fixed income primer

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17 August 2010

E m

e r g i n g M a r k e t s

A s i a

Woon Khien Chia

Emerging Markets Strategy

+65 6518 5169

[email protected]

Teck Wee Yeo

Emerging Markets Strategy

+65 6518 6160

[email protected]

www.rbsm.com/strategy

Top View | IndiaA primer on India’s fixed income

marketThe Indian fixed income market has developed rapidly since the structural

changes made in the 1990s. These changes included technological and

regulatory changes such as the electronic screen-based trading, the

establishment of Clearing Corporation of India Ltd. (CCIL) and new instruments

and initiatives to broaden the investor base. This primer provides a full spectrumof India’s fixed income market, describing the different market instruments and

the roles, objectives and choice of instruments of the central bank, banks, non-

banks and foreign investors. A brief listing of settlement, pricing and taxation

issues is also contained in this primer.

Monetary Policy Framework

- Policy decision making, policy targets, policy tools. Pages 2-5

Instruments

- Money market instruments, long-term instruments, derivatives. Pages 5-10

Supply

- Issuers, issuance patterns. Pages 10-12

Demand

- Primary dealers, banks, insurance companies, pension funds, FII, retailinvestors. Pages 12-14

Settlement, pricing and taxation. Pages 15-16

Conclusion. 6

List of tables

- Table 1: Cash instruments’ basic features. Page 9- Table 2: Derivative instruments’ basic features. Page 10- Table 3: Cash instruments’ supply and demand. Page 14- Table 4: Settlement and FII regulation and taxation. Page 16

Glossary. Pages 17-19

Appendix

- Lists of credit rating agencies, primary dealers, custodians and countries withdouble taxation avoidance agreement (DTAA). Pages 20-22



The Royal Bank of Scotland

Monetary Policy Framework

The Reserve Bank of India (RBI) is the monetary authority, regulator and

supervisor of the financial system, manager of foreign exchange, issuer of

currency and a banker to the banks. In setting its monetary policy, the RBI

balances growth and price and financial stability.

The RBI uses a multiple-indicator approach to achieve its multiple objectives,

monitoring the movements of interest rates, inflation rate, money supply, credit,

exchange rate, capital flows along with trends in output. As the economy is

heavily dependent on agriculture, weather factors such as monsoon sometimes

influence the RBI’s decisions, compelling the central bank to adopt both price

and quantitative instruments for implementing the policy.

Policy decision-making

The process of monetary policy formulation has largely been an internal process.

At the very apex of the policy process is the governor, assisted by a maximum of

four deputy governors and guided by the Central Board of Directors (see below).

The RBI’s Monetary Policy Department (MPD) formulates the monetary policy in

consultation with banks, insurance companies, pension funds and industry and

trade associations. In parallel, a Technical Advisory Committee (TAC) reviews

the macroeconomic conditions and advises the RBI. The final decision is solely

that of the governor who seeks consensus from a 12-member (5 internal/ 7

external) Monetary Policy Committee (MPC) who sits on the board of directors.

As announced at the 27 July 2010 policy meeting, monetary policy reviews are

now conducted mid-quarter in addition to the quarterly reviews. The intention is

to reduce the element of surprise to market participants from the inter-policy

moves which have occurred quite often in the past.

E m e r g i n g M a r k e t s A s i a | 1 7

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The central board of directors

The Board is appointed by the government comprising 19 members divided into

official and non-official directors. The official directors include the governor and

the four deputy governors. The non-official directors include four directors

nominated by the government to represent each local board, 10 directors

nominated by the government possessing expertise in various segments of the

economy and 1 representative of the central government.

Policy targets

Within its policy toolkit, the cash reserve ratio (CRR) and repo/reverse repo rates

are the most commonly used tools by the RBI. Tools like Statutory Liquidity Ratio(SLR) and bank rate are used for long-term planning and are seldom adjusted.

Repo/Reverse repo rates

These are the rates used for the RBI’s repo and reverse repo auctions with

scheduled commercial banks and primary dealers under its Liquidity Adjustment

Facility (LAF, see section below). Through the LAF, the RBI indirectly aims to

keep the market overnight call rate within the corridor set by its targeted repo/

reverse repo rates. Oftentimes the market overnight call breaches this policy rate

corridor due to a combination of reasons such as a shortage of eligible

government securities among banks and dislocations in interbank credit risks.

The current repo rate is at 5.75 % while the reverse repo rate is at 4.5% giving a

spread of 125 bps. On a hiking cycle, the operational or effective policy rate is

the repo rate as the interbank market as a whole would be generally short of

2




liquidity and would need to be net borrowing from the RBI at the repo rate. Vice

versa, on an easing cycle, the operational rate is the reverse repo rate. At the

beginning of a turning point in the policy cycle, the RBI tends to maintain a

tighter policy rate corridor so as to guide the market towards the desired

operational rate while towards the end of a policy cycle, it tends to broaden the

policy rate corridor to provide the scope for the market to trade away from the

operational rate towards the other rate. Over the past ten years, the spread has

varied from 100bp to 700bp averaging around 175bp (see Figure 1).


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Bank rate

Bank rate is the rate at which the RBI is ready to either buy back or rediscount

bills of exchange or other commercial papers with banks. The bank rate is used

to signal the medium to long-term stance of monetary policy. The rate has not

changed since April 2003 and currently stands at 6%.

3

Source: RBI

Figure 1: RBI’s targets on reverse repo rate, repo rateand bank rate (%)

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Figure 2: RBI’s policy tools CRR and SLR (%)

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CRR SLR

Policy tools

Cash reserve ratio (CRR)

The RBI requires banks to maintain a fraction of their net demand and time

liabilities (NDTL) in the form of cash with the central bank so that they have

sufficient cash to cover customer withdrawals. The ratio is applied to ScheduledCommercial Banks (SCB) but excludes regional rural banks.

Under it the RBI Act, the RBI can raise CRR to a maximum of 20% and a

minimum of 3% of NDTL. CRR reached a peak of 9 % in July 2008 before it was

brought down sharply to 5% after the breakout of the global credit crisis in

2008/09. Currently, the CRR stands at 6% (see Figure 2).

Statutory liquidity ratio (SLR)

The SLR is the percentage a commercial bank needs to maintain in the form of

cash, gold or government approved securities against its total credit

outstanding. As borrowing from the open market forms a critical part of thegovernment’s financing over the years, this tool has become an important

support for the government’s fiscal financing programme.




SLR has remained at 25 % since November 1997 except at the peak of the

2008/09 crisis period when it was reduced to 24% for a year from November

2008 to November 2009. The ratio can be increased to a maximum of 40%.


A u g u s t 2 0 1 0

Bonds which are eligible for SLR include the central and local government

securities, T-bills and cash management bills. All other bonds are not eligible for

SLR, including Public Sector Undertaking (PSU) bonds, corporate bonds and

Government securities issued for special purposes like Oil Bonds, Food Bonds,

Fertilizer Bonds, etc.

Liquidity adjustment facility (LAF)

This is a facility extended by the RBI to allow banks to park their funds with the

central bank in case of an excess or borrow from it in case of a shortage. It is

done on an overnight basis against the collateral of eligible securities, including

all the SLR-eligible securities as well as selected government securities issued

for special purposes. Repo auction operations facilitate liquidity injection

whereas reverse repo auctions are used to absorb the liquidity (see Figure 3).

Open market operations (OMO)

In addition to LAF, the RBI also makes outright sale and purchase of government

securities in the market. RBI soaks the liquidity from the market by selling

government securities and vice versa it injects liquidity into the system by buying

securities from the market. However, more often than not, he RBI uses the

window to smooth out fluctuations in the bond market rather than to manage

liquidity.

Market stabilization scheme (MSS)

The MSS was introduced in 2004 to absorb the surplus cash generated due tothe central bank’s dollar buying intervention in the FX market. It is thus essentially

an FX sterilization tool. Under the MSS, the government issues treasury bills

and/or dated securities on top of its normal fiscal borrowing requirements for

absorbing the excess liquidity from the market which resulted from the RBI’s FX

intervention. These securities are issued and serviced like existing bills and

dated securities by way of the RBI’s weekly auction. The amount raised under

MSS is held in a separate cash account which is maintained and operated by the

RBI. This amount is appropriated only for the purpose of redemption or to buy

back treasury bills and dated securities issued under this scheme. Payments for

interest and discount are not made from the MSS account and the receipts due

to premium and/or accrued interest are not credited to the MSS account. Such

payments or receipts are dealt through the government’s account with the RBI.

During the 2008/09 global credit crisis, the government held back from issuing

MSS bonds to allow outstanding MSS bonds to roll off and release liquidity back

into the market to support the government’s fiscal stimulus spending. In addition,

the RBI also de-sequestered some MSS bonds to the government’s account. As

a result of these actions, MSS balances came down from INR1.7trn in March

2008 to INR880bn in March 2009 and further to INR27.4bn by March 2010. As at

June 2010, the MSS balance stood at INR3.17bn (see Figure 4).

After the global credit crunch subsided, the RBI has restarted issuing MSS

bonds, with a INR500bn limit set for FY2010/11 which is substantially lower than

the INR2.5trn limit for FY2007/08.

4




Refinance facilities


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The RBI provides refinance facilities to banks for lending to specific sectors, with

the most important being the export sector. All scheduled banks which are

authorized dealers in foreign exchange and have extended export credit are

eligible to avail of the export credit refinance facility. The government increases

the ceiling for these loan facilities when it wishes to pump in liquidity to specific

sectors. The refinance facility is available at the RBI’s repo rate and is allocated

in multiples of hundred thousand rupees. As at April 2010, the RBI has

INR99.38bn in export credit refinance facility.

5

* negative refers to liquidity withdrawal. Source: Bloomberg, RBS

Figure 3: Net reverse repo outstanding under LAF*

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Figure 4: MSS bonds outstanding (INR trn)

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Markets and instruments

The Indian fixed income market is one of the most actively traded markets in Asia

with its size and depth comparable to those of the developed markets. As is the

case with the developed world, the Indian fixed income market is also dominated

by the government securities, commonly known as GSecs or gilts. The GSec

market is characterized by an efficient auction process and a liquid secondary

market. Areas for future development would be to deepen the retail investor base

on the demand side and the corporate bond market on the supply side.

Money market instruments (reference Table 1, page 9)

Treasury bills (T-Bills)

Treasury bills are short-term debt instruments issued by the RBI on behalf of the

government. They are issued as discount (zero coupons) securities in three

tenors namely, 91 days, 182 days and 364 days. The RBI conducts T-bill

auctions every Wednesday.

Call money/ notice money/ term money

Call money market is a market for uncollateralized lending and borrowing of

funds. This market is predominantly overnight and is open for participation only

to scheduled commercial banks and primary dealers. If the money lent exceeds




one day but is less than 15 days, it is called notice money market. If it exceeds

15 days but doesn’t exceed 1 year, it is referred to as term money market.


A u g u s t 2 0 1 0

Repo

In addition to engaging in repo transactions with the RBI under LAF, interbank

market participants also engage in repos among themselves. The daily turnover

of the interbank market repo is generally higher than the call market but lower

than LAF. The list of eligible collaterals for market repos are more wide-ranging

than that for LAF, including GSecs, T-bills, special securities and state

development loans (SDL). As of 1 March 2010, even corporate bonds rated AA

or above can be used for repo borrowing with an initial margin of 25%.

Predominantly, the repos are undertaken on an overnight basis although there is

no restriction on term repos.

Certificates of deposit (CD)

Certificates of deposits are the certificates issued by banks and financial

institutions. The tenor ranges from 7 days to 1 year for banks and from 1 year to3 years for financial institutions.

Commercial paper (CP)

Commercial paper is issued in the form of a promissory note which is essentially

an unsecured money market instrument. Corporate, primary dealers and all

financial institutions are permitted to issue them to raise short-term financing of

funds under an umbrella limit set by the RBI. Main investors are banks, insurance

companies and mutual funds. Mandatory credit rating by an RBI approved

credit rating agency has to be attained by the issuer for its commercial paper.

Maturities of CPs can range from 7 days to 1 year.

Collateralized borrowing and lending obligation (CBLO)

This money market instrument is operated by the Clearing Corporation of India

Limited (CCIL) for the benefit of entities which have no access to interbank call

money market or have restricted access in terms of ceiling on call borrowing and

lending. Securities eligible as collateral can be GSecs or securities specified by

the CCIL. It is available in electronic book entry form as a discounted instrument

with maturities ranging from 1 day to 1 year. In terms of turnover volume, CBLOs

are the most traded money market instrument behind RBI’s LAF.

Cash management bills (CMB)

In August 2009, the government decided to introduce a new short-term

instrument known as cash management bills to meet its temporary cash flow

mismatches. These bills are non-standardized and the tenor which can be no

more than 91 days, amount and date of issue depend on the temporary cash

requirement of the government. The bills are sold at a discount. The

announcement of the auction is made by the RBI one day prior to the auction.

Thus far, the government has auctioned CMB twice, once on 11 May 2010 and a

second time on 18 May 2010 for a notified amount of INR60bn with the same

maturity date on 16 June 2010.

Long-term securities

Dated government securities (GSecs)

6




Dated government securities are issued by the government to finance its fiscal

deficit or infrastructure development programmes. These are long-term

securities, with maturities ranging from 2 years to 30 years. The yields are driven

by factors such as policy rates, domestic inflation and sometimes follow the

direction of the US treasuries (see Figures 5 and 6).


A u g u s t 2 0 1 0

7

Source: Bloomberg, RBS

Figure 5: 10y GSec yield vs. WPI YoY (%)

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Figure 6: 10y GSec yield vs. 10y UST yield (%)

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Special securities

The government issues special securities to companies like oil marketing

companies, fertilizer companies, the Food Corporation of India as compensation

in lieu of cash subsidies. These are usually long-dated bonds about 20-25 basis

points higher than regular GSecs of similar maturity to compensate for the

illiquidity.

As the companies given these special GSecs are usually state-owned (e.g. oil

bonds are given to Indian Oil Corp), these bonds can be kept off the

government’s budget. The government pays out approximately INR100bn a year

as interest payments on oil bonds alone. Since 2005, the government has issued

special securities mainly to oil and fertilizer companies apart from a small

handful of issues to the Food Corporation of India, a state bank and a non-bankFI.

A conscious effort is now being made to avoid issuing new oil and fertilizer

bonds so that the government now extends its subsidy in cash thereby bringing

all subsidy-related liabilities onto the balance sheet for fiscal accounting. Except

for interest payments and redemption for FY 2008/09, no new oil and fertilizer

bonds were issued in FY 2009/10. Special securities are not SLR-eligible but

some are selectively eligible as collateral under LAF.

Capital Indexed Bonds

The principal of these bonds are linked to an accepted index of inflation with aview to protecting the holder from inflation. One variant of capital indexed bonds

was issued in December 1997 linked to the wholesale price index. It was not too

successful as it offered inflation hedging only against the principal while the




coupons were unprotected. Steps are now being taken to come up with new

capital indexed bonds which have both the coupon and principal linked to the

wholesale price index.


A u g u s t 2 0 1 0

Bonds with call/put options

GSecs with put/call options up to a maturity of 10 years were issued on 18 July

2002. The optionality on the bond could be exercised after the completion of five

years from the date of issuance on any coupon date thereafter. Out of the

INR30bn issued then, INR 5.5bn worth of bonds are currently still outstanding.

Separate trading for registered interest and principal of securities (STRIPS)

The guidelines for stripping/reconstitution of the securities came into effect on 1

April 2010, allowing participants to strip/reconstitute eligible GSecs through the

Negotiated Dealing System (NDS) subject to terms and conditions. STRIPS are

tradable only in the OTC market and is reported to the NDS for clearing and

settlement through the CCIL. STRIPS give rise to sovereign zero coupon bonds

which will gradually lead to the development of a market-determined zerocoupon yield curve. As STRIPS do not have any reinvestment risk, they can be

attractive to retail/non-institutional investor.

State development loans (SDL)

State governments issue dated securities called State Development Loans (SDL)

to directly raise funds from the market. Generally the yields on SDLs are slightly

higher than the yields on GSecs of similar maturities. They are eligible for SLR

and for borrowing from the RBI through repo under LAF.

Public sector undertaking (PSU) bonds

Public sector undertaking (PSU) bonds are medium to long-term bonds issued

by public sector organizations (e.g. State Electricity boards, improvement trusts,

metropolitan authorities etc). Some of the bonds are guaranteed by the central or

state government. Typical maturities for PSU bonds are 3-10 years. These bonds

might carry a call/put option.

Corporate bonds

A well developed corporate bond market may enable the corporates to tap the

market for their financial needs thereby reducing the systemic stress on banks.

The RBI has every now and then initiated measures to develop the corporate

bond market, which as of now stands barely a fraction of the government bondmarket. Nevertheless, there has been a significant growth in the secondary

market activity for the corporate bond markets. Corporate bonds tend to have a

maturity of up to 20 years and often come with call or put options and sometimes

in the form of convertibles.

8




Table 1 : Cash instruments’ basic features


A u g u s t 2 0 1 0Issuer(s) Tenor(s) Coupon Day Count LAF Eligible SLR eligible

Central government 91,182 and 364 days Zero. Discounted Instrument Actual/365 Yes YesTreasury Bills

CashManagementBills

Central government Up to 91 days Zero. Discounted Instrument Actual/365 Yes Yes

GSecs Central government 2-30 years Mostly fixed, with semi annualpayments

30/360 Yes Yes

State GovtLoans

State governments 2-15 years Mostly fixed with semi annualpayments

30/360 Yes Yes

CommercialPaper

Indian companies,supranaturals

7 days -1 year Zero. Discounted Instrument Actual/365 No No

Certificates of Deposit

Banks and financialinstitutions

7 days-1 year Zero. Discounted Instrument Actual/365 No No

Corporate Bonds Public limited companies 1-20 years Mostly fixed. Annual or specificissuance

Actual/365 No No

PSU bonds Public sector organisations

1-15years Mostly fixed with semi annualpayments

Actual/365 No No

SpecialSecurities

Central government 1-20years Mostly fixed with semi annualpayments

30/360 Yes selectively No

Source: RBI, Bloomberg, RBS

Derivatives (reference Table 2, page 10)

Interest rate swaps (IRS)

In the INR swap market, several alternative floating rate benchmarks have

evolved over time, among which the most commonly traded one is the OIS. One

main reason for the innovation of the different floating rate benchmarks is

because of the ban on the use of optionality in interest rate swaps.

- Overnight Index Swaps (OIS) – The floating benchmark used is the overnight

call money rate, MIBOR, which is a daily fixing set by the national stock

exchange using inputs provided by the market makers. The market is highlyliquid up to the 5-year tenor.

- MIFOR Swaps – The floating rate in this case is the implied INR offer rate

derived from USD/INR FX forward exchange rate. A large number of Indian

corporates regularly use MIFOR to manage their interest rate risk.

- Swaps with floating rates linked to GSec yields - These swaps allow banks and

corporates to take views on the relative movements of GSec yields and

corporate spreads without any underlying positions in the securities.

Currency swaps

These are interest rate derivatives where the INR payments can be swapped into

another currency or vice versa. USD and JPY are the two most common second

currencies for a currency swap in INR.

Interest rate futures

Interest rate futures were re-launched in 2009 by the RBI. An earlier edition

launched in 2003 failed due to faulty benchmarks and the fact that the futures

could only be used for hedging and not for trading.

New contracts on 10y notional coupon-bearing GSecs were issued in August

2009, with a notional coupon of 7% per annum with semi-annual compounding.

A proposal is underway to introduce interest rate futures on 5y and 2y notional

coupon-bearing securities and 91-day treasury bills.

9





A u g u s t 2 0 1 0

Table 2: Derivative instruments’ basic features

Tenors Liquidity Day Count Fixing Rate Participants Non-resident accessEffectiveDate

2m-10y (liquid 1y-5y) 10-30bp for <1y Actual/365 Overnight rate T+1 Interbank,corporates

Not allowedOnshore OIS

2-4bp up to 1y

5-15bp for >5y

1y-10y (liquid up to 5y) 3-4bp up to 5yOffshore NDIRS

5-10bp for >5y Actual/365 Overnight rate T+1 Interbank,

corporates Allowed

MIFOR Swaps 1y-10y (liquid up to 5y) 30bp up to 5y

30-50bp for >5y

Actual/365 6m implied USD/INRswap offer rate

T+1 Interbank,corporates

Not allowed

Onshore CCS 1m-10y (liquid up to 5y) ≥30bp Actual/360 6m mifor T+2 Interbank,corporates

Principal hedging allowed

Offshore CCS 1m-10y (liquid up to 5y) ≥20bps Actual/360 6m libor T+2 Interbank,corporates

Allowed

Source: FIMMDA, RBS

Credit Default Swap (CDS)

The RBI has drafted rules proposing the introduction of plain vanilla over-the-

counter single-name CDS for corporate bonds. Infrastructure bonds will be the

first bonds which can be hedged using CDS. The plan of launching CDS has

been deferred twice in the past in 2003 and 2007. No timeline has been set yet

for the latest proposal.

Supply

Apart from the central and local governments, banks and financial institutions are

the next biggest group of bond issuers in the market (see Figure 7). As said,

corporate issuance has not been keeping apace with the average market growth

over the years. The average issue size of corporate bonds is also the smallest in

the market at INR1bn compared to the average GSec issue size of INR150bn.

By maturity, the GSec market offers the longest maturity up to 30 years while

corporate bonds have tenors stretching into 20y. The maturity profile of the GSecmarket is bunched up heavily in the 4y to 8y segment (see Figure 8). Table 3 on

page 14 lists the supply and demand picture by instruments and primary and

secondary market participants.

10

Source: CEIC, RBS

Figure 7: Market share of bonds listed on NSE byinstrument type/ issuer (INR trn)

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Figure 8: Maturity profile of outstanding GSecs (INRbn)

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GSec T-bill Special securities




Issuers

Central government

For FY 2010/11, the government has set a target fiscal deficit of 5.5% of GDP or

close to INR 3.8trn. To finance approximately 90% of this deficit, the government

has set a borrowing program targeting net INR3.45trn to be raised mostly

through the issuance of new GSecs. The tentative targets for fiscal deficit are setat 4.8% and 4.1% of GDP for FY 2011/12 and 2012/13 respectively. In the 12

five-year plan, the government has set a target of USD1trn for infrastructure

spending and will allow private companies to issue infrastructure bonds.

State governments

State governments fund their budget through both transfers from the central

government and issuing their own bonds, known as state development loans

(SDL). In FY2009/10, state governments in total raised INR1.3trn of SDLs. This

compares to INR4.2trn of GSecs and INR3.8trn of T-bills issued in the same year.

Corporates

Corporate bonds include bonds issued by PSUs, banks and private sector

companies, with PSU bonds holding the largest share. One reason for

corporates’ preference to rely on bank borrowing to raise funds rather than

issuing bonds is that they have to get a credit rating to determine the premium of

their bonds over GSecs.


A u g u s t 2 0 1 0

Issuance patterns

GSecs

The RBI announces the half-yearly auction calendar of GSecs in March and

September each year. Usually, close to 60% of the annual fiscal borrowing is

completed in the first half of the year.

There are 15 to 18 benchmarks on the GSec curve, depending on how many

issues qualified as benchmarks at any point in time. On average, each

benchmark issue stays on the benchmark curve for about a year except for the

5y and 10y tenors which sometimes get revised more than once a year.

Changes are decided by the Fixed Income Money Market and Derivatives

Association of India (FIMMDA) based on size, trading volume and market

consensus during its meeting towards the end of each month. Observing that the

government usually stops tapping into a particular issue when its outstanding

size gets too large to avoid bunching its liability into a single maturity date, the

FIMMDA replaces a benchmark when it gets close to the government’s

undisclosed ceiling, observed to be around INR650bn. The issue with the

highest trading volume close to the outgoing benchmark is usually selected as

the new benchmark. A new issue by the government thus does not automatically

come in as a new benchmark.

T-bills

Treasury bills are auctioned on every Wednesday. 91-day bills are issued every

Wednesday while 182-day and 364-day bills are issued on alternate

Wednesdays. 364-day bills are auctioned on the Wednesday preceding the

Friday when the banks are required to report their reserve requirements to theRBI. 182-day bills are auctioned prior to non-reporting Fridays. The settlements

for the T-bills are made on the following Friday.

11




State development loans (SDL)

SDLs are issued through an auction similar to that for GSecs i.e. multiple-price

competitive bidding and typically, 5 to 6 state bonds are being auctioned

together. There are usually 6 to 8 auctions conducted a year.

Quasi-government/ Corporates


A u g u s t 2 0 1 0

PSU bonds are privately placed with the major investors, being banks, insurance

companies, mutual funds, financial institutions, state-run pension funds and

cash-rich corporates. Other corporate bonds are usually sold through a book-

building process.

Special securities

Special securities are directly issued to corporates or state agencies to

subsidise their operations. There is therefore no open market auction. The

number of issues also varies from year to year and as aforesaid, the government

is gradually phasing out the issuance of special securities.

Demand

The major investors of the GSec market include banks, pension funds and

insurance companies, with banks accounting for just below 70% of the total

market (see Figure 9). Most GSec investors are fairly stable investors including

even foreign institutional investors which have gradually shifted their asset

allocations from equity into debt from less than 1% a decade ago to nearly 15%

now (Figure 10). Mutual funds are by comparison relatively volatile. Quite

understandably, the RBI’s GSec holdings are also fairly unstable given its

conduct of daily open market operations and having entered into quantitative

easing (QE) during 2007/08 to help ease the government’s then fiscal fundingpressure.

12

Source: CEIC, SEBI, RBS

Source: CEIC, RBS

Figure 9: GSec holdings by banks, mutual funds, FIIand RBI (INR trn)

0

2

4

6

8

10

12

14

16

00 01 02 03 04 05 06 07 08 09 10

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

Banks M utual funds (RHS)

RBI (RHS) FII (RHS)

Figure 10: Cumulative net FII flows into debt vs. equity(USD bn)

0

2

4

6

8

10

12

14

16

98 99 00 01 0 2 0 3 0 4 05 06 07 08 09 10

0

10

20

30

40

50

60

70

80

90

debt (LHS) equity (RHS)

Primary Dealers (PD)

Primary dealers are either banks (presently 12 of them, see list in Appendix) or

specialized financial firms (presently 8). For auctions, bids are invited from PDs




one day before the GSec auction wherein the PDs indicate the amount to be

underwritten by them and the underwriting fees. PDs have to meet two

commitments for underwriting.


A u g u s t 2 0 1 0

- Minimum underwriting commitment (MUC) per PD: This is computed in a way

that ensures that at least 50% of each issue is covered by the aggregate of all

MUCs. Each PD has a uniform MUC irrespective of the size of its balance

sheet or capital.

- Additional competitive underwriting (ACU) per PD: The remaining portion of

the notified amount is opened to competitive underwriting through underwriting

auctions. Each PD is required to bid for a minimum of 3%. The auction could

be uniform price based or multiple price-based.

PDs do not have to underwrite fully subscribed issues unless they want to bid. If

there is a devolvement, the successful bids put in by the PDs are set off against

the amount underwritten by them when deciding the amount of devolvement.

BanksThe banking sector is the single largest subscriber of Gsecs largely as a result of

having to fulfil the statutory liquidity ratio. Scheduled Urban Co-operative banks

(UCB) are supposed to hold 25% of their SLR requirement in Government and

approved securities (Gsecs, T-bills and SDL). Non-scheduled urban co-

operative banks with NDTL more than INR250mn have to hold 15% of their SLR

requirement in government approved securities. Those with less than INR100mn

NDTL have to hold 10% of their SLR requirement

Regional rural banks are supposed to maintain their entire SLR requirement

(which is 25% of NDTL) in GSecs and other approved securities. Rural co-

operative banks can maintain their SLR requirement in cash, gold or approved

securities. Non-government provident funds, superannuation funds and gratuity

funds are required to invest 40% of their incremental accretions in central and

state government securities.

Insurance companies and pension funds

The other key bond investors are pension funds, insurance companies and

mutual funds. Life insurance companies tend to hold a large amount of GSecs,

the largest one being the Life Insurance Corporation. Among pension funds, the

largest investor in GSecs is the Employee Provident Fund. Life insurance

companies and pension funds tend to hold close to 50% and 25 % of their

liabilities against GSecs. Insurance companies, provident funds and banks have

restrictions on private sector securities and hence the demand for the corporate

bonds is low. Even if they do purchase corporate bonds, their tendency to hold

them to maturity will only further reduce the trading volume of these bonds.

Funds are allowed to invest only up to 10% into corporate bonds and up to 40%

in PSU bonds.

Foreign Institutional Investors (FII)

The key restriction on foreign institutional investors (FII) is in the form on

aggregate ceilings on how much they can hold in the GSecs and corporate bond

markets. An earlier restriction on a 70:30 investment ratio between equity and

debt was removed in 2008. In the same year, the ceiling for investments in

GSecs was lifted from USD3.2bn to USD5bn. In March 2009, the FII ceiling for

investments in corporate bonds was lifted from USD6bn to USD15bn. There arecurrently talks about further increasing the ceilings.

13




Registered FIIs are eligible to invest in all securities issued by the central and

state governments as well as quasi-government entities as long as the

organisation is more than 51% owned by the central or a state government.

They are also allowed to invest in corporate bonds or debentures as long as they

are listed in the national stock exchange. FIIs are not permitted to invest in

certificates of deposit. FIIs have recently become a driving force in the

secondary market for corporate bonds, accounting for almost half of the overall

volumes in the first four months of 2010. Their ceiling for the GSec market has

also been hit.


A u g u s t 2 0 1 0

For a list of FAQs on FII investments, please see the following SEBI’s website

link: http://investor.sebi.gov.in/faq/foreign%20institutional%20investor.html.

Not to be confused with the FII limits, there is another limit set by the RBI on local

corporates’ external commercial borrowings (ECB) to restrict their overseas

borrowing. To promote the country’s infrastructure development plans, rules

governing prior approvals and spreads over USD Libor have been relaxed for

infrastructure firms in 2008.

Retail Investors

Retail investors have very low participation but over the past few years, they

have gradually increased their participation in mutual funds and bond funds. To

enable small and medium-sized retail investors to participate in the auction

process, the RBI has introduced non-competitive bidding in GSecs.

Table 3: Cash instruments’ supply and demand

Issuance CycleIssuer Auction Style Primary Market

Participants

Secondary Market

Participants

Outstanding

Amount (as atJun 2010)

Average

Auction Size(number of

issuesoutstanding)

Central government Multiple Price 10-80bn(51)

1.3trn 91d every Wednesday182d-364d alternate

Wednesday

Institutions, banks, mutualfunds

Fund managers,insurance companies,

banks

Treasury Bills

Cash MgmtBills (CMB)

Central government Multiple Price 60bn 0 Ad hoc Institutions, banks, mutualfunds


banks(0)

Central government Multiple Price 20-60bn 20.2trn 2-4 auctions per month Institutions, banks, mutualfunds

GSecs

(96)


banks

State GovtLoans (SDL)

State governments Multiple Price 20-60bn

(1342)

5.55trn 6-8 auctions per year Institutions, banks Fund managers,insurance companies,

banks

CommercialPaper (CP) Indian companies,supranaturals Bilateral Issuance 1-2bn 1trn Ad hoc Institutions, banks, mutualfunds Fund managers,insurance companies,banks

Certificates of Deposit (CD)

Banks Bilateral Issuance 1-2bn 3.2trn Ad hoc Institutions, banks, mutualfunds


banks

CorporateBonds

Public listedcompanies

Mainly book-building

1-2bn

(1049)

1.46trn Ad hoc Institutions, banks,corporates, mutual funds


banks

PSU Public sector organisations

Private placement 3-5bn for tenors<=5y

1-2bn for tenors>=10y

(850)

1.78trn Ad hoc Institutions, banks, mutualfunds


banks

Specialsecurities

Central government Bilateral placement INR10-200bn

(31)

2trn Ad hoc Corporations receivingsubsidies in strategic

sectors including oil, food& fertilizer or for bank

recapitalisation

Insurance companies,fund managers

Source: Bloomberg, RBI, RBS

14

http://investor.sebi.gov.in/faq/foreign%20institutional%20investor.html

http://investor.sebi.gov.in/faq/foreign%20institutional%20investor.html




Settlement, Pricing and Taxation


A u g u s t 2 0 1 0

(Reference Table 4, page 16)

Settlement

Government securities

GSecs are held in security accounts maintained by interbank counterparties with

the RBI. All the deals are settled through CCIL using the DvP (Delivery vs.

Payment) mechanism. This mechanism ensures that on settlement date, transfer

of securities by the seller occurs simultaneously with transfer of funds from the

buyer. In the secondary market, CCIL guarantees settlement of trades on the

settlement date by becoming a central counter-party to every trade. All outright

secondary market transactions in GSecs are settled on T+1 basis. However, in

case of repo transactions in GSecs, market participants have the choice of

settling the first leg on T+0 basis or T+1 basis while the second leg has to be

settled on a T+1 basis.

Corporate securities

As decided by SEBI in 2009, all trades in corporate bonds between mutual

funds, foreign institutional investors or their sub-accounts, venture capital funds,

foreign venture capital investors, portfolio managers and RBI-regulated entities

are cleared and settled through the NSSCL (National Securities Clearing

Corporation Limited) or the Indian Clearing Corporation Limited (ICCL). This is

applicable to all corporate bonds traded after 1 December 2009 on OTC or on

the debt segment of the stock exchange. This arrangement facilitates the

settlement of secondary market trades on corporate bonds on a DvP basis.

Pricing Sources

Negotiated Dealing system (NDS)

The price and other information of a trade are stored under NDS on the RBI

website or on the CCIL website through NDS Order matching (NDS-OM).Since

NDS-OM is a live and anonymous platform where the trades are disseminated as

they are struck and where counterparties to the trades are not revealed, NDSOM

is the safest and most transparent pricing source.

Transactions undertaken between market participants in the OTC market or

through the telephone are expected to be reported on the NDS platform within

15 minutes after the deals are put through. All OTC trades are required to be

reported on the secondary market module of the NDS for settlement.

Fixed Income Money Market and Derivatives Association of India (FIMMDA)

FIMMDA is also a source of price information, especially for securities that are

not traded frequently. FIMMDA releases rates of various GSec issues that are

used by market participants for valuation purposes.

For benchmark, liquid securities, the prices are polled from various active market

participants between 3pm and 4pm every working day. The collected data gets

automatically transferred to Bloomberg’s valuation system for generating the

prices of all outstanding securities.

For the illiquid securities, the various market participants are polled for different

illiquidity premiums on different maturity buckets. These illiquidity premiums are

then added to the liquid yield curve and an illiquid yield curve is established by

15




the FIMMDA. There is no mathematical way of deriving the illiquidity premium – it

is generally estimated by market makers who would base it on maturity, coupon

rate, issue size and distribution of the illiquid bonds.

Taxation

Currently the interest income tax on FIIs is 20% subject to double taxation

agreement (DTA) whereas the capital gains tax is 30% and 10% for short-termand long-term respectively. The capital gains tax is also subject to double tax

agreement. India has entered into a Double Taxation Avoidance Agreement

(DTAA) with numerous countries (see Appendix). If the capital asset is held for

more than 36 months prior to its transfer, the gains are long term gains. However,

the qualifying period of holding is 12 months in the case of GSecs and listed

corporate bonds. The government is the midst of streamlining the tax rates for all

holding periods of bonds by FIIs.


A u g u s t 2 0 1 0

Table 4: Settlement and FII Regulation and Taxation

Settlement primary

market

Settlement secondary

market

Restrictions for FII Interest Income Tax Capital gains tax

Treasury Bills T+2 T+2 Subject to USD5bn limit on GSec 20% subject to DTA 30% subject to DTA

Cash ManagementBills

T+1 or T+2 T+1 Subject to USD5bn limit on GSec 20% subject to DTA 30% subject to DTA

T+1 T+1 Subject to USD5bn limit on GSec 20% subject to DTA 10% for long-term,30%for short-term subject to

DTA

GSecs

State DevelopmentLoans

T+1 or T+2 T+1 Subject to USD5bn limit on GSec 20% subject to DTA 10% for long-term,30%for short-term subject to

DTA

T+0 or T+2 T+1 Subject to USD15bn limit on corporatebonds

- 30% for short-termsubject to DTA

Commercial Paper

Certificates of Deposit

T+0 or T+2 T+1 Not permitted - 30% for short-termsubject to DTA

T+0 or T+2 T+0 to T+2 Subject to USD15bn limit on corporate

bonds

20% subject to DTA 10% for long-term,30%

for short-term subject toDTA

Corporate Bonds

Public Sector Undertaking (PSU)

T+0 or T+1 T+2 Subject to USD15bn limit on corporatebonds

20% subject to DTA 10% for long-term,30%for short-term subject to

DTA

Source: RBI, CCIL, SEBI, RBS

Conclusion

While the Indian fixed income is characterised by a well-defined set of rules and

regulations and a deep matured GSec market, the slow growth of the corporate

bond market as well as retail investors’ participation are areas for future

development. Although credit rating and issuer knowledge are generally quite

well developed relative to other emerging markets, an active secondary market

and credit curve have not fully evolved. Addressing these deficiencies are

acknowledged priorities of the SEBI.

16




Glossary Broad Based Funds – This refers to a fund established or incorporated outside

India having at least twenty investors with no single investor holding more than

10% of the shares or units of the fund. The exceptions to the requirements

arise when the fund has institutional investors, then it is not required to have

twenty investors. In the case that the institutional investor is holding more than

10 % of the shares, the institutional investor itself must be a broad based fund.

BSE – Bombay Stock Exchange


A u g u s t 2 0 1 0

CCIL – Clearing Corporation of India Limited (CCIL) is the clearing agency for

government securities. It acts as a central counterparty for all transactions of

the government securities. CCIL guarantees the settlement of all the trades of

all trades in the government securities.

CMB – Cash management bills were introduced in August 2009 to allow the

government to meet temporary cash flow mismatches. Their tenors can be no

more than 91 days. The government issued two such bills in H1 2010 which

had since matured.

CSGL – Constituent’s Subsidiary General Ledger Account also known as SGL

II account is an account in which a bank or primary dealer acting as a

custodian of gilt accounts can hold its constituents.

Depositories – Investors can hold government securities in dematerialized

account with a depository. The most prominent depositories are NSDL and

CDSL.

DvP – Delivery versus Payment is the mode of settlement wherein the transfer

of securities and funds happens simultaneously. There are three types of DvP

settlements: DvP I, where the securities and the funds legs of the transactions

are settled on a gross basis; DvP II, where the securities are settled on a gross

basis whereas the funds are settled on a net basis; and DvP III, where both

securities and funds legs are settled on a net basis.

ECB – External commercial borrowing limit is set by the RBI on local

corporates’ to restrict their overseas borrowing. To promote the country’s

infrastructure development plans, rules governing prior approvals and spreads

over USD Libor have been relaxed for infrastructure firms in 2008.

FII – Foreign institutional investor refers to a non-resident investor which has

been licensed by the Securities Exchange Board of India (SEBI) to trade and

invest in the Indian equity and debt markets.

FIMMDA – Fixed income money market and derivatives association of India

Gilt Account – Since registration of SGL accounts with RBI is restricted,

investors have the option of opening a Gilt Account with a bank of primary

dealer which has a CSGL account.

LAF – Liquidity adjustment facility is the repo/ reverse repo window provided

by the RBI for overnight borrowing or lending by the banks with the central

bank.

MIBOR – Mumbai inter-bank offered rate

17




MIFOR – Mumbai inter-bank forward offered rate

MSS – Market stabilization scheme was introduced in 2004 for the RBI to issue

GSecs to sterilize its USD buying intervention in the FX market where the

proceeds of these GSec issuance would be kept in a MSS account set up at

the RBI, withheld from the government so that the proceeds cannot be used

for fiscal funding.

NDS – The negotiated dealing system was introduced in 2002 for electronic

dealing and reporting of the transactions of government securities. NDS

members can send in bids for primary issuance of GSecs. Membership is

restricted to members holding SGL or Current accounts with RBI. NDS also

facilitates settlement of transactions for GSecs in the secondary market.


A u g u s t 2 0 1 0

NDS-OM – An order driven electronic system was introduced where the

participants can trade anonymously by matching their orders with other market

participants. Direct access to NDS-OM is available to selected commercial

banks, primary dealers, insurance companies and mutual funds while others

can only access this system through their custodians.

NDTL – Net demand and time liabilities are the base used by scheduled

commercial banks to compute their required cash reserves to be placed with

the RBI.

NSE – National stock exchange

Participatory Notes (PN) – These are notes issued to foreign funds with no FII

licence by FII-registered institutions to trade in the domestic markets on their

behalf.

PSU – Public sector undertaking

SEBI – Securities exchange board of India

SGF – CCIL guarantees settlement of all the trades in the government

securities and provides funds/securities by its own means in case the

participant fails. To hedge this risk, the CCIL collects margins from all

participants and this maintained margin is called the settlement guarantee

fund (SGF). It can be in the form of cash or securities (minimum 10% cash).

Eligible securities for SGF are specific issues of central government securities

and treasury bills listed by the CCIL through notification where the list is

reviewed periodically.

SGL – Subsidiary General Ledger Account (SGL) facility is provided by RBI to

select entities who can maintain their securities in SGL accounts with the

Public Debt Office of RBI

Shut Period – Shut period is the period for which securities can not be

delivered or settled. This shut period serves the purpose of facilitating the

servicing of the security e.g. payment of coupon and redemption proceeds

and to avoid any change in ownership during this process. Example if the

coupon payments dates are 26th August and 26th February then the shut

period will fall on 25th August and 25th February and trading in this security for

settlement on these two days is not allowed. Currently the shut period for

securities held in SGL accounts is one day.

18




Sub accounts (FII) – Sub accounts refer to foreign corporates, foreign

individuals and institutions, funds or portfolios established or incorporated

outside India on whose behalf a registered FII can make investments.


A u g u s t 2 0 1 0

19




Appendix


A u g u s t 2 0 1 0

List of Credit Rating Agencies, Primary Dealers and Custodians

Credit Rating Agencies

CRISIL limited

Fitch Ratings India Private Ltd.

ICRA Limited

Credit Analysis & Research Ltd. (CARE)

Brickwork Ratings India Pvt ltd.

Bank Primary Dealers Standalone Primary Dealers

Royal Bank of Scotland N.V. Deutsche Securities (India) Pvt. Ltd.

Bank of America ICICI Securities Primary Dealership Limited

Bank of Baroda IDBI Gilts Ltd.

Canara Bank Morgan Stanley India Primary Dealer Pvt. Ltd.

Citibank N.A. Nomura Fixed Income Securities Pvt. Ltd.

Corporation Bank PNB Gilts Ltd.

HDFC Bank Ltd. SBI DFHI Ltd

Hongkong and Shanghai Banking Corpn. Ltd STCI Primary Dealer Limited

J.P Morgan Chase N.A., Mumbai Branch

Kotak Mahindra Bank Ltd.

Standard Chartered Bank

Registered Custodian of Securities Entities where in-principal approval hasbeen granted

ABN AMRO Bank N.V. India Infoline Ltd.

AXIS BANK DSP Merril Lynch Limited

BNP Paribas MF Global Sify Securities India Pvt. Ltd.

Citibank N.A. Globe Capital market Ltd.DBS Bank Ltd. India Edelweiss Custodial Services Limited

Deutsche Bank AG

HDFC Bank Ltd.

Hongkong and Shanghai Banking Corpn. Ltd

ICICI Bank Ltd.

IL&FS Securities Services Ltd.

JPMorgan Chase Bank, N.A.

Kotak Mahindra Bank Limited

Orbis Financial Corporation Ltd.

SBI Custodial Services Pvt. Ltd.

Standard Chartered Bank

Source: See list below

20




List of Countries with Double Taxation Avoidance Agreement (DTAA)


A u g u s t 2 0 1 0Dividends InterestCountry Royalties

15Australia 15 15

Austria 20 20 30

21

15 10 10Bangladesh

15Belarus 10 15

Belgium 15 15 20

15 15 15Brazil

15 15 20Bulgaria

25 15 15Canada

10 10 10China

15 10 15Cyprus

20 15 30Czechoslovakia

10 10 10Czech Republic

20 15 20Denmark

20 20 30Egypt

15 10 20Finland

10 15 20France

10 10 10Germany

20 20 30Greece

15 15 30Hungary

15 10 15Indonesia

10 10 10Israel

20 15 20Italy

15 15 20Japan

10 10 20Jordan

10 10 10Kazakhstan

15 15 20Kenya

20 15 15Korea

10 10 15Kyrgyzstan

20 20 30Libya

20 20 30Malaysia

15 10 15Malta

15 20 15Mauritius

15 15 15Mongolia

10 10 10Morocco

10 10 10Namibia

15 15 15Nepal

10 10 10Netherlands

15 10 10New Zealand

15 15 30Norway

12.5 10 15Oman

20 15 15Philippines

15 15 22.5Poland

15 10 10Portugal

10 10 10Qatar

20 15 22.5Romania

10 10 10Russian Federation

15 15 15Singapore

10 10 10South Africa

15 15 20Spain

15 10 10Sri Lanka

10 10 10Sweden

15 15 20Switzerland

0 7.5 10Syria

15 12.5 20Tanzania





A u g u s t 2 0 1 0

22

20 20 15Thailand

10 10 10Trinidad and Tobago

15 15 15Turkey

10 10 10Turkmenistan

15 12.5 10United Arab Emirates

15 15 15United Kingdom

20 15 15United States

15 15 15Uzbekistan

10 10 10Vietnam

15 10 10Zambia

Source: MOF

Sources

www.rbi.org.in

www.sebi.gov.in

www.bseindia.com

www.fimmda.org

www.finmin.nic.in

www.commerce.nic.in

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