call money and repos. Its

participants include Banks, Financial Institutions, the RBI, Primary Dealers,

Insurance companies, Provident Funds, MFs, Corporates and FIIs.

In order to understand the entirety of the wholesale debt market, we have

looked at it through a framework based on its main elements. The market is

best understood by understanding these elements and their mutual

interaction. These elements are as follows:

Instruments i.e. the instruments that are being traded in the debt

market.

Issuers i.e. entities which issue these instruments.

Investors i.e. entities which invest in these instruments or trade in

these instruments.

Interventionists or Regulators i.e. the regulators and the regulations

governing the market.

Each of these is discussed in depth later on as separate chapters.

Types of Trades

There are usually two types of trades in the wholesale debt market:

An outright sale or purchase and

A Repo trade.

16

IV


An outright sale or purchase means that one participant buy or sells the

securities to the other. An outright Buy or sell transaction is a one where

there is no intended reversal of the trade at the point of execution of the

trade. The Buy or sell transaction is an independent trade and is in no way

connected with any other trade at the same or a later point of time.

A Ready Forward Trade (which is normally referred to as a Repo trade or a

Repurchase Agreement) is a transaction where the said trade is intended to

be reversed at a later point of time at a rate, which will include the interest

component for the period between the two opposite legs of the transactions.

So in such a transaction, one participant sells securities to other with an

agreement to purchase them back at a later date. The trade is called a Repo

transaction from the point of view of the seller and it is called a Reverse Repo

transaction from point of view of the buyer.

Repos therefore facilitate creation of liquidity by permitting the seller to

avail of a specific sum of money (the value of the repo trade) for a certain

period in lieu of payment of interest by way of the difference between the two

prices of the two trades.

Repos and reverse repos are commonly used in the money markets as

instruments of short-term liquidity management and can also be termed as a

collateralised lending and borrowing mechanism. Banks and Financial

Institutions usually enter into reverse repo transactions to manage their

reserve requirements or to manage liquidity.

Turnover

The trading volume on the WDM segment has been growing rapidly. The

trading volume (face value) increased from Rs. 6,781 crores during 1994-95

(June-March) to Rs. 4,75,523 crores during 2005-06. The average daily

trading volume increased from Rs. 30 crores to Rs.1,755 crores during the

same period. However, the financial year 2005-06 period has recorded a

substantial decline compared to the financial year 2004-05. The highest

recorded WDM trading volume of Rs. 13,912 crores was registered on August

17


25, 2003. The business growth of the WDM segment is presented in Table 1

and Chart 1.

Table 1 – Business Growth of WDM Segment

Chart 1 – Business Growth of WDM Segment

18

Source: NSE Fact Sheet 2006



The transactions in dated government securities account for a substantial

share of transactions on the WDM segment. The details of transactions in

government securities and treasury bills, outright as well as repo transactions

are presented in Table 2. The WDM's SGL Outright Transactions as a

percentage to the NDS reporting system Outright transactions was 63.67% in

2005-06.

Table 2 – WDM Transactions in Government Securities

The security-wise and participant-wise distribution of WDM trades is

presented in Table 3. It is observed that the market is dominated by dated

government securities (including state development loan), which accounted

for 72.67% of WDM trades during 2005-06. Among the market participants,

the dominance of the domestic banks reduced this year to 28.07% from

29.89% in 2004-05.

19



Table 3 – Security-wise & Participation-wise Distribution of WDM

Trades

Market Capitalisation

Market capitalisation of the WDM segment has witnessed a constant

increase indicating an increase in the number of securities available for

trading on this segment. Total market capitalisation of the securities available

for trading on WDM segment stood at Rs. 15,67,574 crores as on March 31,

2006. Central Government securities accounted for the largest share of the

market capitalisation with 67.61%. The details of market capitalisation of

WDM securities are presented in Table 4.

Table 4 – Market Capitalisation of WDM Securities

20




Role of the Exchanges in the Wholesale Debt market

Exchanges offer order-driven screen based trading facilities for Govt.

securities. The trading activity on the systems is however restricted with

most trades today being put through in the broker offices and reported to the

Exchange through their electronic systems.

Constituent SGL Account

A Constituent Subsidiary General Ledger Account (CSGL) is a service

provided by Reserve Bank of India through Primary Dealers and Banks to

those entities who are not allowed to hold direct SGL Accounts with it. This

account provides for holding of Central/State Government Securities and

Treasury bills in book entry/dematerialized form. Individuals are also allowed

to hold a Constituent SGL Account.

Settlement in the Wholesale Debt Market

The settlement for the various trades is finally carried out through the SGL

of the RBI except for transfers between the holders of Constituent SGL A/c’s

in a particular Bank or Institution like intra-a/c transfers of securities held at

the Banks.

As far as the Broker Intermediated transactions are concerned, the

settlement responsibility for the trades in the Wholesale market is primarily

on the clients i.e. the market participants and the broker has no role to play

in the same. The member only has to report the settlement details to the

Exchange for monitoring purposes. The Exchange reports the trades to RBI

regularly and monitors the settlement of these trades.

21

The Debt Market in India Yield Curve

Retail Debt Market

The transaction sizes in the wholesale debt market are so large that

individual investors can’t participate in it. So there is a separate market

called the retail debt market for individual investors. But the retail investors

don’t have much of a choice as far as investment in the debt market is

concerned. Following are some of the instruments in the retail debt market:

Public issues of debt by corporates : The corporates make public

issues of the debt they want to raise from the market. The individual

investors can invest in these issues. These issues also include the

issues made by the FIs to raise money from the public.

Deposits of banks : Maximum amounts of retail savings in India go in

to the deposits of banks. Banks accept deposits from the public and

pay interest on them. These deposits are secure and liquid but they

don’t carry attractive yields.

Mutual Funds : Since the retail investors can’t participate in the

wholesale debt market, it can invest in this market via mutual funds.

The mutual funds accumulate individual savings from the investors and

invest them in these markets. The best example of such type of MFs is

a money market mutual fund.

Insurance companies and provident funds : Just like mutual funds,

these also mobilize individual savings and invest them in wholesale

debt market and other attractive investment avenues.

Fixed deposits of companies : This presents a very attractive

investment avenue with reasonable yields but here the risk of default

is very high. The recent NBFC episode is a case in point, where a lot of

NBFCs took money from people and vanished. One should look at the

financial performance of that particular company and the previous

history of deposits and their repayments before investing in such

deposits.

22

V


Investment/saving products: It must be noted that there are few

tradable instruments available for investment by retail investors. Most

of the available products are different kinds of schemes that are

largely illiquid. The different investment products available for retail

participation are listed below:

Products from banks

Fixed/term deposits

Recurring deposits

Savings deposits

Small savings schemes of government

Public Provident Fund (PPF) scheme

Tax free Relief Bonds

Small savings schemes from Department of Posts

National Savings Scheme (NSS)

National Savings Certificates (NSC)

Postal fixed deposits

Indira Vikas Patra

Kisan Vikas Patra

Savings oriented life insurance schemes

Company fixed deposits

Bonds of development financial institutions

Debentures of private sector companies

Debentures of infrastructure companies

Debentures of state government backed entities

Unit Trust of India

Guaranteed return monthly income schemes

Income/bond funds

Other Mutual funds

Broad Trends in Retail Debt Market

Traditionally, fixed deposits of companies used to be the biggest avenue

for retail investors. Within this category, it was the deposits of finance

23


companies (NBFCs), which were most popular with investors and mobilizers

alike – with investors because of the higher interest rates offered (typically 1-

2% higher and additional incentives like gold coin etc.) and with mobilizers

because of the high commissions. In South India, nidhi companies, benefit

and chit funds were quite popular due to the high returns offered.

The last 3 years have been times of dramatic disorder in the retail debt

market. The key events relate to defaults by many of the issuers especially

the finance companies and the benefit companies. Prominent default cases

include the CRB group of companies, Lloyds Finance, and most recently the

Kuber group of companies. The market was also rocked by the US 64 problem

when for a brief period of time investors were scared and withdrawing money

from the scheme.

The reasons for default by manufacturing companies are related to the

overall decline in profitability due to increased competition, dumping of

imports, sharp fall in commodity prices and general slowdown in the

economy.

The reasons for defaults in finance companies are related to their

investments. Most NBFCs had invested in real estate (either directly or

builder financing), stock market, promoter funding and other illiquid

investments. In addition, they had invested in 100% depreciation leases

(often fictitious sale and leaseback transactions) to obtain tax shields. They

witnessed widespread defaults in their lending portfolio, huge losses in

investment portfolio and often were disallowed tax shields by the income tax

authorities. In the wake of credit problems, the RBI came down heavily on

these companies and investors stopped investing in their FD’s, which further

aggravated their liquidity crisis. Ironically, the loss of business and the losses

they faced resulted in their so-called tax shield being irrelevant.

All these resulted in a huge flight to safety. This can be seen from the

increase in popularity of institutional bond issues (i.e. ICICI "Safety Bonds"

and IDBI "Flexi Bonds") and the sharp increase in the collection of

Government sponsored small savings schemes and postal schemes (In FY 99,

small savings collections were about Rs320bn as against about Rs91bn 5

years ago). While it is difficult to obtain data to support the feeling that

24


nationalized banks have also received larger amounts of money, empirical

experience on the ground does point towards that trend.

Despite the US 64 problem and the consequent loss of image suffered by

UTI, it continued to collect large quantum of funds from retail investors. Many

retail investors thought that the UTI was the lesser evil especially after the

Finance minister and a host of government officials came out openly in

support of UTI.

Apart from UTI, private sector mutual funds also witnessed substantial

increase in collections, although from low bases.

Listing

All Government securities and Treasury bills are deemed to be listed on

the Exchange automatically, as and when they are issued.

Initially, 85 central government securities would be traded in the retail

debt market segment. The Exchange will introduce additional securities for

trading from time to time. Other securities like state government securities,

T-Bills etc. would be added in subsequent phases.

Security Details

Every security will be identified with a unique symbol and series. The

nomenclature (classification) of the symbol will be as follows:

First 4 characters - Coupon Rate (without the decimal point)

Next character - Month of Maturity (A - Jan, B - Feb, C - Mar, etc.)

Next 2 characters - Year of Maturity (03 - 2003, 04 - 2004, etc.)

In cases where more than one security has the same characteristic,

then the last character shall have an additional character descriptor,

viz. A/B etc.

Example:

Security Name Maturity date Symbol

GOI Loan 5.75% 2003 12-May-2003 0575E03

25


GOI Loan 6.65% 2009 05-Apr-2009 0665D09

GOILoan11.50% 2011 05-Aug-2011 1150H11

All government securities will be traded under the series GC

Face Value of all the securities is 100

Permitted Lot size of all the securities is 10

Trading in the Retail Debt Market

Trading in the Retail Debt Market takes place in the same manner in which

the trading takes place in the equities (Capital Market) segment. The

RETDEBT Market facility on the NEAT (National Exchange for Automated

Trading) system of Capital Market Segment is used for entering transactions

in RDM session.

Members eligible for trading in RDM segment

Trading Members who are registered members of NSE in the Capital

Market segment and Wholesale Debt Market segment are allowed to trade in

Retail Debt Market (RDM) subject to fulfilling the capital adequacy norms.

Trading Members with membership in Wholesale Debt Market segment only,

can participate in RDM on submission of a letter in the prescribed format.

Market Timings and Market Holidays

Trading in RDM segment takes place on all days of the week, except

Saturdays and Sundays and holidays declared by the Exchange in advance

(The holidays on the RDM segment shall be the same as those on the Equities

segment). The market timings of the RDM segment are the same as the

Equities segment, viz.:

Normal Market Open: 09:55 hours

Normal Market Close: 15:30 hours

Trading System

26


Trading in RDM takes place on the 'National Exchange for Automated

Trading' (NEAT) system, a fully automated screen based trading system,

which adopts the principle of an order driven market. The RETDEBT Market

facility on the NEAT system of Capital Market Segment is used for entering

transactions in RDM session.

The future scenario for the Retail Debt Market in India

The Retail Debt Market is set to grow tremendously in India with the

broadening of the market participation and the availability of a wide range of

debt securities for retail trading through the Exchanges. The following are the

trends, which will impact the Retail Debt Market in India in the near future:

Expansion of the Retail Trading platform to enable trading in a wide

range of government and non-government debt securities.

Introduction of new instruments like securitised paper etc.

Development of the secondary market in Corporate Debt

Introduction of Interest Rate Derivatives based on a wide range of

underlying in the Indian Debt and Money Markets.

Development of the Secondary Repo Markets.

27


Yield Curve

Coupon rate of the Security

The Coupon rate is simply the interest rate that every debenture/Bond

carries on its face value and is fixed at the time of issuance. For example, a

12% p.a coupon rate on a bond/debenture of Rs 100 implies that the investor

will receive Rs 12 p.a. The coupon can be payable monthly, quarterly, half-

yearly, or annually or cumulative on redemption. Thus, a coupon rate is the

periodic interest rate that the issuer agrees to pay to the owners of the

security till maturity.

Coupon

The annual amount of the interest payment made to the holders of the

government security is called the coupon. The coupon is determined by

multiplying the coupon rate by the par value of the government securities.

Accrued Interest

Accrued Interest is the amount of interest accrued since the last coupon

payment; the G-Sec buyer must include the value of accrued interest while

pricing the securities. In government securities Accrued Interest is calculated

on a 30-day month/360 day year basis and the coupon payment is semi-

annual.

To calculate AI we need three pieces of information:

The number of days in the AI period

The number of days in the coupon period and

The amount of the coupon payment

28

VI


Dirty Price

Dirty Price of a security is the agreed upon price i.e. buy price plus

accrued interest.

Clean Price

Clean Price of a security is the agreed upon price i.e. buy price without

accrued interest.

Valuation of Government Securities

The valuation process involves following steps.

Estimating the expected cash flows

Determining the appropriate interest rate or interest rates that should

be used to discount the cash flows and

Calculating the present value of the expected cash flows

The sum of the present values for a security’s expected cash flows is the

value of the security.

Premium

A security whose value is greater than its maturity value is said to be

trading at a premium to maturity value.

Discount

A security whose value is less than its maturity value is said to be trading

at a discount to maturity value.

Relationship between discount rate and coupon rate:

Discount rate less than the coupon rate implies that the security is

traded at a premium.

Discount rate greater than the coupon rate implies that the security is

traded at a discount.

29


Discount rate equal to the coupon rate implies that the security is

traded at a par.

Maturity date for Security

Securities are issued for a fixed period of time at the end of which the

principal amount borrowed is repaid to the investors. The date on which the

term ends and proceeds are paid out is known as the Maturity date. It is

specified on the face of the instrument. In respect of Demat Debt instrument

due date is known from ISIN Number of the security.

Yield

Yield refers to the percentage rate of return paid on a stock in the form of

dividends, or the effective rate of interest paid on a bond or note. There are

many different kinds of yields depending on the investment scenario and the

characteristics of the investment.

Yield To maturity (YTM)

The yield or the return on the instrument held till its maturity is known as

the Yield-to-maturity (YTM). It basically measures the total income earned by

the investor over the entire life of the Security. This total income consists of

the following:

Coupon income: The fixed rate of return that accrues from the

instrument

Interest-on-interest at the coupon rate: Compound interest earned on

the coupon income

Capital gains/losses: The profit or loss arising on account of the

difference between the price paid for the security and the proceeds

received on redemption/maturity

Yield to Maturity (YTM) is the most popular measure of yield in the Debt

Markets and is the percentage rate of return paid on a bond, note or other

fixed income security if you buy and hold the security till its maturity date.

30


The yield on the government securities is influenced by various factors

such as level of money supply in the economy, inflation, future interest rate

expectations, borrowing program of the government & the monetary policy

followed by the government.

Price determination in the debt markets

The price of a bond in the markets is determined by the forces of demand

and supply, as is the case in any market. The price of a bond in the

marketplace also depends on a number of other factors and will fluctuate

according to changes in

Economic conditions

General money market conditions including the state of money supply

in the economy

Interest rates prevalent in the market and the rates of new issues

Future Interest Rate Expectations

Credit quality of the issuer

There is however, a theoretical groundwork to the determination of the

price of the bond in the market based on the measure of the yield of the

security.

31

4.50%

4.80%

5.10%

5.40%

5.70%

6.00%

6.30%

6.60%

6.90%

7.20%

7.50%

7.80%

1 2 3 5 7 10 12 15 18 21 29 30

Tenor (yrs)

Yie

ld T

o M

atu

rity


Relationship between yields and price

Yields and Bond Prices are inversely related. So a rise in price will

decrease the yield and a fall in the bond price will increase the yield.

There will be an immediate and mostly predictable effect on the prices of

bonds with every change in the level of interest rates. (The predictability here

however refers to the direction of the price change rather than the quantum

of the change)

When the prevailing interest rates in the market rise, the prices of

outstanding bonds will fall to equate the yield of older bonds into line with

higher-interest new issues. This will happen, as there will be very few takers

for the lower coupon bonds resulting in a fall in their prices. The prices would

fall to an extent where the same yield is obtained on the older bonds as is

available for the newer bonds.

When the prevailing interest rates in the market fall, there is an opposite

effect. The prices of outstanding bonds will rise, until the yield of older bonds

is low enough to match the lower interest rate on the new bond issues.

These fluctuations ensure that the value of a bond will never be the same

throughout the life of the bond and is likely to be higher or lower than its

original face value depending on the market interest rate, the time to

maturity (or call as the case may be) and the coupon rate on the bond.

Yield Curve

The relationship between time and yield on a homogenous risk class of

securities is called the Yield Curve. The relationship represents the time value

of money - showing that people would demand a positive rate of return on

the money they are willing to part today for a payback into the future. It also

shows that a Rupee payable in the future is worth less today because of the

relationship between time and money. A yield curve can be positive, neutral

or flat. A positive yield curve, which is most natural, is when the slope of the

curve is positive, i.e. the yield at the longer end is higher than that at the

shorter end of the time axis. This results, as people demand higher

compensation for parting their money for a longer time into the future. A

32


neutral yield curve is that which has a zero slope, i.e. is flat across time. This

occurs when people are willing to accept more or less the same returns

across maturities. The negative yield curve (also called an inverted yield

curve) is one of which the slope is negative, i.e. the long-term yield is lower

than the short-term yield.

Diagram- Yield Curve

Factors affecting yield curve

The Monetary Policy

Suppose the Reserve Bank feels that there is too much liquidity in the

financial system and there is a threat that inflation may rise. In such a

scenario, the Reserve Bank will adopt a tight monetary policy. It therefore,

sells government bonds (and collects money), reducing the money

availability in the system. In case the central bank wants to ease the

monetary policy, it buys back the bonds, in effect infusing liquidity in the

economy.

The central bank can therefore, effectively control the short-term interest

rates and the lower end of the yield curve. When the market expects the

central bank to cut rates, the short-term instruments become expensive as

33


they continue to offer higher interest or coupon rates. Consequently, the yield

declines; adjusting to the lower interest rate environment. On the contrary,

when the expectations are that the central bank will increase interest rates,

the price of the debt instruments fall causing the yield to increase.

The central bank’s decision to cut interest rates or to increase it also

depends on the economic scenario in the country. The central bank has to

keep in mind two objectives- to promote economic growth and to keep

inflation under control. If the growth prospects of the economy are good, then

investment activity will be buoyant, resulting in demand for money (to fund

expansion).

However, unchecked investment activity could lead to a heating up of the

economy, giving rise to inflationary pressures. In such a scenario, the central

bank needs to adjust the fast rise in demand to the slower growth in supply.

The central bank does this by increasing the cost of money. When the cost of

money is high, both investment and consumption demand suffer.

Economic Growth

Economic growth and its prospects affect the yield curve. This is because

the monetary policy is largely influenced by the health of the economy.

The growth prospects of the economy affect the allocation of capital. If

there are little or no growth prospects, the demand for capital will be slow-

moving.

Banks would be saddled with surplus funds, which would probably be

diverted to the debt markets. Also, in a slowing economy, banks themselves

might not be comfortable giving loans to the industry for fear of accumulating

bad debts.

Consequently, the investment avenue that guarantees almost risk-free

returns is the G-secs and T-bills. This drives up demand for debt instruments.

Higher demand results in price of debt instruments being marked up,

implying that yields decline.

On the other hand, when the growth prospects for the economy become

brighter the demand for these instruments weakens.

34


Fiscal Policy

The fiscal policy controls the government’s earnings and spending. If a

government spends more than it earns it will incur a fiscal deficit. A higher

fiscal deficit increases the risk of default by a government.

Therefore, the interest rates in these countries are higher. Rising budget

deficits cause the yield curve to be steep while falling budget deficits tend to

flatten the curve.

India Inc’s balance sheet

However, in case a fiscal situation of a country looks precarious, the short-

term interest rates will tend to be much higher than long-term interest rates.

The long-term interest rates will be relatively lower on hopes that the

situation improves in the future.

But if the fiscal deficit continues to rise then interest rates in the long-term

will be higher because the government will continue to borrow to meet its

fiscal deficit, increasing the demand for money. The markets as a result

would demand higher interest rates causing the prices for instruments to

decline.

Inflation

Inflation affects both the long-term and the short-term yields. If the inflation

is around 7 percent and the long-term yield is about 11 percent, the real rate

of return is just 4 percent. Therefore, if inflation rises, the real rate of return

would decline causing the price of the instrument to head south and thereby

increasing the yield.

35

The Debt Market in India Instruments

Instruments

When a nation has capital, it can utilize it in two ways: either consume the

capital i.e. spend it on things that will not give any further benefit or invest

the capital into capacity building that will help the economy to grow.

Sustainable economic growth is dependent on the level of investment

activity. Therefore, industries and the government need money to grow.

Household is one of the supply avenues. And the job of financial markets is to

channelize this money into the industrial sector. Though deposits in banks are

the safest form of investments, in a scenario where the interest rates are

decreased by the central bank, the investor is the loser.

However, if the same investor would hold a bond that had fixed returns,

the bond would become valuable in a scenario where interest rates declined.

The retail investor in India did not have much of a choice. Either he was at

the mercy of the banks for deposits or at the mercy of the securities and the

real estate market. Equities and real estates are risky. The numerous scams

have time and again highlighted the so-called credibility of the equities

market in the country. Also, due to the inherent uncertainty in returns, these

markets did not suit the risk appetite of many investors. Therefore the need

of the hour was to have a market in which the price discovery was far more

realistic, market determined and more in favour of the investor. Also,

important was liquidity. The answer to this was debt markets, where

instruments with fixed returns could be traded.

Traditionally when a borrower takes a loan from a lender, he enters into

an agreement with the lender specifying when he would repay the loan and

what return (interest) he would provide the lender for providing the loan. This

entire structure can be converted into a form wherein the loan can be made

tradable by converting it into smaller units with pro rata allocation of interest

and principal. This tradable form of the loan is termed as a debt instrument.

Therefore, debt instruments are basically obligations undertaken by the

issuer of the instrument as regards certain future cash flows representing

36

VII


interest and principal, which the issuer would pay to the legal owner of the

instrument. Debt instruments are of various types. The key terms that

distinguish one debt instrument from another are as follows:

Issuer of the instrument

Face value of the instrument

Interest rate

Repayment terms (and therefore maturity period/tenor)

Security or collateral provided by the issuer

Different kinds of debt instruments and their key terms and characteristics

are discussed below.

Money Market Instruments

By convention, the term "money market" refers to the market for short-

term requirement and deployment of funds. Money market instruments are

those instruments, which have a maturity period of less than one year. The

most active part of the money market is the market for overnight and term

money between banks and institutions (called call money) and the market for

repo transactions. The former is in the form of loans and the latter are sale

and buy back agreements – both are obviously not traded. The main traded

instruments are commercial papers (CPs), certificates of deposit (CDs) and

treasury bills (T-Bills). All of these are discounted instruments i.e. they are

issued at a discount to their maturity value and the difference between the

issuing price and the maturity/face value is the implicit interest. These are

also completely unsecured instruments. One of the important features of

money market instruments is their high liquidity and tradability. A key reason

for this is that these instruments are transferred by endorsement and

delivery and there is no stamp duty or any other transfer fee levied when the

instrument changes hands. Another important feature is that there is no tax

deducted at source from the interest component. A brief description of these

instruments is as follows:

Commercial paper (CP)

These are issued by corporate entities in denominations of Rs2.5mn and

usually have a maturity of 90 days. CPs can also be issued for maturity

37


periods of 180 days and one year but the most active market is for 90 day

CPs.

Two key regulations govern the issuance of CPs-firstly, CPs have to be

compulsorily rated by a recognized credit rating agency and only those

companies can issue CPs which have a short term rating of at least P1.

Secondly, funds raised through CPs do not represent fresh borrowings for the

corporate issuer but merely substitute a part of the banking limits available

to it. Hence, a company issues CPs almost always to save on interest costs

i.e. it will issue CPs only when the environment is such that CP issuance will

be at rates lower than the rate at which it borrows money from its banking

consortium.

Certificates of deposit (CD)

These are issued by banks in denominations of Rs0.5mn and have

maturity ranging from 30 days to 3 years. Banks are allowed to issue CDs

with a maturity of less than one year while financial institutions are allowed

to issue CDs with a maturity of at least one year. Usually, this means 366 day

CDs. The market is most active for the one-year maturity bracket, while

longer dated securities are not much in demand. One of the main reasons for

an active market in CDs is that their issuance does not attract reserve

requirements since they are obligations issued by a bank.

Treasury Bills (T-Bills)

These are issued by the Reserve Bank of India on behalf of the

Government of India and are thus actually a class of Government Securities.

At present, T-Bills are issued in maturity of 14 days, 91 days and 364 days.

The RBI has announced its intention to start issuing 182 day T-Bills shortly.

The minimum denomination can be as low as Rs100, but in practice most of

the bids are large bids from institutional investors who are allotted T-Bills in

dematerialised form. RBI holds auctions for 14 and 364 day T-Bills on a

fortnightly basis and for 91 day T-Bills on a weekly basis. There is a notified

value of bills available for the auction of 91 day T-Bills that is announced 2

days prior to the auction. There is no specified amount for the auction of 14

38


and 364 day T-Bills. The result is that at any given point of time, it is possible

to buy T-Bills to tailor one’s investment requirements.

Potential investors have to put in competitive bids at the specified times.

These bids are on a price/interest rate basis. The auction is conducted on a

French auction basis i.e. all bidders above the cut off at the interest rate/price

which they bid while the bidders at the clearing/cut off price/rate get pro rata

allotment at the cut off price/rate. The cut off is determined by the RBI

depending on the amount being auctioned, the bidding pattern etc. By and

large, the cut off is market determined although sometimes the RBI utilizes

its discretion and decides on a cut off level, which results in a partially

successful auction with the balance amount devolving on it. This is done by

the RBI to check undue volatility in the interest rates.

Non-competitive bids are also allowed in auctions (only from specified

entities like State Governments and their undertakings and statutory bodies)

wherein the bidder is allotted T-Bills at the cut off price.

Apart from the above money market instruments, certain other short-term

instruments are also in vogue with investors. These include short-term

corporate debentures, Bills of exchange and promissory notes.

Like CPs, short-term debentures are issued by corporate entities.

However, unlike CPs, they represent additional funding for the corporate i.e.

the funds borrowed by issuing short term debentures are over and above the

funds available to the corporate from its consortium bankers. Normally,

debenture issuance attracts stamp duty; but issuers get around this by

issuing only a letter of allotment (LOA) with the promise of issuing a formal

debenture later – however the debenture is never issued and the LOA itself is

redeemed on maturity. These LOAs are freely tradable but transfers attract

stamp duty.

Bills of exchange are promissory notes issued for commercial transactions

involving exchange of goods and services. These bills form a part of a

company’s banking limits and are discounted by the banks. Banks in turn

rediscount bills with each other.

Long-Term Debt Instruments

39


By convention, these are instruments having a maturity exceeding one

year. The main instruments are Government of India dated securities

(GOISEC), State Government securities (state loans), public sector bonds

(PSU bonds), corporate debentures etc.

Most of these are coupon bearing instruments i.e. interest payments

(called coupons) are payable at pre specified dates called "coupon dates". At

any given point of time, any such instrument has a certain amount of accrued

interest with it i.e. interest, which has accrued (but is not due) calculated at

the "coupon rate" from the date of the last coupon payment e.g. if 30 days

have elapsed from the last coupon payment of a 14% coupon debenture with

a face value of Rs 100, the accrued interest will be

Whenever coupon-bearing securities are traded, by convention, they are

traded at a base price with the accrued interest separate – in other words,

the total price would be equal to the summation of the base price and the

accrued interest.

A brief description of these instruments is as follows:

Government of India dated securities (GOISECs)

Like treasury bills, GOISECs are issued by the Reserve Bank of India on

behalf of the Government of India. These form a part of the borrowing

program approved by Parliament in the Finance Bill each year (Union

Budget). They are issued in dematerialised form but can be issued in

denominations as low as Rs 100 in physical certificate form. They have

maturity ranging from 1 year to 30 years. Very long dated securities i.e.

those having maturity exceeding 20 years were in vogue in the seventies and

the eighties while in the early nineties, most of the securities issued have

been in the 5-10 year maturity bucket. Very recently, securities of 15 and 20

years maturity have been issued.

Like T-Bills, GOISECs are most commonly issued in dematerialised form in

the "SGL" account although it can be issued in physical certificate form on

specific request. Tradability of physical securities is very limited. The SGL

40

100*0.14*30/365 = 1.15


passbook contains a record of the holdings of the investor. The RBI acts as a

clearing agent for GOISEC transactions by being the custodian and operator

of the SGL account. GOISECs are transferable by endorsement and delivery

for physical certificates. Transactions of securities held in SGL form are

effected through SGL transfer notes. Transfer of GOISECs does not attract

stamp duty or transfer fee. Also no tax is deductible at source on the coupon

payments made on GOISECs.

Like T-Bills, GOISECs are issued through the auction route. The RBI pre

specifies an approximate amount of dated securities that it intends to issue

through the year. However, it has broad flexibility in exceeding or being

under that figure. Unlike T-Bills, it does not have a pre set timetable for the

auction dates and exercises its judgement on the timing of each issuance, the

duration of instruments being issued as well as the quantum of issuance.

Sometimes the RBI specifies the coupon rate of the security proposed to

be issued and the prospective investors bid for a particular issuance yield.

The difference between the coupon rate and the yield is adjusted in the issue

price of the security. On other occasions, the RBI just specifies the maturity of

the proposed security and prospective investors bid for the coupon rate itself.

In either case, just as in T-Bills, the auction is conducted on a French auction

basis. Also, the RBI has wide freedom in deciding the cut off rate for each

auction and can end up with unsold securities, which devolve on it.

Apart from the auction program, the RBI also sells securities in its Open

Market Operations (OMO), which it has acquired in devolvement or

sometimes directly through private placements. Similarly, it also buys

securities in open market operations if it feels fit. Earlier, the RBI used to

issue straight coupon bonds i.e. bonds with a stated coupon payable

periodically. In the last few years, the RBI has been innovative and new types

of instruments have also been issued. These include

Inflation linked bonds – These are bonds for which the coupon

payment in a particular period is linked to the inflation rate at that

time – the base coupon rate is fixed with the inflation rate

(consumer price index-CPI) being added to it to arrive at the total

coupon rate. Investors are often unwilling to invest in longer dated

41


securities due to uncertainty of future interest rates. The idea

behind these bonds is to make them attractive to investors by

removing the uncertainty of future inflation rates, thereby

maintaining the real value of their invested capital.

Floating Rate Bonds (FRBs) – They come with a coupon floater,

which is usually a margin over and above a benchmark rate. E.g.,

the Floating Bond may be nomenclature/denominated as +1.25%

FRB YYYY (the maturity year). +1.25% coupon will be over and

above a benchmark rate, where the benchmark rate may be a six-

month average of the implicit cut-off yields of 364-day Treasury bill

auctions. If this average works out 9.50% p.a, then the coupon will

be established at 9.50% + 1.25% i.e., 10.75%p.a. Normally FRBs

(floaters) also bear a floor and cap on interest rates. Interest so

determined is intimated in advance before such coupon payment,

which is normally, Semi-Annual.

Zero coupon bonds – These are bonds for which there is no

coupon payment. They are issued at a discount to face value with

the discount providing the implicit interest payment. In effect, these

can be interpreted as long duration T – Bills or as bonds with

cumulative interest payment.

State Government Securities (state loans)

The respective state governments issue these but the RBI coordinates the

actual process of selling these securities. Each state is allowed to issue

securities up to a certain limit each year. The planning commission in

consultation with the respective state governments determines this limit.

While there is no central government guarantee on these loans, they are

deemed to be extremely safe. This is because the RBI debits the overdraft

accounts of the respective states held with it for payment of interest and

principal. Generally, the coupon rates on state loans are marginally higher

than those of GOISECs issued at the same time.

The procedure for selling of state loans, the auction process and allotment

procedure is similar to that for GOISEC. They also qualify for SLR status and

interest payment and other modalities are similar to GOISECs. They are also

42


issued in dematerialised form and no stamp duty is payable on transfer. The

procedure for transfer is similar to GOISECs. In general, state loans are much

less liquid than GOISECs.

Public Sector Undertaking Bonds (PSU Bonds)

These are long-term debt instruments issued by Public Sector

Undertakings (PSUs). The term usually denotes bonds issued by the central

PSUs (i.e. PSUs funded by and under the administrative control of the

Government of India). The issuance of these bonds began in a big way in the

late eighties when the central government stopped/reduced funding to PSUs

through the general budget. Typically, they have maturities ranging between

5-10 years and they are issued in denominations (face value) of Rs.1000

each. Most of these issues are made on a private placement basis to a

targeted investor base at market determined interest rates. Often,

investment bankers are roped in as arrangers for these issues.

These PSU bonds are transferable by endorsement and delivery and no

tax is deductible at source on the interest coupons payable to the investor

(TDS exempt). In addition, from time to time, the Ministry of Finance has

granted certain PSUs, an approval to issue limited quantum of tax-free bonds

i.e. bonds for which the payment of interest is tax exempt in the hands of the

investor. This feature was introduced with the purpose of lowering the

interest cost for PSUs which were engaged in businesses which could not

afford to pay market determined rates of interest eg. Konkan Railway

Corporation was allowed to issue substantial quantum of tax free bonds. Thus

we have taxable coupon PSU bonds and tax free coupon PSU bonds.

Bonds of Public Financial Institutions (PFIs)

Apart from public sector undertakings, Financial Institutions are also

allowed to issue bonds, that too in much higher quantum. They issue bonds in

2 ways – through public issues targeted at retail investors and trusts and also

through private placements to large institutional investors. Usually, transfers

of the former type of bonds are exempt from stamp duty while only part of

the bonds issued privately have this facility. On an incremental basis, bonds

of PFIs are second only to GOISECs in value of issuance.

43


Retail bond issues of PFI bonds have become a big rage with investors in

the last three years. PFIs have also been offering bonds with different

features to meet differing needs of investors. Eg. monthly return bonds

(which pay monthly coupons), cumulative interest bonds, step up coupon

bonds, etc.

Corporate Debentures

These are long-term debt instruments issued by private sector companies.

These are issued in denominations as low as Rs. 1000 and have maturities

ranging between 1 and 10 years. Long maturity debentures are rarely issued,

as investors are not comfortable with such maturities. Generally, debentures

are less liquid as compared to PSU bonds and the liquidity is inversely

proportional to the residual maturity.

A key feature that distinguishes debentures from bonds is the stamp duty

payment. Debenture stamp duty is a state subject and the quantum of

incidence varies from state to state. There are two kinds of stamp duties

levied on debentures, viz. issuance and transfer. Issuance stamp duty is paid

in the state where the principal mortgage deed is registered. Over the years,

issuance stamp duties have been coming down and are reasonably uniform.

Stamp duty on transfer is paid to the state in which the registered office of

the company is located. Transfer stamp duty remains high in many states

and is probably the biggest deterrent for trading in debentures resulting in

lack of liquidity. Debentures are divided into different categories on the basis

of:

Convertibility of the instrument

Security

Debentures can be classified on the basis of convertibility into:

Non-Convertible Debentures (NCD): These instruments retain

the debt character and cannot be converted in to equity shares

Partly Convertible Debentures (PCD): A part of these

instruments are converted into Equity shares in the future at notice

of the issuer. The issuer decides the ratio for conversion. This is

normally decided at the time of subscription.

44


Fully convertible Debentures (FCD): These are fully convertible

into Equity shares at the issuer's notice. Upon conversion the

investors enjoy the same status as ordinary shareholders of the

company.

Optionally Convertible Debentures (OCD): The investor has the

option to either convert these debentures into shares at price

decided by the issuer/agreed upon at the time of issue.

On basis of Security, debentures are classified into:

Secured Debentures: These instruments are secured by a charge

on the fixed assets of the issuer company. So if the issuer fails on

payment of either the principal or interest amount, his assets can

be sold to repay the liability to the investors.

Unsecured Debentures: These instruments are unsecured in the

sense that if the issuer defaults on payment of the interest or

principal amount, the investor has to be along with other unsecured

creditors of the company.

Secured Redeemable Debenture: Secured refers to the security

given by the issuer for the loan transaction represented by the

debenture. This is usually in the form of a first mortgage or charge

on the fixed assets of the company on a pari passu basis with other

first charge holders like financial institutions. Sometimes, the

charge can also be a second charge instead of a first charge. A

trustee specifically appointed for the purpose creates the charge on

behalf of the entire pool of debenture holders. Typically, financial

institutions and banks are trustees and their job is to create and

maintain the security. Redemption refers to the process whereby

the debenture is extinguished on payment of all the obligations due

to the holder after the repayment of the last instalment of the

principal amount of the debenture.

Sometimes investors get confused and think that the above-mentioned

type of debenture is secured by a guarantee of the trustee financial

institution. The presence of the name of a reputed financial institution as a

trustee confuses them.

45


Difference between a bond and a debenture:

Generally speaking, long-term debt securities issued by the Government

of India or any of the State Government's undertakings owned by them or by

development financial institutions are called bonds. Instruments issued by

other entities are called debentures. The difference between the two is

actually a function of where they are registered and pay stamp duty and how

they trade. Issuance stamp duty on bonds is a central subject and a bond is

transferable by endorsement and delivery without payment of any transfer

stamp duty. The stamp duty on debentures is a state subject and has to be

paid both on issuance and transfer. On issuance it is linked to finance

creation, while on transfer, it is levied in accordance with the laws of the

state in which the registered office of the company in question is located.

Unlike a bond, a debenture transfer has to be effected through a transfer

deed.

Pass Through Certificates (PTCs)

Pass through certificate is an instrument with cash flows derived from the

cash flow of another underlying instrument or loan. Most commonly, they

have been issued by foreign banks like Citibank on the basis of their car loan

or mortgage/housing loan portfolio. The issuer is a special purpose vehicle

which just receives money from a multitude of (may be several hundreds or

thousands) underlying loans and passes the money to the holders of the

PTCs. This process is called securitization. Legally speaking PTCs are

promissory notes and therefore tradable freely with no stamp duty payable

on transfer. Most PTCs have 2-3 year maturity because the issuance stamp

duty rate of 0.75% makes shorter duration PTCs unviable.

46

The Debt Market in India Issuers

Issuers

Issuers of debt instruments can be classified into five broad categories.

These are as follows:


The largest volumes of instruments issued and traded in the debt market

fall in this category. Issuers within this category include the Government of

India, various State Governments and some statutory bodies. Instruments

issued by the Central Government carry the highest credit rating because of

the ability of the Government to tax and repay its obligations.

As mentioned earlier, government of India issues T-Bills and GOISECs of

varying maturities, while state government’s issue state loans. Apart from

these, the government also issues instruments, which are tailor-made for

retail investors. These include tax-free relief bonds, Indira Vikas Patra, Kisan

Vikas Patra, etc.

Banks and Development Financial Institutions (DFI)

Instruments issued by DFIs and banks carry the highest credit ratings

amongst non-government issuers primarily because of their linkage with the

Government. There is also a perception that the Government will not allow

important DFIs and banks to fail or default on their obligations. Prominent DFI

issuers include ICICI, IDBI, IFCI, IRBI, as well as some state level DFIs like

SICOM, GIIC, etc. ICICI and IDBI have been the most aggressive issuers.

Virtually all banks raise CDs, while prominent bond issuers have been SBI,

47


Banks and Development Financial Institutions

Public Sector Undertakings


Government or quasi government owned non-corporate entities

VIII


Bank of Baroda, Bank of India etc. Most banks have floated issues last year in

order to raise capital to meet their capital adequacy requirements.

DFIs issue 1-3 year CDs as well as longer maturity bonds. Banks mainly

issue short term CDs and they have also issued bonds from time to time

(although infrequently). For DFIs, bonds used to originally account for a very

small part of their overall resource raising; but the picture has changed

dramatically in the past 5 years as Government has discontinued other

cheaper avenues of funds to them. For new private sector banks and foreign

banks, which do not have access to a large branch network, CDs constitute

an extremely important part of overall resource raising.

DFIs are the second largest issuer of debt instruments after the

Government and sovereign bodies. The total value of outstanding bonds and

CDs issued by DFIs is estimated at Rs.1 trillion while the total outstanding

value of CDs and bonds issued by scheduled commercial banks is estimated

at Rs.60 bn. The incremental gross issuance of bonds by DFIs and banks is

estimated at Rs.320 bn, while the gross and net annual issuance of CDs is

estimated at Rs.120 bn and Rs.60 bn respectively.

DFIs raise bonds through public issues targeted at retail investors and

trusts. These retail issues account for about 20% of total funds raised. Private

placement of bonds with institutional investors is the main mechanism for

raising money. Privately placed bonds can be issued at any time to any

investor with the only restriction being the ceiling defined by the

shareholders of the PFI. Since these private placements happen throughout

the year, they are called on-tap bond issues.

Public Sector Undertakings (PSUs)

PSUs issue PSU bonds, which enjoy special concessions. These

concessions are indirect i.e. these PSU bonds are approved securities for

investment by various trusts, provident funds etc. The prominent PSU issuers

include Mahanagar Telephone Nigam Ltd. (MTNL), National Thermal Power

Corporation (NTPC), Indian Railway Finance Corporation (IRFC), Konkan

Railway Corporation (KRC), Neyveli Lignite Corporation (NLC), Steel Authority

of India (SAIL), National Hydel Power Corporation (NHPC), HUDCO, Coal India,

48


Rashtriya Ispat Nigam Ltd (RINL) etc. IRFC is the fund raising arm of the

Indian railways while MTNL raises funds for itself as well as for the

Department of Telecom. In addition to PSU bonds, PSUs issue CPs like any

other corporate.

The total value of PSU bonds outstanding as at March 31, 1999 is

estimated at Rs.500 bn with MTNL, NTPC, IRFC and SAIL being the largest

issuers. The overall issuance of PSU bonds was very high in the late eighties

and early nineties when they were the biggest issuers after the Government

of India and other sovereign bodies. However the total issuance has declined

considerably in the last 3 - 4 years.


Private sector companies issue commercial papers (CPs) and short and

long-term debentures. The total value of outstanding debentures issued by

private sector corporates is estimated at Rs.500 bn. There were large issues

of debentures by private sector companies in the early and mid nineties.

Capital investment in the private sector was booming on the back of a strong

capital market and private sector companies were raising loans by way of

debentures (among other means) in order to meet their overall fund

requirements. Sometimes, debentures were issued together with equity

issues in the form of partly convertible debentures. Since then three

developments have taken place. Firstly, there was overall decline in the

investment spending by the private corporate sector leading to decline in

demand for raising money in all forms including this one. On the other hand,

the demand for top quality debentures – i.e. debentures issued by top rated

companies – has increased substantially due to general flight to quality.

Thirdly, banks have been allowed to invest in private sector debentures,

which is an indirect way of giving term loans to these companies. Banks have

begun debenture investment in a big way and demand for debentures by

banks and newer investors like mutual funds have been high. These opposing

forces have resulted in a market that is stagnant at about Rs.100 bn per year.

Most of the debentures issued by the private sector are privately placed with

institutional investors. It is not feasible for a typical company to have a public

49


issue of debentures because the cost of making a public issue is very high for

amounts less than Rs.5 bn.

Government owned or quasi government non-corporate

entities

This is a new class of issuers, which has emerged in the last 3 years. The

origin of these issuers lies in the inability of state governments to execute

large infrastructure projects through budgetary allocations. Consequently,

these state governments have created Special Purpose Vehicles (SPVs) for

executing these projects. These SPVs issue bonds/debentures. Typical

maturity of the instruments ranges from 3-7 years. The first prominent

issuance of this type was made in 1993 - that of Sardar Sarovar Narmada

Nigam Ltd., a vehicle created by the Government of Gujarat to execute the

Sardar Sarovar project. Since then, Krishna Bhagya Jala Nigam (KBJNL),

Maharashtra Krishna Valley Development Corporation (MKVDC), Maharashtra

State Road Development Corporation (MSRDC), etc. have come with larger

and larger issues for funding such ambitious infrastructure projects.

The credit rating of these debentures takes into account the implicit and

sometimes explicit support of the State Government and the ratings issued

are called SO rating (called Supplemental Obligation rating). In effect, it is an

indirect rating of the state government in question. Most of these issues are

public issues and the size of each issue is fairly large - ranging from Rs.5 bn

to Rs.15 bn per issue. But the actual subscribers are largely institutional.

There is a widespread belief that the state government behind the issuance

would not be willing to face the wrath of a large number of retail investors

and therefore would not let the issuer default. Hence, these issues are

perceived to be safe. The total value of outstanding debentures from this

class of issuers is estimated at Rs.150 bn. Many private developers have

come forward to sponsor infrastructure projects. We expect similar issues

from such private sector infrastructure developers in the years to come.

50

The Debt Market in India Investors

Investors

While understanding the behaviour of institutional investors, one will have

to appreciate the very fundamental point that in most cases debt market is a

market of compulsion as against the equity market which is a market of

choice. Many institutional investors have no choice but to invest in specific

debt instruments by virtue of their constitution or due to the regulations,

which govern their functioning, or by their orientation as to whom they

represent.

We have classified institutional investors operating in the Indian debt

market in the following main categories:

While banks, corporate treasuries, mutual funds and some FIIs can and do

invest in other kinds of securities like equities; provident funds, insurance

companies and trusts almost exclusively invest in various debt instruments.

Banks

Collectively, all the banks put together are the largest investors in the

debt market. They invest in all instruments ranging from T-Bills, CPs and CDs

to GOISECs, private sector debentures etc. By regulation, a bank has to invest

25% of its total deposits in GOISECs or other approved securities. This

percentage figure (25%) is called the Statutory Liquidity Ratio (SLR) and

these eligible securities are called SLR securities. These securities are the

ones, which are supposed to be extremely safe and carry minimal risk

51

Banks

Insurance companies

Provident funds

Mutual funds

Trusts

Corporate treasuries

Foreign Investors (FIIs)

IX


weightage. GOISECs used to carry zero risk weightage till very recently,

which has now been changed to 5%.

The SLR regulation makes the banks the largest investors in the market

for Government of India securities. In reality most banks have exposure to

Government of India securities much higher than the minimum 25%

stipulated by regulation. This is because of the prevailing recessionary

environment wherein many industrial and commercial borrowers have been

performing poorly and have been unable to meet their repayment obligations

on time. In such an environment, investing in GOISECs represents a sure fire

way of avoiding Non-Performing Assets (NPAs). Similarly, investment in bonds

and CDs of DFIs is another safe investment in the present environment.

Banks would be amongst the largest investors in DFI bonds.

Banks lend to corporate sector directly by way of loans and advances and

also invest in debentures issued by the private corporate sector and in PSU

bonds. A few years ago, the total ceiling for investment by banks in corporate

debentures, shares and other securities was fixed at 5% of the incremental

deposits of the previous year. This regulation has since been changed. Banks

can now invest 5% of the incremental deposits of the previous year in shares

of private sector while there is no ceiling for debentures. Banks’ investment

in private sector investment has grown manifold due to this relaxation.

Banks also keep on investing in CDs and CPs - but that is more as a way of

managing their liquidity on a day-to-day basis. By and large, bank treasuries

are not very active. In most cases, banks just buy and hold the investments,

which they make and not trade too much on them. Things have been

changing in recent times with some of the more aggressive banks churning

over part of their portfolio and having a more active treasury.

Insurance companies

The second largest category of investors in the debt market are the

insurance companies which have aggregate outstanding investments of

Rs.1250 bn and gross annual incremental investments of Rs.250 bn. By

regulation, LIC has to allocate 60% of its annual incremental investments to

GOISECs, while the GIC and its 4 subsidiaries (New India Assurance, Oriental

52


Insurance, United India Insurance and National Insurance) are supposed to

allocate 40% of their annual incremental investments in GOISECs. LIC is

allowed to invest up to a maximum of 15% of its incremental investments in

private sector debentures and shares while GIC and it subsidiaries are

allowed to invest up to a maximum of 25% of their incremental investments

in private sector shares and debentures. Hence, collectively, the insurance

companies are one of the largest investors in GOISEC’s. Of their annual

incremental investments of Rs.250 bn, not less than Rs.150 bn would be in

GOISECs.

Provident funds

Provident funds are estimated to have a total corpus of Rs.800 bn. The

total incremental investment by provident funds every year is approximately

Rs.150 bn, which makes them the third largest investors in the debt market.

Again by virtue of regulation, provident funds are supposed to invest a

minimum of 25% of their incremental accretions each year in GOISECs, 15%

in state government securities, 40% in PSU bonds, etc. with a maximum of

10% in rated private sector debentures. Investment guidelines for provident

funds are being progressively liberalized and investment in private sector

debentures is one step in this direction.

Most of the provident funds are very safety oriented and tend to give

much more weightage to investment in government securities although they

have been considerable investors in PSU bonds as well as state government

backed issues like SSNL, MSRDC, etc. The largest provident fund is the one

managed by the State Bank of India on behalf of the Central Provident Fund

Commissioner. This has an estimated corpus of Rs.400 bn and fresh annual

investments of Rs.70 bn. This Provident fund has taken a policy decision not

to invest in private sector debentures although recent regulation allows it to

do so.

By their very orientation as well as by regulation, provident funds are buy

and hold investors and almost never trade on their investments.

53


Mutual funds

Mutual funds represent an extremely important category of investors.

World over, they have almost surpassed banks as the largest direct collector

of primary savings from retail investors and therefore as investors in the

wholesale debt market.

Mutual funds include the Unit Trust of India, the mutual funds set up by

nationalized banks and insurance companies like the SBI Mutual Fund, the

GIC Mutual Fund, the LIC Mutual Fund, etc. as well as the new private sector

mutual funds set up by corporates and overseas mutual fund companies. Of

these, the largest is the Unit Trust of India, which has almost 85% of the

market share of the mutual fund business and a total corpus of about Rs.700

bn. The total corpus of all the mutual funds put together is about Rs.850 bn

while the annual gross incremental investments are in the range of around

Rs.150 bn.

While all mutual funds including the Unit Trust of India invest in GOISECs

in a big way, they are collectively one of the largest investors in PSU bonds

and private sector corporate debentures. Private sector mutual funds like

Birla, Prudential ICICI, etc. have emerged as major investors in the

debentures issued by top rated private sector companies. Short-term

debentures are a favourite of mutual funds. This has resulted in a scenario

where the yield on some of the top quality private sector corporates is at a

very low differential compared to risk free sovereign instruments and bonds

of financial institutions.

Most mutual funds trade at least 30-40% of their portfolio with the

exception of UTI, which does very little trading.

Trusts

Trusts include religious and charitable trusts as well as statutory trusts

formed by the government and quasi government bodies. The largest trusts

in India are the port trusts, which have been constituted under the Major Port

Trust Act. These include the Bombay Port Trust, Madras Port Trust, Calcutta

Port Trust, Cochin Port Trust etc. The aggregate corpus of the Port Trusts is

54


estimated at Rs.80 bn, while their annual investments would be about Rs.20

bn of that amount.

Religious trusts and Charitable trusts range from the very small ones to

large ones like Tirupati Devasthanam, Mata Amritanandmayi, Ramkrishna

Mission, etc. Other trusts include hospital trusts like Jaslok, Bombay Hospital

etc, armed forces trusts like Army Wives Welfare Association, Air Force

Officers Association and many other general trusts like the Rajiv Gandhi

Foundation, Birla Science Foundation etc.

There are very few instruments in which trusts are allowed to invest. Most

of the trusts invest in CDs of banks and bonds of financial institutions and

units of Unit Trust of India. The total aggregate corpus of all trusts is

estimated at Rs.250 bn while the total incremental investment would be

approximately Rs.40 bn per annum.

Corporate Treasuries

Corporate treasuries have become prominent investors only in the last

few years. Treasuries could be either those of the public sector units or

private sector companies or any other government bodies or agencies.

The treasuries of PSUs as well as the governmental bodies are heavily

regulated in the instruments they can invest in. These regulations were put in

place by the administrative ministries as a reaction to the Harshad Mehta

scam. These treasuries are allowed to invest in papers issued by DFIs and

banks as well as GOISECs of various maturities. However, the orientation of

the investments is mostly in short-term instruments or sometimes in

extremely liquid long-term instruments, which can be sold immediately in the

markets. Some have been investing in preference shares issued by DFIs.

In complete contrast to public sector treasuries, those in the private sector

are very adventurous, fleet footed and savvy. They invest in CDs of banks

and CPs of other private sector companies, GOISECs as well as debentures of

other private sector companies. Of late, preference shares of DFIs and open-

ended mutual funds have also become popular with these treasuries. Some of

the savvier treasuries have also been investing in badla financing which gives

much superior returns as compared to any other security although with

55


higher risk perception. Another favourite is the inter-corporate deposit (ICD),

which is also non tradable like badla financing. The big private sector

treasuries are those belonging to the Birla companies, Reliance group,

Gujarat Ambuja, Bajaj Auto, Parle Products, etc.

Foreign Institutional Investors

India does not allow capital account convertibility either to overseas

investors or to domestic residents. Registered FIIs are an exception to this

rule. More than 300 FIIs invest in Indian equities, while the number of FIIs

investing in Indian domestic debt is less than 20.

FIIs have to be specifically and separately approved by SEBI for equity and

debt. Each debt FII is allocated a limit every year up to which it can invest in

Indian debt securities. It can do so without asking for any permission from

anyone. They are also free to disinvest any of their holdings, at any point of

time, without asking for any permission from anyone.

The total aggregate limit or ceiling of investments by debt FIIs is US$

1.5bn. As on date, the aggregate investments are less than US$100mn. Most

of the debt FIIs are extremely quick traders. They invest wherever they can

make a quick buck. They are unlikely to invest in Indian debt at a time when

the currency risk is high and the expected gains from price appreciation in

Indian debt paper are not very high. FII investment limit in debt market raised

to $1.75 billion in Union Budget 2004.

56

The Debt Market in India Regulators

Regulators

Reserve Bank of India (RBI)

The Reserve Bank of India is the main regulator for the debt market. Apart

from its role as a regulator, it has to simultaneously fulfil several other

important objectives, viz. managing the borrowing program of the

Government of India, controlling inflation, ensure adequate credit at

reasonable costs to various sectors of the economy, managing the foreign

exchange reserves of the country and ensuring a stable currency

environment. This shows the importance of RBI’s role as a fundraiser for the

Government of India.

Inevitably, there are occasions when one of RBI’s objectives clashes with

another one and the bank is forced to choose between trying to fulfil two

different objectives. It makes this choice depending on the exigencies of the

situation. eg. in the wake of the Asian crisis, maintaining currency stability

was a more important objective than keeping interest rates low.

Consequently, the RBI chose to ignore latter objective for some time. Such a

perspective of the issues confronting the RBI is extremely important for

understanding and forecasting events in the debt market.

RBI controls the issuance of new banking licenses to either foreign banks

or to new private sector banks. It controls the manner in which various

scheduled banks raise money from depositors. Further, it controls the

deployment of money through its policies on CRR, SLR, priority sector

lending, export refinancing, guidelines on investment assets, etc. E.g. its

policy on the cash reserve ratio and the statutory liquidity ratio determines

the extent to which banks money is locked away and the extent to which

money is available for lending/investment. Incremental changes in these

ratios can result in substantial change in the liquidity scenario and hence the

short term interest rates. The Reserve bank also regulates the market

57

X


through the control of the investment policy followed by banks. As an

example, RBI has recently allowed banks to invest in debentures of private

sector companies. This was earlier controlled by a limit and therefore in

earlier days, banks were unable to invest in debentures to a worthwhile

extent. Similarly, the limit for investment in shares has been enlarged

substantially making banks active investors in shares after decades. For the

non-banking financial companies (NBFCs), the RBI determines the extent to

which these companies can be leveraged and the extent to which they can

raise deposits from public depositors. Simultaneously it controls the asset

portfolio through changes in liquidity ratios, etc.

The next major area under the control of the RBI is the interest rate policy.

Earlier, it used to strictly control interest rates through a directed system of

interest rates. Each type of lending activity was supposed to be carried out at

a pre-specified interest rate. This system has changed over the years and RBI

has moved slowly towards a regime of market-determined controls. It now

seeks to control interest rate policy through various benchmarks and portrays

changes in these benchmarks as signals of its intent. These benchmarks

include the cut off interest rate of the various auctions for government

securities and T-Bills, the bank rate, the repo rates, and the rates on

refinance provided to banks, CRR etc. It also gives signals through the open

market operations that it carries out. eg. if it wants to signal a rise in interest

rate for a particular maturity, it would sell securities with similar maturities at

a yield higher than the prevailing market yield.

As mentioned earlier, in pursuit of its objective of ensuring a stable

currency environment, RBI temporarily abandoned its easy money policy,

when it had to defend the rupee against speculative forces in the worst days

of the Asian crisis. It reversed a long run trend of lowering of CRR and

increased the short term interest rates in such a way that speculators found it

difficult to speculate, reducing the volatility in the foreign exchange market.

On the reverse side, RBI has been buying dollars in times of heavy dollar

inflows to keep the rupee from appreciating against the dollar and hurting the

prospects of Indian exports.

58


SEBI

Another regulator for the debt market is the Securities and Exchange

Board of India (SEBI). SEBI gets involved whenever there is any entity raising

money from Indian individual investors through public issues. It regulates the

manner in which such moneys are raised and tries to ensure a fair play for

the retail investor. It forces the issuer to make the retail investor aware of the

risks inherent in the investment. SEBI is also a regulator for the entire family

of mutual funds, which are becoming an increasingly important player in the

debt market. SEBI regulates the entry of new mutual funds in the industry. It

also regulates the instruments in which mutual funds can invest. SEBI also

regulates the investments of debt FIIs.

Others

Apart from the two main regulators, the RBI and SEBI, there are several

other regulators specific for different classes of investors, eg. The Central

Provision Fund Commissioner and the Ministry of Labour regulate the

Provident Funds. The religious and charitable trusts are regulated by some of

the State governments of the states in which the trusts are located. The

Ministry of Surface Transport regulates Port Trusts. The Ministry of Human

Resource Development of the Government of India regulates some religious

trusts.

59

The Debt Market in India Credit Rating of Instruments

Credit Rating of Instruments

Credit rating is the process of assigning standard scores, which summarize

the probability of the issuer being able to meet its repayment obligations for

a particular debt instrument in a timely manner. Credit rating is integral to

debt markets as it helps market participants to arrive at quick estimates and

opinions about various instruments. In this manner it facilitates trading in

debt and money market instruments, especially in instruments other than

Government of India Securities.

Rating is usually assigned to a specific instrument rather than the

company as a whole. In the Indian context, the rating is done at the instance

of the issuer, which pays rating fees for this service. If it is unsatisfied with

the rating assigned to its proposed instrument, it is at liberty not to disclose

the rating given to it. There are 4 rating agencies in India. These are as

follows:

CRISIL - The oldest rating agency was originally promoted by ICICI.

Standard & Poor, the global leader in ratings, has recently taken a

small 10% stake in CRISIL.

ICRA - Promoted by IFCI. Moody’s, the other global rating major, has

recently taken a small 11% stake in ICRA.

CARE - Promoted by IDBI.

Duff and Phelps - Co-promoted by Duff and Phelps, the world’s 4th

largest rating agency.

CRISIL is believed to have about 42% market share followed by ICRA with

about 36%, CARE with 18% and Duff and Phelps with 4%.

Grading system

Each of the rating agencies has different codes for expressing rating for

different instruments; however, the number of grades and sub-grades is

similar. eg. for long-term debentures/bonds and fixed deposits, CRISIL has 4

60

XI


main grades and a host of sub grades. In decreasing order of quality, these

are AAA, AA+, AA, AA-, A+, A, A-, BBBB, BBB+, BB+, BB, BB-, B+, B, B-, C and

D. ICRA, CARE and Duff and Phelps have similar grading systems.

Credit rating is a dynamic concept and all the rating companies are

constantly reviewing the companies rated by them with a view to changing

(either upgrading or downgrading) the rating. They also have a system

whereby they keep ratings for particular companies on "rating watch" in case

of major events, which may lead to change in rating in the near future.

Ratings are made public through periodic newsletters issued by rating

companies, which also explain briefly the rationale for particular ratings. In

addition, they issue press releases to all major newspapers and wire services

about rating events on a regular basis.

Factors involved in credit rating

Credit rating depends on several factors, some of which are

tangible/numerical and some of which are judgmental and intangible. Some

of these factors are listed below:

Overall fundamentals and earnings capacity of the company and

volatility of the same

Overall macro economic and business/industry environment

Liquidity position of the company (as distinguished from profits)

Requirement of funds to meet irrevocable commitments

Financial flexibility of the company to raise funds from outside sources

to meet temporary financial needs

Guarantee/support from financially strong external bodies

Level of existing leverage (borrowings) and financial risk

As mentioned earlier, ratings are assigned to instruments and not to

companies and two different ratings may be assigned to two different

instruments of the same company. eg. a company may be in a fundamentally

weak business and may have a poor rating assigned for 5 year debentures

while its liquidity position may be good, leading to the highest possible rating

for a 3 month commercial paper. Very few companies may be assigned the

highest rating for a long term 5 or 7 year instrument. eg. CRISIL has only 20

61


companies rated as AAA for long term instruments and these companies

include unquestionable blue chips like Videsh Sanchar Nigam, Bajaj Auto,

Bharat Petroleum, Nestle India apart from institutions like ICICI, IDBI, HDFC

and SBI.

Derived ratings and structured obligations

Sometimes, debt instruments are so structured that in case the issuer is

unable to meet repayment obligations, another entity steps in to fulfil these

obligations. Sometimes there is a documented, concrete mechanism for

recourse to the third party, while on other occasions, the arrangement is

loose. On such occasions, the debt instrument in question is said to be "credit

enhanced" by a "structured obligation" and the rating assigned to the

instrument factors in the additional safety mechanism. The extent of

enhancement is a function of the rating of the "enhancer", the nature of the

arrangement etc and usually there is a suffix to the rating which expresses

symbolically that the rating is enhanced. e.g. A bond backed by the

guarantee of the Government of India may be rated AAA (SO) with the SO

standing for structured obligation.

Limitations of credit rating - rating downgrades

Rating agencies all across the world have often been accused of not being

able to predict future problems. In part, the problem lies in the rating process

itself, which relies heavily on past numerical data and standard ratios with

relatively lower usage of judgment and understanding of the underlying

business or the country economics. Data does not always capture all aspects

of the situation especially in the complex financial world of today. An

excellent example of the meaningless over reliance on numbers is the poor

country rating given to India. Major rating agencies site one of the reasons for

this as the low ratio India’s exports to foreign currency indebtedness. This

completely ignores two issues – firstly, India gets a very high quantum of

foreign currency earnings through remittances from Indians working abroad

and also services exports in the form of software exports, which are not

counted as "merchandise" exports. These two flows along with other

62


"invisible" earnings accounted for almost US$ 11 bn in FY 99. Secondly, since

India has tight control on foreign currency transactions, there is very little

error possible in the foreign currency-borrowing figure. As against this, for a

country like Korea, the figure for foreign currency borrowing increased by

US$ 50 bn after the exchange crisis began. This was on account of hidden

forward liabilities through swaps and other derivative products.

In general, Indian rating agencies have lost some amount of their

credibility in the last two years due to their inability to predict defaults in

many companies, which they had rated quite highly. Sometimes, some of the

agencies had an investment grade rating in place when the company in

question had already defaulted to some of the fixed deposit holders. Further,

rating agencies resorted to mass downgrading of 50-100 companies as a

reaction to public criticism, which further eroded their credibility. The major

reasons for these downgrades are as follows:

Corporate earnings fell very sharply due to persistent recessionary

conditions prevailing in the economy. Many of the corporates are in

commodity sectors where fluctuations in selling prices of products can be

very sharp - leading to complete erosion of profitability. This problem was

compounded by the Asian crisis, which led to increased competition from

cheap imports in many product categories.

Rating agencies substantially overestimated financial flexibility of

corporates especially from traditional corporate houses. Much of the financial

flexibility was implicit on raising money from new issues from the capital

market, which has been impossible in the last 3 years.

In the case of finance companies, widespread defaults and tightening of

regulations made it virtually impossible for them to raise money in any form.

These finance companies had been in the habit of investing in longer term,

illiquid assets by borrowing shorter term fixed deposits. When the flow of

credit stopped, they faced liquidity problems. These were further

compounded by defaults by some of the companies to which they had lent

money.

63


The experience is no different from the international scenario where

reputed and highly experienced rating agencies like Standard & Poor (S&P)

and Moody’s were unable to predict the Asian crisis and had to face the

embarrassment of seeing the credit rating of South Korea as a country go

from A+ to BB+ in a short span of 3 months.

By and large, the rating is a very good estimate of the actual

creditworthiness of the company; however, it is not able to predict extreme

situations such as the ones described above, which are unlikely to have been

predicted by most investors in any case. Investors should realize that a credit

rating is not sacrosanct and that one has to do one’s own due diligence and

investigation before investing in any instrument. They should use the rating

as a reference and a base point for their own effort. One good way of doing

this is examining the behaviour of the stock price in case the stock is listed.

As a collective, the market is far smarter at predicting problems than any

credit rating agency. Witness the sharp erosion in stock prices of companies

much before their credit ratings were downgraded. Witness also the fact that

foreign currency bonds from Indian issuers trade at yields lower than

countries, which have been rated higher by rating agencies.

64

The Debt Market in India Judicious Investment

Judicious Investment

The main points to be kept in mind by the investor while investing in the

Debt Markets:

Coupon (or the discount implied by the price as in the case of zero

coupon bonds) and the frequency of interest payments. The securities

can also be chosen in such a manner so that the interest payments

coincide with any requirements of funds at that point of time.

Timing of Cash Flows - In case the interest and redemption

proceeds, at one single point or at different points of time, are planned

to be used for meeting certain planned expenses in the future.

Information about the Issuer and the Credit Rating – It is

essential to obtain enough information about the background, the

business operations, the financial position, the use of the funds being

collected and the future projections to satisfy oneself of the suitability

of the investment. As per the regulations in force in the capital

markets, it is essential for any corporate debt security to obtain a

credit rating from any of the major credit rating agencies. A proper

analysis of the background and the financials of the issuer of any non-

govt. debt instrument and especially the credit rating would lend

greater safety to your investments.

Other Terms of particular Issue – It is also advisable to check on

certain terms of the issue like the use of the issue proceeds, the

monitoring agency, the formation of trustees, the secured or

unsecured nature of the bonds, the assets underlying the security and

the credit-worthiness of the organization.

Most of the said information can be available from the prospectus of the

said issue (and any required and relevant details can also be obtained on

demand from the lead manager of the issue)

Obtain all the relevant knowledge on the debt security like the coupon,

maturity, interest payments, Yield To Maturity (at the particular price

65

XII

The Debt Market in India Judicious Investment

at which the trade is intended to be carried out) and the Duration of

the Instrument.

Check the Yield To Maturity (YTM) of the debt security with the YTMs of

other comparable debt securities of the same class and features.

Remember that the Yield and the Price are inversely related. So, you

will be able to obtain a higher yield at a lower price.

It is desirable to check on the liquidity of any corporate debt

instrument before investing in it so as to ensure the availability of

satisfactory exit options.

The Debt Markets are suited for investors who seek decent returns

over a longer time horizon with periodic cash flows.

The investor should be well aware of the set of risks associated with the

Debt Markets like the default risk (non-receipt or delay in receipt of interest

or principal), price risk, interest rate risk (risk of rates moving adversely after

investment), settlement risk (or risk of non-delivery of securities and funds in

the secondary market) and the re-investment risk (interest payments

fetching a lower return when re-invested).

Investors in the Debt Markets should follow a process of judicious

investing after a careful study of the economic and money market condition,

various instruments available for investment, the desired returns and its

compatibility with existing investment opportunities, alternative modes

available for investments and the relevant transaction costs.

66

The Debt Market in India Frequently Asked Questions

Frequently Asked Questions

Can a retail investor buy Government of India Securities, State

Government Bonds or treasury bills?. If so what is the mechanism for

doing the same? Are these securities available on the Bombay Stock

Exchange or National Stock Exchange and can they be bought

through BSE/NSE brokers?

Theoretically, a retail investor can buy Government of India Securities,

State Government securities and Treasury Bills. The minimum amount for

participation in securities auctions is Rs10000 but these securities can be

made available in denominations of Rs100. However, there are enormous

practical difficulties in buying these. The main problems are as follows:

These securities are usually traded in large lots – at least Rs5mn with the

average transaction size being at least 10 times higher

These securities are usually traded in the dematerialized form through the

SGL accounts maintained by the Reserve Bank of India. An individual cannot

open an individual SGL account but has to get a constituent or subsidiary

account opened with a bank. This process is tedious and costly and most

banks may not entertain individuals

Sometimes, these securities are also available in the form of physical

certificates in the secondary market. Even here, the transaction size would be

higher – in the range of Rs0.5mn and the prices quoted for these are

extremely unattractive.

Securities bought in physical certificate form are extremely illiquid and an

investor may have to hold it till redemption. Alternatively, he may be offered

a very bad price for it.

All the above suggest that buying and selling of such securities on the

secondary market is almost impossible. They are listed on the BSE/NSE but

do not actually trade there in any significant manner. The debt market is

67

XIII


actually a telephone market where transactions get verbally concluded on

the phone but are then "routed" or "consummated" on the NSE just to fulfil

the internal requirements of many institutions. Hence, BSE/NSE brokers may

not be able to help an investor in buying these securities.

The best way to buy these is directly from the RBI in the periodic auctions

held by it. There is a special counter at the RBI where an investor can submit

a bid in an auction or in an Open Market Operation. Here also, individual

investors have to present RBI with Demand Drafts.

Are fixed deposits issued from various private sector companies

completely safe? Are they guaranteed buy the Government of India

or any other government body?

On the contrary, company fixed deposits are completely unsecured. Unlike

bank fixed deposits which are guaranteed by the Deposit Insurance and

Guarantee Corporation (DICGIC) up to Rs100,000 per account, the repayment

of company fixed deposits is completely dependent on the company issuing

them. There have been widespread defaults and delays in the last three

years especially in finance company fixed deposits.

How risky is it to invest in company fixed deposits? How can an

investor understand the risk involved with a particular company and

avoid it? Would you recommend an investor to invest money in FDs?

To the extent that deposits are completely unsecured, it is definitely risky.

But rather than being general, one has to look at the specific company in

question before taking a decision. We are not at all against the idea of risk

taking especially if a particular individual can afford to take it – but taking

risks should be in a calculated and sensible manner. It does not make any

sense whatsoever to invest in a riskier FD for 2% higher interest rate. The

potential reward is just not worth it. For risk takers, the stock market has a

68


much superior risk-reward pay off. A successful pay off in the stock market

can be 50% not 2%.

All investors should remember the old adage - " Anything which looks too

good to be true usually is".

A few years ago, some of the finance companies were offering very high

rates of interest. Further, brokers who were marketing these deposits also

offered on the spot cash incentives and other attractions like gold coins etc.

Prudent investors should have thought about the ultimate end use of their

funds – which activities were these companies engaged in that they were

able to afford high rates of interest and the freebies - because there are very

few businesses in the world which could be profitable after offering such high

interest rates.

The last person to look for advice in fixed deposit investing is the FD

broker. Assuming that he or she belongs to a professional organization which

is not out to cheat you and make a quick commission, investors should

remember that typical brokers may not be well informed about the risks of

investing in a particular company.

Is it possible for a retail investor to buy debentures of private sector

companies? If so, what is the avenue for buying this?

Retail investors can buy debentures of private sector companies. This is

possible in 2 ways. Firstly, by subscribing to new issues and secondly in

secondary market transactions on stock exchanges.

Up to the early nineties, large private sector companies made public

issues of debentures. Now, such issues have virtually stopped except for the

bond issues being made by Financial Institutions like ICICI and IDBI and issues

being made by state government sponsored agencies like Maharashtra State

Road Development Corporation.

The secondary market for debentures and bonds is not very active but it

exists. Everyday debentures get traded on the BSE/NSE albeit in small

quantities. However, bonds of Financial Institutions are becoming more and

69


more liquid and available on the stock exchanges. This is probably because of

the sheer base of investor population and the massive efforts being made by

these institutions in making their bonds liquid in the secondary market.

Are the safety bonds and flexibonds issued by financial institutions

really safe? Does the Government of India or any other government

body guarantee them?

"Nothing is really certain in this world except death and taxes". While the

Government of India has not directly guaranteed the safety/flexi bonds of

financial institutions, these bonds are very safe. Doubts of their safety have

arisen only in the last few years after the stock prices of these companies

have fallen substantially reflecting the uncertainty of non performing

assets/loans made by these institutions to the corporate world. These

institutions have a fair amount of equity capital, which is at a much higher

risk than the public borrowings made by them.

Moreover, it is unlikely that these institutions, or for that matter

nationalized banks, which are also facing similar problems, will be allowed to

fail. These institutions are one of the key pillars of the financial system and

their problems are in effect the problems of the corporate sector in general.

In the past, whenever problems have arisen, the Government has stepped in

to bail out the concerned entity. Indian Bank is a good example and so is the

recent case involving US 64.

What is a difference between a bond and a debenture?

Generally speaking, long term debt securities issued by the Government

of India or any of the State Government’s or undertakings owned by them or

by development financial institutions are called bonds. Instruments issued by

other entities are called debentures. The difference between the two is

actually a function of where they are registered and pay stamp duty and how

they trade. Issuance stamp duty on bonds is a central subject and a bond is

70


transferable by endorsement and delivery without payment of any transfer

stamp duty. The stamp duty on debentures is a state subject and has to be

paid both on issuance and transfer. On issuance it is linked to mortgage

creation, while on transfer, it is levied in accordance with the laws of the

state in which the registered office of the company in question is located.

Unlike a bond, a debenture transfer has to be effected through a transfer

deed.

What is exactly meant by the term secured redeemable debenture?

Secured refers to the security given by the issuer for the loan transaction

represented by the debenture. This is usually in the form of a first mortgage

or charge on the fixed assets of the company on a pari passu basis with other

first charge holders like financial institutions. Sometimes, the charge can also

be a second charge instead of a first charge. The charge is created on behalf

of the entire pool of debenture holders by a trustee specifically appointed for

the purpose. Typically, financial institutions and banks are trustees and their

job is to create and maintain the security.

Redemption refers to the process whereby the debenture is extinguished

on payment of all the obligations due to the holder after the repayment of the

last installment of the principal amount of the debenture.

Sometimes investors get confused and think that the above mentioned

type of debenture is secured by a guarantee of the trustee financial

institution. They get confused by the presence of the name of a reputed

financial institution as a trustee.

If debentures carry a fixed interest rate why do prices of debentures

fluctuate like shares? Why are debentures available at prices other

than face value?

The price of a debenture is inversely proportional to changes in interest

rates. Let us take the example of a blue chip company issuing a debenture or

a bond which carries a fixed interest rate say 10% per annum payable

71


annually. This implies that for every debenture of Rs100 face value, the

holder gets Rs10 per year as interest. If the interest rate environment

undergoes a change and the overall interest rates for all securities comes

down by say 2%, then new debentures would be issued by the same

company at the new rate of 8%. If so, the older debenture is quite valuable

because the company is obliged to pay the holders a higher interest rate.

Consequently, the price of the debenture goes up. The price is likely to go up

to such an extent that the annual interest of Rs10 gives the same yield as the

new 8% debenture – crudely put it will be 10*100/8 = 125. The real

calculation is much more complicated than this simple example but this

example can give an idea about the general direction of the price.

Conversely, if the interest rates go up, the price of the debentures will fall

below face value to reflect the new yields.

The sensitivity of a particular debt instrument to a change in interest rates

is directly proportional to the "duration" of the instrument, which is broadly

linked to the residual maturity of the instrument. Thus a longer maturity

instrument will rise or fall more than a shorter maturity instrument.

There are other situations when the prices can fluctuate eg If the said blue

chip company no longer remains blue chip, and its credit quality falls due to

its business problems, then the market expectations of the interest rate from

the company will increase – thus resulting in a fall in the debenture price.

However, in most real life cases, the price fluctuations in debentures will

be much less than price fluctuations in other asset classes like shares.

What factors determine interest rates? Are they fixed by anyone?

When we talk of interest rates, there are different types of interest rates –

rates that banks offer to their depositors, rates that they lend to their

borrowers, rate at which the Government borrows in the bond market, rates

offered to small investors in small savings schemes like NSC/NSS, rates at

which companies issue fixed deposits etc Ten years ago, almost all interest

rates in India were rigidly administered or directed by the Reserve Bank of

India and there was nothing anyone could do about it. This controlled interest

72


rate regime has been progressively loosened in the last 5 years and now

most of the interest rates in the economy are freely determined by market

sources. The RBI ensures that there is a free and fair market and that things

do not go out of hand. Also the overall direction of rates is definitely a

function of the policies followed by RBI.

Many investors, especially older persons who were used to a controlled

interest rate regime, find it difficult to adjust to the new dispensation.

However, investors have to constantly keep track of changes affecting the

interest rate environment and we will endeavor to help them in

understanding these.

The factors which govern the interest rates are mostly economy related

and are commonly referred to as macroeconomic. Some of these factors are

as follows:

Demand for money – When the economy is booming, the demand

for money is high, because all industries need money to finance larger

working capital and fixed capital investments. At such times, they are

not bothered excessively about the interest rates because their

businesses are booming and they are able to pass on the higher costs to

their consumers. On the other hand, in recessionary times, when the

demand for money is low, everyone is averse to borrowing money at

higher rates and rates tend to come down

Government borrowings– The largest borrower in the debt

market is the Government, which borrows money in the form of GOI

Securities issued by the RBI. Excessive amounts of these borrowings

raise the level of interest in the economy. The important point is that

since the Government borrowing is said to be risk free, all interest rates

are benchmarked on that basis and this pushes up all interest rates in

the economy. Many international bodies like the World Bank believe that

this is the biggest problem of the Indian economy and one of the factors

that makes industries uncompetitive. Going one step deeper,

government borrowings are a reflection of inability of the Government to

live within its means i.e. expenditure more than income. Technically, this

73


is reflected in the indicator, fiscal deficit as a percentage of national

income, which each finance minister talks about at budget time.

Supply of money – When the government is running large

amounts of deficit financing, the "printing" of notes leads to excess

supply of money in the economy. Similarly, when the country receives a

large amount of inflows from overseas, there is excess supply of money.

On the other hand foreign exchange leaving the country leads to a

shortage of money supply. The supply of money is reflected in the

Money Supply figure or M3, which is released by the RBI every week.

Excess leads to decline in level of interest rates while shortage leads to

an increase.

Inflation rate – Normally, a higher inflation rate leads to a high

interest rate. This is very much true about developed countries but less

so about India. In India, the main determinant of inflation is the price of

primary articles like food and vegetables.

Are interest rates influenced by any authority like the RBI or by the

Government? Why have interest rates in India fluctuated so widely in

the last 5 years?

The RBI and the Government change policies frequently in order to fulfill

various national objectives and these policy changes have a bearing on some

or all of the variables mentioned in the answer to question 11. Such changes

lead to changes in the level of interest rates.

A chronology of events in the last 5 years, which affected interest rates, is

given below.

In 1994, money supply was increasing at a very fast pace due to large

amount of foreign currency inflows caused by Foreign Institutional

Investors (FIIs) investing in India in a major way. This caused a very

sharp reduction in the interest rates.

The inflation rate was very high and the RBI took steps to reduce the

money supply in order to fight it. This sharp reduction in money supply

74


at a time when the economy was booming (7% GDP growth rate) caused

an acute shortage of funds leading to a very sharp rise in interest rates.

The recession that followed led to a drastic decrease in the demand for

money and this lowered the interest rates.

In 1998, there was a fear of foreign exchange crisis sparked by the

crisis in the Asian region. In order to prevent a runaway depreciation of

the rupee, the RBI imposed certain controls, reduced money supply and

engineered a rise in interest rates so that it would be difficult for the

rupee to depreciate sharply.

Again when the threat against the rupee receded, it reversed its

policies leading to a decline in interest rates once again.

Is it possible for the Reserve Bank of India to control inflation?

Inflation is caused by many factors, many of which are inter linked to each

other. In developed economies, inflation is generally a function of the

demand and supply of money. A booming economy generates high demand

for money causing a rise in inflation while a recessionary economy has a low

demand for money leading to low inflation. However, this simple equation

need not be necessarily true as can be seen by the current happenings in the

United States. The US economy is in a continuous boom phase but has one of

the lowest ever inflation rates. One of the key reasons is that prices of

commodities and manufactured goods have slumped due to general global

over capacity and the Asian crisis.

In the Indian context, many experts believe that inflation is cost pushed

and not demand pulled. Administered costs like transportation, electricity etc

constantly going up and they have to be passed on. Secondly, inflation is

linked to the cost of food and vegetables, which keeps going up due to the

rising support prices announced by the Government to keep farmers happy.

There are also sharp price surges in specific food items due to shortage as we

saw in onions in 1998.

75


In this context, it appears extremely difficult for the RBI to keep control

over inflation.

Which debt instruments/schemes available for retail investors earn

tax free interest?

Tax-free Relief Bonds

Voluntary Provident Fund

Public Provident Fund

US 64 (which is not an interest bearing scheme in true sense)

Long term postal deposit schemes

Each investor can invest in certain instruments, the interest on which is

exempt from tax up to a limit of Rs12000 per annum, under the section 80L

of the Income Tax Act. These instruments are as follows:

All kinds of bank deposits

All small savings schemes excluding National Savings Scheme

Bonds of Development Financial Institutions.

All kinds of postal deposits

Government of India and State Government Securities

Kisan Vikas Patra

Indira Vikas Patra

For a more detailed idea about the tax implications of retail instruments

please refer to the special section on tax implications in each scheme profile.

While mutual funds are not interest bearing instruments, income mutual

funds are almost similar since they invest only in interest bearing

instruments.

Which are the largest brokers of fixed deposits?

Integrated Finance Enterprises

Kotak Securities

76


JM Share & Stock Brokers

Bajaj Capital

Karvy Securities

Birla Global Finance

Are all nationalized banks safe from the point of view of investment?

All the nationalized banks are owned fully or substantially by the

Government of India. Together with the State Bank of India and its

subsidiaries, they have more than 25000 branches spread across the length

and breadth of the country. They would be having more than 100 million

deposit accounts.

Given this background, it is extremely unlikely that the Government will

allow any nationalized bank to fail. The implications of such a failure can be

explosive. Its past actions when it bailed out troubled banks like the New

Bank of India and the Indian Bank and injected capital in the entire banking

system to improve the capital adequacy of all banks can be taken as signals

in this regard. Its handling of the US 64 crisis is also a pointer.

This is not unusual in other parts of the world as well. The US Government

handled an almost trillion dollar bailout of its savings and loan associations

(S&Ls) in the late eighties. It also bailed out banks, which were overexposed

to Latin America through the Brady bond mechanism.

In addition to the support of the Government, deposits up to Rs100,000

per account are completely insured by the Deposit Insurance and Guarantee

Corporation (DICGC). This has however never been tested in practice.

In conclusion, nationalized banks are as safe as anything you can get. If

some people feel uncomfortable about investing in banks, which are believed

to be relatively deeper in trouble, we provide below a list of such banks

United Commercial bank (UCO Bank)

Allahabad Bank

United Bank of India (UBI)

Bank of Maharashtra

77


Indian Bank

Indian Overseas Bank

However, we would advise investors to be cautious about investing in

small and less known cooperative banks where the extra interest earned may

not be worth the additional risk.

Why is the trading volume in the debt market significantly lower as

compared to the amount of outstanding securities issued?

Most of the investors in the debt market are of the buy and hold profile

especially the provident funds, insurance companies etc. Bank treasuries are

also quite inactive with only some small part of the portfolio being

traded/churned. Secondly, the debt market is a market where it is difficult for

speculators to operate because buyers have to pay for 100% of what they

have bought and there is no concept of intra-settlement squaring up. As

against this, in equity markets, investors just pay for their net positions at the

end of each settlement and the actual delivery trades settled are less than

10% of the total volume.

78

The Debt Market in India Conclusion

Conclusion

Increasing Retail Participation with the help of Mutual

Funds

The prospects for the debt markets seem to be bright as volumes are

increasing every day with comparatively less volatility than the equity

markets. For the long-term development of the debt funds, mutual funds

have to now compete with the commercial banks. There will be a tough race

between both for the retail investors’ savings and the surplus funds with the

corporates. This is just the beginning for the mutual funds. As far as

attracting retail investments are concerned debt funds have only scratched

the surface. There is a vast potential in the debt funds to attract and hold

retail investors. Currently only institutions, banks and corporates are large

players in this market. The exposure to the retail investor is significantly low

due to lack of awareness. An informed investor will understand that fund

managers make better decisions for both, long-term and short-term plans.

The key to the development of the mutual fund industry is the education of

investors towards the various aspects of risk, return and diversification. Even

today bank deposits are perceived as the risk-free whereas these are mostly

totally unsecured deposits. Once the concept of risk and diversification is

embodied, one has to look at avenues of optimising returns through reduced

risk. That is where; mutual funds offer the best avenues for deployment.

The debt funds also need to upgrade their servicing standards to the level

of international banks. They have to further diversify their portfolio and

introduce electronic transfer of funds. They must also introduce lower

denominations of units in debt schemes so that more and more retail

investors are attracted to the debt fund schemes.

Investors with adequate appetite for safety, liquidity and tax benefits

would do well to invest in debt funds. With the pace for reforms in the mutual

79

XIV

The Debt Market in India Conclusion

funds sector all set to increase by leaps and bounds the investors can look

forward to a wider and safer choice of investment avenues.

Policy changes in the Debt market

Over a long period of time the market has undergone a lot of

transformation due to the various measures taken by the government. Now,

debt instruments are traded on exchanges on screen-based terminals, private

placements of debt instruments are frequently seen. In spite of all the

positive changes that have so far taken place, there is still a long way to go

for the markets. The participation of the small investors is low; investor-

confidence in corporate debt is not what it should be, there are claims that

the government is maintaining low interest rates for its own benefit, stamp

duties are strangling some segments to death, financial institutions dominate

the market and the list goes on.

At the same time, it should also be said that the situation is undergoing a

steady change. Debt instruments traded in dematerialised form are exempt

from stamp duties, regulations relating to credit rating agencies have been

tightened and the need for Internet based trading has been realized. Also the

Securities Transaction Tax (STT) levied on the equities market in not levied

on the debt market. All these changes, together with those on the anvil, like

activating mechanisms for retailing of government securities and starting of

operations of the clearing corporation of India are likely to bring about a

welcome change in the prospects of the debt markets.

80

The Debt Market in India Bibliography

Bibliography

Book Referred:

Debt Markets New Horizons – A. Suryanarayana

Websites Referred:

www.nseindia.com

www.bseindia.com

www.indiainfoline.com

www.fimmda.org

www.debtonnet.com

www.valuenotes.com

www.investorwords.com

81

XV

http://www.investorwords.com/

http://www.valuenotes.com/

http://www.debtonnet.com/

http://www.fimmda.org/

http://www.indiainfoline.com/

http://www.bseindia.com/

http://www.nseindia.com/

Documents

Debt Markets in India