Bond market in India HISTORYTowards the eighteenth century, the borrowing needs of Indian Princely States were largelymet by Indigenous bankers and financiers. The concept of borrowing from the public in Indiawas pioneered by the East India Company to finance its campaigns in South India (the AngloFrench wars) in the eighteenth century. The debt owed by the Government to the public,over time, came to be known as public debt. The endeavors of the Company to establishgovernment banks towards the end of the 18th Century owed in no small measure to theneed to raise term and short term financial accommodation from banks on more satisfactoryterms than they were able to garner on their own.Public Debt, today, is raised to meet the Governments revenue deficits (the differencebetween the income of the government and money spent to run the government) or tofinance public works (capital formation). Borrowing for financing railway construction andpublic works such irrigation canals was first undertaken in 1867. The First World War saw arise in Indias Public Debt as a result of Indias contribution to the British exchequer towardsthe cost of the war. The provinces of British India were allowed to float loans for the first timein December, 1920 when local government borrowing rules were issued under section 30(a)of the Government of India Act, 1919. Only three provinces viz., Bombay, United Provincesand Punjab utilised this sanction before the introduction of provincial autonomy. Public Debtwas managed by the Presidency Banks, the Comptroller and Auditor-General of India till1913 and thereafter by the Controller of the Currency till 1935 when the Reserve Bankcommenced operations.Interest rates varied over time and after the uprising of 1857 gradually came down to about5% and later to 4% in 1871. In 1894, the famous 3 1/2 % paper was created which continuedto be in existence for almost 50 years. When the Reserve Bank of India took over themanagement of public debt from the Controller of the Currency in 1935, the total funded debtof the Central Government amounted to Rs 950 crores of which 54% amounted to sterlingdebt and 46% rupee debt and the debt of the Provinces amounted to Rs 18 crores.Broadly, the phases of public debt in India could be divided into the following phases.Upto 1867: when public debt was driven largely by needs of financing campaigns.
1867- 1916: when public debt was raised for financing railways and canals and other suchpurposes.1917-1940: when public debt increased substantially essentially out of the considerations of1940-1946: when because of war time inflation, the effort was to mop up as much aspossible of the current war time incomes1947-1951: represented the interregnum following war and partition and the economy wasunsettled. Government of India failed to achieve the estimates for borrwings for which credithad been taken in the annual budgets.1951-1985: when borrowing was influenced by the five year plans.1985-1991: when an attempt was made to align the interest rates on government securitieswith market interest rates in the wake of the recommendations of the Chakraborti CommitteeReport.1991 to date: When comprehensive reforms of the Government Securities market wereundertaken and an active debt management policy put in place. Ad Hoc Treasury bills wereabolished; commenced the selling of securities through the auction process; newinstruments were introduced such as zero coupon bonds, floating rate bonds and capitalindexed bonds; the Securities Trading Corporation of India was established; a system ofPrimary Dealers in government securities was put in place; the spectrum of maturities wasbroadened; the system of Delivery versus payment was instituted; standard valuation normswere prescribed; and endeavours made to ensure transparency in operations throughmarket process, the dissemination of information and efforts were made to give an impetusto the secondary market so as to broaden and deepen the market to make it more efficient.In India and the world over, Government Bonds have, from time to time, have not onlyadopted innovative methods for rasing resources (legalised wagering contracts like the PrizeBonds issued in the 1940s and later 1950s in India) but have also been used for variousinnovative schemes such as finance for development; social engineering like the abolition ofthe Zamindari system; saving the environment; or even weaning people away from gold (thegold bonds issued in 1993).Normally the sovereign is considered the best risk in the country and sovereign paper setsthe benchmark for interest rates for the corresponding maturity of other issuing entities.Theoretically, others can borrow at a rate above what the Government pays depending on
how their risk is perceived by the markets. Hence, a well developed Government Securities market helps in the efficient allocation of resources. A country‟s debt market to a large extent depends on the depth of the Government‟s Bond Market. It in in this context that the recent initiatives to widen and deepen the Government Securities Market and to make it more efficient have been taken. INTRODUCTION Traditionally, the capital markets in India are more synonymous with the equity markets – both on account of the common investors‟ preferences and the oft huge capital gains it offered – no matter what the risks involved are. The investor‟s preference for debt market, on the other hand, has been relatively a recent phenomenon – an outcome of the shift in the economic policy, whereby the market forces have been accorded a greater leeway in influencing the resource allocation. In a developing economy such as India, the role of the public sector and its financial requirements need no emphasis. Growing fiscal deficits and the policy stance of “directed investment” through statutory pre emption (the statutory liquidity ratio – SLR - for banks), ensured a captive but passive market for the Government securities. Besides, participation of the Reserve Bank of India (RBI) as an investor in the Government borrowing programme (monetisation of deficits) led to a regime of financial repression. In an eventual administered interest rate regime, the asset liability mismatches pose no threat to the balance sheets of financial institutions. As a result, the banking system, which is the major holder of the Government securities portfolio, remained a dominant passive investor segment and the market remained dormant. The Indian Bond Market has been traditionally dominated by the Government securities market. The reasons for this are· The high and persistent government deficit and the need to promote an efficient government securities market to finance this deficit at an optimal cost,· A captive market for the government securities in the form of public sector banks which are required to invest in government securities a certain per cent of deposit liabilities as per statutory requirement1,
· The predominance of bank lending in corporate financing and· Regulated interest rate environment that protected the banks‟ balance sheets on account of their exposure to the government securities. While these factors ensured the existence of a big Government securities market, the market was passive with the captive investors buying and holding on to the government securities till they mature. The trading activity was conspicuous by its absence. The scenario changed with the reforms process initiated in the early nineties. The gradual deregulation of interest rates and the Government‟s decision to borrow through auction mechanism and at market related rates DEBT MARKET Debt market as the name suggests is where debt instruments or bonds are traded. The most distinguishing feature of these instruments is that the return is fixed i.e. they are as close to being risk free as possible, if not totally risk free. The fixed return on the bond is known as the interest rate or the coupon rate. Thus, the buyer of a bond gives the seller a loan at a fixed rate, which is equal to the coupon rate. Debt Markets are therefore, markets for fixed income securities issued by:· Central and State Governments· Municipal Corporations· Entities like Financial Institutions, Banks, Public Sector Units, and Public Ltd. companies. The money market also deals in fixed income instruments. However, difference between money and bond markets is that the instruments in the bond markets have a larger time to maturity (more than one year). The money market on the other hand deals with instruments that have a lifetime of less than one year.
Segments of Debt Markets There are three main segments in the debt markets in India,· Government Securities,· Public Sector Units (PSU) bonds and· Corporate securities. The market for Government Securities comprises the Centre, State and State-Sponsored securities. The PSU bonds are generally treated as surrogates of sovereign paper, sometimes due to explicit guarantee and often due to the comfort of public ownership. Some of the PSU bonds are tax free while most bonds, including government securities are not tax free. The Government Securities segment is the most dominant among these three segments. Many of the reforms in pre-1997 period were fundamental, like introduction of auction systems and PDs. The reform in the Government Securities market which began in 1992, with Reserve Bank playing a lead role, entered into a very active phase since April 1997, with particular emphasis on development of secondary and retail markets MARKET STRUCTURE
There is no single location or exchange where debt market participants interact for common business. Participants talk to each other, conclude deals, send confirmations etc. on the telephone, with clerical staff doing the running around for settling trades. In that sense, the wholesale debt market is a virtual market. In order to understand the entirety of the wholesale debt market we have looked at it through a framework based on its main elements. The market is best understood by understanding these elements and their mutual interaction. These elements are as follows:· Instruments - the instruments that are being traded in the debt market.· Issuers - entity which issue these instruments.· Investors - entities which invest in these instruments or trade in these instruments.· Interventionists or Regulators - the regulators and the regulations governing the market. It is necessary to understand microstructure of any market to identify processes, products and issues governing its structure and development. In this section a schematic presentation is attempted on the micro-structure of Indian corporate debt market so that the issues are placed in a proper perspective. Figure gives a bird‟s eye view of the Indian debt market structure.
ParticipantsAs is well known, a large participant base would result in lower cost of borrowing for theGovernment. In fact, retailing of Government Securities is high on the agenda of furtherreforms.Banks are the major investors in the Government Securities markets. Traditionally, banksare required to maintain a part of their net demand and time liabilities in the form of liquidassets of which Government Securities have always formed the predominant share. Despitelowering the Statutory Liquidity Ratio (SLR) to the minimum of 24 per cent, banks areholding a much larger share of Government Stock as a portfolio choice. Other majorinvestors in Government Stock are financial institutions, insurance companies, mutual funds,
corporate, individuals, non-resident Indians and overseas corporate bodies. Foreign institutional investors are permitted to invest in Treasury Bills and dated Government Securities in both primary and secondary markets. Often, the same participants are present in the non-Government debt market also, either as issuers or investors. For example, banks are issuers in the debt market for their Tier-II capital. On the other hand, they are investors in PSU bonds and corporate securities. Foreign Institutional Investors are relatively more active in non-Government debt segment as compared to the Government debt segment.· Central Governments, raising money through bond issuances, to fund budgetary deficits and other short and long term funding requirements.· Reserve Bank of India, as investment banker to the government, raises funds for the government through bond and t-bill issues, and also participates in the market through open- market operations.· Primary Dealers, who are market intermediaries appointed by the Reserve Bank of India who underwrite and make market in government securities, and have access to the call markets and repo markets for funds.· State Governments, municipalities and local bodies, which issue securities in the debt markets to fund their developmental projects, as well as to finance their budgetary deficits.· Public Sector Units are large issuers of debt securities, for raising funds to meet the long term and working capital needs. These corporations are also investors in bonds issued in the debt markets.· Public Sector Financial Institutions regularly access debt markets with bonds for funding their financing requirements and working capital needs. They also invest in bonds issued by other entities in the debt markets.· Banks are the largest investors in the debt markets, particularly the treasury bond and bill markets. They have a statutory requirement to hold a certain percentage of their deposits (currently the mandatory requirement is 24% of deposits) in approved securities
· Mutual Funds have emerged as another important player in the debt markets, owing primarily to the growing number of bond funds that have mobilized significant amounts from the investors.· Foreign Institutional Investors FIIs can invest in Government Securities upto US $ 5 billion and in Corporate Debt up to US $ 15 billion.· Provident Funds are large investors in the bond markets, as the prudential regulations governing the deployment of the funds they mobilise, mandate investments pre-dominantly in treasury and PSU bonds. They are, however, not very active traders in their portfolio, as they are not permitted to sell their holdings, unless they have a funding requirement that cannot be met through regular accruals and contributions.· Corporate treasuries issue short and long term paper to meet the financial requirements of the corporate sector. They are also investors in debt securities issued in the debt market.· Charitable Institutions, Trusts and Societies are also large investors in the debt markets. They are, however, governed by their rules and byelaws with respect to the kind of bonds they can buy and the manner in which they can trade on their debt portfolios. DEBT MARKET INSTRUMENTS The instruments traded can be classified into the following segments based on the characteristics of the identity of the issuer of these securities
Commercial Paper (CP): They are primarily issued by corporate entities. It is compulsoryfor the issuance of CPs that the company be assigned a rating of at least P1 by a recognizedcredit rating agency. An important point to be noted is that funds raised through CPs do not
represent fresh borrowings but are substitutes to a part of the banking limits available tothem.Certificates of Deposit (CD): While banks are allowed to issue CDs with a maturity periodof less than 1 year, financial institutions can issue CDs with a maturity of at least 1 year. Theprime reason for an active market in CDs in India is that their issuance does not warrantreserve requirements for bank.Treasury Bills (T-Bills): T-Bills are issued by the RBI at the behest of the Government ofIndia and thus are actually a class of Government Securities. Presently T-Bills are issued inmaturity periods of 91 days, 182 days and 364 days. Potential investors have to put incompetitive bids. Non-competitive bids are also allowed in auctions (only from specifiedentities like State Governments and their undertakings, statutory bodies and individuals)wherein the bidder is allotted T-Bills at the weighted average cut off price.Long-term debt instruments: These instruments have a maturity period exceeding 1year.The main instruments are Government of India dated securities (GOISEC), StateGovernment securities (state loans), Public Sector Undertaking bonds (PSU bonds) andcorporate bonds/debenture. Majority of these instruments are coupon bearing i.e. interestpayments are payable at pre specified dates.Government of India dated securities (GOISECs): Issued by the RBI on behalf of theCentral Government, they form a part of the borrowing program approved by Parliament inthe Finance Bill each year (Union Budget). They have a maturity period ranging from 1 yearto 30 years. GOISECs are issued through the auction route with the RBI pre specifying anapproximate amount of dated securities that it intends to issue through the year. But unlikeT-Bills, there is no pre set schedule for the auction dates. The RBI also issues productsother than plain vanilla bonds at times, such as floating rate bonds, inflation-linked bondsand zero coupon bonds.State Government Securities (state loans): Although these are issued by the StateGovernments, the RBI organizes the process of selling these securities. The entire process,17 right from selling to auction allotment is akin to that for GOISECs. They also form a partof the SLR requirements and interest payment and other modalities are analogous toGOISECs. Although there is no Central Government guarantee on these loans, they arebelieved to be exceedingly secure. One important point is that the coupon rates on state
oans are slightly higher than those of GOISECs, probably denoting their sub-sovereign status. Public Sector Undertaking Bonds (PSU Bonds): These are long-term debt instruments issued generally through private placement. The Ministry of Finance has granted certain PSUs, the right to issue tax-free bonds. This was done to lower the interest cost for those PSUs who could not afford to pay market determined interest rates. Bonds of Public Financial Institutions (PFIs): Financial Institutions are also allowed to issue bonds, through two ways - through public issues for retail investors and trusts and secondly through private placements to large institutional investors. Corporate debentures: These are long-term debt instruments issued by private companies and have maturities ranging from 1 to 10 years. Debentures are generally less liquid as compared to PSU bonds. TERMS IN DEBT MARKET An individual must be aware about the following terms associated with Government Securities:· Coupon: The Coupon denotes the rate of interest payable on the security. E.g. a security with a coupon of 7.40% would draw an interest of 7.40% on the face value.· Interest Payment Dates (IP dates): The dates on which the coupon (interest) payments are made are called as the IP dates.· Last Interest Payment Date (LIP Date): LIP date refers to the date on which the interest was last paid.· Accrued Interest: Accrued interest is the interest charged at the coupon rate from the Last Interest Payment to the date of settlement. Accrued Interest for a security depends upon its coupon rate and the number of days from its LIP date to the settlement date.· Day count convention: The market uses quite a few conventions for calculation of the number of days that has elapsed between two dates. The ultimate aim of any convention is to calculate (days in a month)/(days in a year). The Fixed Income Instruments in India 18/90
conventions used are as below. We take the example of a bond with Face Value 100, coupon 12.50%, last coupon paid on 15th June, 2008 and traded for value 5th October, 2008. – A/360(Actual by 360) :In this method, the actual number of days elapsed between the two dates is divided by 360, i.e. the year is assumed to have 360 days. – A/365 (Actual by 365) :In this method, the actual number of days elapsed between the two dates is divided by 365, i.e. the year is assumed to have 365 days. – A/A (Actual by Actual): In this method, the actual number of days elapsed between the two dates is divided by the actual days in the year. – 30/360-Day Count: A 30/360-day count says that all months consist of 30 days. i.e. the month of February as well as the month of March is assumed to have thirty days.· Yield: Yield is the effective rate of interest received on a security. It takes into consideration the price of the security and hence differs as the price changes, since the coupon rate is paid on the face value and not the price of purchase. The concept can be best understood by the following example: Ø A security with a coupon of 7.40%: Ø If purchased at Rs. 100 the yield will be 7.40% Ø If purchased at Rs. 200 the yield becomes 3.70%. Ø If purchased at Rs. 50 the yield becomes 14.80% Ø Thus it is seen that higher the price lesser will be the yield and vice-versa. Ø The yield will be equal to the coupon rate if and only if the security is purchased at the face value (Par).· Yield to Maturity (YTM): YTM implies the effective rate of interest received if one holds the security till its maturity. This is a better parameter to see the effective rate of return as YTM also takes into consideration the time factor.· Holding Period Yield (HPY): HPY comes into the picture when an investor does not hold the security till maturity. HPY denotes the effective Fixed Income Instruments in India 19/90 yield for the period from the date of purchase to the date of sale.
· Clean Price: Clean Price denotes the actual price of the security as determined by the market.· Dirty Price: Dirty Price is the price that is obtained when the accrued interest is added to the Clean Price.· Shut Period: The government security pays interest twice a year. This interest is paid on the IP dates. One working day prior to the IP date, the security is not traded in the market. This period is referred to as the Shut Period.· Face Value: The Face Value of the securities in a transaction is the number of Government Security multiplied by Rs.100 (face Value of each Government Security). Say, a transaction of 5000 Government Security will imply a face value of Rs. 5,00,000 (i.e. 5000 * 100)· "Cum-Interest" and "Ex-Interest”: Cum-interest means the price of security is inclusive of the interest accrued for the interim period between last interest payment date and purchase date. Security with ex-interest means the accrued interest has to be paid separately· Trade Value: The Trade Value is the number of Government Security multiplied by the price of each security. Primary and Satellite Dealers: Primary Dealers can be referred to as Merchant Bankers to Government of India, comprising the first tier of the government securities market. They were formed during the year 1994-96 to strengthen the market infrastructure.PDs are expected to absorb government securities in primary markets, to provide two-way quotes in the secondary market and help develop the retail market. The capital adequacy requirements of PDs take into account both credit risk and market risk. They are required to maintain a minimum capital of 15 per cent of aggregate risk weighted assets, including market risk capital (arrived at using the Value at Risk method). ALM discipline has been extended to PDs. RBI is also vested with the responsibility of on-site supervision of PDs. PDs have now been brought under the purview of the Board for Financial Supervision. The satellite dealer system was introduced in 1996 to act as a second tier to the Primary Dealers in developing the market particularly the retail segment. The system which was in operation for more than six years was discontinued because it did not yield the desired results.
SIZE OF DEBT MARKETWorldwide debt markets are three to four times larger than equity markets. However, thedebt market in India is very small in comparison to the equity market. This is because thedomestic debt market has been deregulated and liberalized only recently and is at arelatively nascent stage of development. The debt market in India is comprised of two mainsegments, the Government securities market and the corporate securities market.Government securities form the major part of the debt market-accounting for about 90-95%in terms of outstanding issues, market capitalization and trading value. In the last few yearsthere has been significant growth in the Government securities market. The aggregatetrading volumes of Government securities in the secondary market have grown significantlyfrom 1998-99 to 2008-09. Turnover in the Government Securities Market (FaceValue)GOI TURNOVER
summary of average maturity and cut-off yields in primary market borrowings of thegovernment.In terms of size, the Indian debt market is the third largest in Asia after Japan and Korea. It,however, fairs poorly when compared to other economies like the US and the Euro area.The Indian debt market also lags behind in terms of the size of the corporate debt market.The share of corporate debt in the total debt issued had in fact declined.
Market Capitalization - NSE-WDM Segment as on March 31,2008REGULATORSThe Securities Contracts Regulation Act (SCRA) defines the regulatory role of variousregulators in the securities market. Accordingly, with its powers to regulate the money and
Government securities market, the RBI regulates the money market segment of the debt products (CPs, CDs) and the Government securities market. The non Government bond market is regulated by the SEBI. The SEBI also regulates the stock exchanges and hence the regulatory overlap in regulating transactions in Government securities on stock exchanges have to be dealt with by both the regulators (RBI and SEBI) through mutual cooperation. In any case, High Level Co-ordination Committee on Financial and Capital Markets (HLCCFCM), constituted in 1999 with the Governor of the RBI as Chairman, and the Chiefs of the securities market and insurance regulators, and the Secretary of the Finance Ministry as the members, is addressing regulatory gaps and overlaps. FACTORS AFFECTING MARKET• Internal Factors– Interest rate movement in the system– RBI economic policies– Demand for money– Government borrowings to tide over its fiscal deficit– Supply of money– Inflation rate– Credit quality of the issuer.• External Factors– World Economy & its impact– Foreign Exchange– Fed rate cut– Crude Oil prices– Economic Indicators BENEFITS OF INVESTING IN A DEBT MARKET· Safety: The Zero Default Risk is the greatest attraction for investments in Government Securities. It enjoys the greatest amount of security possible, as the Government of India issues it. Hence they are also known as Gilt-Edged Securities or Gilts.· Fixed Income: During the term of the security there is likely to be fluctuations in the Government Security prices and thus there exists a price risk associated with investment in Government Security. However, the return on the holding of investment is fixed if the
security is held till maturity and the effective yield at the time of purchase is known and certain. In other words the investment becomes a fixed income investment if the buyer holds the security till maturity.· Convenience: Government Securities do not attract deduction of tax at source (TDS) and hence the investor having a non-taxable gross income need not file a return only to obtain a TDS refund.· Simplicity: To buy and sell Government Securities all an individual has to do is call his / her Broker and place an order. If an individual does not trade in the Equity markets, he / she has to open a demat account and then can commence trading through any broker.· Liquidity: Government Security when actively traded on exchanges will be highly liquid, since a national trading platform is available to the investors.· Diversification Government Securities are available with a tenor of a few months up to 30 years. An investor then has a wide time horizon, thus providing greater diversification opportunities DEVELOPMENTS IN MARKET INFRASTRUCTURE: Securities Settlement System: Settlement of government securities and funds is being done on a gross trade-by-trade Delivery vs. Payments (DvP) basis in the books of Reserve Bank, since 1995. A Special Funds Facility from Reserve Bank for securities settlement has also been in operation since October 2000 for breaking gridlock situations arising in the course of DvP settlement. With the introduction of Clearing Corporation of India Ltd (CCIL) in February 2002, which acts as clearing house and a central counterparty, the problem of gridlock of settlements has been reduced. To enable Constituent Subsidiary General Ledger (CSGL) account holders to avail of the benefits of dematerialised holding through their bankers, detailed guidelines have been issued to ensure that entities providing custodial services for their constituents employ appropriate accounting practices and safekeeping procedures. Negotiated Dealing System: A Negotiated Dealing System (NDS) (Phase I) has been operationalised effective from February 15, 2002. In Phase I, the NDS provides on line electronic bidding facility in primary auctions, daily LAF auctions, screen based electronic dealing and reporting of transactions in money market instruments, facilitates secondary
market transactions in Government securities and dissemination of information on tradeswith minimal time lag. In addition, the NDS enables "paperless" settlement of transactions ingovernment securities with electronic connectivity to CCIL and the DvP settlement system atthe Public Debt Office through electronic SGL transfer form.Clearing Corporation of India Limited:The Clearing Corporation of India Limited (CCIL)commenced its operations in clearing and settlement of transactions in Governmentsecurities (including repos) with effect from February 15, 2002. Acting as a centralcounterparty through novation, the CCIL provides guaranteed settlement and has in placerisk management systems to limit settlement risk and operates a settlement guarantee fundbacked by lines of credit from commercial banks. All repo transactions have to benecessarily put through the CCIL, while all outright transactions up to Rs.200 million have tobe settled through CCIL (Transactions involving larger amounts are settled directly in RBI).Transparency and Data Dissemination : To enable both institutional and retail investors toplan their investments better and also to providing further transparency and stability in theGovernment securities market, an indicative calendar for issuance of dated securities hasbeen introduced in 2002. To improve the information flow to the market Reserve Bankannounces auction results on the day of auction itself and all transactions settled throughSGL accounts are released on the same day by way of press releases/on RBI website.Statistical information relating to both primary and secondary market for Governmentsecurities is disseminated at regular interval to ensure transparency of debt managementoperations as well as of secondary market activity. This is done through either pressreleases or Bank‟s publications viz., (e.g., RBI monthly Bulletin, Weekly StatisticalSupplement, Handbook of Statistics on Indian Economy, Report on Currency and Financeand Annual Report). Fixed Income Auction INTRODUCTIONThe Government of India issues securities in order to borrow money from the market. Oneway in which the securities are offered to investors is through auctions. The governmentnotifies the date on which it will borrow a notified amount through an auction. The investorsbid either in terms of the rate of interest (coupon) for a new security or the price for anexisting security being reissued. Since the process of bidding is somewhat technical, onlythe large and informed investors, such as, banks, primary dealers, financial institutions,mutual funds, insurance companies, etc generally participate in the auctions. This left out a
large section of medium and small investors from the primary market for government securities which is not only safe and secure but also gives market related rates of return. The Reserve Bank of India has announced a facility of non-competitive bidding in dated government securities on December 7th 2001 for small investors. NON-COMPETITIVE BIDDING Non-competitive bidding means the bidder would be able to participate in the auctions of dated government securities without having to quote the yield or price in the bid. Thus, he will not have to worry about whether his bid will be on or off-the-mark; as long as he bids in accordance with the scheme, he will be allotted securities fully or partially. Participation Participation in the Scheme of non-competitive bidding is open to individuals, HUFs, firms, companies, corporate bodies, institutions, provident funds, trusts and any other entity prescribed by RBI. As the focus is on the small investors lacking market expertise, the Scheme will be open to those who do not have current account (CA) or Subsidiary General Ledger (SGL) account with the Reserve Bank of India do not require more than Rs.one crore (face value) of securities per auction As an exception, Regional Rural Banks (RRBs), Urban Cooperative Banks (UCBs) and Non- banking Financial Companies (NBFCs) can also apply under this Scheme in view of their statutory obligations. However, the restriction in regarding the maximum amount of Rs. one crore per auction per investor will remain applicable. Silent Features· Eligible investors cannot participate directly. They have to necessarily come through a Bank or Primary Dealer (PD) for auction.· The minimum amount for bidding will be Rs.10,000 (face value) and in multiples in Rs.10,000.· An investor can make only a single bid through any bank or PD under this scheme in each specified auction.· The bank or PD through whom the investor bids will obtain and keep on record an undertaking to the effect that the investor is making only a single bid.
Advantages The non competitive bidding facility will encourage wider participation and retail holding of government securities. It will enable individuals , firms and other mid segment investors who do not have the expertise to bid competitively in the auctions. Such investors will have fair chance of assured allotments at the rate which emerges in the auction. Scope of the scheme· Non-competitive bids will be allowed upto 5 percent of the notified amount in the specified auctions of dated securities.· Non-competitive bidding will be allowed only in select auctions of dated Government of India securities which will be announced as and when proposed to be issued.· The scheme is not applicable for Treasury Bills. Auction Process· Each bank or PD will, on the basis of firm orders, submit a single bid for the aggregate amount of non-competitive bids on the day of the auction. The bank or PD will furnish details of individual customers, viz., name, amount, etc. along with the application.· This will be notified at the time of announcement of the specific auction for which non competitive bids will be invited.· The Government of India notifies the auction of government securities. It also notifies the amount and whether it will be a new loan or reissue of an existing loan. It also announces whether the bidders have to bid for the price or the coupon (interest rate).The competitive bidders put in competitive bids for the price or the coupon. The cutoff price or the coupon is then announced by RBI on the basis of the bids received. All successful bidders will be allotted the security auctioned either in full or in part. Example Recently, an auction was held for government of Indias 12 year Government Stock in which the notified amount was Rs.5,000 crore. The coupon rate for cut-off yield was 8.40 per cent. The weighted average yield was, however, 8.36 per cent since allotments were made to
different successful bidders at the rates quoted by them at or below the cut off rates (i.e. multiple price auction system).· The allotment to the non-competitive segment will be at the weighted average rate that will emerge in the auction on the basis of competitive bidding. Allotment Process· The RBI will allot the bids under the non-competitive segment to the bank or PD which, in turn, will allocate to the bidders.· In case the aggregate amount bid is more than the reserved amount through non- competitive bidding, allotment would be made on a pro rata basis. Example: Suppose, the amount reserved for allotment in non competitive basis is 10 crore. The total amount bid at the auction for Non competitive segment is 12 crore. The partial allotment percentage is =10/12=83.33%. The actual allocation in the auction will be as follows:· It may be noted that the actual allotment may vary slightly at times from the partial allotment ratio due to rounding off with a view to ensuring that the allotted amounts are in multiples of 10,000/-.· In case the aggregate amount bid is less than the reserved amount all the applicants will be allotted in full and the shortfall amount will be taken to the competitive portion.· It will be responsibility of the bank or PD to appropriately allocate securities to their clients in a transparent manner. Settlement Process
· In the above example, where the auction was yield based, the cut off rate that emerged in the auction was 8.40 per cent; while the weighted average cut off rate was 9.36 per cent. At the weighted average rate of 8.36 per cent the price of the security works out to Rs.100.27. Therefore, under the Scheme, the investor will get the security at Rs.100.27. Hence, price payable for every Rs.100 (face value) is Rs. 100.27. Therefore, for securities worth Rs.10,000, he will have to pay (Price x Face value/100) = 100.27 x 10,000/100=Rs.10,270/-· Since the bank/PD has to make payment on the date of issue itself , in case payment is made by the client after date of issue of the security, the consideration amount payable by the client to the bank or the PD would include accrued interest. For example, if for security 8.40% GOI 2022, the payment is made three days after the date of issue, the accrued interest component will amount to 8.40/100x3/360x10,000 = Rs.7.83. Hence, if the security price is Rs.100.27, the total amount payable by the investor for acquiring securities worth Rs.10,000 after three days will be Rs. 10, 270 + Rs. 7.83 = Rs.10, 277. 83 (if not rounded off).· The non competitive bidders will pay the weighted average price which will emerge in the auction.· For example, on December 5, 2009 RBI held a price based auction of an existing security 8.20% GOI 2022 maturing on 19 April, 2022. The cut off price emerged in the auction was Rs. 100.62. The weighted average price was Rs. 100.69. Thus the non competitive bidders will pay the weighted average price of Rs. 100.69. In addition, they have to pay accrued interest as indicated below.· Price payable for every Rs.100 (face value) is Rs.100.69. Therefore, for securities worth Rs.10,000, he will have to pay (Price x Face value/100) = 100.69 x 10,000/100=Rs.10,069/-. Since the coupon on dated GOI securities are payable half yearly, the coupon payment dates for the security are 19 April/ 19 October. Now if the security was paid for (settled) on December 6, 2009, the accrued interest from the last coupon date to the date of settlement viz. from 19 October, 2009 to December 6, 2009, i.e. for 47 days will be 8.22/100 x 47/360x10000=Rs 107.31· Hence, the amount payable by the investor will be price plus accrued interest, i.e. Rs 10069 + 107.31 = 10,176.31/- (if not rounded off). If the payment is not made on December 6, 2009 but, say, on December 9, 2009, the accrued interest component will be for 50 days
instead of 47 days (i.e.3 days more) and it will work out to 8.22/100x50/360 x10,000=Rs.114.16 .The total amount payable by the investor will then be 10069 + 114.16 =10,183.16/-(if not rounded off)· The transfer of securities to the clients should be completed within five working days from the date of the auction. Delivery and Form of Holding.· RBI will issue securities only in demat (SGL) form. It will credit the securities to the CSGL account of the bank/PD.· SGL or CSGL are a demat form of holding government securities with the RBI. Just as an investor can hold shares in demat form with a depository participant, he can also hold government securities in an account with a bank or a PD. Securities kept on behalf of customers by banks or PDs are kept in a segregated CSGL A/c with the RBI. Thus, if the bank or the PD buys security for his client, it gets credited to the CSGL account of bank or PD with the RBI.· It will not be mandatory for the retail investor to maintain a constituent subsidiary general ledger (CSGL) account with a bank or a primary dealer (PD) through whom it proposes to participate in the auction. It will, however, be convenient for the investor to have such an account.· RBI will issue the securities to the bank or PD that has bid on behalf of non-competitive bidder against payment made by the bank or PD on the date of issue itself.· The non-competitive bidder will make payment to the bank or the PD through which he has put the bid and receive his securities from them.· In other words, the RBI will issue securities to the bank or the PD against payment received from the bank or the PD on the date of issue irrespective of whether the bank or the PD has received payment from their clients.· The bank or the PD can recover upto six paise per Rs.100 as commission for rendering this service to their clients.· The bank or the PD can build this cost into the sale price or it can recover separately from the clients.
· Modalities for obtaining payment from clients towards the cost of securities, accrued interest, wherever applicable and commission will have to be worked out by the bank or the PD and clearly stated in the contract made for the purpose with the client.· The bank or the PD is not permitted to build any other cost, such as funding cost, into the price. In other words, the bank or the PD cannot recover any other cost from the client other than accrued interest as indicated.· PDs and banks will furnish information relating to the Scheme to the Reserve Bank of India as and when called for. RBI can also review the guidelines. If and when the guidelines are revised, RBI will notify the modified guidelines. Fixed Income Instruments INTRODUCTION A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as an issuer. In return for that money, the issuer provides you with a bond in which it promises to pay a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it matures, or comes due. Fixed income instruments constitute a claim on the issuer of a loan. The yield is normally paid in the form of interest. There are various types of fixed income instruments depending on which the issuer has issued the instrument, the collateral given by the issuer for the loan, the maturity until repayment date and the form of disbursement of interest. TYPES OF FIXED INCOME INSTRUMENTS· BASED ON COUPON OF A BOND· BASED ON MATURITY OF A BOND· BASED ON THE PRINCIPAL REPAYMENT OF A BOND· ASSET BACKED SECURITIESBASED ON COUPON OF A BOND
Zero Coupon BondIn such a bond, no coupons are paid. The bond is instead issued at a discount to its facevalue, at which it will be redeemed. There are no intermittent payments of interest. Whensuch a bond is issued for a very long tenor, the issue price is at a steep discount to theredemption value. Such a zero coupon bond is also called a deep discount bond. Theeffective interest earned by the buyer is the difference between the face value and thediscounted price at which the bond is bought. There are also instances of zero couponbonds being issued at par, and redeemed with interest at a premium. The essential featureof this type of bonds is the absence of intermittent cash flows.Treasury StripsIn the United States, government dealer firms buy coupon paying treasury bonds, and createout of each cash flow of such a bond, a separate zero coupon bond. For example, a 7-yearcoupon-paying bond comprises of 14 cash flows, representing half-yearly coupons and therepayment of principal on maturity. Dealer firms split this bond into 14 zero coupon bonds,each one with a differing maturity and sell them separately, to buyers with varying tenorpreferences. Such bonds are known as treasury strips. (Strips is an acronym for SeparateTrading of Registered Interest and Principal Securities). We do not have treasury strips yetin the Indian markets. RBI and Government are making efforts to develop market for strips ingovernment securities.Floating Rate BondsInstead of a pre-determined rate at which coupons are paid, it is possible to structure bonds,where the rate of interest is re-set periodically, based on a benchmark rate. Such bondswhose coupon rate is not fixed, but reset with reference to a benchmark rate, are calledfloating rate bonds. For example, IDBI issued a 5 year floating rate bond, in July 2009, withthe rates being reset semi-annually with reference to the 10 year yield on CentralGovernment securities and a 50 basis point mark-up. In this bond, every six months, the 10-year benchmark rate on government securities is ascertained. The coupon rate IDBI wouldpay for the next six months is this benchmark rate, plus 50 basis points. The coupon on afloating rate bond thus varies along with the benchmark rate, and is reset periodically.
The Central Government has also started issuing floating rate bonds tying the coupon to the average cut-off yields of last six 364-day T-bills yields. Some floating rate bonds also have caps and floors, which represent the upper and lower limits within which the floating rates can vary. For example, the IDBI bond described above had a floor of 9.5%. This means, the lender would receive a minimum of 9.5% as coupon rate, should the benchmark rate fall below this threshold. A ceiling or a cap represents the maximum interest that the borrower will pay, should the benchmark rate move above such a level. Most corporate bonds linked to the call rates, have such a ceiling to cap the interest obligation of the borrower, in the event of the benchmark call rates rising very steeply. Floating rate bonds, whose coupon rates are bound by both a cap and floor, are called as range notes, because the coupon rates vary within a certain range. The other names, by which floating rate bonds are known, are variable rate bonds and adjustable rate bonds. These terms are generally used in the case of bonds whose coupon rates are reset at longer time intervals of a year and above. These bonds are common in the housing loan markets. In the developed markets, there are floating rate bonds, whose coupon rates move in the direction opposite to the direction of the benchmark rates. Such bonds are called inverse floaters. Other Variations In the mid-eighties, the US markets witnessed a variety of coupon structures in the high yield bond market (junk bonds) for leveraged buy-outs. In many of these cases, structures that enabled the borrowers to defer the payment of coupons were created. Some of the more popular structures were: (a) deferred interest bonds, where the borrower could defer the payment of coupons in the initial 3 to 7 year period; (b) Step-up bonds, where the coupon was stepped up by a few basis points periodically, so that the interest burden in the initial years is lower, and increases over time; and (c) extendible reset bond, in which investment bankers reset the rates, not on the basis of a benchmark, but after re-negotiating a new rate, which in the opinion of the lender and borrower, represented the rate for the bond after taking into account the new circumstances at the time of reset.BASED ON MATURITY OF A BOND
Callable BondsBonds that allow the issuer to alter the tenor of a bond, by redeeming it prior to the originalmaturity date, are called callable bonds. The inclusion of this feature in the bond‟s structureprovides the issuer the right to fully or partially retire the bond, and is therefore in the natureof call option on the bond. Since these options are not separated from the original bondissue, they are also called embedded options. A call option can be an European option,where the issuer specifies the date on which the option could be exercised. Alternatively, theissuer can embed an American option in the bond, providing him the right to call the bond onor anytime before a pre-specified date. The call option provides the issuer the option toredeem a bond, if interest rates decline, and re-issue the bonds at a lower rate. The investor,however, loses the opportunity to stay invested in a high coupon bond, when interest rateshave dropped.The call option, therefore, can effectively alter the term of a bond, and carries an added setof risks to the investor, in the form of call risk, and re-investment risk. As we shall see later,the prices at which these bonds would trade in the market are also different, and depend onthe probability of the call option being exercised by the issuer. In the home loan markets,pre-payment of housing loans represent a special case of call options exercised byborrowers. Housing finance companies are exposed to the risk of borrowers exercising theoption to pre-pay, thus retiring a housing loan, when interest rates fall. The CentralGovernment has also issued an embedded option bond that gives options to both issuer(Government) and the holders of the bonds to exercise the option of call/put after expiry of 5years. This embedded option would reduce the cost for the issuer in a falling interest ratescenario and helpful for the bond holders in a rising interest rate scenario.Puttable BondsBonds that provide the investor with the right to seek redemption from the issuer, prior to thematurity date, are called puttable bonds. The put options embedded in the bond provides theinvestor the rights to partially or fully sell the bonds back to the issuer, either on or beforepre-specified dates. The actual terms of the put option are stipulated in the original bondindenture.A put option provides the investor the right to sell a low coupon-paying bond to the issuer,and invest in higher coupon paying bonds, if interest rates move up. The issuer will have tore-issue the put bonds at higher coupons. Puttable bonds represent a re-pricing risk to the
issuer. When interest rates increase, the value of bonds would decline. Therefore put options, which seek redemptions at par, represent an additional loss to the issuer. Convertible Bonds A convertible bond provides the investor the option to convert the value of the outstanding bond into equity of the borrowing firm, on pre-specified terms. Exercising this option leads to redemption of the bond prior to maturity, and its replacement with equity. At the time of the bond‟s issue, the indenture clearly specifies the conversion ratio and the conversion price. The conversion ratio refers to the number of equity shares, which will be issued in exchange for the bond that is being converted. The conversion price is the resulting price when the conversion ratio is applied to the value of the bond, at the time of conversion. Bonds can be fully converted, such that they are fully redeemed on the date of conversion. Bonds can also be issued as partially convertible, when a part of the bond is redeemed and equity shares are issued in the pre-specified conversion ratio, and the nonconvertible portion continues to remain as a bond.BASED ON THE PRINCIPAL REPAYMENT OF A BOND Amortising Bonds The structure of some bonds may be such that the principal is not repaid at the end/maturity, but over the life of the bond. A bond, in which payment made by the borrower over the life of the bond, includes both interest and principal, is called an amortising bond. Auto loans, consumer loans and home loans are examples of amortising bonds. The maturity of the amortising bond refers only to the last payment in the amortising schedule, because the principal is repaid over time. Bonds with Sinking Fund Provisions In certain bond indentures, there is a provision that calls upon the issuer to retire some amount of the outstanding bonds every year. This is done either by buying some of the outstanding bonds in the market, or as is more common, by creating a separate fund, which calls the bonds on behalf of the issuer. Such provisions that enable retiring bonds over their lives are called sinking fund provisions. In many cases, the sinking fund is managed by trustees, who regularly retire part of the outstanding bonds, usually at par. Sinking funds also enable paying off bonds over their life, rather than at maturity. One usual variant is
applicability of the sinking fund provision after few years of the issue of the bond, so that the funds are available to the borrower for a minimum period, before redemption can commence.ASSET BACKED SECURITIES Asset backed securities represent a class of fixed income securities, created out of pooling together assets, and creating securities that represent participation in the cash flows from the asset pool. For example, select housing loans of a loan originator (say, a housing finance company) can be pooled, and securities can be created, which represent a claim on the repayments made by home loan borrowers. Such securities are called mortgage–backed securities. In the Indian context, these securities are known as structured obligations (SO). Since the securities are created from a select pool of assets of the originator, it is possible to „cherry-pick‟ and create a pool whose asset quality is better than that of the originator. It is also common for structuring these instruments, with clear credit enhancements, achieved either through guarantees, or through the creation of exclusive preemptive access to cash flows through escrow accounts. Assets with regular streams of cash flows are ideally suited for creating asset-backed securities. In the Indian context, car loan and truck loan receivables have been securitized. Securitized home loans represent a very large segment of the US bond markets, next in size only to treasury borrowings. However, the market for securitization has not developed appreciably because of the lack of legal clarity and conducive regulatory environment. The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act were approved by parliament in November 2002. The Act also provides a legal framework for securitization of financial assets and asset reconstruction. The securitization companies or reconstruction companies shall be regulated by RBI. The security receipts issued by these companies will be securities within the meaning of the Securities Contract (Regulation) Act, 1956. These companies would have powers to acquire assets by issuing a debenture or bond or any other security in the nature of debenture in lieu thereof. Once an asset has been acquired by the asset reconstruction company, such company would have the same powers for enforcement of securities as the original lender. This has given the legal sanction to securitized debt in India. Bond Investment Strategies INTRODUCTION
How do you make bonds work for your investment goals? Strategies for bond investingrange from a buy-and-hold approach to complex tactical trades involving views on inflationand interest rates. As with any kind of investment, the right strategy for you will depend onyour goals, your time frame and your appetite for risk.Bonds can help you meet a variety of financial goals such as: preserving principal, earningincome, managing tax liabilities, balancing the risks of stock investments and growing yourassets. Because most bonds have a specific maturity date, they can be a good way to makesure that the money will be there at a future date when you need it.Your goals will change over time, as will the economic conditions affecting the bond market.As you regularly evaluate your investments, check back often for information that can helpyou see if your bond investment strategy is still on target to meet your financial goals.As you build your investment portfolio of fixed-income securities, there are varioustechniques you and your investment advisor can use to help you match your investmentgoals with your risk tolerance.BOND INVESTMENT STRATEGIESThe way you invest in bonds for the short-term or the long-term depends on your investmentgoals and time frames, the amount of risk you are willing to take and your tax status. Whenconsidering a bond investment strategy, remember the importance of diversification.DIVERSIFICATIONAs a general rule, it‟s never a good idea to put all your assets and all your risk in a singleasset class or investment. You will want to diversify the risks within your bond investmentsby creating a portfolio of several bonds, each with different characteristics. Choosing bondsfrom different issuers protects you from the possibility that any one issuer will be unable tomeet its obligations to pay interest and principal. Choosing bonds of different types(government, agency, corporate, municipal, mortgage-backed securities, etc.) createsprotection from the possibility of losses in any particular market sector. Choosing bonds ofdifferent maturities helps you manage interest rate risk.
Bond Ladders, barbells, and bullets are strategies that will help the investor diversify andbalance their bond portfolios to achieve their desired result. The terminology of thesestrategies actually reflects the character of that strategy. For example, a bond ladder willenable the bond investor to set up a bond re-investment strategy, in steps. The barbellapproach resembles a barbell in that bonds are purchased heavily in the short end and thelong end. Medium term notes are left out of the mix. Finally, with the bullet strategy, eachbond will share the same maturity date. They will typically start at different intervals, but theyall will mature togetherLaddersLadders are a popular strategy for staggering the maturity of your bond investments and forsetting up a schedule for reinvesting them as they mature. A ladder can help you reap thetypically higher coupon rates of longer-term investments, while allowing you to reinvest aportion of your funds every few years.ExampleYou buy three bonds with different maturity dates: two years, four years, and six years. Aseach bond matures, you have the option of buying another bond to keep the ladder going. Inthis example, you buy 10-year bonds. Longer-term bonds typically offer higher interest rates.
Ladders are popular among investors who want bonds as part of a long-term investment objective, such as saving for college tuition, or seeking additional predictable income for retirement planning. Ladders have several potential advantages:· The periodic return of principal provides the investor with additional income beyond the set interest payments· The income derived from principal and interest payments can either be directed back into the ladder if interest rates are relatively high or invested elsewhere if they are relatively low· Interest rate volatility is reduced because the investor now determines the best investment option every few years, as each bond matures· Investors should be aware that laddering can require commitment of assets over time, and return of principal at time of redemption is not guaranteed Barbells Barbells are a strategy for buying short-term and long-term bonds, but not intermediate-term bonds. The long-term end of the barbell allows you to lock into attractive long-term interest rates, while the short-term end insures that you will have the opportunity to invest elsewhere if the bond market takes a downturn. Example: You see appealing long-term interest rates, so you buy two long-term bonds. You also buy two short-term bonds. When the short-term bonds mature, you receive the principal and have the opportunity to reinvest it.
BulletsBullets are a strategy for having several bonds mature at the same time and minimizing theinterest rate risk by staggering when you buy the bonds. This is useful when you know thatyou will need the proceeds from the bonds at a specific time, such as when a child beginscollege.Example:You want all bonds to mature in 10 years, but want to stagger the investment to reduce theinterest rate risk. You buy the bonds over four years.
BOND SWAPPING Techniques to lower your taxes and improve the quality of your portfolio. A bond swap is a technique whereby an investor chooses to sell a bond and simultaneously purchase another bond with the proceeds from the sale. Fixed-income securities make excellent candidates for swapping because it is often easy to find two bonds with similar features in terms of credit quality, coupon, maturity and price. In a bond swap, you sell one fixed-income holding for another in order to take advantage of current market and/or tax conditions and better meet your current investment objectives or adjust to a change in your investment status. A wide variety of swaps are generally available to help you meet your specific portfolio goals. Why You Would Consider Swapping Swapping can be a very effective investment tool to:1. increase the quality of your portfolio;2. increase your total return;3. benefit from interest rate changes; and4. lower your taxes. These are just a few reasons why you might find swapping your bond holdings beneficial. Although this booklet contains general information regarding federal tax consequences of swapping, we suggest you consult your own tax advisor for more specific advice regarding your individual tax situation. 1. Swapping for Quality A quality swap is a type of swap where you are looking to move from a bond with a lower credit quality rating to one with a higher credit rating or vice versa. The credit rating is generally a reflection of an issuer‟s financial health. It is one of the factors in the market‟s determination of the yield of a particular security. The spread between the yields of bonds with different credit quality generally narrows when the economy is improving and widens when the economy weakens. So, for example, if you expect a recession you might swap from lower-quality into higher-quality bonds with only a negligible loss of income.
Standard rating agencies classify most issuers‟ likelihood of repayment of principal andpayment of interest according to a grading system ranging from, say, triple-A to C (or anequivalent scale), as a quality guideline for investors. Issuers considered to carry goodlikelihood of payment are “investment grade” and are rated Baa3 or higher by Moody‟sInvestors Service or BBB- or higher by Standard & Poor‟s Ratings Services and FitchRatings. Those issuers rated below Baa3 or below BBB- are considered “below investmentgrade” and the repayment of principal and payment of interest are less certain. Suppose youown a corporate bond rated BBB (lower-investment-grade quality) that is yielding 7.00% andyou find a triple-A-rated (higher-investment-grade quality) corporate bond that is yielding6.70%.1 You could swap into the superior-credit, triple-A-rated bond by sacrificing only 30basis points (one basis point is 1/100th of one percent, or .01%). Moreover, during aneconomic downturn, higher-quality bonds, which represent greater certainty of repayment indifficult market conditions, will typically hold their value better than lower-quality bonds.Also, if a market sector or a particular bond has eroded in quality, it may no longer meet yourpersonal risk parameters. You may be willing to sacrifice some current income and/or yieldin exchange for enhanced quality.2. Swapping to Increase YieldYou can sometimes improve the taxable or tax-exempt returns on your portfolio byemploying a number of different bond-swapping strategies. In general, longer-maturity bondswill typically yield more than those of a shorter maturity will; therefore, extending the averagematurity of a portfolio‟s holdings can boost yield. The relationship between yields on differenttypes of securities, ranging from three months to 30 years, can be plotted on a graph knownas the yield curve. The curve of that line is constantly changing, but you can often pick upyield by extending the maturity of your investments, assuming the yield curve is slopingupward. For example, you could sell a two-year bond that‟s yielding 5.50% and purchase a15-year bond that is yielding 6.00%. However, you should be aware that the price of longer-maturity bonds might fluctuate more widely than that of short-term bonds when interest rateschange.When the difference in yield between two bonds of different credit quality has widened, acautious swap to a lower-quality bond could possibly enhance returns. But sometimesmarket fluctuations create opportunities by causing temporary price discrepancies betweenbonds of equal ratings. For example, the bonds of corporate issuers may retain the same
credit rating even though their business prospects are varying due to transient factors suchas a specific industry decline, a perception of increased risk or deteriorating credit in thesector or company. So, suppose you purchased in the past (at par) a 30-year A-rated$50,000 corporate bond with a 6.25% coupon. Assume that comparable bonds are nowbeing offered with a 6.50% coupon. Assume that you can replace your bond with another$50,000 A-rated corporate bond having the same maturity with a 6.50% coupon. By sellingthe first bond and buying the second bond you will have increased your annual income by 25basis points ($125). Discrepancies in yield among issuers with similar credit ratings oftenreflect perceived risk in the marketplace. These discrepancies will change as marketconditions and perceptions change.3. Swapping for Increased Call ProtectionSwaps may achieve other investment objectives, such as building a more diversifiedportfolio, or establishing better call protection. Call protection is useful for reducing the risk ofreinvestment at lower rates, which may occur if an issuer retires, calls or pre-refunds itsbonds early. Call protection swaps are particularly advantageous in a declining interest rateenvironment. For example, you could sell a bond with a short call, e.g., five years, andpurchase a bond with 10 years of call protection. This will enable you to lock in your couponfor an additional five years and not worry about losing your higher-coupon bonds in the nearfuture. You may have to sacrifice yield in exchange for the stronger call protection.Anticipating Interest RatesIf you believe that the overall level of interest rates is likely to change, you may choose tomake a swap designed to benefit or help you protect your holdings.If you believe that rates are likely to decline, it may be appropriate to extend the maturity ofyour holdings and increase your call protection. You will be reducing reinvestment risk ofprincipal and positioning for potential appreciation as interest rates trend down. Conversely,if you think rates may increase, you might decide to reduce the average maturity of holdingsin your portfolio. A swap into shorter-maturity bonds will cause a portfolio to fluctuate less invalue, but may also result in a lower yield.It should be noted that various types of bonds perform differently as interest rates rise or fall,and may be selectively swapped to optimize performance. Long-term, zero-coupon2 anddiscount bonds3 perform best during interest rate declines because their prices are more
sensitive to interest rate changes. Floating-rate, short- and intermediate-term, callable andpremium bonds4 perform best when interest rates are rising because they limit the downsideprice volatility involved in a rising yield environment; their price fluctuates less on apercentage basis than a par or discount bond.However, you should remember that rate-anticipation swaps tend to be somewhatspeculative, and depend entirely on the outcome of the expected rate change. Moreover,shorter- and longer-term rates do not necessarily move in a parallel fashion. Differenteconomic conditions can impact various parts of the yield curve differently. To the extent thatthe anticipated rate change does not come about, a decline in market value could occur.4. Swapping to Lower Your TaxesTax swapping is the most common of all swaps. Anyone who owns bonds that are sellingbelow their amortized purchase price and who has capital gains or other income that couldbe partially, or fully, offset by a tax loss can benefit from tax swapping.You may have realized capital gains from the sale of a profitable capital asset (e.g., realestate, your business, stocks or other securities). Or you may expect to sell such an asset ata potential profit in the near future. By swapping those assets that are currently tradingbelow the purchase price (due to a rise in interest rates, deteriorating credit situation, etc.)you can reduce or eliminate the capital gains you would otherwise have paid on your otherprofitable transactions in the current tax year.The traditional tax swap involves two steps: (1) selling a bond that is worth less than youpaid for it and (2) simultaneously purchasing a bond with similar, but not identical,characteristics. For example, assume you own a $50,000, 20-year, triple-A-rated municipalbond with a 5.00% coupon that you purchased five years ago at par. If interest ratesincrease (such that new bonds are now being issued with a 5.50% coupon), the value ofyour bond will fall to approximately $47,500. If you sell the bond, you will realize a $2,500capital loss, which you can use to offset any capital gains you have realized. If you have nocapital gains, you can use the capital loss to offset ordinary income. You then purchase inthe secondary market a replacement triple-A-rated 5.00% municipal bond (from a differentissuer), maturing in 15 years, at an approximate cost of $47,500. Your yield, maturity andquality of bond will be the same as before, plus you will have realized a loss that will saveyou money on taxes in the year of the bond sale. Of course, if you hold the new bond tomaturity, you will realize a $2,500 gain in 15 years, taxable as ordinary income at that time.
By swapping, you have converted a “paper” loss into a real loss that can be used to offset taxable gain. ASSET ALLOCATION Asset allocation describes the percentage of total assets invested in different investment categories, also known as asset classes. The most common broad financial asset classes are Fixed Income, Equities, Commodities, Currencies& Real Estate and “alternative investments” such as hedge funds and commodities can also be viewed as asset classes. Each broad asset class has various subclasses with different risk and return profiles. In general, the more return an asset class has historically delivered, the more risk that its value could fall as well as rise because of greater price volatility. To earn higher potential returns, investors have to take higher risk. Asset classes differ by the level of potential returns they have historically generated and the types of risk they carry. Virtually all investments involve some type of risk that you might lose money. Asset subclasses of stocks include: · Large cap stocksstocks of large, well established and usually well known companies · Small cap stocksstocks of smaller, less well known companies · International stocksstocks of foreign companiesLarge cap, small cap and international stocks can in turn be considered: · Value stocks whose prices are below their true value for temporary reasons · Growth stocks of companies that are growing at a rapid rate.Asset subclasses of bonds include: · Different maturities long-term (10 years or longer), intermediate-term (3-10 year) or short- term (3 years or less) · Different issuers government and agencies, corporate, municipal, international · Different types of bonds callable bonds, zero-coupon bonds, inflation-protected bonds, high-yield bonds, etc.
Stocks are generally considered a risky investment because, among other things, theirvalues can decline if the stock market goes down (market risk) or the issuing company doespoorly (company risk). As owners of the company, stockholders are paid after all creditors,including bond holders, are paid. In theory at least, a stock‟s value can go to zero.Historically, stock prices have been the most volatile of all the different types of investments,meaning their prices can move up and down quickly, frequently and not always in apredictable way.Bonds are considered less risky than stocks because bond prices have historically beenmore stable and because bond issuers promise to repay the debt to the bondholders atmaturity. That promise is generally kept unless the issuer falls on hard times; some bondshave credit risk based on the financial health of their issuer. When a bond issuer goes intobankruptcy, bondholders are paid off before stockholders. Bonds are also vulnerable tointerest rate risk: when interest rates rise, bond prices fall and vice versa.Cash investments carry opportunity risk. For example, investing in very safe, short-terminvestments like Treasury bills may protect you from loss, but you may miss the opportunityof more generous returns offered by other investments. Even people who keep their moneyunder their mattress have the risk that their money will be worth less in the future because ofinflation that reduces the purchasing power of the cash.Smart investors do not put all their assets in one type of investment or “asset class.” Instead,they spread or diversify their risk by investing in different types of investments. When oneasset class is performing poorly, another may be doing well and compensating for the poorperformance in the other.Some studies have shown that overall asset allocation is more important to investmentsuccess than the choice of investments within the allocation.MARKET SIGNALSSeven bond market signals in four market-driving categories.Category: Fundamentals
Two fundamental forces drive bond yields: growth and inflation. If you understand that bondprices are present values of future cash flows, then you know that forecasts of future growthand inflation are more important than historical data reports on what has already occurred.Signal one: Market consensus for year-ahead GDP growth, as measured monthly in theBlue Chip survey of 50 professional forecasters.Signal two: Market consensus for year-ahead inflation, as measured monthly in the BlueChip survey of 50 professional forecasters.Trade: Buy the 10-year Treasury note when the consensus lowers its estimate of year-aheadgrowth and inflation, suggesting interest rates will go down and bond prices will go up. Sellthe 10-year Treasury note when the consensus raises its estimate of year-ahead growth andinflation, suggesting rates will rise and prices will fall. Hold for one month until nextconsensus figures are released. Roll trade if consensus moves in same direction; reverse ifconsensus turns; close if consensus in unchanged.Category: ValuePresuming that asset prices fluctuate around a stable, long-term equilibrium, extremedeviations serve as lead indicators of trend reversals.Signal three: Real (inflation-adjusted) yields.Trade: Buy the 10-year Treasury note when real yields are more than one standard deviationabove the long-term moving average sell when they are more than one standard deviationbelow. Hold the position until real yields cross the opposite threshold.Signal four: Ratio of the S&P 500 earnings yield to the 30-year Treasury yield.Trade: Buybonds when the ratio is more than half a standard deviation below its long-run movingaverage (bonds are cheap relative to stocks) sell when it‟s more than half a standarddeviation above its long-run moving average (stocks are cheap relative to bonds).Category: Risk appetiteRisk appetite refers to investors‟ relative preference for safe and risky assets, prompted bybusiness cycle fluctuations, policy developments or exogenous events.
Signal five: Credit Appetite Index, where zero represents minimum appetite (widestspreads, positive for U.S. government bonds) and 100 represents maximum appetite(tightest spreads, negative for U.S. government bonds).Trade: Sell U.S. government bonds when credit appetite is high, as signaled by the CAIbeing more than one standard deviation above its 50-day moving average, and buy when itis low, or more than one standard deviation below its 50-day moving average.Category: TechnicalsTechnical indicators trace market patterns in price and volume.Signal six: Price data.Trade: Buy when the short-term moving average of prices crosses the long-term averagefrom below sell when it crosses from above. In this momentum measure, the strongestreturns were generated when short-term was 10 days and long-term was 20 days.Signal seven: Flow data, defined as net purchases of bond market mutual funds, as anindicator of cash flow into the bond marketTrade: Buy the 10-year Treasury when the flow indicator is more than one standarddeviation above the long-term moving average sell when it‟s more than one standarddeviation below.CONCLUSIONDiversification pays no single indicator works at all times or in all trading environments. Inthe absence of foresight, a diversified strategy that combines different information sources(fundamentals, value, risk appetite and technicals), trading strategies (momentum andcontrarian) and holding periods (daily, weekly and monthly) far outperforms narrowerapproaches over the longer term.Fixed Income RisksINTRODUCTIONAs an integral part of a well-balanced and diversified portfolio, fixed income securities affordopportunities for predictable cash flows to match investors‟ individual needs and provide
capital preservation. In addition, they may offset the volatility of the stock market. However,all investments have some degree of risk. In general, the higher the return potential, thehigher the risk. Safer investments usually offer relatively lower returns.While the interest payment or coupon on most bonds is fixed and the principal amount,known as par value, is returned to the investor upon maturity, the market price of a bondduring its life varies as market conditions change. Consequently, if a bond is sold prior tomaturity, the proceeds may be more or less than the original purchase price or the quotedyield. If a bond is held to maturity, an investor can expect to receive the return or yield atwhich the bond was initially purchased, subject to the credit worthiness of the issuer.There are a number of variables to consider when investing in bonds that may affect thevalue of the investment. These variables include changes in interest rates, incomepayments, bond maturity, redemption features, credit quality, and priority in the capitalstructure, price, yield, tax status and other provisions that are covered in the offeringdocuments.In general, investors demand higher yields to compensate for higher risks. Discussed beloware the most common risks associated with fixed income securities.Interest Rate RiskThe market value of the securities is inversely affected by movements in interest rates.When rates rise, market prices of existing debt securities fall as these securities becomeless attractive to investors when compared to higher coupon new issues. As prices decline,bonds become cheaper so the overall return, when taking into account the discount, cancompete with newly issued bonds at higher yields. When interest rates fall, market prices onexisting fixed income securities tend to rise because these bonds become more attractivewhen compared to newly issued bonds priced at lower rates.Price RiskInvestors who need access to their principal prior to maturity must rely on the secondarymarket to sell their securities. The price received may be more or less than the originalpurchase price and may depend, in general, on the level of interest rates, time to term, creditquality of the issuer and liquidity. Among other factors, prices may also be affected bycurrent market conditions or by the size of the trade (prices may be different for 10 bonds
versus 1,000 bonds). It is important to note that selling a security prior to maturity may affectthe actual yield received which may be different than the yield at which the bond wasoriginally purchased. This is because the initially quoted yield assumed holding the bond toterm.As mentioned above, there is an inverse relationship between interest rates and bond prices.Therefore, when interest rates decline, bond prices increase, and when interest ratesincrease, bond prices decline. Generally, longer maturity bonds are more sensitive tointerest rate changes. Dollar for dollar, a long-term bond should go up or down in value morethan a short-term bond in response to the same change in yield.Liquidity RiskLiquidity risk is the risk that an investor will be unable to sell securities due to lack of demandfrom potential buyers and thus must sell them at a substantial loss and/or incur substantialtransaction costs in the sale process. Broker-dealers, although not obligated to do so, mayprovide secondary markets.Reinvestment RiskDownward trends in interest rates also create reinvestment risk, or the risk that the incomeand/or principal repayments must be invested at lower rates. Reinvestment risk is animportant consideration for investors who hold callable securities. Some bonds may beissued with a call feature which allows the issuer to call, or repay, bonds prior to maturity.Bonds with this feature are generally called when market rates fall low enough for the issuerto save money by repaying existing higher coupon bonds and issuing new ones at lowerrates. Investors will stop receiving coupon payments if the bonds are called. Generally,
callable fixed income securities do not appreciate in value as much as comparable non-callable securities.Prepayment RiskSimilar to call risk, prepayment risk is the risk that the issuer may repay bonds prior tomaturity. This type of risk is generally associated with mortgage-backed securities.Homeowners who prepay their mortgages in an effort to save money may adversely affectthe holders of the mortgage-backed securities. If the bonds are repaid early, investors facethe risk of reinvesting at lower rates.Purchasing Power RiskFixed income investors often focus on the real rate of return, or the actual return minus therate of inflation. Rising inflation has a negative impact on real rates of return becauseinflation reduces the purchasing power of both investment income and principal.Credit RiskThe safety of the fixed income investors principal depends on the issuers credit quality andability to meet its financial obligations, such as payment of coupon and repayment ofprincipal at maturity. Rating agencies assign ratings based on their analysis of the issuer‟sfinancial condition, economic and debt characteristics, and specific revenue sourcessecuring the bond. Issuers with lower credit ratings usually must offer investors higher yieldsto compensate for additional credit risk. A change in either the issuers credit rating or themarkets perception of the issuers business prospects will affect the value of its outstandingsecurities. Ratings are not a recommendation to buy, sell or hold, and may be subject toreview, revision, suspension or reduction, and may be withdrawn at any time. If a bond isinsured, attention should be given to the creditworthiness of the underlying issuer or obligoron the bond as the insurance feature may not represent additional value in the marketplaceor may not contribute to the safety of principal and interest payments.Default RiskThe risk of default is the risk that the issuer will not be able to make interest payments and/orreturn the principal at maturity.
Holder Profile in Central Govt securities as on end Mar 2010 1. Commercial Banks 4% 2. Bank- Primary Dealers 12% 3. Non-Bank PDs 4. Insurance Companies 7% 38% 5. Mutual Funds 1% 6. Co-operative Banks 3% 0% 7. Financial Institutions 3% 8. Corporates 1% 9. FIIs 10. Provident Funds 22% 11. RBI 9% 12. Others 0% Trend in corproate bond trades8000070000600005000040000300002000010000 0 Sep/07 Sep/08 Sep/09 Jan/07 Jan/08 Jan/09 Jan/10 May/07 May/08 May/09 May/10
Trends in Government Debt-GDP Ratio 90 80 70 60Per cent 50 40 30 20 10 0 1980-81 1990-91 1996-97 2000-01 2004.05 2006-07 (BE) Centre States Total Centre’s Fiscal Responsibility Act • Enactment of FRBM Act : August 26, 2003 • Came into force from July 5, 2004 • Elimination of RD by 2008-09 (3.6% in 2003-04) and revenue surplus thereafter • Containment of GFD to 3 % of GDP by 2008-09 (4.5% in 2003-04) • RD and GFD placed at 2.0% and 3.7% of GDP in 2006-07 (RE) • RD and GFD budgeted to decline to 1.5% and 3.3% of GDP in 2007-08 • RBI prohibited from Participation in Primary Issuances of G-Secs Maturity and Yield
• Elongation of Maturity Profile • General Reduction in Weighted Average Yield 18 16 14 Per cent / Years 12 10 8 6 4 2 0 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 Weighted Average Yield (per cent) Weighted Average Maturity (years)Yield Curve • Development of a Smooth Yield Curve 16 14 12Per cent 10 8 6 4 2 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 Maturity (Years) Mar-97 Mar-04 Jan-07