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CHAPTER 1: OVERVIEW OF FINANCIAL SYSTEM
[1.1] INTRODUCTION ON FINANCIAL SYSTEM
Economic growth and development of any country depends up on a well-knit financial
system. Financial system comprises a set of sub-systems of financial institutions financial
markets, financial instruments and services which help in the formation of capital. Thus a
financial system provides a mechanism by which savings are transformed into investments
and it can be said that financial system play an significant role in economic growth of the
country by mobilizing surplus funds and utilizing them effectively for productive purpose.
The financial system is characterized by the presence of integrated, organized and regulated
financial markets, and institutions that meet the short term and long term financial needs of
both the household and corporate sector. Both financial markets and financial institutions
play an important role in the financial system by rendering various financial services to the
community. They operate in close combination with each other.
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The word "system", in the term "financial system", implies a set of complex and
closely connected or interlined institutions, agents, practices, markets, transactions, claims,
and liabilities in the economy. The financial system is concerned about money, credit and
finance-the three terms are intimately related yet are somewhat different from each other.
Indian financial system consists of financial market, financial instruments and financial
intermediation.
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[1.2] Components Of Indian Financial System:
The following are the four main components of Indian Financial system are:
Financial Institutions.
Financial Markets.
Financial Instruments/Assets/Securities.
Financial Services.
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Financial Institutions:
Financial institutions are the intermediary who facilitates smooth functioning of
the financial system by making investors and borrowers meet. They mobilize savings
of the surplus units and allocate them in productive activities promising a better rate of
return. Financial institutions also provide a service to entities seeking advises on
various issues ranging from restructuring to diversification plans. They provide whole
range of services to the entities who want to raise funds from the markets elsewhere.
Financial institutions act as financial intermediaries because they act as middlemen
between savers and borrowers. Were these financial institutions may be of Banking or
Non-Banking institutions.
Financial Markets:
Finance is a prerequisite for modern business and financial institutions play a
vital role in economic system. It's through financial markets the financial system of an
economy works. The main functions of financial markets are:
• To facilitate creation and allocation of credit and liquidity.
• To serve as intermediaries for mobilization of savings.
• To assist process of balanced economic growth.
• To provide financial convenience.
Financial Instruments/Assets/Securities:
Another important constituent of financial system is financial instruments. They
represent a claim against the future income and wealth of others. It will be a claim
against a person or an institution, for the payment of the some of the money at a
specified future date.
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Financial Services:
Efficiency of emerging financial system largely depends upon the quality and
variety of financial services provided by financial intermediaries. The term financial
services can be defined as "activities, benefits and satisfaction connected with sale of
money that offers to users and customers, financial related value".
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[1.3] INDIAN FINANCIAL MARKET
A Financial Market can be defined as the market in which financial assets are
created or transferred. As against a real transaction that involves exchange of money
for real goods or services, a financial transaction involves creation or transfer of a
financial asset. Financial Assets or Financial Instruments represents a claim to the
payment of a sum of money sometime in the future and /or periodic payment in the
form of interest or dividend. Financial market is broadly divided into 4 parts:
Money Market:
The money market ifs a wholesale debt market for low-risk, highly-liquid,
short-term instrument. Funds are available in this market for periods ranging from a
single day up to a year. This market is dominated mostly by government, banks and
financial institutions.
Capital Market:
The capital market is designed to finance the long-term investments. The
transactions taking place in this market will be for periods over a year.
Forex Market:
The Forex market deals with the multicurrency requirements, which are met by
the exchange of currencies. Depending on the exchange rate that is applicable, the
transfer of funds takes place in this market. This is one of the most developed and
integrated market across the globe.
Credit Market:
Credit market is a place where banks, FIs and NBFCs purvey short, medium
and long-term loans to corporate and individuals.
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[1.2] Components Of Indian Financial System:
The following are the four main components of Indian Financial system are:
Financial Institutions.
Financial Markets.
Financial Instruments/Assets/Securities.
Financial Services.
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often termed as the 'coupon rate' or the 'interest rate'. Therefore, the buyer (of bond) is giving
the seller a loan at a fixed interest rate, which equals to the coupon rate.
Indian debt market can be broadly classified into two categories, namely debt instruments
issued by Central or State Governments and debt instruments issued by Public and Private
Sector. Different instruments issued have some prominent features in respect of period of
maturity and the investors for such instruments.
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A list of the structure of Indian debt market is given below:-
Who Issues Type of Instruments Maturity Periods Who Invests
Central
Government
Zero Coupon Bonds;
Coupon Bearing GOI
securities.
1 year to 30 years
Banks, Insurance
and PF Trusts, RBI,
Mutual Funds,
Individuals
Central
Government
Treasury Bills 91 days and 364 days
Banks, Insurance
and PF Trusts, RBI,
Mutual Funds,
Individuals
State Government
Coupon Bearing State
Govt securities
5 years to 10 years
Banks, Insurance
and PF Trusts
Government
Enterprises &
PSU Bonds
Govt guaranteed bonds 5 years to 10 years
Banks, Insurance,
PF Trusts and
Individuals
PSU
PSU Bonds, Zero
coupon bonds
5 years to 10 years
Banks, Insurance,
PF Trusts, Corporate
and,
Individuals
Private Sector
Corporates
Debentures and Bonds 1 year to 12 years
Banks, Corporate,
Mutual Funds and
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Individuals
Private and Public
Sector Corporates
Commercial Paper 15 days to 1 year
Banks, Corporate,
Mutual Funds,
Financial
Institutions and
Individuals
Banks and
Finance
Certificate of Deposits 15 days to 3 years
Banks and
Corporate
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[2.2] CLASSIFICATION OF DEBT MARKET
The instruments traded can be classified into the following segments based on the
characteristics of the identity of the issuer of these securities:
Market
Segment
Issuer Instruments
Government
Securities
Central Government Zero Coupon Bonds, Coupon Bearing
Bonds, Treasury Bills, STRIPS
State Governments Coupon Bearing Bonds.
Public Sector
Bonds
Government
Agencies / Statutory
Bodies
Govt. Guaranteed Bonds, Debentures
Public Sector Units PSU Bonds, Debentures, Commercial
Paper
Private Sector
Bonds
Corporates Debentures, Bonds, Commercial Paper,
Floating Rate Bonds, Zero Coupon Bonds,
Inter-Corporate Deposits
Banks Certificates of Deposits, Debentures,
Bonds
Financial Institutions Certificates of Deposits, Bonds
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Indian debt market can be classified into two categories:
Government Securities Market (G-Sec Market): It consists of central and state
government securities. It means that, loans are being taken by the central and state
government. It is also the most dominant category in the India debt market.
Bond Market: It consists of Financial Institutions bonds, Corporate bonds and
debentures and Public Sector Units bonds. These bonds are issued to meet financial
requirements at a fixed cost and hence remove uncertainty in financial costs.
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[2.3] IMPORTANCE OF DEBT MARKET
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.
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.
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.
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[2.4] ADVANTAGES OF DEBT MARKET
The following are the advantages of debt market:
The biggest advantage of investing in Indian debt market is its assured returns. The
returns that the market offer is almost risk-free (though there is always certain amount
of risks, however the trend says that return is almost assured).
Safer are the government securities. On the other hand, there are certain amounts of
risks in the corporate, FI and PSU debt instruments. However, investors can take help
from the credit rating agencies which rate those debt instruments. The interest in the
instruments may vary depending upon the ratings.
Another advantage of investing in India debt market is its high liquidity. Banks offer
easy loans to the investors against government securities.
Greater safety and lower volatility as compared to other financial instruments.
Variations possible in the structure of instruments like Index linked Bonds, STRIPS.
Higher leverage available in case of borrowings against G-Secs.
No TDS on interest payments.
Example: Tax exemption for interest earned on G-Secs. up to Rs.3000/- over and
above the limit of Rs.12000/- under Section 80L (as amended in the latest Budget).
Greater diversification opportunities adequate trading opportunities with continuing
volatility expected in interest rates the world over.
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[2.5] DISADVANTAGES OF DEBT MARKET
As there are several advantages of investing in India debt market, there are certain
disadvantages as well.
As the returns here are risk free, those are not as high as the equities market at the
same time. So, at one hand you are getting assured returns, but on the other hand, you
are getting less return at the same time.
Retail participation is also very less here, though increased recently. There are also
some issues of liquidity and price discovery as the retail debt market is not yet quite
well developed.
Debt securities usually have much smaller relative price changes than stocks or
commodities. Traders in debt securities must take larger positions to achieve the same
level of profits. It is not uncommon for individual stocks or even stock indexes to
move two percent or more during a trading day. Debt securities may move two percent
over several weeks or a month. Even with ten-to-one leverage, trading debt securities
requires the trader to use much larger position sizes than a stock market trader.
The debt trading markets are dominated by hedge funds and the trading desks of large
financial institutions. These traders have access to information and capital that is
difficult or impossible for the individual trader to obtain. By the time the small trader
gets the news that these large players are trading on, it may be too late to profit from
the news.
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Traders in corporate debt securities trade high-yield or junk bonds to earn the higher
interest rates these bonds pay. The trader can also achieve capital gains if the issuing
corporation gets an upgrade in its credit rating. The downside of high yield bonds is a
bankruptcy and total loss of the principal invested.
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Financial Institutions:
Financial institutions are the intermediary who facilitates smooth functioning of
the financial system by making investors and borrowers meet. They mobilize savings
of the surplus units and allocate them in productive activities promising a better rate of
return. Financial institutions also provide a service to entities seeking advises on
various issues ranging from restructuring to diversification plans. They provide whole
range of services to the entities who want to raise funds from the markets elsewhere.
Financial institutions act as financial intermediaries because they act as middlemen
between savers and borrowers. Were these financial institutions may be of Banking or
Non-Banking institutions.
Financial Markets:
Finance is a prerequisite for modern business and financial institutions play a
vital role in economic system. It's through financial markets the financial system of an
economy works. The main functions of financial markets are:
• To facilitate creation and allocation of credit and liquidity.
• To serve as intermediaries for mobilization of savings.
• To assist process of balanced economic growth.
• To provide financial convenience.
Financial Instruments/Assets/Securities:
Another important constituent of financial system is financial instruments. They
represent a claim against the future income and wealth of others. It will be a claim
against a person or an institution, for the payment of the some of the money at a
specified future date.
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Commercial Papers:
There are short term securities with maturity of 7 to 365 days. CPs are issued by
corporate entities at a discount to face value.
Treasury Bills:
Treasury bills are short-term instruments issued by the RBI on behalf of the
government to tide over short term liquidity shortfalls. The instruments are issued by
government to raise short term funds to bridge seasonal or temporary gaps between its
receipts (revenue & capital) and expenditure. They form the most important segment
of the money market not only in India but all over the world as well.
Bonds:
A bond is a debt security in which authorized issuer owes the holder a debt and
it is obligated to repay the principle and interest rate (coupon) at a later date or
maturity date. It is a financial contract which pledge to repay a specified or fixed
amount of money with the interest paid to the lender upon maturity of the contract.
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[2.7] PLAYERS IN DEBT MARKET
Players in debt market are similar to players in most financial markets and are
essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often both.
Players include:
• Institutional investors
• Governments
• Traders
• Individuals
• Banks
Because of the specificity of individual bond issues, and the lack of liquidity in many smaller
issues, the majority of outstanding bonds are held by institutions like pension funds, banks
and mutual funds. In the United States, approximately 10% of the market is currently held by
private individuals.
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CHAPTER 3: REGULATORS OF DEBT MARKET
[3.1] INTRODUCTION
Indian Debt Market has been subject to regulations by two authorities, RBI and SEBI. The
dual control used to create overlapping of jurisdiction and thereby confusion. In a
notification issued by the Government on March, 2, 2000 the areas of responsibility
betweenRBI and SEBI have been clearly defined.
The RBI now regulates contracts for the sale and purchase of Government securities, gold
related securities, money market securities and ready forward contract in debt securities.
SEBI regulates all mutual fund, including money market mutual funds. It also regulates the
stock markets and the member brokers of the stock exchange. Further it regulates the listing
and trading mechanism of the debt instruments. The issue of corporate debts is also under the
regulation of SEBI.
The issuance of debt instruments by the government is regulated by the Government
Securities Act 2006. The issuance of corporate securities is regulated by the SEBI Guidelines
for disclosure and Investor protection.
The Government Securities Act, 2006was enacted by the Parliament in August 2006. The
RBI made Government Securities Regulation, 2007 to carry out the purpose of the
Government Securities Act, 2006. The Act and the Regulations are applicable to
Government securities created and issued by the Central and the State Government.
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[3.2] Reserve Bank of India
The Reserve Bank of India was established on April 1, 1935 in accordance with the
provisions of the Reserve Bank of India Act,1934.The Central Office of the Reserve Bank
was initially established in Calcutta but was permanently moved to Mumbai in 1937. The
Central Office is where the Governor sits and where policies are formulated. Though
originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned
by the Government of India.
Role of RBI in Debt Market
1. Issuer Of Debt Instruments :
Government securities are issued through auctions conducted by the RBI.
Auctions are conducted on the electronic platform called the NDS – Auction
platform. Commercial banks, scheduled urban co-operative banks, Primary
Dealers, insurance companies and provident funds, who maintain funds
account (current account) and securities accounts (SGL account) with RBI,
are members of this electronic platform.
2. Started the Banking Ombudsman Scheme:
The Scheme is introduced with the object of enabling resolution of
complaints relating to certain services rendered by banks and to facilitate
the satisfaction or settlement of such complaints.
3. Determines the investment of commercial banks in debt:
RBI decides amount of investment of commercial bank in debt
instrument.
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[3.3] GOVERNMENT SECURITIES ACT, 2006:
‘Government security’ means a security created and issued by the Government for the
purpose of raising a public loan or for any other purpose as may be notified by the
Government in the Official Gazette.
A Government security may be issued in the form of:
a. A Government promissory note,
b. A bearer bond payable to bearer,
c. A stock or
d. A bond
A stock means a Government security:
a. Registered in the books of the RBI for which a stock certificate is issued; or
b. Held at the credit of the holder in the SGL account including the CSGL account
maintained in the books of the RBI
The transfer of the Government securities shall be made in such form and in such manner as
may be prescribed.
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Financial Services:
Efficiency of emerging financial system largely depends upon the quality and
variety of financial services provided by financial intermediaries. The term financial
services can be defined as "activities, benefits and satisfaction connected with sale of
money that offers to users and customers, financial related value".
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[3.5] Securities and Exchange Board of India
The Securities and Exchange Board of India was enacted on April 12, 1992 in accordance
with the provisions of the Securities and Exchange Board of India Act, 1992.
Role of SEBI
1. Regulating the business in stock exchanges and any other securities
markets;
2. Registering and regulating the working of stock brokers, sub-
brokers, share transfer agents, bankers to an issue, trustees of trust
deeds, merchant bankers and such other intermediaries who may be
associated with securities markets in any manner;
3. Registering and regulating the working of the depositories,
custodians of securities, foreign institutional investors, credit rating
agencies and such other intermediaries.
4. Registering and regulating the working of venture capital funds and
collective investment schemes, including mutual funds;
5. Promoting and regulating self-regulatory organizations.
6. Prohibiting fraudulent and unfair trade practices relating to
securities markets;
7. Promoting investors' education and training of intermediaries of
securities markets;
8. Prohibiting insider trading in securities;
9. Regulating substantial acquisition of shares and take-over of
companies;
10.Calling for information from, undertaking inspection, conducting
inquiries and audits of the intermediaries and self- regulatory
organizations in the securities market.
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[3.6] SEBI (DISCLOSURE AND INVESTOR PROTECTION)
GUIDELINES, 2000
SEBI has issued Securities and Exchange Board of India (Disclosure and Investor
Protection) Guidelines in 2000
SEBI GUIDELINES
A. For Issue of Debt Instruments
• The issuer making a public issue or rights issue of debt securities shall appoint one or
more debenture trustees in accordance with the provisions of Section 117B of the
Companies Act, 1956.
• The issuer making a public issue or rights issue of debt securities shall appoint one or
more Merchant Bankers.
• The issuer shall enter into an arrangement with a depository registered with the SEBI
for dematerialization of the debt securities that are proposed to be issued to the public.
• The issuer shall give an option to the subscribers to receive the debt securities either in
the physical form or in dematerialized form.
• A trust deed shall be executed by the issuer in favor of the debenture trustees before
filling of offer document with the Registrar of Companies and the Designated Stock
Exchange.
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B. Advertisements of Public Issues:
The issuer company shall make an advertisement in an English national Daily with
wide circulation, one Hindi National newspaper and a regional language newspaper
with wide circulation at the place where the registered office of the issuer is situated
At the time of filing of the offer document with the Registrar of Companies.
Issue Opening Date, Issue Closing Date.
And contain the minimum disclosures as per Schedule IV.
C. Requirement of Credit Rating
No public issue or Rights issue shall be made unless credit rating from a credit rating
agency has been obtained.
For a public or rights issue greater than or equal to Rs. 100 crores two ratings from
two different credit rating agencies shall be obtained.
Where credit rating has been obtained from more than one credit rating agencies, all
credit ratings, shall be disclosed.
All credit ratings obtained during the three years for any listed security of the issuer
company shall be disclosed in the offer document.
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D. Requirement of Debenture Trustee
In case of issue of debentures having maturity more than 18 months, the issuer shall
appoint a Debenture Trustee.
The name of the debenture trustee must be stated in the offer document.
A trust deed must be executed by the issuer company in favor of the trustee within six
months of the closure of the issue.
Trustees of the debenture issue shall be vested with the power for protecting the
interest of the debenture holders.
E. Debenture Redemption Reserve (DRR)
A company has to create Debenture Redemption Reserve (DRR) in case of issue of
debentures with maturity of more than 18 months.
The DRR should be created in accordance with the following provisions:
• Company shall create DRR equivalent to 50% of the amount of debenture issue
before debenture redemption commences.
• Withdrawal from DRR is permitted only after 10% of the debenture liability has
been actually redeemed by the company.
• The requirement of creation of DRR shall not be applicable in case of issue of
debt instruments by infrastructure companies.
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[1.3] INDIAN FINANCIAL MARKET
A Financial Market can be defined as the market in which financial assets are
created or transferred. As against a real transaction that involves exchange of money
for real goods or services, a financial transaction involves creation or transfer of a
financial asset. Financial Assets or Financial Instruments represents a claim to the
payment of a sum of money sometime in the future and /or periodic payment in the
form of interest or dividend. Financial market is broadly divided into 4 parts:
Money Market:
The money market ifs a wholesale debt market for low-risk, highly-liquid,
short-term instrument. Funds are available in this market for periods ranging from a
single day up to a year. This market is dominated mostly by government, banks and
financial institutions.
Capital Market:
The capital market is designed to finance the long-term investments. The
transactions taking place in this market will be for periods over a year.
Forex Market:
The Forex market deals with the multicurrency requirements, which are met by
the exchange of currencies. Depending on the exchange rate that is applicable, the
transfer of funds takes place in this market. This is one of the most developed and
integrated market across the globe.
Credit Market:
Credit market is a place where banks, FIs and NBFCs purvey short, medium
and long-term loans to corporate and individuals.
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[3.7] SEBI (ISSUE AND LISTING OF DEBT SECURITIES)
REGULATIONS, 2008
Issue and Listing of Debt Securities was Implemented by SEBI & has simplified the
Debt market and given it structure.
A. Issue Requirements for Public Issues
Electronic Issuance:
An issuer proposing to issue debt securities to the public through the online system of
the designated stock exchange should comply with the relevant application
requirements as may be specified by SEBI.
Price Discovery through Book Building:
The issuer may determine the price of debt securities in consultation with the lead
merchant banker. The issue may be at fixed price or the price may be determined
through the book building process in accordance with the procedure as may be
specified by SEBI.
Minimum Subscription:
The issuer may decide the amount of minimum subscription which it seeks to raise by
issue of debt securities and disclose the same in the offer document. In the event of
non-receipt of minimum subscription all application moneys received in the public
issue shall be refunded to the applicants.
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Listing of Debt Securities:
An issuer desirous of issuing debt securities to the public has to make an application
for listing to one or more recognized stock exchanges in terms of Sections 73(1) of the
Companies Act , 1956. The issuer has to comply with the conditions of listing of such
debt securities as specified in the Listing Agreement with the Stock exchanges where
such debt securities are sought to be listed.
B. Continuous Listing Conditions:
1. All the issuers making public issues of debt securities issued on private
placement basis should comply with the conditions of listing specified in the
respective agreement for debt securities.
2. Every rating obtained by an issuer should be periodically reviewed by the
registered credit rating agency and any revision in the rating shall be promptly
disclosed by the issuer to the stock exchange where the debt securities are listed.
3. Any changes in rating should be promptly disseminated to investor.
4. Debenture trustee should disclose the information to the investors and the
general public by issuing a press release.
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CHAPTER 4: OVERVIEW OF BONDS
[4.1] INTRODUCTION OF BONDS
In finance, a bond is a debt security, in which the authorized issuer owes the holders a
debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) and/or
to repay the principal at a later date, termed maturity. A bond is a formal contract to repay
borrowed money with interest at fixed intervals. Thus a bond is like a loan: the issuer is the
borrower (debtor), the holder is the lender (creditor), and the coupon is the interest. Bonds
provide the borrower with external funds to finance long-term investments, or, in the case of
government bonds, to finance current expenditure. Certificates of deposit (CDs) or
commercial paper are considered to be money market instruments and not bonds. Bonds
must be repaid at fixed intervals over a period of time. Bonds and stocks are both securities,
but the major difference between the two is that (capital-) stockholders have an equity stake
in the company (i.e., they are owners), whereas bondholders have a creditor stake in the
company (i.e., they are lenders). Another difference is that bonds usually have a defined
term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding
indefinitely. An exception is a console bond, which is a perpetuity (i.e., bond with no
maturity).A number of bond indices exist for the purposes of managing portfolios and
measuring performance, similar to the S&P 500 or Russell Indexes for stocks. The most
common American benchmarks are the (ex) Lehman Aggregate, Citigroup BIG and Merrill
Lynch Domestic Master. Most indices are parts of families of broader indices that can be
used to measure global bond portfolios, or may be further subdivided by maturity and/or
sector for managing specialized portfolios.
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[4.2] PLAYERS OF BOND MARKET
The bond market can essentially be broken down into three main groups:
Issuers:
The issuers sell bonds or other debt instruments in the bond market to fund the
operations of their organizations. This area of the market is mostly made up
of governments, banks and corporations. The biggest of these issuers is
the government, which uses the bond market to fund a country's operations, such
as social programs and other necessary expenses. The government segment also
includes some of its agencies such as Fannie Mae, which offers mortgage-
backed securities. Banks are also key issuers in the bond market and they can
range from local banks up to supranational banks such as the European Investment
Bank, which issues debt in the bond market. The final major issuer is the corporate
bond market, which issues debt to finance corporate operations.
Underwriters:
The underwriting segment of the bond market is traditionally made up of investment
banks and other financial institutions that help the issuer to sell the bonds in the
market. In general, selling debt is not as easy as just taking it to the market. In most
cases, millions - if not billions - of dollars are being transacted in one offering. As a
result, a lot of work needs to be done - such as creating a prospectus and other legal
documents - in order to sell the issue. In general, the need for underwriters is greatest
for the corporate debt market because there are more risks associated with this type of
debt.
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CHAPTER 2:OVERVIEW OF DEBT MARKET
[2.1] INTRODUCTION OF DEBT MARKET
The capital market comprises of equities market and debt market. The Debt Market is the
market where fixed income securities of various types and features are issued and traded.
Debt Markets are therefore, markets for fixed income securities issued by Central and State
Governments, Municipal Corporations, Govt. bodies and commercial entities like Financial
Institutions, Banks, Public Sector Units, Public Ltd. companies and also structured finance
instruments. Debt market is a market for the issuance, trading and settlement in fixed income
securities of various types. The debt market is any market situation where trading debt
instruments take place. Examples of debt instruments include mortgages, promissory notes,
bonds, and Certificates of Deposit. A debt market establishes a structured environment where
these types of debt can be traded with ease between interested parties.
The debt market often goes by other names, based on the types of debt instruments
that are traded. In the event that the market deals mainly with the trading of municipal and
corporate bond issues, the debt market may be known as a bond market. If mortgages and
notes are the main focus of the trading, the debt market may be known as a credit market.
When fixed rates are connected with the debt instruments, the market may be known as a
fixed income market.
Debt market refers to the financial market where investors buy and sell debt securities,
mostly in the form of bonds. These markets are important source of funds, especially in a
developing economy like India. India debt market is one of the largest in Asia. Like all other
countries, debt market in India is also considered a useful substitute to banking channels for
finance. The most distinguishing feature of the debt instruments of Indian debt market is that
the return is fixed. This means, returns are almost risk-free. This fixed return on the bond is
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[4.3] FEATURES OF BOND
The most important features of a bond are:
Nominal, principal or face amount:
The amount on which the issuer pays interest, and which, most commonly, has
to be repaid at the end of the term. Some structured bonds can have a redemption
amount which is different to the face amount and can be linked to performance of
particular assets such as a stock or commodity index, foreign exchange rate or a fund.
This can result in an investor receiving less or more than his original investment at
maturity.
Issue price:
The price at which investors buy the bonds when they are first issued, which
will typically be approximately equal to the nominal amount. The net proceeds that the
issuer receives are thus the issue price, less issuance fees.
Maturity date:
The date on which the issuer has to repay the nominal amount. As long as all
payments have been made, the issuer has no more obligations to the bond holders after
the maturity date. The length of time until the maturity date is often referred to as the
term or tenor or maturity of a bond. The maturity can be any length of time, although
debt securities with a term of less than one year are generally designated money
market instruments rather than bonds. Most bonds have a term of up to thirty years.
Some bonds have been issued with maturities of up to one hundred years, and some
even do not mature at all. In the market there are three groups of bond maturities:
Short term (bills): maturities up to one year;
Medium term (notes): maturities between one and ten years;
Long term (bonds): maturities greater than ten years.
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Coupon:
The interest rate that the issuer pays to the bond holders. Usually this rate is
fixed throughout the life of the bond. It can also vary with a money market index, such
as LIBOR, or it can be even more exotic. The name coupon originates from the fact
that in the past, physical bonds were issued which had coupons attached to them. On
coupon dates the bond holder would give the coupon to a bank in exchange for the
interest payment.
Indentures and Covenants:
An indenture is a formal debt agreement that establishes the terms of a bond
issue, while covenants are the clauses of such an agreement. Covenants specify the
rights of bondholders and the duties of issuers, such as actions that the issuer is
obligated to perform or is prohibited from performing. In the U.S., federal and state
securities and commercial laws apply to the enforcement of these agreements, which
are construed by courts as contracts between issuers and bondholders. The terms may
be changed only with great difficulty while the bonds are outstanding, with
amendments to the governing document generally requiring approval by a majority (or
super-majority) vote of the bondholders.
Coupon dates:
The dates on which the issuer pays the coupon to the bond holders. In the U.S.
and also in the U.K. and Europe, most bonds are semi-annual, which means that they
pay a coupon every six months.
Optionality:
Occasionally a bond may contain an embedded option; that is, it grants option-
like features to the holder or the issuer.
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Call ability:
Some bonds give the issuer the right to repay the bond before the maturity
date on the call dates; see call option. These bonds are referred to as callable bonds.
Most callable bonds allow the issuer to repay the bond at par. With some bonds, the
issuer has to pay a premium, the so called call premium. This is mainly the case for
high-yield bonds. These have very strict covenants, restricting the issuer in its
operations. To be free from these covenants, the issuer can repay the bonds early, but
only at a high cost.
Put ability:
Some bonds give the holder the right to force the issuer to repay the bond before the
maturity date on the put dates; see put option. (Note: "Puttable" denotes an embedded
put option; "Puttable" denotes that it may be put.)
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[4.4] TYPES OF BOND
After you decide to invest in bonds, you then need to decide what kinds of bond
investments are right for you. Most people don’t realize it, but the bond market offers
investors a lot more choices than the stock market.
Depending on your goals, your tax situation and your risk tolerance, you can choose
from municipal, government, corporate, mortgage-backed or asset-backed securities and
international bonds. Within each broad bond market sector you will find securities with
different issuers, credit ratings, coupon rates, maturities, yields and other features. Each one
offers its own balance of risk and reward.
1. DOMESTIC BONDS:
Municipal bonds:
Municipal bonds are debt obligations issued by states, cities, counties and other
governmental entities, which use the money to build schools, highways, hospitals, sewer
systems, and many other projects for the public good. When you purchase a municipal bond,
you are lending money to a state or local government entity, which in turn promises to pay
you a specified amount of interest (usually paid semiannually) and return the principal to you
on a specific maturity date. Not all municipal bonds offer income exempt from both federal
and state taxes. There is an entirely separate market of municipal issues that are taxable at
the federal level, but still offer a state—and often local—tax exemption on interest paid to
residents of the state of issuance. Most of this municipal bond information refers to munis
which are free of federal taxes.
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often termed as the 'coupon rate' or the 'interest rate'. Therefore, the buyer (of bond) is giving
the seller a loan at a fixed interest rate, which equals to the coupon rate.
Indian debt market can be broadly classified into two categories, namely debt instruments
issued by Central or State Governments and debt instruments issued by Public and Private
Sector. Different instruments issued have some prominent features in respect of period of
maturity and the investors for such instruments.
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Inflation Linked Bonds:
Bonds in which the principal amount and the interest payments are indexed to
inflation. The interest rate is normally lower than for fixed rate bonds with a
comparable maturity. However, as the principal amount grows, the payments increase
with inflation. The United Kingdom was the first sovereign issuer to issue inflation
linked Gilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds
are examples of inflation linked bonds issued by the U.S. government.
Other Indexed Bonds:
For example equity-linked notes and bonds indexed on a business indicator (income,
added value) or on a country's GDP.
Asset-backed Securities:
Bonds whose interest and principal payments are backed by underlying cash
flows from other assets. Examples of asset-backed securities are mortgage-backed
securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized
debt obligations (CDOs).
Subordinated Bonds:
Bonds are those that have a lower priority than other bonds of the issuer in case
of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the
liquidator is paid, then government taxes, etc. The first bond holders in line to be paid
are those holding what is called senior bonds. After they have been paid, the
subordinated bond holders are paid. As a result, the risk is higher. Therefore,
subordinated bonds usually have a lower credit rating than senior bonds. The main
examples of subordinated bonds can be found in bonds issued by banks, and asset-
backed securities.
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Perpetual Bonds:
Bonds are also often called perpetuities or 'Perps'. They have no maturity date.
The most famous of these are the UK Consoles, which are also known as Treasury
Annuities or Undated Treasuries. Some of these were issued back in 1888 and still
traded today.
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2. INTERNATIONAL BONDS:
Some companies, banks, governments, and other sovereign entities may decide to
issue bonds in foreign currencies as it may appear to be more stable and predictable than
their domestic currency. Issuing bonds denominated in foreign currencies also gives issuers
the ability to access investment capital available in foreign markets. The proceeds from the
issuance of these bonds can be used by companies to break into foreign markets, or can be
converted into the issuing company's local currency to be used on existing operations
through the use of foreign exchange swap hedges. Foreign issuer bonds can also be used to
hedge foreign exchange rate risk. Some foreign issuer bonds are called by their nicknames,
such as the "samurai bond." These can be issued by foreign issuers looking to diversify their
investor base away from domestic markets. These bond issues are generally governed by the
law of the market of issuance, e.g., a samurai bond, issued by an investor based in Europe,
will be governed by Japanese law. Not all of the following bonds are restricted for purchase
by investors in the market of issuance.
Eurodollar bond, a U.S. dollar-denominated bond issued by a non-U.S. entity outside
the U.S.
Yankee bond, a US dollar-denominated bond issued by a non-US entity in the US
market.
Kangaroo bond, an Australian dollar-denominated bond issued by a non-Australian
entity in the Australian market.
Maple bond, a Canadian dollar-denominated bond issued by a non-Canadian entity in
the Canadian market.
Samurai bond, a Japanese yen-denominated bond issued by a non-Japanese entity in
the Japanese market.
Uri dashi bond, a non-yen-denominated bond sold to Japanese retail investors.
Shibosai Bond is a private placement bond in Japanese market with distribution
limited to institutions and banks.
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[4.5] ISSUERS OF BONDS
Many entities issue bonds. The bond market separates bond issuers into categories
based on the similarities of these issuers and their characteristics. These major categories are:
supranational agencies (i.e. World Bank), national governments (i.e. Government of
Canada), provincial or state governments (i.e. Province of Ontario), municipal governments
(i.e. City of Edmonton) and corporate bonds (i.e. General Motors). Bonds are issued by
public authorities, credit institutions, companies and supranational institutions in the primary
markets. The most common process of issuing bonds is through underwriting. In
underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue
of bonds from an issuer and re-sell them to investors. The security firm takes the risk of
being unable to sell on the issue to end investors. Primary issuance is arranged by book
runners who arrange the bond issue, have the direct contact with investors and act as advisors
to the bond issuer in terms of timing and price of the bond issue.
The book runners' willingness to underwrite must be discussed prior to opening
books on a bond issue as there may be limited appetite to do so. In the case of Government
Bonds, these are usually issued by auctions, where both members of the public and banks
may bid for bond. Since the coupon is fixed, but the price is not, the percent return is a
function both of the prices paid as well as the coupon.
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A list of the structure of Indian debt market is given below:-
Who Issues Type of Instruments Maturity Periods Who Invests
Central
Government
Zero Coupon Bonds;
Coupon Bearing GOI
securities.
1 year to 30 years
Banks, Insurance
and PF Trusts, RBI,
Mutual Funds,
Individuals
Central
Government
Treasury Bills 91 days and 364 days
Banks, Insurance
and PF Trusts, RBI,
Mutual Funds,
Individuals
State Government
Coupon Bearing State
Govt securities
5 years to 10 years
Banks, Insurance
and PF Trusts
Government
Enterprises &
PSU Bonds
Govt guaranteed bonds 5 years to 10 years
Banks, Insurance,
PF Trusts and
Individuals
PSU
PSU Bonds, Zero
coupon bonds
5 years to 10 years
Banks, Insurance,
PF Trusts, Corporate
and,
Individuals
Private Sector
Corporates
Debentures and Bonds 1 year to 12 years
Banks, Corporate,
Mutual Funds and
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B2 B B
B3 B- B-
CAA1 CCC+
C CCC C
Substantial risks
CAA2 CCC
Extremely
speculative
CAA3 CCC- In default with little
prospect for
recovery
CA
CC
C
C
D /
DDD
/ In default
• / • DD
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CREDIT RATING AGENCIES:
Credit rating agencies registered as such with the SEC are known as “Nationally
Recognized Statistical Rating Organizations.” The following firms are currently
registered as NRSROs: A.M. Best Company, Inc.; DBRS Ltd.; Egan-Jones Rating
Company; Fitch, Inc.; Japan Credit Rating Agency, Ltd.; LACE Financial Corp.;
Moody’s Investors Service, Inc.; Rating and Investment Information, Inc.; Real point
LLC; and Standard & Poor’s Ratings Services. Under the Credit Rating Agency
Reform Act, an NRSRO may be registered with respect to up to five classes of credit
ratings: (1) financial institutions, brokers, or dealers; (2) insurance companies; (3)
corporate issuers; (4) issuers of asset-backed securities; and (5) issuers of government
securities, municipal securities, or securities issued by a foreign government.
S&P, Moody's, and Fitch dominate the market with approximately 90-95 percent of
world market share.
The Development of Bond market in In Credit Rating Tiers
Moody's assigns bond credit ratings of AAA,A A,A,BAA, BA, B, CAA, CA, C, with
WR and NR as withdrawn and not rated. Standard & Poor's and Fitch assign bond
credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, D.
As of October 16, 2009, there were 4 companies rated AAA by S&P: Automatic Data
Processing (NYSE:ADP)
Johnson & Johnson (NYSE:JNJ)
Microsoft (NASDAQ:MSFT)
ExxonMobil (NYSE:XOM)
Moody's, S&P and Fitch will all also assign intermediate ratings at levels between AA
and CCC (e.g., BBB+, BBB and BBB-), and may also choose to offer guidance
(termed a "credit watch") as to whether it is likely to be upgraded (positive),
downgraded (negative) or uncertain (neutral).
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Moody's Standard
& Poor's
Credit worthiness
AAA AAA Triple A = Credit risk almost zero
AA1 AA+ Safe investment, low risk of failure
AA2 AA "
AA3 AA- "
A1 A+ Safe investment, unless unforeseen events should occur in the
economy at large or in that particular field of business
A2 A "
A3 A- "
BAA1 BBB+ Medium safe investment. Occurs often when economy has
deteriorated. Problems may arise
BAA2 BBB "
BAA3 BBB- "
BA1 BB+ Speculative investment. Occurs often in deteriorated
circumstances, usually problematic to predict future
development
BA2 BB "
BA3 BB- "
B1 B+ Speculative investment. -Deteriorating situation expected
B2 B "
B3 B- "
CAA CCC High likelihood of bankruptcy or other business interruption
CAA CC "
C C "
D Bankruptcy or lasting inability to make payments most likely
WR Rating withdrawn
NR Not rated
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Investment grade:
A bond is considered investment grade or IG if its credit rating is BBB- or higher by
Standard & Poor's or Baa3 or higher by Moody's or BBB(low) or higher by DBRS.
Generally they are bonds that are judged by the rating agency as likely enough to meet
payment obligations that banks are allowed to invest in them.
Ratings play a critical role in determining how many companies and other entities that
issue debt, including sovereign governments; have to pay to access credit markets, i.e.,
the amount of interest they pay on their issued debt. The threshold between
investment-grade and speculative-grade ratings has important market implications for
issuers' borrowing costs.
Bonds that are not rated as investment-grade bonds are known as high yield bonds or
more derisively as junk bonds.
The risks associated with investment-grade bonds (or investment-grade corporate
debt) are considered noticeably higher than in the case of first-class government
bonds. The difference between rates for first-class government bonds and investment-
grade bonds is called investment-grade spread. It is an indicator for the market's belief
in the stability of the economy. The higher these investment-grade spreads (or risk
premiums) are, the weaker the economy is considered.
The debt market is much more popular than the equity markets in most parts of the
world. In India
The reverse has been true. Nevertheless, the Indian debt market has transformed itself
into a much
More vibrant trading field for debt instruments from the rudimentary market about a
decade ago.
The sections below encompass the transformation of government and corporate debt
markets in
India along with a comparison of the developments in equity market.
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Individuals
Private and Public
Sector Corporates
Commercial Paper 15 days to 1 year
Banks, Corporate,
Mutual Funds,
Financial
Institutions and
Individuals
Banks and
Finance
Certificate of Deposits 15 days to 3 years
Banks and
Corporate
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[5.2] YIELD TO MATURITY
The yield to maturity is the discount rate which returns the market price of the
bond; it is identical to (required return) in the above equation. YTM is thus the internal rate
of return of an investment in the bond made at the observed price. Since YTM can be used to
price a bond, bond prices are often quoted in terms of YTM. 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. The calculation of YTM helps the investor
in rational decision making. YTM serves as a cutoff point to the investor and enables him to
determine whether he should or should not invest in the given debt instrument. YTM
represents the yield on bond, provided the bond id held to maturity and the intermittent
coupons are reinvested at the same YTM rate. In other words, YTM assumes that investor
can reinvest the coupon received at same rate as YTM over the investment horizon.
To achieve a return equal to YTM, i.e. where it is the required return on the bond, the bond
owner must:
• Buy the bond at price P0,
• Hold the bond until maturity, and
• Redeem the bond at par.
Coupon yield:
The coupon yield is simply the coupon payment (C) as a percentage of the face value
(F).Coupon yield is also called nominal yield.
Coupon yield = C / F
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Current yield:
The current yield is simply the coupon payment (C) as a percentage of the (current) bond
price (P).
Current yield = C / P0.
Relationship:
The concept of current yield is closely related to other bond concepts, including yield to
maturity, and coupon yield. The relationship between yield to maturity and the coupon rate is
as follows:
When a bond sells at a discount, YTM > current yield > coupon yield.
When a bond sells at a premium, coupon yield > current yield > YTM.
When a bond sells at par, YTM = current yield = coupon yield amt.
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CHAPTER 6: STATISTICAL DATA
[6.1] STATISTICAL DATA ON DEBT MARKET
The following table gives us the information of last ten years bonds issued by Public Sector
Undertakings.
Bonds Issued by Public Sector Undertakings(Rupees crore)
Year Tax-free Bonds Taxable Bonds Total (2+3)
1 2 3 4
2000-01 662.2 15969.4 16631.6
2001-02 274.2 14161.5 14435.7
2002-03 286.0 7243.0 7529.0
2003-04 5443.2 5443.2
2004-05 7590.6 7590.6
2005-06 4845.5 4845.5
2006-07 10325.1 10325.1
2007-08 13404.4 13404.4
2008-09 12839.8 12839.8
2009-10 29937.8 29937.8
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It is analyzed that since 2003 till date there is no Tax Free Bonds issued by public
sector undertakings. It is also been interpreted that the value of taxable bonds are
increasing on yearly basis.
Debt-to-GDP and the Market:
Decades from now, when historians write about the current era, the relationship between the
stock market and the debt ratio will likely be a hot topic — one that will encompass politics,
economics, demographics and cultural history. The first few decades after World War II
witnessed an inverse relationship between a rising market and shrinking debt ratio. But after
the decade of stagflation, the 18-year bull market that started in 1982 was accompanied by a
change in the debt relationship from inverse to tandem, as the overlay below suggests. Those
good times came at a cost — one that was increasingly covered by debt.
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[2.2] CLASSIFICATION OF DEBT MARKET
The instruments traded can be classified into the following segments based on the
characteristics of the identity of the issuer of these securities:
Market
Segment
Issuer Instruments
Government
Securities
Central Government Zero Coupon Bonds, Coupon Bearing
Bonds, Treasury Bills, STRIPS
State Governments Coupon Bearing Bonds.
Public Sector
Bonds
Government
Agencies / Statutory
Bodies
Govt. Guaranteed Bonds, Debentures
Public Sector Units PSU Bonds, Debentures, Commercial
Paper
Private Sector
Bonds
Corporates Debentures, Bonds, Commercial Paper,
Floating Rate Bonds, Zero Coupon Bonds,
Inter-Corporate Deposits
Banks Certificates of Deposits, Debentures,
Bonds
Financial Institutions Certificates of Deposits, Bonds
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Note that I've changed the color of the ratio from red (my usual color for debt) to black to
avoid any suggestion of political responsibly. Ultimately politics is but one factor in the debt
equation, which is driven by larger historical forces (World Wars, the Great Depression and
the Cold War) as well as profound social, economic and cultural changes (e.g., trickle-down
economics meets the Boomer era of conspicuous consumption).
I've interpolated monthly values for the debt data in the market overlay so it aligns properly
with the monthly market data for the S&P Composite. Thus the Office of Management and
Budget (OMB) dot estimates in the top chart are shown as a smooth rosy line in the second.
That line represents the White House OMB's six-year debt and GDP forecasts. Note that the
curve becomes less steep from 2012-2015. Let's hope this isn't a wishful view through rosy
colored glasses.
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CHAPTER 7: CONCLUSION
[7.1] CONCLUSION
After you decide to invest in bonds, you then need to decide what kinds of bond
investments are right for you. Most people don’t realize it, but the bond market offers
investors a lot more choices than the stock market.
Depending on your goals, your tax situation and your risk tolerance, you can
choose from municipal, government, corporate, mortgage-backed or asset-backed securities
and international bonds. Within each broad bond market sector you will find securities with
different issuers, credit ratings, coupon rates, maturities, yields and other features. Each one
offers its own balance of risk and reward.
Individual investors as well as groups or corporate partners may participate in a debt
market. Depending on the regulations imposed by governments, there may be very little
distinction between how an individual investor versus a corporation would participate in a
debt market. However, there are usually some regulations in place that require that any type
of investor in debt market offerings have a minimum amount of assets to back the activity.
This is true even with situations such as bonds, where there is very little chance of the
investor losing his or her investment.
One of the advantages to participating in a debt market is that the degree of risk
associated with the investment opportunities is very low. For investors who are focused on
avoiding riskier ventures in favor of making a smaller but more or less guaranteed return,
going with bonds and similar investments simply makes sense. While the returns will never
be considered spectacular, it is possible to earn a significant amount of money over time, if
the right debt market offerings are chosen.