INTRODUCTION TO INDIAN DEBT MARKETTowards 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 endeavors 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. 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 utilized 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 was1|Page

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 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 was unsettled. Government of India failed to achieve the estimates for borrwings for which credit had been taken in the annual budgets.2|Page

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 were abolished; 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 endeavors 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.

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 engineering like the abolition of the Zamindari system; saving the environment; or even weaning people away from gold (the gold bonds issued in 1993).3|Page

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 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 investors 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)4|Page

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 the5|Page

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 Governments 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.

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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.

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The market for Government Securities comprises the Centre, State and StateSponsored 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.

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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 birds eye view of the Indian debt market structure.

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The Structure of the Indian Debt Market

Participants

As is well known, a large participant base would result in lower cost of borrowing for the Government. In fact, retailing of Government Securities is high on the agenda of further reforms.10 | P a g e

Banks are the major investors in the Government Securities markets. Traditionally, banks are required to maintain a part of their net demand and time liabilities in the form of liquid assets of which Government Securities have always formed the predominant share. Despite lowering the Statutory Liquidity Ratio (SLR) to the minimum of 24 per cent, banks are holding a much larger share of Government Stock as a portfolio choice. Other major investors 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.

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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.12 | P a g e

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 securities13 | P a g e

Commercial Paper (CP): They are primarily issued by corporate entities. It is compulsory for the issuance of CPs that the company be assigned a rating of at least P1 by a recognized credit 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 to them.

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Certificates of Deposit (CD): While banks are allowed to issue CDs with a maturity period of less than 1 year, financial institutions can issue CDs with a maturity of at least 1 year. The prime reason for an active market in CDs in India is that their issuance does not warrant reserve requirements for bank.

Treasury Bills (T-Bills): T-Bills are issued by the RBI at the behest of the Government of India and thus are actually a class of Government Securities. Presently T-Bills are issued in maturity periods of 91 days, 182 days and 364 days. Potential investors have to put in competitive bids. Non-competitive bids are also allowed in auctions (only from specified entities like State Governments and their undertakings, statutory bodies and individuals) wherein the bidder is allotted TBills 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), State Government securities (state loans), Public Sector Undertaking bonds (PSU bonds) and corporate bonds/debenture. Majority of these instruments are coupon bearing i.e. interest payments are payable at pre specified dates.

Government of India dated securities (GOISECs): Issued by the RBI on behalf of the Central Government, they form a part of the borrowing program approved by Parliament in the Finance Bill each year (Union Budget). They have a maturity period ranging from 1 year to 30 years. GOISECs are issued through the auction route with the RBI pre specifying an approximate amount of dated securities that it intends to issue through the year. But unlike T-Bills, there is no pre set schedule for the auction dates. The RBI also issues products other than plain vanilla bonds

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at times, such as floating rate bonds, inflation-linked bonds and zero coupon bonds.

State Government Securities (state loans): Although these are issued by the State Governments, 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 part of the SLR requirements and interest payment and other modalities are analogous to GOISECs. Although there is no Central Government guarantee on these loans, they are believed 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.16 | P a g e

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.

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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,18 | P a g e

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:

A security with a coupon of 7.40%: If purchased at Rs. 100 the yield will be 7.40% If purchased at Rs. 200 the yield becomes 3.70%. If purchased at Rs. 50 the yield becomes 14.80% Thus it is seen that higher the price lesser will be the yield and vice-versa. 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.19 | P a g e

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 the20 | P a g e

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 MARKET

Worldwide debt markets are three to four times larger than equity markets. However, the debt market in India is very small in comparison to the equity market. This is because the domestic debt market has been deregulated and liberalized only recently and is at a relatively nascent stage of development. The debt market in India is comprised of two main segments, 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 years there has been significant growth in the Government securities market. The aggregate trading volumes of Government securities in the secondary market have grown significantly from 1998-99 to 2008-09.

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Turnover in the Government Securities Market (Face Value) GOI TURNOVER

summary of average maturity and cut-off yields in primary market borrowings of the government.

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.

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Bonds Issued by Public Sector Undertakings - (Rupees crore)

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REGULATORS The Securities Contracts Regulation Act (SCRA) defines the regulatory role of various regulators 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

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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.25 | P a g e

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 gridlock26 | P a g e

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 trades with minimal time lag. In addition, the NDS enables "paperless" settlement of transactions in government securities with electronic connectivity to CCIL and the DVP settlement system at the 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 Government securities (including repos) with effect from February 15, 2002. Acting as a central counterparty through innovation, the CCIL provides guaranteed settlement and has in place risk management systems to limit settlement risk and operates a settlement guarantee fund backed by lines of credit from commercial banks. All repo transactions have to be necessarily put through the CCIL, while all outright transactions up to Rs.200 million have to be settled through CCIL (Transactions involving larger amounts are settled directly in RBI). Transparency and Data Dissemination : To enable both institutional and retail investors to plan their investments better and also to providing further transparency and stability in the Government securities market, an indicative calendar for issuance of dated securities has been introduced in 2002. To improve the information flow to the market Reserve Bank announces auction results on27 | P a g e

the day of auction itself and all transactions settled through SGL 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 Government securities is disseminated at regular interval to ensure transparency of debt management operations as well as of secondary market activity. This is done through either press releases or Banks publications viz., (e.g., RBI monthly Bulletin, Weekly Statistical Supplement, Handbook of Statistics on Indian Economy, Report on Currency and Finance and Annual Report).

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INTRODUCTION ZERO COUPON BONDSA bond which pays no coupons, is sold at a deep discount to its face value, and matures at its face value. A zero-coupon bond has the important advantage of being free of reinvestment risk, though the downside is that there is no opportunity to enjoy the effects of a rise in market interest rates. Also, such bonds tend to be very sensitive to changes in interest rates, since there are no coupon payments to reduce the impact of interest rate changes. In addition, markets for zero-coupon bonds are relatively illiquid. Under U.S. tax law, the imputed interest on a zero-coupon bond is taxable as it accrues, even though there is no cash flow. Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus the imputed interest, which is discussed below. The maturity dates on zero coupon bonds are usually long-term many dont mature for ten, fifteen, or more years. These long-term maturity dates allow an investor to plan for a long-range goal, such as paying for a childs college education. With the deep discount, an investor can put up a small amount of money that can grow over many years. Investors can purchase different kinds of zero coupon bonds in the secondary markets that have been issued from a variety of sources, including the U.S. Treasury, corporations, and state and local government entities. Because zero coupon bonds pay no interest until maturity, their prices fluctuate more than other types of bonds in the secondary market. In addition, although no payments are made on zero coupon bonds until they mature, investors may still have to pay federal, state, and local income tax on the imputed or "phantom" interest that accrues each year. Some investors avoid paying tax on the imputed29 | P a g e

interest by buying municipal zero coupon bonds (if they live in the state where the bond was issued or purchasing the few corporate zero coupon bonds that have tax-exempt status A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity. It does not make periodic interest payments, or have socalled "coupons," hence the term zero-coupon bond. When the bond reaches maturity, its investor receives its par (or face) value. Examples of zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds,[1] and any type of coupon bond that has been stripped of its coupons. In contrast, an investor who has a regular bond receives income from coupon payments, which are usually made semi-annually. The investor also receives the principal or face value of the investment when the bond matures. Some zero coupon bonds are inflation indexed, so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power rather than a set amount of money, but the majority of zero coupon bonds pay a set amount of money known as the face value of the bond. Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond markets. Short-term zero coupon bonds generally have maturities of less than one year and are called bills. The U.S. Treasury bill market is the most active and liquid debt market in the world. 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 zero coupon 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 lesser30 | P a g e

would be the issue price and vice-versa. These types of bonds are also known as Deep Discount Bonds.

Types of Zero-Coupon SecuritiesThere are as many kinds of zero-coupon securities as there are bonds, plus a number of interesting variations. Corporate zeros: These are corporate bonds, done zero-style. Because you are buying into the credit risk of the corporation, corporate zeros are the most risky kind of zero coupon. These are even riskier than a corporate coupon bond (or registered bond), because if the issuing company defaults on the zero, the holder receives no interest at all. Strips: Strips are zeros that are backed by government securities and offered by brokerage houses. Brokerages are proliferating their own proprietary brands of strips under a dizzying array of acronyms: TIGRs, CATS, and other species. Each has different features but works in a similar way. The brokerage buys either U.S. government or municipal securities and holds them in escrow. It then separates-strips--the principal from the interest and markets zero certificates based on one or the other. One example is the Salomon Brothers CATS (Certificate of Accrual on Treasury Securities), a zero in which the face value is based on the accrued value of the underlying Treasury securities. STRIPS: The Treasury also offers STRIPS--which stand for "separate trading of registered interest and principal of securities"--based on Treasury bonds. Some of the venerable U.S. savings bonds are actually forms of zeros as well. Municipal zeros: Municipal and state governments also issue zeros in the form of zero-coupon municipal bonds, which frequently have lower returns but are generally tax-free on the federal level.

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Zero-coupon convertibles: Finally, zero-coupon convertible bonds can be changed from zeros to other kinds of securities. Companies may issue zero-coupon bonds that may be converted into shares of common stock in the company. Convertible municipal zeros can change from zero coupon to regular interest-paying bonds at some time before maturity.

Strategic Considerations of Zero Coupon SecuritiesZero coupon bonds share many of the characteristics of other types of bonds, with one important exception. Since they do not feature regular interest payments, they are not an income investment, as other bonds are, but should be considered an appreciation investment. It is important to remember, however, that unlike the growth in value of a stock portfolio or mutual fund, the appreciating value of a zero is really a representation of accrued compound interest, and is taxed as such--not as capital gains, which are taxed at lower rates. There are, however, a variety of tax-free government zeros available. Zeros are also suitable in an IRA or other taxdeferred or tax-free plan since they make no distinction between capital gains and ordinary income for tax purposes. Since zeros are debt instruments, the risk involved depends largely on the credit strength of the issuer. Zeros backed by government securities like U.S. Treasury bonds have very low credit risk, while corporate zeros can be much riskier. If the issuer does default, you may be out quite a bit, because you have not received any interest payments. Also, as with other bonds, the real values of zeros depend on how the returns compare with prevailing interest rates--a factor that makes zeros quite volatile on the secondary market. As a result, most investors hold zeros to maturity.

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ZERO COUPON BOND AND YIELD CURVEThe zero coupon yield curve is one of the most fundamental tool in finance and is essential in the pricing of various fixed income securities. Unfortunately, zero coupon rates are not observable in the market for a range of maturities. Therefore, an estimation methodology is required to derive the zero coupon yield curves from observable data. There are many methodologies and each can provide surprisingly different results. Nevertheless, each seeks to provide an estimation that fit the data well while maintaining an easily interpretable form.

BASIC CONCEPTSThe Law of One Price The law of one price states that two securities with identical cash flows and risk should sell for the same price. Hence it is possible for a security to be priced identically to a combination of other securities by way of a replicating portfolio on the securitys cash flows. Zero Coupon Rates A zero coupon rate is an interest rate or bond yield that corresponds to a single cash payment at a single point of time in the future. Also commonly known as spot rates, it is the compounded return from investing in a zero coupon bond with t time to maturity. By the law of one price, a coupon bond is identical to a replicating portfolio of zero coupon bonds. Thus, pricing the coupon bond is equivalent to summing its cash flows and discounting each cash flow with the corresponding zero coupon rates at the specific time of coupon dissemination. Yield to Maturity The yield to maturity (YTM) is a single rate that represents the internal rate of return of a bonds stream of cash flows. In other words, it can be seen as the33 | P a g e

average of a portfolio of zero coupon rates weighted by the timing of the corresponding cash flows with an assumption that all intermediate cash flows are reinvested. In simple mathematics, the relationship between YTM and zero coupon rates is defined as follows: The Coupon Effect Since YTM is seen as a time weighted average of cash flow returns, it follows that coupon levels will have an impact on the resulting yield. Thus two bonds with differing coupons but same maturities will have different YTM. This is called the coupon effect. Because of the coupon effect, using YTM to price a bond can only be done for the specific bond to which it was derived from. Zero coupon rates though, can be used to price any single cash flow asit is not affected by the coupon effect. Par Yield Par yield is an YTM rate that a bond would have if priced at approximately its par, i.e. a bonds YTM must equal to its coupon rate. This means in curve terms, samples of bonds are used to estimate the hypothetical par yields at the given tenure followed by usage of estimation methodologies to obtain a good fit to all the observed YTMs. It is the theoretical rate for the various YTMs of existing bonds that have the same maturity to provide par valuation. Like YTMs, par yields a time weighted average of zero coupon rates with reinvestment assumption but its representation is for the sample at the specific tenure rather than a single bond. Yield Curve Construction As mentioned, zero coupon rates are often not observable in the market hence estimation methodology is required to derive the zero coupon curves from observable data. On the other hand, the availability of market data such as YTM and YTM derived prices means par yield curves may be modeled and constructed34 | P a g e

directly. Recall that the par yield is an aggregation of observed YTMs for a given tenure. For example, a sample of seven year tenure AAA bonds traded and issued at par for the day may be used to derive the AAA par yield curves rate at seven year tenure point. Therefore, critical to the construction of zero coupon yield curves are par yield curves. After the par yield curve is constructed, using bootstrapping techniques, zero coupon yield curves are extracted from the constant maturity par yield curves. 4.1 Par Yield Curve Two important issues are addressed; curve tenure point selection and data sample of observable rates. Prior to constructing the par yield curve, constant tenure points are set. Classification of tenure points would be above the mean of the preceding adjacent tenure point to the mean of the next adjacent tenure point. For example, if the set tenure points are 5, 7 and 10 years, seven year tenure point is defined as time to maturity of above 6 to 8.5 years i.e. 6 < tenure(7) < 8.5.Raw data are then sourced for manipulation. Brokers live quotes End of day indicative quotes Daily trades BWMs mark to market rates Interest rate swaps Bankers weekly par yield curve contribution

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KLIBOR rates Indicative deposit rates or deposit rate fixings Overnight policy rates Included for short term tenure points Repo rates Bankers acceptance rate Bills Bands The raw data are aggregated based on a ranged period into a segmented sample pool for each class. For example, a cumulation of one week data prior from today for the AAA par yield curve. Inmost cases, due to the Malaysian bond markets illiquidity, a ranged period is necessary in order to obtain enough samples. The data samples are then filtered. Several filtration methods are done. One of which involves omitting traded data samples which transacted at off market levels. These may include pass through, position parking, cross trading and odd lot transactions. Once data samples are segmented to their relevant classes and tenure points, the corresponding yield points are derived using an averaging function on all the filtered samples.Included for short te rm tenure point

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Advantages and Disadvantages of Zero coupon bonds AdvantagesZero coupon bonds have some really attractive features to them. One is that you buy zero coupon bonds at a deep discount. This means that you pay much less than the bond's par value, the amount it is worth at maturity. As the bond matures, the interest is accrued and the bond increases in value. Because the interest isn't paid out yearly, the bonds can be issued at a deep discount Zero coupon bonds also offer investors predictability for the long-term. Zero coupons are volatile investments but they still provide a predictable return for investors who want a lump sum of money paid by a specific date. One last advantage of zero coupon bonds is that they also benefit whoever issues them. Because they don't pay periodic interest, they allow corporations, municipalities, and the government to continue using the loan amount without having to pay back interest.

DisadvantagesZero coupon bonds also have a few drawbacks. The first big drawback is that they are extremely volatile investments. Interest rates changes can swing the price of the bond in either direction. This means that if you want to sell it before it matures, you aren't guaranteed to make a profit. However, if you hold it until maturity, you won't have to worry about this. As with stocks, long-term investing in zero coupon bonds is the best way to go. Another major drawbacks is that you still have to pay income taxes on the bonds while they are maturing. With regular interest-yielding bonds, you would have to pay income taxes on the amount of interest you earned. Well, with zero coupon bonds, you have to pay taxes each year on the amount of interest you would have earned. One way to get around this is to invest in tax-free zeros, such as municipal zeroes. Or you can find a qualified tax-deferred retirement plan and put the zero coupon bonds in there. One final drawback to investing in zeroes is that they are callable. What this37 | P a g e

means is that the issuer can say that they want to repay the bonds before maturity at a certain percentage rate. This really makes your taxes complicated because if the IRS thinks you made more than you should have, you would have to pay a capital gains tax as well. Zero coupon bonds offer investors one more way to invest in bonds and they do have advantages. For those who understand them, they provide an excellent way of investing for the long-term. Just because they are bonds, that doesn't mean they don't carry their own risks. We encourage you to weigh the risks and rewards before investing.

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Zero Coupon Bond issued by HDFC

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