Bond Market Instruments

Government Dated Securities

• These securities are issued by RBI on behalf of GoI– Long term securities– Carry fixed or floating coupon (interest rate) which is paid on

face value, at fixed time periods (usually semi-annually)– Fixed maturity, ranging from 1 year to 30 years

• Fixed Rate Bonds - Coupon rate is fixed for the entire life of the bond. Most Government bonds are issued as fixed rate bonds.

• Floating Rate Bonds – Coupon rate is floating and is re-set at pre-announced intervals (say, every 6 months or 1 year) by adding a spread over base rate. For floating rate bonds issued by the GoI, base rate is the weighted average cut-off yield of last three 364-day Treasury Bill auctions preceding the coupon re-set date

Zero Coupon Bonds

• Issued at discount to face value and redeemed at par• No coupon (or interest) payments to the holders.

Difference between issue price and redemption price acts as the interest

• Issue price is inversely related to maturity, i.e., longer the maturity lesser would be issue price & vice versa

• In India, these were first issued in January, 1994 followed by two subsequent issues in 1994-95 and 1995-96 respectively

• Also known as the deep discount bonds

Capital Indexed Bonds

• Principal linked to accepted index of inflation so as to protect the holder from inflation

• First issued in December 1997 which matured in 2002• Government is currently working on fresh issuance of

Inflation Indexed Bonds wherein payment of both, coupon and principal on the bonds, will be linked to an Inflation Index (WPI)

• In the proposed structure, principal will be indexed and coupon will be calculated on the indexed principal

STRIPS

• Separate Trading of Registered Interest and Principal of Securities (STRIPS)

• STRIPS are instruments wherein each cash flow of the fixed coupon security is converted into a separate tradable Zero Coupon Bond and traded

• For example, when Rs.100 of the 8.24%GS2018 is stripped, each cash flow of coupon (Rs.4.12 each half year) will become coupon STRIP and the principal payment (Rs.100 at maturity) will become a principal STRIP. These cash flows are traded separately as independent securities in the secondary market.

STRIPS

• More popular in the US but now steps are being taken by RBI to introduce these new types of instruments

• STRIPS in G-Secs will ensure availability of sovereign zero coupon bonds, which will facilitate the development of a market determined zero coupon yield curve (ZCYC)

• STRIPS will also provide institutional investors with an additional instrument for asset-liability management

• As STRIPS have zero reinvestment risk, being zero coupon bonds, they can be attractive to retail/non-institutional investors

Convertible Bonds 

• Holder has the option to convert the bond into equity (in the same value as of the bond) of the issuing firm (borrowing firm) on pre-specified terms.

• This results in an automatic redemption of the bond before the maturity date.

• The conversion ratio (number of equity of shares in lieu of a convertible bond) and the conversion price are pre-specified at the time of bonds issue.

• May be fully or partly convertible. For the part of the convertible bond which is redeemed, the investor receives equity shares and the non-converted part remains as a bond.

PSU Bonds & Bonds by FIs

• PSU Bonds– Long term debt instruments having maturities ranging between 5-

10 years– Issued in denominations (face value) of Rs.1,000 each– transferable by endorsement & delivery and no tax is deductible

at source on the interest coupons payable to the investor

• Bonds by Financial Institutions– Issue bonds in 2 ways - through public issues targeted at retail

investors and trusts and secondly, through private placements to large institutional investors

– Transfers of the former type are exempt from stamp duty while only part of the bonds issued privately have this facility

Corporate Bonds

• Long-term debt instrument used by large private sector companies to borrow medium to long-term funds

• Issued in denominations as low as Rs 1,000 and have maturities ranging between 1-10 years

• Less liquid as compared to PSU bonds and the liquidity is inversely proportional to the residual maturity

• The interest paid to the bond holders is a charge against profit in the company's financial statements

Bonds with Call/ Put Option

• Bonds are issued with features of optionality wherein the issuer can have the option to buy-back (call option) or the investor can have the option to sell the bond (put option) to the issuer during the currency of the bond.

• First such bond issued by RBI in 2002 with coupon of 6.72%, maturity of 10 years (2012) and call and put option in year 2007.

• The Government had the right to buy-back the bond (call option) at par value while the investor had the right to sell the bond (put option) to the Government at par value at the time of any of the half-yearly coupon dates starting from July 18, 2007.

Interest Rate Futures

• Underlying instrument is bond - a “notional” government bond which may not exist in reality– In India, these bonds carry coupon rate of 7% p.a. and maturity

period of 10 years, as defined by RBI and SEBI

• Have to be physically settled unlike the equity derivatives which are cash settled in India. – Seller is allowed to deliver any bond from a basket of deliverable

bonds identified by the authorities

• Banks, insurance companies, primary dealers and provident fund entities use this instrument for hedging mismatch in the tenure of their assets (such as loans and Govt. securities) and liabilities

• Each counterparty agrees to pay either a fixed or floating rate denominated in a particular currency to the other counterparty – At regular intervals (say 6 months) over a defined period of time

(say 5 years)

• The fixed or floating rate is multiplied by a notional principal amount– which is not exchanged between counterparties, but is used only

for calculating size of cash flows to be exchanged.

Interest Rate Swap

• Example: – A agrees to pay B periodic fixed interest rate payments of 8.65%

in exchange for periodic variable interest rate payments of LIBOR + 70 basis points (0.70%)

– In this case, there will be no exchange of principal amounts & only the interest payments will be settled in net, i.e., A pays 8.65% - (LIBOR+0.70%)

• The fixed rate (8.65%) is the swap rate which is fixed at the initiation of swap, so that sum of present value of the cash inflows for A is equal to sum of the present value of the cash outflows for A. This is called as Plain Vanilla Swap