bonds market in india

7/31/2019 Bonds Market in India

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BONDSMARKET IN

INDIA

MADE BY:-ASHMIT GROVER

SEMESTER:-II

PRN NO. :-11021021017

SECTION :-A


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BONDS MARKET IN INDIA

BONDS

DEFINITION:-

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 (thecoupon) to use 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 (semi annual, annual, sometimes monthly).[1]

Thus a bond is like a loan: the holderof the bond is the lender (creditor), the issuerof the bond isthe borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external

funds to finance long-term investments, or, in the case ofgovernment bonds, to finance current

expenditure. Certificates of deposit (CDs) orcommercial paper are considered to be money

market instruments and not bonds.

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 consol bond, which is a perpetuity (i.e., bond with

no maturity).

BONDS MARKET :-

The Bond Market in India with the liberalization has been transformed completely. The

opening up of the financial market at present has influenced several foreign investors holding

upto 30% of the financial in form of fixed income to invest in the bond market in India.

The bond market in India has diversified to a large extent and that is a huge contributor to thestable growth of the economy. The bond market has immense potential in raising funds to

support the infrastructural development undertaken by the government and expansion plans of

the companies.

Sometimes the unavailability of funds become one of the major problems for the large

organization. The bond market in India plays an important role in fund raising for developmental
http://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Coupon_(bond)http://en.wikipedia.org/wiki/Maturity_(finance)http://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Bond_(finance)#cite_note-0http://en.wikipedia.org/wiki/Bond_(finance)#cite_note-0http://en.wikipedia.org/wiki/Bond_(finance)#cite_note-0http://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Investmenthttp://en.wikipedia.org/wiki/Government_bondhttp://en.wikipedia.org/wiki/Certificate_of_deposithttp://en.wikipedia.org/wiki/Commercial_paperhttp://en.wikipedia.org/wiki/Money_markethttp://en.wikipedia.org/wiki/Money_markethttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Equity_(finance)http://en.wikipedia.org/wiki/Consolshttp://en.wikipedia.org/wiki/Perpetuityhttp://en.wikipedia.org/wiki/Perpetuityhttp://en.wikipedia.org/wiki/Consolshttp://en.wikipedia.org/wiki/Equity_(finance)http://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Money_markethttp://en.wikipedia.org/wiki/Money_markethttp://en.wikipedia.org/wiki/Commercial_paperhttp://en.wikipedia.org/wiki/Certificate_of_deposithttp://en.wikipedia.org/wiki/Government_bondhttp://en.wikipedia.org/wiki/Investmenthttp://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Bond_(finance)#cite_note-0http://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Maturity_(finance)http://en.wikipedia.org/wiki/Coupon_(bond)http://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Security_(finance)


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ventures. Bonds are issued and sold to the public for funds.

Bonds are interest bearing debt certificates. Bonds under the bond market in India may be issued

by the large private organizations and government company. The bond market in India has huge

opportunities for the market is still quite shallow. The equity market is more popular than thebond market in India. At present the bond market has emerged into an important financial sector.

The Indian financial system is changing fast, marked by strong economic growth, more robust

markets, and considerably greater efficiency. But to add to its world-class equity markets, and

growing banking sector, the country needs to improve its bond markets. While the government

and corporate bond markets have grown in size, they remain illiquid. The corporate market, in

addition, restricts participants and is largely arbitrage-driven.

To meet the needs of its firms and investors, the bond market must therefore evolve. This will

mean creating new market sectors such as exchange traded interest rate and foreign exchangederivatives contracts. It will need a relaxation of exchange restrictions and an easing of

investment mandates on contractual savings institutions to attract a greater variety of investors

(including foreign) and to boost liquidity. Tax reforms, particularly stamp duties, and a

revamping of disclosure requirements for corporate public offers, could help develop the

corporate bond market. And streamlining the regulatory and supervisory structure of the local

currency bond market could substantially increase efficiency, spurring innovation, economies of

scale, liquidity and competition. Such reforms will help level the playing field for investors.

In deciding the course for reform, however, the innovations and experiences of markets in the

region are also important. Developing markets often mimic more advanced European and NorthAmerican markets. But complex structures designed for diverse developed markets are

sometimes ill-suited to less-developed economies. Instead, looking to neighboring, emerging

markets at similar stages of development can be more useful. For example, Indias unique

collateralized borrowing and lending obligations (CBLO) system and its successful electronic

trading platform could usefully be studied by its neighbors, many of which suffer from limited

repo markets or which have (like India) tried unsuccessfully to move bonds on to electronic

platforms. India could benefit, by contrast, from the lessons of its neighbors in developing its

corporate bond market.

This paper reviews these issues and discusses policies that can help further develop Indias debtmarket. Section II highlights and compares market development and outlook to emerging East

Asian economies. Sections III and IV summarize salient characteristics, reforms and obstacles.

Section V discusses the development and prospects for Indias securitization market.

Section VI looks at the main market participants and the depth of the pool of available investors,

arguably the most significant factor in market development. Section VII tackles policy


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issues.And Section VIII concludes with a look at the importance of the lessons and innovations

of other countries.

OVERVIEW OF THE BOND MARKET:-

There are three main segments of debt market in India, viz., Government securities, Public

Sector Units (PSU) bonds and private sector corporate bonds.

India being a federal state, Government securities are issued by Central Government and all the

provincial Governments (India has 28 states), although in case of the latter such securities

constitute a relatively small portion of their fiscal deficits. In India, banks are required to

maintain statutorily a certain percentage of their liabilities in Government securities and other

specified liquid assets which creates a captive demand for Government securities. At present, the

Statutory Liquidity Ratio (SLR) for banks is 25 per cent. Similar statutory requirements in

varying degrees are there for other type of financial institutions, viz., insurance companies,

provident funds, non-banking financial institutions etc.

The PSU bonds are generally treated as surrogates of sovereign paper, sometimes due to explicit

guarantee of Government, and often due to the comfort of public ownership. Some of the PSU

bonds are tax free, a status not enjoyed even by Government securities. Corporate bonds and

debentures have maturities beyond 1 year and generally up to 10 years. Corporates also issue

short-term commercial paper with maturity ranging from 15 days to one year.

STATE OF BOND MARKET:-

The Indian financial system is not well developed and diversified. One major missing element is

an active, liquid, and large debt market. In terms of outstanding issued amount,Indian debt

market ranks as the third largest in Asia, next only to that of Japan and South Korea. Further, in

terms of the primary issues of debt instruments, Indian market is quite large. The government

continues to be a large borrower unlike South Korea where the private sector is the main

borrower. If we compare the size of the Indian GDP with the outstanding size of the debt

flotation, Indian debt market is not very much underdeveloped.

The gross domestic savings rate in the Indian economy is reasonably satisfactory at around 23%.

According to RBIs annual studies on savings, about 78% of the aggregate financial savings of

the household sector were invested in fixed income assets. The average Indian household has

great appetite for debt instruments provided they are packaged properly. The main financial

instruments popular with the households are bank deposits, provident funds, insurance, income-


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oriented mutual funds, and postal savings schemes. However, the share of fixed income

instruments that could be traded in the secondary markets is negligible. The main reason for this

is the absence of an active secondary market in debt instruments. Investors are not willing to

invest in tradable instruments as they lack required liquidity. It is thus a typical case of chicken

and egg problem. Since there are not enough number of issues and the floating stock in the

secondary market is very small there is hardly any trading in them. Currently almost 98% of the

secondary market transactions in debt instruments relate to government securities, treasury bills

and bonds of public sector companies. The quality of secondary market debt trading is very poor

if we compare it with the quality of the secondary market in equities.

Debt markets lack the required transparency, liquidity, and depth. With reference to the usual

standards or yardsticks of market efficiency the Indian debt markets would not score more than

30% of the marks that the Indian equity markets would score.The US has one of the most active

secondary markets in both government and corporate bonds. The trading volume in the US debt

market is said to be on an average ten times the size of the equity trading. In India the average

daily trading in debt during the last year was about one tenth of the average daily trading in

equities. These comparisons bring out the underdeveloped nature of the Indian debt markets. The

secondary debt market suffers from several infirmities. It is highly non-transparent compared to

the equity market. It is highly fragmented since the ownership titles of government securities are

fragmented in 14 offices of the RBI, which acts as a depository for the government debt

including the treasury bills. A seller from New Delhi cannot trade in Mumbai market since

security held in RBI office in New Delhi cannot be easily transferred to Mumbai office of RBI

and vice-versa. Since the current small order book stands fragmented city-wise the price

discovery process does not throw up the best possible prices.

Corporate Bond Market

For too long, most of the corporate entities have been depending on loans from banks and

institutions and they have not shown any interest to raise at least a small of the required

resources from the market through bonds or commercial paper. The cash credit system also made

them complacent about cost effective fund management through treasury operations. Under their

age-old cash credit system, banks grant credit/borrowing limits to the corporates. They can use

bank funds within the granted credit limits at theirconvenience and return the same back to the

banks as they receive from their customers.

Since the interest is charged by banks only on the average outstanding drawals, the cash

management responsibility of the corporates got transferred from the borrowers to the banks.

Corporates have been raising funds from the retail markets by way of term deposits just as the

banks do. This is an age-old system quite popular with several corporates. The company statute

permits corporate entities to raise public deposits within certain limits.


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Currently the amount of deposits that a corporate can raise is equal to 50% of its capital and free

reserves. Surprisingly even the corporate units which raise funds through public deposits have

also not shown interest in issuing bonds although they could raise more money this way than

through public deposits. Corporates can raise bond funds so long as their term debt does not

exceed twice the amount of paid up capital plus free reserves.

Several good credit-rated corporates have been showing interest in raising funds by way of

private placement from big lenders/investors but they do not like to tap the public issue market.

One of the reasons why they do not like to make public issue of debt is that the regulatory

requirements including quality and the type of disclosures are more rigorous or onerous in the

case of public issues. Although the interest rates they pay on suchplacements would be equally

attractive to retail investors, corporates have not shown much interest in the retail investors.

Recently through an amendment to Companies Act government has tried to plug possible misuse

of the system by stipulating that the privately placed debt cannot be distributed to more than 50

investors. Market feed back

suggests that the corporates are not happy with this amendment and a number of them are trying

to find ways for bypassing the legal requirement of distributing debt among not more than 50

investors. One of the possible that is being discussed is to issue the privately place to less than 50

investors in the initial stage and these investors to sell it to larger number of investors at the

second stage as if it is a secondary market operation.

The US experience clearly bears out that the Indian private corporate sector is adopting a myopic

approach by overlooking the advantages of financial disintermediation. Sooner it gets out of the

habit of depending excessively on the banks, institutions, and the private placement market, the

better it would be for it from a long-term point of view. The problem of asset-liabilitymismatches is going to catch up with the banks sooner than later and their appetite for term debt

will decline. In so far as the DFIs are concerned they are already in a transition phase toying with

the idea of commercial/universal banking.

Since their access to long-term funds has dwindled they will not be in a position to meet demand

for term funds of industry and infrastructure sectors when investment activity picks up from the

present low levels. Continued excessive dependence on banks and DFIs is not in the interest

good credit-worthy borrowers, as they would end up paying up more than what they would have

to pay if they decide to raise funds from the market directly.

Initially, before an extensive good retail distribution network is built up, the borrowing costs of

good-credit rated borrowers from the primary savers including the hous eholds may turn out to

be slightly higher than those charged to them by banks and institutions.

There are also those hassles of servicing large number of investors, which the corporates


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have been avoiding all these years by either taking loans or tapping the private placement

market. A number of significant reforms have taken place in the Indian financial and capital

market areas, which make it possible to tap the retail bond market with minimum hassles.

During the last five years movement to depository form for ownership and secondary market

transactions has made tremendous progress. Currently, 99.7% of the secondary markettransactions in equities are settled through book entry transfers in the depository.

The National Securities Depository Ltd (NSDL) promoted by the National Stock Exchange

(NSE) along with IDBI and UTI has helped in almost getting rid of paperbased settlements in

equities. About a year ago through suitable legislative changes the debt instruments have been

brought under the ambit of depository. As a result all ownership transfers through the depository

have been completely exempted from the payment of stamp duty, which is quite prohibitively

costly. NSE now provides direct online connectivity to 430 cities and towns across the whole

country through a satellite communication link-up for secondary market trades. The response

time for trades from any part of the country is less than 1.5 seconds.

NSE has extended its secondary market infrastructure for making primary issues of debt and

equity through either direct fixed price mechanism or through the book-building route. The costs

of primary issues as also of secondary market trades of debt and equity can be kept at very

modest levels by relying on the infrastructure of NSE and NSDL.

With the disappearance of paper securities and abolition of stamp duty in depository mode

transfers, the costs of secondary market transactions as also the costs and hassles of servicing of

large number of investors can be significantly minimised. Banks and the DFIs can earn good

returns if they undertake market making in bonds of their choice.

Market making will provide liquidity to the bonds and help in popularising them among millions

of investors who have natural preference for fixed income securities. Banks can perform this role

with minimum level of risk if they hold investors security accounts as depository participants

besides holding their cash accounts.

Like in most of the well-developed markets all over the world the Indian stock exchanges had

also adopted trading systems that relied overwhelmingly on the jobbing or market making

mechanism. The Bombay Stock Exchange (BSE), which until November 1994 used to account

for about 70% of the trading turnover of all the stock exchanges in India, had adopted jobbing or

market makers system of trade. It was in November 1994 that NSE introduced fully screen-based

order driven trading system in India. Many market observers had opined that NSE, as an

Exchange would not take off since it did not adopt the time-tested market making trading system.

For about a year since November 1994 there was a fierce competition between the order driven

system adopted by a totally new exchange like NSE and the market making system of a well-

entrenched stock exchange like the BSE. Interestingly the market preferred the order driven

system as could be noted from the fact that after about a years time, that is by November 1995,


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NSE emerged as the largest stock exchange of the country in terms of daily trading turnover.

Since the Indian equity market has a history of more than a 120 years investors could quickly

discover that the advantages of the order driven trading system in terms of much lower

transaction costs and freedom from the stranglehold of the market makers.

However, Indian investor is still new to the debt market. As of now, most of the investors infavour of fixed income assets prefer bank deposits, postal savings schemes, etc. To entice these

investors to the debt market they will have to be assured of adequate liquidity in the secondary

market for debt instruments. In the case of the fixed income assets such as bank deposits or

postal savings schemes the investors are protected in regard to both the principle value of

investment and the rate of return. However, principal value of the debt instruments traded in the

secondary market may not always be equal to their original investment value. Most of the

investors are aware that the market value of the bond is likely to fluctuate in response to

movements in interest rates. For instance, the market value of the bond may be below its issued

price in response to upward movement in interest rates. The opposite would happen if interest

rates decline. Most of the investors would be prepared to absorb this price risk. But what they

may not be willing to live with is the decline in the bond value merely because there is hardly

any liquidity in the secondary market. Until the market provides a mechanism for pricing bonds

based on their intrinsic worth and that bonds do not get quoted at a discount merely because

there is no liquidity investors may be unwilling to go in for traded debt instruments.

Conscious efforts therefore need to be made to create liquidity in the debt instruments by

encouraging market makers to give two-way bid and offer quotes with reasonably narrow

spreads. Once the investors are convinced that they are assured of liquidity in the market their

willingness to shift from the currently popular fixed income assets like bankdeposits to tradable

debt instruments like corporate debentures would be greater.

As of now the average investors are not yet aware of the advantages of investing in debt

instruments that are traded in the market. Tradable debt instruments are yet to catch fancy of

most of the average investors although they prefer to invest major part of their savings in the

fixed income securities. Therefore, it is more a matter of developing investors tastes for such

instruments before the fixed income oriented investors naturally start investing in them. In the

early stages of development of the debt market it would be both desirable and necessary to

introduce active market making so that investors are assured of liquidity for the debt instruments.

The banks and DFIs are best suited to take upon themselves the role of market makers for their

clients who enjoy good credit rating. The existence of information asymmetry is actually in

favour of the banks and DFIs. They have good access to far more dependable information about

their corporate clients than 10 average investors do. Since they can assess credit risk of the

debentures of their clients they are in a better position to make bid and offer quotes for such

debentures. Instead of extending loans/credits to their corporate clients, banks and institutions

should persuade some of their clients to tap the debt market for long-term bonds or commercial


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paper. The attractions of such instruments to the investors would be considerable if the banks

actively make market in these instruments by making two-way quotes.

Banks can offer both cash account and depository account facilities to investors at most of their

branches. They are, therefore, in a better position to tempt their depositors to invest in the bonds

floated by their good clients. Investors would be better inclined to invest in a debt instrument ifthey know that their bank would be willing to buy/sell the instrument from them at a pre-

announced price. This being a fee-based income activity banks will be passing on the credit risk

directly to the investors. Banks do not have to raise additional capital to meet the stringent

capital adequacy norms if they choose to play the intermediary role in the sale of debenture

rather accept deposits to extend credit to their corporate clients.

HISTORY :-

Towards the eighteenth century, the borrowing needs of Indian Princely States were largely met

by Indigenous bankers and financiers. The concept of borrowing from the public in India was

pioneered by the East India Company to finance its campaigns in South India (the Anglo French

wars) in the eighteenth century. The debt owed by the Government to the public, over time, came

to be known as public debt. The endeavours of the Company to establish government banks

towards the end of the 18th Century owed in no small measure to the need to raise term and short

term financial accommodation from banks on more satisfactory terms than they were able to

garner on their own. The incentive to set up Government banks (read central banks), had a lot to

do with debt management.

Public Debt, today, is raised to meet the Governments revenue deficits (the difference between

the income of the government and money spent to run the government) or to finance public

works (capital formation). Borrowing for financing railway construction and public works such

irrigation canals was first undertaken in 1867. The First World War saw a rise in India's Public

Debt as a result of India's contribution to the British exchequer towards the cost of the war. The

provinces of British India were allowed to float loans for the first time in 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 Provinces and Punjab utilised this

sanction before the introduction of provincial autonomy. Public Debt was managed by the

Presidency Banks, the Comptroller and Auditor-General of India till 1913 and thereafter by the

Controller of the Currency till 1935 when the Reserve Bank commenced operations.

Interest rates varied over time and after the uprising of 1857 gradually came down to about 5%

and later to 4% in 1871. In 1894, the famous 3 1/2 % paper was created which continued to be in

existence for almost 50 years. When the Reserve Bank of India took over the management of

public debt from the Controller of the Currency in 1935, the total funded debt of the Central


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Government amounted to Rs 950 crores of which 54% amounted to sterling debt 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 such

purposes.

1917-1940: when public debt increased substantially essentially out of the considerations of

1940-1946: when because of war time inflation, the effort was to mop up as much a spossible of

the current war time incomes

1947-1951: represented the interregnum following war and partition and the economy wasunsettled. Government of India failed to achieve the estimates for borrwings for which credit had

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 securities with

market interest rates in the wake of the recommendations of the Chakraborti Committee Report.

1991 to date: When comprehensive reforms of the Government Securities market were

undertaken and an active debt management policy put in place. Ad Hoc Treasury bills wereabolished; commenced the selling of securities through the auction process; new instruments

were introduced such as zero coupon bonds, floating rate bonds and capital indexed bonds; the

Securities Trading Corporation of India was established; a system of Primary Dealers in

government securities was put in place; the spectrum of maturities was broadened; the system of

Delivery versus payment was instituted; standard valuation norms were prescribed; and

endeavours made to ensure transparency in operations through market process, the dissemination

of information and efforts were made to give an impetus to the secondary market so as to

broaden and deepen the market to make it more efficient.

As at the end of March, 2003, it is estimated that the combined outstanding liabilities of the

centre and state governments amounted to Rs 18 trillion which worked out to over 75 percent of

the country's gross domestic product (GDP). In India and the world over, Government Bonds

have, from time to time, have not only adopted innovative methods for rasing resources

(legalised wagering contracts like the Prize Bonds issued in the 1940s and later 1950s in India)

but have also been used for various innovative schemes such as finance for development; social


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engineering like the abolition of the Zamindari system; saving the environment; or even weaning

people away from gold (the gold bonds issued in 1993).

Normally the sovereign is considered the best risk in the country and sovereign paper sets the

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 countrys debt market to a large extent depends

on the depth of the Governments Bond Market. It in in this con text that the recent initiatives to

widen and deepen the Government Securities Market and to make it more efficient have been

taken.

An early debt instrument issued by

the East India Company

An early debt instrument issued

by the East India Company

A Government Promissory Noteissued by the Princely State of

Travancore

A Government Stock CertificateIssued by the Princely State of

Hyderabad

Premium Prize Bonds issued byGovernment of India

The Finance Minister inauguratingthe Premium Prize Bonds

The Bihar Zamindari Abolition Compensation Bonds represented theuse of Government Bonds to help undertake social engineering

initiatives.

REGULATORY BODY FOR BONDS IN INDIA:-

Establishment

The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of

theReserve Bank of India Act, 1934.
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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 nationalisation in 1949, the Reserve Bank is fully

owned by the Government of India.

Preamble

The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as:

"...to regulate the issue of Bank Notes and keeping of reserves with a view to securing

monetary stability in India and generally to operate the currency and credit system of the

country to its advantage."

TRADING OF BONDS IN INDIA:-

Bonds generally can trade anywhere in the world that a buyer and seller can strike a deal.

There is no central place or exchange for bond trading, as there is for publicly traded

stocks. The bond market is known as an "over-the-counter" market, rather than an

exchange market. There are some exceptions to this. For example, some corporate bonds in

the United States are listed on an exchange. Also, bond futures, and some types of bond

options, are traded on exchanges. But the overwhelming majority of bonds do not trade on

exchanges. (This article refers to marketable bonds where trading is permitted. Trading is

sometimes not permitted for government savings bonds.)

INVESTING IN BONDS:-

Bonds are bought and traded mostly by institutions like central banks, sovereign wealth

funds, pension funds, insurance companies and banks. Most individuals who want to own bonds

do so through bond funds. Still, in the U.S., nearly 10% of all bonds outstanding are held directly

by households.

Sometimes, bond markets rise (while yields fall) when stock markets fall. More relevantly, the

volatility of bonds (especially short and medium dated bonds) is lower than that of stocks. Thus

bonds are generally viewed as safer investments than stocks, but this perception is only partiallycorrect. Bonds do suffer from less day-to-day volatility than stocks, and bonds' interest payments

are often higher than the general level ofdividend payments. Bonds are liquid it is fairly easy

to sell one's bond investments, though not nearly as easy as it is to sell stocks and the

comparative certainty of a fixed interest payment twice per year is attractive. Bondholders also

enjoy a measure of legal protection: under the law of most countries, if a company

goes bankrupt, its bondholders will often receive some money back (the recovery amount),
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whereas the company's stock often ends up valueless. However, bonds can also be risky but less

risky than stocks:

Fixed rate bonds are subject tointerest rate risk, meaning that their market prices willdecrease in value when the generally prevailing interest rates rise. Since the payments are

fixed, a decrease in the market price of the bond means an increase in its yield. When the

market interest rate rises, the market price of bonds will fall, reflecting investors' ability to

get a higher interest rate on their money elsewhereperhaps by purchasing a newly issued

bond that already features the newly higher interest rate. Note that this drop in the bond's

market price does not affect the interest payments to the bondholder at all, so long-term

investors who want a specific amount at the maturity date do not need to worry about price

swings in their bonds and do not suffer from interest rate risk.

Bonds are also subject to various other risks such as call and prepayment risk, credit

risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation

risk, sovereign riskand yield curve risk.

Price changes in a bond will also immediately affect mutual funds that hold these bonds. If the

value of the bonds held in a trading portfolio has fallen over the day, the value of the portfolio

will also have fallen. This can be damaging for professional investors such as banks, insurance

companies, pension funds and asset managers (irrespective of whether the value is immediately

"marked to market" or not). If there is any chance a holder of individual bonds may need to sell

his bonds and "cash out", interest rate riskcould become a real problem (conversely, bonds'

market prices would increase if the prevailing interest rate were to drop, as it did from 2001

through 2003.One way to quantify the interest rate risk on a bond is in terms of its duration.

Efforts to control this risk are called immunization or hedging.

Bond prices can become volatile depending on the credit rating of the issuer for instance ifthe credit rating agencies like Standard & Poor's and Moody's upgrade or downgrade the

credit rating of the issuer. A downgrade will cause the market price of the bond to fall. As

with interest rate risk, this risk does not affect the bond's interest payments (provided the

issuer does not actually default), but puts at risk the market price, which affects mutual funds

holding these bonds, and holders of individual bonds who may have to sell them.

A company's bondholders may lose much or all their money if the company goes bankrupt.Under the laws of many countries (including the United States and Canada), bondholders arein line to receive the proceeds of the sale of the assets of a liquidated company ahead of

some other creditors. Bank lenders, deposit holders (in the case of a deposit taking institution

such as a bank) and trade creditors may take precedence.

There is no guarantee of how much money will remain to repay bondholders. As an example,

after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications

company Worldcom, in 2004 its bondholders ended up being paid 35.7 cents on the dollarIn a
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bankruptcy involving reorganization or recapitalization, as opposed to liquidation, bondholders

may end up having the value of their bonds reduced, often through an exchange for a smaller

number of newly issued bonds.

Some bonds are callable, meaning that even though the company has agreed to makepayments plus interest towards the debt for a certain period of time, the company can choose

to pay off the bond early. This creates reinvestment risk, meaning the investor is forced to

find a new place for his money, and the investor might not be able to find as good a deal,

especially because this usually happens when interest rates are falling.

The GOI bond market in the 1990s

In 1992, the GOI bond market did not use trading on an exchange. It featured bilateral

negotiation between dealers. A major consequence of bilateral negotiation is that the

market lacks pricetime priority. Further, the lack of anonymity implies that a variety of

malpractices can flourish, such as shading prices for favoured counterparties, forming and

enforcing cartels, etc.

Bilateral transactions impose counterparty credit risk on participants. This tends to

narrow down the market into a club which has homogeneous credit risk, and thus

throws up entry barriers in the market.

The negotiations between dealers took place on telephone, and were effectively restricted to

individuals in one square kilometer of south Bombay. The rest of India could not

participate in the market. This was similar to the BSE floor, which produced a south-

Bombay domination in the equity market.

Bilateral transactions are extremely nontransparent in terms of both pretrade and post

trade transparency. Before the trade takes place, trading intentions are not publicly visible.

After the trade takes place, information about the trade is not made publicly available in

realtime. The settlement of GOI bond trades is done through the database called SGL

maintained by RBI. SGL suffered from serious operational problems as of 1991. Partly as a

response to these problems, participants took to trading in IOUs called bankers receipts(BRs). The practice of9bilateral netting flourished, in a dangerous environment of weak

back office software and internal controls.
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These problems were present from the middle 1980s onwards. However, the increase in

transaction volume in the early 1990s, and the euphoria on the stock market following the

liberalization of 1991, were the triggers which converted these systemic problems into a

crisis. Most systemic crises in the financial sector are rooted in uncontrolled leverage; the

Scam of 1992 can be attributed to a twostage leverageone stage at the interbank GOI

bond market (using IOUs) and another on the stock market (using badla).

In terms of sheer market size, the equity market saw a drop from 42% of GDP in 199394

to 28.6% of GDP in 2000-01. Over the same period, the GOI bond market saw an increase

in market size, fueled by large fiscal deficits, from 28% of GDP in 199394 to 36.7% of

GDP in 200001. Other things being equal, this should have generated an improvement in

liquidity of the GOI bond market and a reduction in liquidity in the equity market.

Instead,changes in market design on the equity market over this period gave the opposite

outcome, where the improvement in liquidity on the equity market was superior to that

observed on the GOI bond market.

BUSINESS IN THE INDIAN BOND MARKET FROM 1993-2001:-

Rs. billion Percent of GDP

Year Equity GOI Bond Equity GOI Bond

1993-94 3681 2457 42.0 28.0

1994-95 4334 2665 41.8 25.7

1995-96 5265 3079 43.2 25.3

1996-97 4639 3445 32.9 24.4

1997-98 5603 3890 33.8 25.7

1998-99 5429 4597 30.9 26.0

1999-00 9128 7143 46.6 36.5

2000-01 6255 8045 28.6 36.7


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MAJOR PARTICIPANTS:-

Market Participants

In India the major investors in government securities are the commercial banks, cooperative

banks, insurance companies, provident funds, financial institutions includingthe DFIs, mutual

funds (including the gilt funds), primary dealers, and non-bank financecompanies. RBI also

invests in government securities either through the private placement route or by absorbing the

un-subscribed portion of an auction for notified amount. Commercial banks are the dominantinvestors historically because of the Statutory Liquidity Ratio (SLR) compulsions. But during the

last several years banks are investing substantially more than what is required by the SLR

compulsions as the demand for funds is not growing or that they prefer investing in government

securities in view of the capital adequacy requirements. Given the risk-reward matrix banks find

it more attractive to invest in government securities. Life Insurance Corporation (LIC) is another

major investor next to the banks. As at end 1999while RBI held 9.1% of the stock of the Central

and State Government securities, 59.5% was held by commercial banks,17.9% by LIC, and

13.5% by others. During the last decade the mandatory SLR ratio was brought down by RBI

from 38.5% of the total demand time liabilities of the banks to 25% as of now. But banks

investment in government securities is around one-third more than what is statutorily required

indicating thereby that banks now consider government securities to be a preferred option. From

the viewpoint of the debt markets this is a healthy development, as it will help in developing an

efficient government securities market that can throw up a meaningful benchmark yield rate. An

equally important development has been the growing popularity of the Gilt Funds, which invest

all their disposable resources into gilt securities. Slowly but surely many investors are

discovering the advantages of gilt securities and the risk-reward matrix. This should help in the

development of a retail market in government securities for a class of investors who would invest

either through the Gilt Funds or directly. One major attraction of gilt investments is the abolition

of the Tax Deducted at Source (TDS) for gilt investments.

This will also facilitate in the development of the yield curve that does not contain the noise

generated by TDS.

TYPES OF BONDS:-


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Government Bonds

In general, fixed-income securities are classified according to the length of time before maturity.

These are the three main categories:

Bills - debt securities maturing in less than one year.

Notes - debt securities maturing in one to 10 years.

Bonds - debt securities maturing in more than 10 years.

Marketable securities from the U.S. government - known collectively as Treasuries - follow this

guideline and are issued as Treasury bonds, Treasury notes and Treasury bills (T-bills).

Technically speaking, T-bills aren't bonds because of their short maturity. (You can read more

about T-bills in ourMoney Markettutorial.) All debt issued by Uncle Sam is regarded as

extremely safe, as is the debt of any stable country. The debt of many developing countries,

however, does carry substantial risk. Like companies, countries can default on payments.

Municipal Bonds

Municipal bonds, known as "munis", are the next progression in terms of risk. Cities don't go

bankrupt that often, but it can happen. The major advantage to munis is that the returns are free

from federal tax. Furthermore, local governments will sometimes make their debt non-taxable for

residents, thus making some municipal bonds completely tax free. Because of these tax savings,

the yield on a muni is usually lower than that of a taxable bond. Depending on your personal

situation, a muni can be a great investment on an after-tax basis.

Corporate BondsA company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility

as to how much debt they can issue: the limit is whatever the market will bear. Generally, a

short-term corporate bond is less than five years; intermediate is five to 12 years, and long term

is over 12 years.

Corporate bonds are characterized by higher yields because there is a higher risk of a company

defaulting than a government. The upside is that they can also be the most rewarding fixed-

income investments because of the risk the investor must take on. The company's credit quality

is very important: the higher the quality, the lower the interest rate the investor receives.

Other variations on corporate bonds includeconvertible bonds, which the holder can convert into

stock, andcallable bonds, which allow the company to redeem an issue prior to maturity.

Types of Bonds
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1. Classification on the basis of Variability of CouponI. Zero Coupon Bonds

Zero Coupon Bonds are issued at a discount to their face value and at the

time of maturity, the principal/face value is repaid to the holders. No interest

(coupon) is paid to the holders and hence, there are no cash inflows in zerocoupon bonds. The difference between issue price (discounted price) and

redeemable price (face value) itself acts as interest to holders. The issue price

of Zero Coupon Bonds is inversely related to their maturity period, i.e.

longer the maturity period lesser would be the issue price and vice-versa.

These types of bonds are also known as Deep Discount Bonds.

II. Treasury StripsTreasury strips are more popular in the United States and not yet available

in India. Also known as Separate Trading of Registered Interest and

Principal Securities, government dealer firms in the United States buy

coupon paying treasury bonds and use these cash flows to further create zero

coupon bonds. Dealer firms then sell these zero coupon bonds, each onehaving a different maturity period, in the secondary market.

III. Floating Rate BondsIn some bonds, fixed coupon rate to be provided to the holders is not

specified. Instead, the coupon rate keeps fluctuating from time to time, with

reference to a benchmark rate. Such types of bonds are referred to as

Floating Rate Bonds.

For better understanding let us consider an example of one such bond from

IDBI in 1997. The maturity period of this floating rate bond from IDBI was 5

years. The coupon for this bond used to be reset half-yearly on a 50 basis

point mark-up, with reference to the 10 year yield on Central Government

securities (as the benchmark). This means that if the benchmark rate was setat X %, then coupon for IDBI s floating rate bond was set at (X

+ 0.50) %.

Coupon rate in some of these bonds also have floors and caps. For example,

this feature was present in the same case of IDBIs floating rate bond

wherein there was a floor of 13.50% (which ensured that bond holders

received a minimum of 13.50% irrespective of the benchmark rate). On the

other hand, a cap (or a ceiling) feature signifies the maximum coupon that

the bonds issuer will pay (irrespective of the benchmark rate). These bonds

are also known as Range Notes.

More frequently used in the housing loan markets where coupon rates arereset at longer time intervals (after one year or more), these are well known

as Variable Rate Bonds and Adjustable Rate Bonds. Coupon rates of some

bonds may even move in an opposite direction to benchmark rates. These

bonds are known as Inverse Floaters and are common in developed markets.


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2. Classification on the Basis of Variability of MaturityI. Callable Bonds

The issuer of a callable bond has the right (but not the obligation) to change

the tenor of a bond (call option). The issuer may redeem a bond fully or

partly before the actual maturity date. These options are present in the bondfrom the time of original bond issue and are known as embedded options. A

call option is either a European option or an American option. Under an

European option, the issuer can exercise the call option on a bond only on the

specified date, whereas under an American option, option can be exercised

anytime before the specified date.

This embedded option helps issuer to reduce the costs when interest rates are

falling, and when the interest rates are rising it is helpful for the holders.

II. Puttable BondsThe holder of a puttable bond has the right (but not an obligation) to seek

redemption (sell) from the issuer at any time before the maturity date. The

holder may exercise put option in part or in full. In riding interest ratescenario, the bond holder may sell a bond with low coupon rate and switch

over to a bond that offers higher coupon rate. Consequently, the issuer will

have to resell these bonds at lower prices to investors. Therefore, an increase

in the interest rates poses additional risk to the issuer of bonds with put

option (which are redeemed at par) as he will have to lower the re-issue price

of the bond to attract investors.

III. Convertible BondsThe holder of a convertible bond has the option to convert the bond into

equity (in the same value as of the bond) of the issuing firm (borrowing firm)

on pre-specified terms. This results in an automatic redemption of the bond

before the maturity date. The conversion ratio (number of equity of shares inlieu of a convertible bond) and the conversion price (determined at the time

of conversion) are pre-specified at the time of bonds issue. Convertible bonds

may be fully or partly convertible. For the part of the convertible bond which

is redeemed, the investor receives equity shares and the non-converted part

remains as a bond.

3. Classification on the basis of Principal RepaymentI. Amortising Bonds

Amortising Bonds are those types of bonds in which the borrower (issuer)

repays the principal along with the coupon over the life of the bond. The

amortising schedule (repayment of principal) is prepared in such a manner

that whole of the principle is repaid by the maturity date of the bond and the

last payment is done on the maturity date. For example - auto loans, home

loans, consumer loans, etc.


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II. Bonds with Sinking Fund ProvisionsBonds with Sinking Fund Provisions have a provision as per which the issuer

is required to retire some amount of outstanding bonds every year. The

issuer has following options for doing so:

i. By buying from the marketii. By creating a separate fund which calls the bonds on behalf of the

issuer

Since the outstanding bonds in the market are continuously retired by the

issuer every year by creating a separate fund (more commonly used option),

these types of bonds are named as bonds with sinking fund provisions. These

bonds also allow the borrowers to repay the principal over the bonds life.

Issuance

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 bookrunners who arrange the bond issue, have direct contact with investors and

act as advisers to the bond issuer in terms of timing and price of the bond issue. The

bookrunners' 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, called a public sale, 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 price paid as well as the coupon. However,

because the cost of issuance for a publicly auctioned bond can be cost prohibitive for a smaller

loan, it is also common for smaller bonds to avoid the underwriting and auction process through

the use of a private placement bond. In the case of a private placement bond, the bond is held by

the lender and does not enter the large bond market.

Sometimes the documentation allows the issuer to borrow more at a later date by issuing further

bonds on the same terms as before, but at the current market price. This is called a tap

issue or bond tap.
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A when-issued (grey) market was introduced in May 2006. Initially, it was only permitted

when the issue was a re-opening of an existing bond (one that was currently trading). The rules

were subsequently relaxed to allow when-issued trading in selected new issuances (bonds that

were not re-openings of old bonds). This is a relatively sophisticated tool which, while common

in developed markets, is not common in Asia, with few exceptions such as Singapore and Hong

Kong, China.

Increasingly, issuers of government bonds have come to realize that transparency of issuance

allows investors to plan their cash flows and investments more accurately. This prevents the

market being distorted by temporary excess supply and ensures better prices. Most issuers now

publish some form of timetable of forthcoming issues. In 2001, a published timetable was

introduced for Treasury bill auctions but not for longer-dated bonds. In part, this was a

consequence of weak control of the budget deficit, leading to frequent revisions in funding

requirements during the course of the year. Since September 2006, the RBI has published a

yearly issuance timetable for dated bonds.

Indian state governments raise finance through omnibus issues organized by the RBI. State

issues are not government guaranteed. The omnibus issues are sold at fixed coupons and prices

(the same for every state). Potential buyers subscribe at the fixed-coupon rate for the bonds of a

particular state (the amount on issue for each state is not announced). The subscription is closed

after 2 days even if some issues are under subscribed.

Current government bonds are fixed-coupon with maturities from 1 to 30 years. The RBI hasexperimented over the years with a number of different types of bonds. These include (i)

zerocoupon bonds; (ii) capital-indexed bonds (inflation-linked principal); and (iii) floating-rate

bonds. None has generated much interest and all have now been discontinued. The RBI is now

working to develop a market for Separate Trading of Registered Interest and Principal of

Securities (STRIPS).

RBI AND THE BOND MARKET

The government securities market is a very important segment of the debt market for several

reasons. In most of the market economies it is perhaps the largest and very active segment. Being

a fairly liquid and large market most of the players in the market use sovereign debt instruments


22/24

for their liquidity management as well as a collateral for several types of transactions including

the repos and collateralised large payments

systems. The yield structure as given by the secondary market in sovereign debt serves asBthe

benchmark rate for all the other yield rates in the system. It is a universally acceptedBproposition

that the term structure of interest rates cannot be meaningfully estimated inBthe absence of a

deep, vibrant, and efficient market in sovereign rated debt instruments.

The yield rate structure for all the other debt instruments in any financial system evolves or

emerges with reference to the term rate structure of the sovereign instruments. RBI has therefore

been laying considerable emphasis on the development of an efficient and vibrant government

securities market.

The last decade witnessed significant transformation in the government securities markets. These

developments were as a result of the joint move by RBI and GOI to gradually align the yield

structure to the market expectations. Till then the coupon rates on government securities were

administratively determined. Until a few years ago the artificially low rates of government

securities in relation to the market expectations had an impact on the entire yield structure in the

entire financial system. This also hindered growth of an active secondary market in government

bonds. As a first step, RBI introduced in June 1992 an auction system for the issue of

government securities. The major objective behind this move was to help the market to

understand the niceties of the price discovery process. RBI has used both the auction method and

the pre-determined coupon/tap issue for this purpose before fully going in for completely market

determined rates.

Treasury bills are issued primarily through the auction method. Generally the multiple price

auctions method used for issuing the instruments. Apart from the allotment through auction, the

practice of non-competitive bids at the cut off yield rates is accepted from certain types of

investors. The State Governments generally manage their liquidity through purchase of treasury

bills issued by the Central Government; they are allotted these at the weighted average price

determined in the auction. Non-competitive bids are accepted outside the notified amount for

auction. This practice has been adopted to encourage participants who do not have the expertise

needed to participate in the auction.RBI also participates in the non-competitive bids in both

dated securities and the treasury bills for part of the issues in case the entire issue is not

subscribed. On a number of occasions RBI has accepted private placements of governmentstocks and released them to the market when the interest rate expectations turned out to be

favourable. RBI has to resort to this system whenever the governments needs for funds suddenly

spurt and the issue through the auction would result in creating sudden destabilisation in the

market rates.


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A multiple price auction method is associated with the problem called winners curse. It is

therefore suggested that a uniform price auction method would be more equitable. RBI 14

therefore recently introduced the uniform price auction method for 91-day treasury bills.

With a view to further the process of consolidation, since 1999-2000 RBI is making mostof the

primary issues of dated securities by way of re-issues and price-based auctions,instead of yield-

based auctions. As the secondary market widens and deepens it needs large-sized issues for

efficient price discovery process in the secondary market and development of proper benchmark

rates. RBI is also planning to develop an active market is Separately Traded Registered Interest

and Principal of Securities (STRIPS). RBI announces a fixed calendar for auctions of all types

treasury bills. The auctions of 14-day and 91-day treasury bills were so far auctioned on a

weekly basis while auctions of 182-day and 364-day treasury bills are held on a fortnightly basis.

RBI has decided to discontinue the 14-day and 182-day treasury bills and have auctions only in

91-day and 364-day treasury bills. Henceforth the weekly auction of 91-day Treasury bill

amountwill be Rs. 2.5 billion and the fortnightly auction of 364-day Treasury bill will be Rs 7.5billion. RBI is yet to adopt a fixed pre-announced calendar in respect of the issues ofdated

securities.

The major reforms in the bond market in India

The system of auction introduced to sell the government securities. The introduction of delivery versus payment (DvP) system by the Reserve Bank of India to

nullify the risk of settlement in securities and assure the smooth functioning of the

securities delivery and payment.

The computerization of the SGL. The launch of innovative products such as capital indexed bonds and zero coupon bonds to

attract more and more investors from the wider spectrum of the populace.

Sophistication of the markets for bonds such as inflation indexed bonds. The development of the more and more primary dealers as creators of the Government of

India bonds market.


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The establishment of the a powerful regulatory system called the trade for trade system bythe Reserve Bank of India which stated that all deals are to be settled with bonds and funds.

A new segment called the Wholesale Debt Market (WDM) was established at the NSE toreport the trading volume of the Government of India bonds market.

Issue of ad hoc treasury bills by the Government of India as a funding instrument wasabolished with the introduction of the Ways And Means agreement.

bonds market in india

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