PRESENTATION ON INVESTMENT ADVISORY
Who are the key players in the debt
and money markets in India?
The above diagram provides a consolidated picture of the various players in the bond/money markets and the securities.
ZCB: Zero Coupon Bond I/L bonds : Inflation linked bonds FRN : Floating rate notes
What are Money Markets and
money market instruments?
Money markets are markets for debt instruments with a
maturity up to one year.
Money markets allow banks to manage their liquidity as
well as provide the central bank means to conduct its
The most active part of the money market is the call money
market (i.e. market for overnight and term money between
banks and institutions) 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).
A Commercial Paper is a short term unsecured
promissory note issued by the raiser of debt to
the investor. In India corporates, primary
dealers (PD), satellite dealers (SD) and
financial institutions (FIs) can issue these
It is generally companies with very good rating
which are active in the CP market, though RBI
permits a minimum credit rating of Crisil-P2.
The tenure of CPs can be anything between 15
days to one year, though the most popular
duration is 90 days. Companies use CPs to
save interest costs
Certificates of Deposit
These are issued by banks/financial
institutions in denominations of Rs 5
lakhs 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.
Treasury Bills are instruments issued by RBI at a
discount to the face value and form an integral
part of the money market. In India treasury bills
are issued in three different maturities 14 days,
182 days and 364 days.
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
What are “on the run” and “off
the run” securities?
An on-the-run security normally is the most liquid
issue for that maturity and therefore generally
trades at lower yields than off-the-run debt.
Because an off-the-run security generally does
not have the same liquidity as an on-the-run
issue, it may trade at higher yields, and thus
lower prices, than on-the-run securities. The
central bank may be able to capture part of the
yield differential and thus reduce the
government's interest costs by purchasing and
retiring older debt and replacing it with lower
yielding on-the-run debt.
What is a Repo?
Repo or Repurchase Agreements or Ready Forward transactions
are short-term money market instruments. Repo is nothing
but collateralized borrowing and lending. In a repo, securities
(like Government securities and treasury bills) are sold in a
temporary sale with an agreement to buy back the securities
at a future date at specified price. In reverse repo`s,
securities are purchased in a temporary purchase with an
agreement to sell it back after a specified number of days at
a pre-specified price. When one is doing a repo, it is reverse
repo for the other party.
For example, RBI could engage in a three-day repo transaction
with SBI, i.e., it would sell a security at, say, Rs. 100 to the
SBI agreeing to buy it back at Rs. 100.07, in three days. The
difference in price, is the interest RBI would have to pay for
the money lent by SBI.
What is Repo Rate?
Repo rate is nothing but the
annualized interest rate for
the funds transferred by the
lender to the borrower in a
How does RBI use the repo rate?
In case of the RBI, it sets the repo rate for all instruments issued by
the central bank (it will be either the lender or borrower in a repo
transaction). Typically the repo rate and reverse repo rate vary by
around 2%. RBI has used repo rates as part of its Liquidity
Adjustment Facility (LAF) to benchmark short-term interest rates
and also as a monetary tool in the past whenever the rupee had
come under pressure.
RBI normally hikes the repo rate to spike speculative arbitrage deals
that are the primary cause for sharp rupee-dollar movements. A
higher repo rate means the central bank is willing to borrow shortterm money at a higher rate. This would prompt market
participants to prefer lending to the RBI unless the other market
rates are higher. A higher repo rate also indirectly sets a higher
floor for other money market rates such as the call rates. As banks
typically borrow in the call market and deploy the proceeds in the
forex market, a higher call rate makes such arbitrage transactions
What is Money Supply?
Money supply is the amount of money in
circulation in the economy at any point of
time. It includes the currency & coins in
circulation and demand & time deposits of
banks, post office deposits.etc. Different
components of money supply are as under:
M1 = Currency with the public + Net demand
deposits of banks + other deposits with RBI
M2 = M1 + Post Office Savings
M3 = M2 + Net Time Deposits
M3 is the level of money supply in an
economy at any given point of time.
What are debt market
Typically those instruments that have a maturity of more
than a year and the main types are – Government
Securities (G-secs or Gilts)
Like T-bills, gilts are issued
by RBI on the behalf of the Government. These instruments
form a part of the borrowing program approved by
Parliament in the Finance Bill each year (Union Budget).
Typically they have maturity ranging from 1 year to 20
years. Like T-Bills, gilts are issued through the auction
route. but RBI can sell/buy securities in its Open Market
Operations (OMO`s include conducting repos as well and are
used by RBI to manipulate short-term liquidity and thereby
the interest rates to desired levels) The other types of
government securities are – Inflation linked bonds Zero
coupon bonds State government securities (state loans)
What is the difference between
bonds and debentures?
World over, a debenture is a debt security issued by a corporation
that is not secured by specific assets, but rather by the general
credit of the corporation. Stated assets secure a corporate bond,
unlike a debenture. But in India these terms are used
interchangeably. A bond is a promise in which the Issuer agrees to
pay a certain rate of interest, usually as a percentage of the bond's
face value to the Investor at specific periodicity over the life of the
bond. Sometimes interest is also paid in the form of issuing the
instrument at a discount to face value and subsequently
redeeming it at par. Some bonds do not pay a fixed rate of interest
but pay interest that is a mark-up on some benchmark rate.
Typically PSUs, public financial institutions and corporate issue
bonds. Another distinction is SLR and non-SLR bonds. SLR bonds
are those bonds which are approved securities by RBI which fall
under the SLR(Statutory liquidity ratio) limits of banks.
What affects bond prices?
Largely interest rates and credit quality of the issuer
are the two main factors which affect bond prices
Interest Rates : The price of a debenture is
inversely proportional to changes in interest rates
that in turn are dependent on various factors. When
interest rates fall, the existing bonds become more
valuable and the prices move up until the yields
become the same as the new bonds issued during
the lower interest rate scenario Credit Quality :
When the credit quality of the issuer deteriorates,
market expects higher interest from the company
and the price of the bond falls and vice-versa
Another factor that determines the sensitivity of a
bond is the “Maturity Period”. A longer maturity
instrument will rise or fall more than a shorter
What affects interest rates?
The factors are largely macro economic in nature –Demand/Supply of money:
When economic growth is high, demand for money increases, pushing the interest
rates up and vice versa. Government Borrowing and Fiscal Deficit : Since the
government is the biggest borrower in the debt market, the level of borrowing also
determines the interest rates. On the other hand, supply of money is done by the
central bank by either printing more notes or through its Open Market Operations
(OMO) RBI : RBI can change the key rates (CRR, SLR and bank rates) depending
on the state of the economy or to combat inflation. The RBI fixes the bank rate
which forms the basis of the structure of interest rates & the Cash Reserve Ratio
(CRR) & Statuary Liquidity Ratio (SLR), which determines the availability of credit
& the level of money supply in the economy. (CRR is the percentage of its total
deposits a bank has to keep with RBI in cash or near cash assets & SLR is the
percentage of its total deposits a bank has to keep in approved securities. The
purpose of CRR & SLR is to keep a bank liquid at any point of time. When banks
have to keep low CRR or SLR, it increases the money available for credit in the
system. This eases the pressure on interest rates & interest rates move down.
Also when money is available & that too at lower interest rates, it is given on
credit to the industrial sector that pushes the economic growth Bank Rate is the
benchmark rate of RBI at which it refinances Banks and Primary Dealers. It is used
as a reference rate to signal the interest policy of the central bank
Inflation Rate : Typically a higher inflation
rate means higher interest rates. The
interest rates prevailing in an economy at
any point of time are nominal interest
rates, i.e., real interest rates plus a
premium for expected inflation. Due to
inflation, there is a decrease in purchasing
power of every rupee earned on account of
interest in the future; therefore the interest
rates must include a premium for expected
inflation. In the long run, other things being
equal, interest rates rise one for one with
rise in inflation.
What is fiscal deficit?
The difference between total government spending on
account of revenue, capital and net loans and
between total government receipts on account of
revenue and of capital receipts that are not
borrowings. The important point to note is that
accumulated interest burden from previous years is
reflected in the Fiscal Deficit as well as this fiscal's
revenue and capital surpluses/ deficits. The Fiscal
Deficit is usually shown as a percentage of GDP. A low
Fiscal Deficit is considered the best symptom of
financial health. India has a Fiscal Deficit in the range
of 5-6 per cent. This is much higher than considered
safe and the higher fiscal deficit could result in firming
up of rates.
What is Yield Curve?
The relationship between time and yield on 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.
A yield curve can be positive, neutral or flat. A typical yield curve
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 happens when people demand higher compensation for
parting their money for a longer time into the future. When the
curve is very steep, it indicates that players expect an expansion
in the economy and interest rates to move up quickly. A 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. It is not often that this happens and has important economic
ramifications when it does. It generally represents an impending
downturn in the economy, where people are anticipating lower
interest rates in the future.
What is Yield to Maturity (YTM)?
Simply put, the annualised
return an investor would get by
holding a fixed income
instrument until maturity. It is
the composite rate of return of
all payouts and coupon.
What is Average Maturity
It is a weighted average of
the maturities of all the
instruments in a portfolio
What is duration and
Duration is a measure of a bonds' price risk. It is
weighted average of all the cash flows associated with
a bond in terms of their present value. For example, a
bond with a duration 1.50 years means that a rise in
its yield by 1% would result in a decline of its value by
approximately 1.50% There are two types of duration,
Macaulay duration and modified duration. Macaulay
duration is useful in immunization, where a portfolio of
bonds is constructed to fund a known liability. Modified
duration indicates the percentage change in the price
of a bond for a given change in yield. The percentage
change applies to the price of the bond including
What is convexity?
Convexity is a measure of the way duration and
price change when interest rates change. A
bond is said to have positive convexity if the
instrument's value increases at least as much
as duration predicts when rates drop and
decreases less than duration predicts when
rates rise. Typically, fund managers and
investors prefer bonds with higher convexity.
This is because such bonds rise higher than
other bonds when interest rate falls. And what
is more, they fall lower than other bonds, when
interest rate rises. Convexity is an important
factor when interest rates are volatile
What is marking to market?
It means adjusting value of any security to
reflect its current market value. While fixed
income instruments carry a fixed rate of return
if held till maturity, interest rate movements
can increase/decrease the returns, if one has
to sell the security during the holding period.
Hence, open end income and liquid funds are
required to value securities with a residual
maturity of over six months based on their
market value. The mark to market component
of a portfolio on a given day includes securities
with residual maturity of more than six months
and does not include CPs and CDs.
What are floating rate
Unlike fixed income instruments, floating rate instruments have
variable interest rates, which change at present frequencies. Since
they don’t have any mark to market component, the possibility of
negative returns doesn’t exist for these instruments. Among the
floating rate instruments, MIBOR (Mumbai Inter-bank Offer Rate)
linked ones have become very popular in the money market segment
as they benefit both the issuer and investor. Coupon rates on shortterm Non-convertible debentures (NCDs) are pegged at a mark-up
over MIBOR. The mark-up on the NCD is typically 25 to 50 basis
points over MIBOR. Borrowing or lending through NCDs with the
call/put option is akin to borrowing or lending in the inter-bank call
money market. So companies use NCDs more like a cash
management tool. Whenever they generate surpluses, companies
exercise the call option and pay off investors. In a falling interest rate
scenario, companies tend to convert the NCD into a fixed-term
borrowing in order to lock into a lower interest rate. Many of these
floaters offer ready liquidity by means of daily put/call option. This
allows mutual funds to tackle illiquidity risk, in case of huge
What are Interest Rate Swaps
Interest Rate Swap (IRS) is a transaction in
which a flow of coupon of one variety is
exchanged for another of a different
variety, but in the same currency. These
derivatives are used by the fund manager
for hedging the portfolio risk on a nonleverage basis (i.e., not used for
speculative activities). In India, IRS are
generally OIS (Overnight Indexed Swaps)
products benchmarked on the MIBOR
Fixed rate payment
Fixed Interest Rate
: 7% p.a.
Variable Interest Rate : NSE Over-Night MIBOR reset
daily and compounded daily.
Notional Principal Amount : Rs. 50 crore
Period of Agreement
: 1 year
: Semi - Annual
Now, suppose the six-month period from the effective
date of the swap to the first payment date comprises
182 days and the daily compounded NSE Over - Night
MIBOR is 6 % p.a. on the first payment date, then the
fixed and variable rate payment on the first payment
date would be as follows:
Fixed Rate Payment : Rs. 1,74,52,055 = (Rs.
50,00,00,000) X (7%) X (182 Days / 365 Days)
: Rs. 1,49,58,904 = (Rs.
50,00,00,000) X (6%) X
(182 Days/ 365 Days)
Often, a swap agreement will call for only the exchange
of net amount between the counter parties. In the
above examples, the fixed - rate payer will pay the
variable - rate payer a net amount of Rs. 24,93,151
= Rs. 1,74,52,055 - Rs. 1,49,58,904. The second and
final payment will depend on the daily NSE MIBOR
compounded daily for the remaining 183 days. The
fixed rate payment will also change to reflect the
change in holding period from 182 days to 183 days.
What are LIBOR & MIBOR?
LIBOR : Stands for London Inter Bank Offered rate. This is
a very popular benchmark and is issued for US Dollar, GB
Pound, Euro, Swiss Franc, Canadian Dollar and the
Japanese Yen. The British Bankers Association (BBA) asks
16 banks to contribute the LIBOR for each maturity and for
each currency. The BBA weeds out the best four and the
worst four, calculates the average of the remaining eight
and the value is published as LIBOR.
MIBOR : Stands for Mumbai Inter Bank Offered Rate and is
closely modeled on the LIBOR. Currently there are two
calculating agents for the benchmark - Reuters and the
National Stock Exchange (NSE). The NSE MIBOR
benchmark is the more popular of the two and is based on
rates polled by NSE from a representative panel of 31
What is a credit rating ?
Credit Rating is an exercise conducted by a rating organisation to
evaluate the credit worthiness of the issuer with respect to the
instrument being issued or a general ability to pay back debt over the
specified period of time. The rating is given as an alphanumeric code
that represents a graded structure or creditworthiness. Typically the
highest credit rating is that of AAA and the lowest being D (for
default). Within the same alphabet class, the rating agency might have
different grades like A, AA, and AAA and within the same grade AA+,
AA- where the “+” denotes better than AA and “-“ indicate the
opposite. For short term instruments of less than a year maturity, the
rating symbol would be typically “P” (varies depending on the rating
agency). India, currently we have four rating agencies –
Fitch (Duff and Phelps is now part of Fitch)
What is the “SO” in a rating ? [AAA(SO)]
Pass Through Certificate/PTC
Structured Obligation (SO) or Structured Finance is a
term that is applied to a wide variety of debt
instruments wherein the repayment of principal
and interest is backed by: Cash flows from a pool
of financial assets and/or Credit enhancement
from a third party The process of converting
financial assets (loans, receivables, etc.) into
tradable securities is generally referred as
‘securitization’ and the securities thus created are
referred as ‘asset backed securities’ (ABS). The
Pass Through Certificates (PTCs) in our portfolios
also fall under this category
Forex Markets How is a
The floating exchange rate system is a confluence of various demand and
supply factors prevalent in an economy like – Current account
balance : The trade balance is the difference between the value of
exports and imports. If India is exporting more than it importing, it
would have a positive trade balance with USA, leading to a higher
demand for the home currency. As a result the demand will translate
into appreciation of the currency and vice versa.
Inflation rate : Theoretically, the rate of change in exchange rate is equal
to the difference in inflation rates prevailing in the 2 countries. So,
whenever, inflation in one country increases relative to other country,
its currency falls down. Interest rates : The funds will flow to that
economy where the interest rates are higher resulting in more
demand for that currency. Often called interest rate differential
Speculation : Another important factor is the speculative and
arbitrage activities of big players in the forex market which
determines the direction of a currency. In the event of global turmoil,
investors flock towards perceived safe heaven currencies like US
dollar resulting in a demand for that currency.
What are the implications of
Depreciation of a currency affects an economy
in two ways, which are in a way counter to
each other. On the one hand, it makes the
exports of a country more competitive,
thereby leading to an increase in exports.
On the other hand, it decreases the value
of a currency relative to other currencies,
and hence imports like oil become dearer
resulting in an increase of deficit.
What does one mean by a currency
being over-valued? What is Real
Effective Exchange Rate (REER)?
When RBI says that the rupee is overvalued, they mean that it has
been appreciating against other major currencies due to their
weakening against dollar which might impact the competitiveness of
REER is the change in the external value of the currency in relation to
its main trading partners. It is Rupee's value on a trade-weighted
basis. It takes into account the Rupee's value not only in terms of
dollar but also Euro, Yen and Pound Sterling.
The exchange rates versus other major currencies are average
weighted by the value of India's trade with the respective countries
and are then converted into a single index using a base period which
is called the nominal effective exchange rate. But the relative
competitiveness of Indian goods increases even when the nominal
effective exchange rate remains unchanged when the rate of price
increases of the trading partner surpasses that of India's. Taking this
into account, prices are adjusted for the nominal effective exchange
rate and this rate is called the "real effective exchange rate."
What are thinly traded debt securities ?
A debt security that has a trading volume of less
than Rs. 5 crores in the previous calendar
month is considered a thinly traded security.
2.What are non traded securities ?
When a security is not traded on any stock
exchange for a period of 30 days prior to the
valuation, it is treated a ‘non traded’ security.
The Valuation Procedure
The methodology is applicable to debt securities that have a maturity
period of over 182 days. (Instruments with less than 182 days of
maturity are valued on the basis of amortization as is the case
with money market instruments). And these securities are
classified into investment grade and non-investment grade
securities based on their credit ratings. This methodology is
applicable only to investment grade securities. The noninvestment grade securities are valued at a discount of 25% to
the face value. The non-investment grade securities are further
be classified as performing and non-performing assets and the
latter are valued on separate norms. To put it briefly, the
valuation methodology starts with the construction of a
benchmark yield using G-secs and then building a matrix which
gives benchmark yields for a certain credit quality and a duration.
After adjusting the yield of a particular security for various risks,
the final yield is used to price the security by using the NPV
method. The various steps involved in the process are –
Construction of risk-free
A risk-free benchmark yield is built using the government
securities (G-secs) as the base. G-secs are used as the
benchmarks as they are traded regularly; are free of
credit risk and are traded across different maturity
spectrums every week. The G-secs are grouped into the
following duration buckets viz., 0.5-1 years, 1-2 years,
2-3 years, 3-4 years, 4-5 years, 5-6 years and 6 years
and the volume weighted yield is computed for each
bucket. Accordingly, there will be a benchmark YTM for
each duration bucket. (Please note that duration is
different from maturity period. As mentioned above,
duration is a measure of a bonds' price risk. It is
weighted average of all the cash flows associated with a
bond in terms of their present value.)
Building a matrix of spreads for
marking-up the benchmark yield
A matrix of spreads (based on the credit rating) is built for
marking up the benchmark yields. The matrix is built
based on traded corporate paper on the stock exchanges
or primary market securities. All traded paper (with
minimum traded value of Rs. 1 crore) is classified by their
ratings and grouped into 7 duration buckets. For each
rating category, average volume weighted yields are
obtained both from trades on the respective stock
exchange and from the primary market issuances. Where
there are neither secondary trades in a particular rating
category nor primary market issuances during the
fortnight under consideration, then trades during the 30
day period prior to the benchmark date are considered for
computing the average YTM for such rating category. This
matrix is sent to us every week by CRISIL. Given below is
a sample matrix as of November 11,2002
All debt securities are prone to certain risk and hence the
marking up or down of yield is essential to get a true
picture about that particular security. The yields calculated
above are marked up/marked down to account for the
liquidity risk, promoter background, finance company risk
and the issuer class risk. The marking differs for rated and
non-rated securities and is as follows : Rated securities:
Securities of less than 2 year duration could be marked up
or down upto 0.5% and for securities of more than 2 year
duration marking is allowed upto +/- 0.25% to be provide
for the above mentioned types of risks Non-rated
securities : Since non-rated securities tend to be more
illiquid than rated securities, the yields are marked up by
adding 0.5% for securities having a duration of upto two
years and 0.25% for securities having duration of higher
than two years to account for the illiquidity risk
Pricing the portfolio
The yields that have been calculated for
the various categories in the matrix
are used to price the portfolio by
using the Net Present Value (NPV)
method. The price of a debt security
is the discounted value of all its
future cash flows (using a suitable
discount rate, which in this case is
the YTM calculated).
Lets take the example of a AAA rated thinly traded debenture of
HDFC which has a duration of 3.25 years and a coupon
rate of 11.45%. Say, we purchased the debenture on July
21, 2002. By looking at the matrix above, we arrive at a
yield of 6.89%.
The enclosed excel sheet provides the calculation of NPV.
(click on the cells to view the formulas -Lets take the
example of a AAA rated thinly traded debenture of HDFC
which has a duration of 3.25 years and a coupon rate of
11.45%. Say, we purchased the debenture on July 21,
2002. By looking at the matrix above, we arrive at a yield of
The enclosed excel sheet provides the calculation of NPV.
(click on the cells to view the formulas -
Par value = Rs.100
Discount rate = 9.65% (ie, yield from the matrix)
Purchase date = July 21, 2001
Long Term Plan
Short Term Plan
A Comparison with Liquid Funds
Liquid Fund Floating Rate Fund
12 - 18 mos.
M + 40 bps
M + 75 bps
Typical tenor of