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Understanding and measuring the liquidity of government bond markets is important to various market participants. Primarily, these markets serve to governments for financing purposes. Market participants use government bonds as collateral, as benchmarks for pricing other financial instruments and as hedging or investment instruments. Central banks extract from these markets information on future interest rates and use government bonds as monetary policy instrument. Liquidity directly affects the usability of government bonds for these purposes. Until recently, most research articles focused on stock or foreign exchange markets and only few were dedicated to government bond markets. Researchers and regulators started to focus on the liquidity of government bond markets after the financial market turmoil in 1998, which had an impact even on such liquid markets like the U.S. Treasury market. Through the efforts of this project, we understood in depth the various instruments used by individuals as well as by organizations for raising and using debt. Earlier we were under the impression that we have limited scope to the debt markets but after this study, we are aware of the various opportunities in the debt instrument market.
Introduction
The debt market is a bigger source of borrowed funds than the banking system. The market for debt is larger than the market for equities (i.e., is larger than the stock market). The debt market is commonly divided into the so-called money market (short-term debt, maturity of one year or less) and the so-called capital market (long-term debt). Both of these terms are misnomers. All productive assets are capital (including equities). The terminology may be rationalized by the convention that capitalized expenses are amortized over periods in excess of one year. "Money market" instruments are debt and although they can be used as a store of value they can only be regarded as a medium of exchange in the sense that they are readily sold at a price which is usually predictable within a short time frame. Moreover, it is hard to base a conceptual distinction between money & non-money based on a one-year maturity dividing line. Most debt instruments are not traded through exchanges, but are traded over-the-counter (OTC) in a telephone/electronic network market where dealers or brokers frequently act as direct intermediaries. Money-market instruments usually have such large denominations that they are not accessible to small investors except through mutual funds.
The market for debt can be viewed as a market for money in the sense that sellers of debt (lenders) have a supply of money which is demanded by would-be buyers (borrowers). In this model, interest rates are the "price" of money. An increase in demand to borrow money due to increased economic opportunity increases interest rates (everything else being equal). The market for debt is influenced by term-to-maturity, credit-worthiness of borrowers, security for loan and many other factors. By their control of money supply, government central banks try to manipulate interest rates to stimulate their economies without causing inflation.
FINANCIAL SYSTEM
Financial System of any country consists of financial markets, financial intermediation and financial instruments or financial products. This paper discusses the meaning of finance and Indian Financial System and focus on the financial markets, financial intermediaries and financial instruments. The brief review on various money market instruments are also covered in this study.
The term "finance" in our simple understanding it is perceived as equivalent to 'Money'. We read about Money and banking in Economics, about Monetary Theory and Practice and about "Public Finance". But finance exactly is not money, it is the source of providing funds for a particular activity. Thus public finance does not mean the money with the Government, but it refers to sources of raising revenue for the activities and functions of a Government.
institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities.
The word "system", in the term "financial system", implies a set of complex and closely connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. The financial system is concerned about money, credit and finance-the three terms are intimately related yet are somewhat different from each other. Indian financial system consists of financial market, financial instruments and financial intermediation. These are briefly discussed below;
Some of the important money market instruments are briefly discussed below;
1. Call/Notice Money 2. Treasury Bills 3. Term Money 4. Certificate of Deposit 5. Commercial Papers 1. Call /Notice-Money Market Call/Notice money is the money borrowed or lent on demand for a very short period. When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day, (irrespective of the number of intervening holidays) is "Call Money". When money is borrowed or lent for more than a day and up to 14 days, it is "Notice Money". No collateral security is required to cover these transactions. 2. Inter-Bank Term Money Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money market. The entry restrictions are the same as those for Call/Notice Money except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days. 3. Treasury Bills Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e.
less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder. The rate of discount and the corresponding issue price are determined at each auction. 4. Certificate of Deposits Certificates of Deposit (CDs) is a negotiable money market instrument and issued in dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time. CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI. Banks have the freedom to issue CDs depending on their requirements. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments viz., term money, term deposits, commercial papers and inter corporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet. 5. Commercial Paper CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the debt obligation is transformed into an instrument. CP is thus an unsecured promissory note privately placed with investors at a discount rate to face value determined by market forces. CP is freely negotiable by endorsement and delivery. A company shall be eligible to issue CP provided - (a) the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b) the working capital (fund-based) limit of the company from the banking system is not less than Rs.4 crore and (c) the borrowal account of the company is classified as a Standard Asset by the financing bank/s. The minimum maturity period of CP is 7 days. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies.
The capital market generally consists of the following long term period i.e., more than one year period, financial instruments; In the equity segment Equity shares, preference shares, convertible preference shares, non-convertible preference shares etc and in the debt segment debentures, zero coupon bonds, deep discount bonds etc.
Hybrid Instruments
Hybrid instruments have both the features of equity and debenture. This kind of instruments is called as hybrid instruments. Examples are convertible debentures, warrants etc.
The raising of capital (in the capital markets) The transfer of risk (in the derivatives markets) International trade (in the currency markets)
and are used to match those who want capital to those who have it. Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends. In mathematical finance, the concept of a financial market is defined in terms of a continuous-time Brownian motion stochastic process.
Definition
Typically, the term market means the aggregate of possible buyers and sellers of a certain good or service and the transactions between them. The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (like the NYSE) or an electronic system (like NASDAQ). Much trading of stocks takes place on an exchange; still, corporate actions (merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange. Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, similar to stock exchanges. Financial markets can be domestic or they can be international.
Capital markets which consist of: o Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. o Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof. Commodity markets, which facilitate the trading of commodities. Money markets, which provide short term debt financing and investment. Derivatives markets, which provide instruments for the management of financial risk. Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market. Insurance markets, which facilitate the redistribution of various risks. Foreign exchange markets, which facilitate the trading of foreign exchange.
The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities. Raising the capital To understand financial markets, let us look at what they are used for, i.e. what Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend money in the form of loans and mortgages. More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. A good example of a financial market is a stock exchange. A company can raise money by selling shares to investors and its existing shares can be bought or sold. The following table illustrates where financial markets fit in the relationship between lenders and borrowers:
Relationship between lenders and borrowers Lenders Financial Intermediaries Financial Markets Borrowers Individuals Companies Central Government Municipalities Public Corporations
Interbank Banks Stock Exchange Individuals Insurance Companies Money Market Companies Pension Funds Bond Market Mutual Funds Foreign Exchange
Lenders
Individuals
Many individuals are not aware that they are lenders, but almost everybody does lend money in many ways. A person lends money when he or she:
puts money in a savings account at a bank; contributes to a pension plan; pays premiums to an insurance company; invests in government bonds; or invests in company shares.
Companies
Companies tend to be borrowers of capital. When companies have surplus cash that is not needed for a short period of time, they may seek to make money from their cash surplus by lending it via short term markets called money markets. There are a few companies that have very strong cash flows. These companies tend to be lenders rather than borrowers. Such companies may decide to return cash to lenders (e.g. via a share buyback.) Alternatively, they may seek to make more money on their cash by lending it (e.g. investing in bonds and stocks.)
Borrowers
Individuals borrow money via bankers' loans for short term needs or longer term mortgages to help finance a house purchase. Companies borrow money to aid short term or long term cash flows. They also borrow to fund modernization or future business expansion.
Governments often find their spending requirements exceed their tax revenues. To make up this difference, they need to borrow. Governments also borrow on behalf of nationalised industries, municipalities, local authorities and other public sector bodies. In the UK, the total borrowing requirement is often referred to as the Public sector net cash requirement (PSNCR). Governments borrow by issuing bonds. In the UK, the government also borrows from individuals by offering bank accounts and Premium Bonds. Government debt seems to be permanent. Indeed the debt seemingly expands rather than being paid off. One strategy used by governments to reduce the value of the debt is to influence inflation. Municipalities and local authorities may borrow in their own name as well as receiving funding from national governments. In the UK, this would cover an authority like Hampshire County Council. Public Corporations typically include nationalised industries. These may include the postal services, railway companies and utility companies. Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid of Foreign exchange markets.
Derivative products
During the 1980s and 1990s, a major growth sector in financial markets is the trade in so called derivative products, or derivatives for short. In the financial markets, stock prices, bond prices, currency rates, interest rates and dividends go up and down, creating risk. Derivative products are financial products which are used to control risk or paradoxically exploit risk. It is also called financial economics.
Currency markets
Seemingly, the most obvious buyers and sellers of currency are importers and exporters of goods. While this may have been true in the distant past, when international trade created the demand for currency markets, importers and exporters now represent only 1/32 of foreign exchange dealing, according to the Bank for International Settlements. The picture of foreign currency transactions today shows:
Banks/Institutions Speculators Government spending (for example, military bases abroad) Importers/Exporters Tourists
enunciated a set of ideas on the subject which are now called Dow Theory. This is the basis of the so-called technical analysis method of attempting to predict future changes. One of the tenets of "technical analysis" is that market trends give an indication of the future, at least in the short term. The claims of the technical analysts are disputed by many academics, who claim that the evidence points rather to the random walk hypothesis, which states that the next change is not correlated to the last change.
FINANCIAL INTERMEDIATION
Having designed the instrument, the issuer should then ensure that these financial assets reach the ultimate investor in order to garner the requisite amount. When the borrower of funds approaches the financial market to raise funds, mere issue of securities will not suffice. Adequate information of the issue, issuer and the security should be passed on to take place. There should be a proper channel within the financial system to ensure such transfer. To serve this purpose, Financial intermediaries came into existence. Financial intermediation in the organized sector is conducted by a wide range of institutions functioning under the overall surveillance of the Reserve Bank of India. In the initial stages, the role of the intermediary was mostly related to ensure transfer of funds from the lender to the borrower. This service was offered by banks, FIs, brokers, and dealers. However, as the financial system widened along with the developments taking place in the financial markets, the scope of its operations also widened. Some of the important intermediaries operating in the financial markets include; investment bankers, underwriters, stock exchanges, registrars, depositories, custodians, portfolio managers, mutual funds, financial advertisers financial consultants, primary dealers, satellite dealers, self regulatory organizations, etc. Though the markets are different, there may be a few intermediaries offering their services in more than one market e.g. underwriter. However, the services offered by them vary from one market to another.
Role Secondary Market to securities Corporate advisory services, Issue of securities Subscribe to unsubscribed portion of securities Issue securities to the
Investment Bankers
Underwriters
Capital Market
Money Market
Forex Market
Conclusion
In India money market is regulated by Reserve bank of India and Securities Exchange Board of India (SEBI) regulates capital market. Capital market consists of primary market and secondary market. All Initial Public Offerings comes under the primary market and all secondary market transactions deals in secondary market. Secondary market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Secondary market comprises of equity markets and the debt markets. In the secondary market transactions BSE and NSE plays a great role in exchange of capital market instruments.
The bond markets exhibit a much lower volatility than equities, and all bonds are priced based on the same macroeconomic information. The bond market liquidity is normally much higher than the stock market liquidity in most of the countries. The performance of the market for debt is directly related to the interest rate movement as it is reflected in the yields of government bonds, corporate debentures, MIBOR-related commercial papers,and non-convertible debentures.
The Wholesale Debt Market (WDM) segment of the Exchange commenced operations on June 30, 1994. This provided the first formal screen-based trading facility for the debt market in the country.
This segment provides trading facilities for a variety of debt instruments including Government Securities, Treasury Bills and Bonds issued by Public Sector Undertakings/ Corporates/ Banks like Floating Rate Bonds, Zero Coupon Bonds, Commercial Papers, Certificate of Deposits, Corporate Debentures, State Government loans, SLR and Non-SLR Bonds issued by Financial Institutions, Units of Mutual Funds and Securitized debt by banks, financial institutions, corporate bodies, trusts and others.
Large investors and a high average trade value characterize this segment. Till recently, the market was purely an informal market with most of the trades directly negotiated and struck
between various participants. The commencement of this segment by NSE has brought about transparency and efficiency to the debt market.
Trading in this retail debt market segment (RDM) on NSE has been introduced w.e.f. January 16, 2003. Trading shall take place in the existing Capital Market segment of the Exchange.
In the first phase, all outstanding and newly issued central government securities would be traded in the retail segment. Other securities like state government securities, T-Bills etc. would be added in subsequent phases.
Efficient mobilization and allocation of resources in the economy Financing the development activities of the Government Transmitting signals for implementation of the monetary policy Facilitating liquidity management in tune with overall short term and long term objectives.
Since the Government Securities are issued to meet the short term and long term financial needs of the government, they are not only used as instruments for raising debt, but have emerged as key instruments for internal debt management, monetary management and short term liquidity management. The returns earned on the government securities are normally taken as the benchmark rates of returns and are referred to as the risk free return in financial theory. The Risk Free rate
obtained from the G-sec rates are often used to price the other non-govt. securities in the financial markets.
Reduction in the borrowing cost of the Government and enable mobilization of resources at a reasonable cost. Provide greater funding avenues to public-sector and private sector projects and reduce the pressure on institutional financing. Enhanced mobilization of resources by unlocking illiquid retail investments like gold. Development of heterogeneity of market participants Assist in development of a reliable yield curve and the term structure of interest rates.
Default Risk: This can be defined as the risk that an issuer of a bond may be unable to make timely payment of interest or principal on a debt security or to otherwise comply with the provisions of a bond indenture and is also referred to as credit risk. Interest Rate Risk: can be defined as the risk emerging from an adverse change in the interest rate prevalent in the market so as to affect the yield on the existing instruments. A good case would be an upswing in the prevailing interest rate scenario leading to a situation where the investors' money is locked at lower rates whereas if he had waited and invested in the changed interest rate scenario, he would have earned more. Reinvestment Rate Risk: can be defined as the probability of a fall in the interest rate resulting in a lack of options to invest the interest received at regular intervals at higher rates at comparable rates in the market.
The following are the risks associated with trading in debt securities:
Counter Party Risk: is the normal risk associated with any transaction and refers to the failure or inability of the opposite party to the contract to deliver either the promised security or the sale-value at the time of settlement. Price Risk: refers to the possibility of not being able to receive the expected price on any order due to a adverse movement in the prices.
Significance
The Indian debt market is composed of government bonds and corporate bonds. However, the Central government bonds are predominant and they form most liquid component of the bond market. In 2003, the National Stock Exchange (NSE) introduced Interest Rate Derivatives.
The trading platforms for government securities are the Negotiated Dealing System and the Wholesale Debt Market (WDM) segment of NSE and BSE. In the negotiated market, the trades are normally decided by the seller and the buyer, and reported to the exchange through the broker, whereas the WDM trading system, known as NEAT (National Exchange for Automated Trading), is a fully automated screen-based trading system, which enables members across the country to trade simultaneously with enormous ease and efficiency.
Debt Instruments are categorized as: Government of India dated Securities: (G Secs) are 100-rupee face-value units/ debt
paper issued by the Government of India in lieu of their borrowing from the market. They are referred to as SLR securities in the Indian markets as they are eligible securities for the maintenance of the SLR ratio by the banks.
Corporate debt market: The corporate debt market basically contains PSU bonds and
private sector bonds. The Indian primary Corporate Debt market is basically a private placement market with most of the corporate bonds being privately placed among the wholesale investors, which include banks, financial Institutions, mutual funds, large corporates & other large investors.
The following debt instruments are available in the corporate debt market:
Non-Convertible Debentures Partly-Convertible Debentures/Fully-Convertible Debentures (convertible into Equity Shares) Secured Premium Notes Debentures with Warrants Deep Discount Bonds PSU Bonds/Tax-Free Bonds
vice versa. Some of the assets underlying interest rate futures include US Treasuries, EuroDollars, LIBOR Swap, and Euro-Yen futures.
Tenure
Interest rate futures contracts can have short-term (less than one year) and long-term (more than one year) interest bearing instruments as the underlying asset. In the US, short-term interest rate futures like 90-day T-Bill and 3-month Euro-Dollar time deposits are more popular. Long-term interest rate futures include the 10-year Treasury Note futures contract, and the Treasury Bond futures contract.
.Debt market refers to the financial market where investors buy and sell debt securities, mostly in the form of bonds. These markets are important source of funds, especially in a developing economy like India. India debt market is one of the largest in Asia. Like all other countries, debt market in India is also considered a useful substitute to banking channels for finance. The most distinguishing feature of the debt instruments of Indian debt market is that the return is fixed. This means, returns are almost risk-free. This fixed return on the bond is often termed as the 'coupon rate' or the 'interest rate'. Therefore, the buyer (of bond) is giving the seller a loan at a fixed interest rate, which equals to the coupon rate.
Government Securities Market (G-Sec Market): It consists of central and state government securities. It means that, loans are being taken by the central and state government. It is also the most dominant category in the India debt market.
Bond Market: It consists of Financial Institutions bonds, Corporate bonds and debentures and Public Sector Units bonds. These bonds are issued to meet financial requirements at a fixed cost and hence remove uncertainty in financial costs.
Advantages
The biggest advantage of investing in Indian debt market is its assured returns. The returns that the market offer is almost risk-free (though there is always certain amount of risks, however the trend says that return is almost assured). Safer are the government securities. On the other hand, there are certain amounts of risks in the corporate, FI and PSU debt instruments. However, investors can take help from the credit rating agencies which rate those debt instruments. The interest in the instruments may vary depending upon the ratings.
Another advantage of investing in India debt market is its high liquidity. Banks offer easy loans to the investors against government securities.
Disadvantages
As there are several advantages of investing in India debt market, there are certain disadvantages as well. As the returns here are risk free, those are not as high as the equities market at the same time. So, at one hand you are getting assured returns, but on the other hand, you are getting less return at the same time.
Retail participation is also very less here, though increased recently. There are also some issues of liquidity and price discovery as the retail debt market is not yet quite well developed.
GOVERNMENT SECURITIES
Government Securities are securities issued by the Government for raising a public loan or as notified in the official Gazette. They consist of Government Promissory Notes, Bearer Bonds, Stocks or Bonds held in Bond Ledger Account. They may be in the form of Treasury Bills or Dated Government Securities. Government Securities are mostly interest bearing dated securities issued by RBI on behalf of the Government of India. GOI uses these funds to meet its expenditure commitments. These securities are generally fixed maturity and fixed coupon securities carrying semi-annual coupon. Since the date of maturity is specified in the securities, these are known as dated Government Securities, e.g. 8.24% GOI 2018 is a Central Government Security maturing in 2018, which carries a coupon of 8.24% payable half yearly.
5. No tax deducted at source 6. Can be held in Demat form. 7. Rate of interest and tenor of the security is fixed at the time of issuance and is not subject to change (unless intrinsic to the security like FRBs - Floating Rate Bonds). 8. Redeemed at face value on maturity 9. Maturity ranges from of 2-30 years. 10. Securities qualify as SLR (Statutory Liquidity Ratio) investments (unless otherwise stated).
then the cut off price are accepted. Price Based auction leads to a better price discovery then the Yield based auction. Underwriting in Auction: One day prior to the auction, bids are received from the Primary Dealers (PD) indicating the amount they are willing to underwrite and the fee expected. The auction committee of RBI then examines the bid on the basis of the market condition and takes a decision on the amount to be underwritten and the fee to be paid. In case of devolvement, the bids put in by the PDs are set off against the amount underwritten while deciding the amount of devolvement and in case the auction is fully subscribed, the PD need not subscribe to the issue unless they have bid for it. G-Secs, State Development Loans & T-Bills are regularly sold by RBI through periodic public auctions. SBI DFHI Ltd. is a leading Primary Dealer in Government Securities. SBI DFHI Ltd gives investors an opportunity to buy G-Sec / SDLs / T-Bills at primary market auctions of RBI through its SBI DFHI Invest scheme (details available on website ). Investors may also invest in high yielding Government Securities through SBI DFHI Trade where buy and sell price and a buy and sell facility for select liquid scrips in the secondary markets is offered.
Sometimes the unavailability of funds become one of the major problems for the large organization. The bond market in India plays an important role in fund raising for developmental ventures. Bonds are issued and sold to the public for funds.
Bonds are interest bearing debt certificates. Bonds under the bond market in India may be issued by the large private organizations and government company. The bond market in India has huge opportunities for the market is still quite shallow. The equity market is more popular than the bond market in India. At present the bond market has emerged into an important financial sector.
Corporate Bond Market Municipal Bond Market Government and Agency Bond Market Funding Bond Market Mortgage Backed and Collateral Debt Obligation Bond Market
The establishment of the a powerful regulatory system called the trade for trade system by the Reserve Bank of India which stated that all deals are to be settled with bonds and funds.
A new segment called the Wholesale Debt Market (WDM) was established at the NSE to report the trading volume of the Government of India bonds market.
Issue of ad hoc treasury bills by the Government of India as a funding instrument was abolished with the introduction of the Ways And Means agreement.
Terminology
Used in Bond Market
Bonds Issuer of Bonds Bond Holder Principal Amount Borrower Lender Amount at which issuer pays interest and which is repaid on the maturity date Issue Price Maturity Date Coupon Price at which bonds are offered to investors Length of time (More than one year) Rate of interest paid by the issuer on the par/face value of the bond Coupon Date The date on which interest is paid to investors
Types of Bonds
1. Classification on the basis of Variability of Coupon
Zero Coupon Bonds Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity, the principal/face value is repaid to the holders. No interest (coupon) is paid to the holders and hence, there are no cash inflows in 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 lesser would be the issue price and vice-versa. These types of bonds are also known as Deep Discount Bonds. Treasury Strips Treasury strips are more popular in the United States and not yet available in India. Also known as Separate Trading of Registered Interest and Principal Securities, government dealer firms in the United States buy coupon paying treasury bonds and use these cash flows to further create zero coupon bonds. Dealer firms then sell these zero coupon bonds, each one having a different maturity period, in the secondary market. Floating Rate Bonds In some bonds, fixed coupon rate to be provided to the holders is not specified. Instead, the coupon rate keeps fluctuating from time to time, with reference to a benchmark rate. Such types of bonds are referred to as Floating Rate Bonds.
is either a European option or an American option. Under an European option, the issuer can exercise the call option on a bond only on the specified date, whereas under an American option, option can be exercised anytime before the specified date. This embedded option helps issuer to reduce the costs when interest rates are falling, and when the interest rates are rising it is helpful for the holders.
(ii) Puttable Bonds The holder of a puttable bond has the right (but not an obligation) to seek redemption (sell) from the issuer at any time before the maturity date. The holder may exercise put option in part or in full. In riding interest rate scenario, the bond holder may sell a bond with low coupon rate and switch over to a bond that offers higher coupon rate. Consequently, the issuer will have to resell these bonds at lower prices to investors. Therefore, an increase in the interest rates poses additional risk to the issuer of bonds with put option (which are redeemed at par) as he will have to lower the re-issue price of the bond to attract investors.
(iii) Convertible Bonds The holder of a convertible bond has the option to convert the bond into equity (in the same value as of the bond) of the issuing firm (borrowing firm) on prespecified terms. This results in an automatic redemption of the bond before the maturity date. The conversion ratio (number of equity of shares in lieu of a convertible bond) and the conversion price (determined at the time of conversion) are pre-specified at the time of bonds issue. Convertible bonds may be fully or partly convertible. For the part of the convertible bond which is redeemed, the investor receives equity shares and the non-converted part remains as a bond.
DEBENTURES
A Debenture is a unit of loan amount. When a company intends to raise the loan amount from the public it issues debentures. A person holding debenture or debentures is called a debenture holder. A debenture is a document issued under the seal of the company. It is an acknowledgment of the loan received by the company equal to the nominal value of the debenture. It bears the date of redemption and rate and mode of payment of interest. A debenture holder is the creditor of the company. As per section 2(12) of Companies Act 1956, Debenture includes debenture stock, bond and any other securities of the company whether constituting a charge on the companys assets or not.
TYPES OF DEBENTURES
Debenture can be classified as under :
(a) First mortgage debentures : The holders of such debentures have a first claim on the assets charged.
(b) Second mortgage debentures : The holders of such debentures have a second claim on the assets charged.
(ii) Unsecured debentures : Debentures which do not carry any security with
regard to the principal amount or unpaid interest are called unsecured debentures. These are called simple debentures.
(i) Redeemable debentures : These are the debentures which are issued for a fixed
period. The principal amount of such debentures is paid off to the debenture holders
on the expiry of such period. These can be redeemed by annual drawings or by purchasing from the open market.
(ii) Non-redeemable debentures : These are the debentures which are not redeemed in
the life time of the company. Such debentures are paid back only when the company goes into liquidation.
payable only to those debenture holders whose name appears in the register of the company.
4. On the basis of convertibility (i) Convertible debentures : These are the debentures that can be converted
into shares of the company on the expiry of predecided period. The term and conditions of conversion are generally announced at the time of issue of debentures.
5. On the basis of priority (i) First debentures : These debentures are redeemed before other debentures. (ii) Second debentures : These debentures are redeemed after the redemption of
first debentures
TERM LOAN
Definition: A loan for equipment, real estate and working capital that's paid off like a mortgage for between one year and ten years Term loans are your basic vanilla commercial loan. They typically carry fixed interest rates, and monthly or quarterly repayment schedules and include a set maturity date. The range of funds typically available is $25,000 and greater.
they make full use of ownership-related benefits, such as depreciation, and should compare the cost with that leasing. The best use of a term loan is for construction; major capital improvements; large capital investments, such as machinery; working capital; purchases of existing businesses. Fortunately, the cost of such a loan is relatively inexpensive if the borrower can pass the financial litmus tests. Rates vary, making it worthwhile to shop, but generally run around 2.5 points over prime for loans of less than seven years and 3.0 points over prime for longer loans. Fees totaling up to 1 percent are common (though this varies greatly, too), with higher fees on construction loans. What do banks look for when making decisions about term loans? Well, the "five C's" continue to be of utmost importance.
Character. How have you managed other loans (business and personal)? What is your business experience?
Credit capacity. The bank will conduct a full credit analysis, including a detailed review of financial statements and personal finances to assess your ability to repay.
Collateral. This is the primary source of repayment. Expect the bank to want this source to be larger than the amount you're borrowing.
Capital. What assets do you own that can be quickly turned into cash if necessary? The bank wants to know what you own outside of the business-bonds, stocks, apartment buildings-that might be an alternate repayment source. If there is a loss, your assets are tapped first, not the bank's. Or, as one astute businessman puts it, "Banks like to lend to people who already have money." You will most likely have to add a personal guarantee to all of that, too.
Comfort/confidence with the business plan. How accurate are the revenue and expense projections? Expect the bank to make a detailed judgment. What is the condition of the economy and the industry--hot, warm or cold?
Mortgage
A mortgage is a secured lien or loan on residential property. The loan is secured by the associated property. More specifically, if the borrower fails to pay, the lender can take the property to fulfill the outstanding debt.
Lease
A lease is an agreement between an owner of property and a tenant or renter. A lease is a type of loan instrument because it secures a regular rent payment from the tenant to the owner, thereby creating a secured long-term debt.
Issuer of the instrument Face value of the instrument Interest rate Repayment terms (and therefore maturity period/tenor) Security or collateral provided by the issuer
Government Securities
It is the Reserve Bank of India that issues Government Securities or G-Secs on behalf of the Government of India. These securities have a maturity period of 1 to 30 years. G-Secs offer fixed interest rate, where interests are payable semi-annually. For shorter term, there are Treasury Bills or T-Bills, which are issued by the RBI for 91 days, 182 days and 364 days.
Greater safety and lower volatility as compared to other financial instruments. Variations possible in the structure of instruments like Index linked Bonds, STRIPS Higher leverage available in case of borrowings against G-Secs. No TDS on interest payments Tax exemption for interest earned on G-Secs. up to Rs.3000/- over and above the limit of Rs.12000/- under Section 80L (as amended in the latest Budget). Greater diversification opportunities Adequate trading opportunities with continuing volatility expected in interest rates the world over
Corporate Bonds
These bonds come from PSUs and private corporations and are offered for an extensive range of tenures up to 15 years. There are also some perpetual bonds. Comparing to G-Secs, corporate bonds carry higher risks, which depend upon the corporation, the industry where the corporation is currently operating, the current market conditions, and the rating of the corporation. However, these bonds also give higher returns than the G-Secs.
averse, you would view this as a disadvantage of corporate bonds. This is where the biggest difference between corporate and government bonds lies. Government bonds are considered to be the safest investments having basically no risk that the government will default on its loans. On the other hand, corporations can and do go bankrupt. Because of this, corporate bonds are considered riskier than government bonds. Because bonds are a fixed investment, they may not offer protection against inflation changes within an economy. If the interest rates on a bond investment are low and inflation increases more than average or expected, the investor has the potential to lose purchasing power within their portfolio. The prices of bonds are affected by fluctuations in interest rates within the economy. Bond prices move inversely to interest rates; when interest rates rise, bond rates fall and vice versa. Some bonds are callable, meaning that the Issuer can redeem the bonds issued. This is common when interest rates decline, making it more favorable for the Issuer to refinance their debts. If this occurs, the investor would be forced to redeem their bond and replace it with a new one that potentially would have lower coupon rates. For an investor who is relying on this income for their lifestyle, this can be a substantial disadvantage.
Certificate of Deposit
These are negotiable money market instruments. Certificate of Deposits (CDs), which usually offer higher returns than Bank term deposits, are issued in demat form and also as a Usance Promissory Notes. There are several institutions that can issue CDs. Banks can offer CDs which have maturity between 7 days and 1 year. CDs from financial institutions have maturity between 1 and 3 years. There are some agencies like ICRA, FITCH, CARE, CRISIL etc. that offer ratings of CDs. CDs are available in the denominations of Rs. 1 Lac and in multiple of that.
CDs typically offer a higher rate of interest than Treasury bills and savings account due to the higher risk associated with them. As the rate of interest is fixed, your return on investment is ensured despite the rate fluctuations in the market. CDs are insured by Federal Deposit Insurance Corporation and hence are a good investment option for single income households and retired folks. CDs are a risk-free investment. The return on CDs is assured and helps in financial planning. Its very easy to set up a CD. One needs to just walk to their local bank and request for purchase of CD. Money from the existing savings account will be ear-marked against the CD that has been purchased. The only thing to be made sure that the bank is FDIC ensured. CDs can be purchased and sold through a brokerage firm. This way you can encash the CD before the maturity term without paying the penalty.
Money is tied down for long durations of time. Though the investor can withdraw money, he has to generally incur penalty in terms of some amount of loss of interest on the deposit amount. You can get a waiver on the penalty in case of special circumstances like disability, death or retirement. As the rate of interest is fixed, it is difficult to change or to take advantage of the market situation when the market rates are favorable. You will not be able to get an interest rate that favors inflation. Though the return rate is higher on CDs than savings account, it is much lower than other money market instruments where you can make possible investments.
Commercial Papers
In the global money market, commercial paper is a unsecured promissory note with a fixed maturity of 1 to 270 days. Commercial Paper is a money-market security issued (sold) by large banks and corporations to get money to meet short term debt obligations (for example, payroll), and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value, and carries higher interest repayment dates than bonds. Typically, the longer the maturity on a note, the higher the interest rate the issuing institution must pay. Interest rates fluctuate with market conditions, but are typically lower than banks' ratesThere are short term securities with maturity of 7 to 365 days. CPs are issued by corporate entities at a discount to face value.
High credit ratings fetch a lower cost of capital. Wide range of maturity provide more flexibility. It does not create any lien on asset of the company. Tradability of Commercial Paper provides investors with exit options.
Its usage is limited to only blue chip companies. Issuances of Commercial Paper bring down the bank credit limits. A high degree of control is exercised on issue of Commercial Paper. Stand-by credit may become necessary
Non-Convertible Debentures
Non-convertible debentures, which are simply regular debentures, cannot be converted into equity shares of the liable company. They are debentures without the convertibility feature attached to them. As a result, they usually carry higher interest rates than their convertible counterparts.
The bond holder meeting decides common concerns of bond holders and expresses opinions on problem issues that may affect setting up claims to a bond, especially on suggestions of changes in terms of bond emission conditions, on suggestions regarding: issuer exchanges, issuer takeover bids by another subject, conclusions of a contract to control a company or contracts on the profit transfer, a sale of a company, a hire of a company or its part - all this in the meaning of a Commercial Code; further on suggestions regarding a bond programme, however also on problem issues of a common process providing a bond issuer delays in discharging the bond engagements. If a bond holder meeting does not agree on any of the suggestions, they can decide an issuer obligation to pay back bond holders a nominal bond value or an emission rate (in case of zero coupon bonds) including a proportionate return. An issuer must do so before one-month time from the date of this decision at the very latest.
Convertible bonds are usually issued offering a higher yield than obtainable on the shares into which the bonds convert. Convertible bonds are safer than preferred or common shares for the investor. They provide asset protection, because the value of the convertible bond will only fall to the value of the bond floor. At the same time, convertible bonds can provide the possibility of high equity-like returns. Also, convertible bonds are usually less volatile than regular shares. Indeed, a convertible bond behaves like a call option. The simultaneous purchase of convertible bonds and the short sale of the same issuer's common stock is a hedge fund strategy known as convertible arbitrage. The motivation for such a strategy is that the equity option embedded in a convertible bond is a source of cheap volatility, which can be exploited by convertible arbitrageurs. In limited circumstances, certain convertible bonds can be sold short, thus depressing the market value for a stock, and allowing the debt-holder to claim more stock with which to sell short. This is known as death spiral financing
To convert the debentures into shares, if these are new: They dont pass immediately through the quotations. The securities have a less quotation price due that temporarily they have lesser rights. They are less liquid, due that there is a lesser amount of them. You cant dispose of money soon due to the former explanation. Usually the type of interests that they offer is inferior to that of the ordinary debentures due that they offer the additional advantage of placing them as shares on the markets
1. Debt Instrument
Debt instruments are used to trade debt instruments. In other words, the business issues a debt instrument, and an investor buys it. In a specific period of time, the investor is paid back for the debt, along with interest. Interest rates and time frames can vary according to the instrument. Bonds are one of the most widely trade debt instruments on the debt instrument. Both large corporations and governments use the debt instrument to raise money or to change economic conditions.
2. Money Instrument
On the money instrument, equity is traded instead of debt. this instrument is more commonly known as the stock instrument. In the stock instrument, stocks are sold as securities that give investors the right to a certain amount of the company's earnings and assets. There are many different types of stock shares sold to different types of investors, but they do not exist as a debt to be paid off.
3. Business Differences
To the business, the difference between a money and debt instrument is important. Every bond that the business issues must be paid back over time--it is a loan, and the business is borrowing from investors. Eventually the loan comes due. Businesses should only sell bonds when they are confident they will have enough money in the future to meet their debt obligations. Stocks, on the other hand, do not incur debt, but they do divide ownership of the company among investors.
4. Holder Difference
To the investor holding the bond or stock, the difference deals mostly with the return on his investment. When an investor buys stock, he is buying ownership of the business and can claim the right to vote on matters the directors of the business decide. Investors do not have any ownership of the business when they buy bonds; they receive only an obligation from the business to repay the loan.
5. Risk
Traditionally, the debt instrument is more secure than the money instrument. Stock dividends can be reduced or suspended when a business suffers, but bond obligations must be paid as the contract stipulates. This also means that stocks have a greater chance for growth than bonds because their success depends on the success of the company.
Before roll over of any NCDs or non-convertible portion of the PCDs, fresh credit rating shall be obtained within a period of six months prior to the due date of redemption and communicated to debenture holders before roll over and fresh trust deed shall be made. Letter of information regarding roll over shall be vetted by SEBI with regard to the credit rating, debenture holder resolution, option for conversion and such other items, which SEBI may prescribe from time to time. The disclosures relating to raising of debentures will contain, amongst other things, the existing and future equity and long term debt ratio, servicing behavior on existing debentures, payment of due interest on due dates on terms loans and debentures, certificate from a financial institution or bankers about their no objection for a second or pari-passu charge being created in favour of the trustees to the proposed debenture issues. And any other additional disclosure requirement SEBI may prescribe from time to time. Most of the listing requirements are common for both equity and debt instruments in terms of disclosures with some additional provisions specified for the debt instruments. Until recently only infrastructure and municipal corporations could list debt before equity, subject to certain requirements. SEBI now permits listing of debt before equity subject to the condition that the debt instrument is rated not below a minimum rating of A or equivalent thereof.
RBI GUIDELINES
1. Short title and commencement of the directions
These directions may be called the Issuance of Non-Convertible Debentures (Reserve Bank) Directions, 2010 and they shall come into force with effect from August 02, 2010.
2. Definition
For the purposes of these Directions, Non-Convertible Debenture (NCD) means a debt instrument issued by a corporate (including NBFCs) with original or initial maturity up to one year and issued by way of private placement; Corporate means a company as defined in the Companies Act, 1956 (including NBFCs) and a corporation established by an act of any Legislature
the corporate has a tangible net worth of not less than Rs.4 crore, as per the latest audited balance sheet; the corporate has been sanctioned working capital limit or term loan by bank/s or all-India financial institution/s; and the borrowal account of the corporate is classified as a Standard Asset by the financing bank/s or institution/s.
4. Rating Requirement
4.1 An eligible corporate intending to issue NCDs shall obtain credit rating for issuance of the NCDs from one of the rating agencies, viz., the Credit Rating Information Services of India Ltd. (CRISIL) or the Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd or such other agencies registered with Securities and Exchange Board of India (SEBI) or such other credit rating agencies as may be specified by the Reserve Bank of India from time to time, for the purpose. 4.2 The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies. 4.3 The Corporate shall ensure at the time of issuance of NCDs that the rating so obtained is current and has not fallen due for review.
5. Maturity
5.1 NCDs shall not be issued for maturities of less than 90 days from the date of issue. 5.2 The exercise date of option (put/call), if any, attached to the NCDs shall not fall within the period of 90 days from the date of issue. 5.3 The tenor of the NCDs shall not exceed the validity period of the credit rating of the instrument.
6. Denomination
NCDs may be issued in denominations with a minimum of Rs.5 lakh (face value) and in multiples of Rs.1 lakh.
7.1 The aggregate amount of NCDs issued by a corporate shall be within such limit as may be approved by the Board of Directors of the corporate or the quantum indicated by the Credit Rating Agency for the rating granted, whichever is lower. 7.2 The total amount of NCDs proposed to be issued shall be completed within a period of two weeks from the date on which the corporate opens the issue for subscription.
9. Debenture Trustee
9.1 Every corporate issuing NCDs shall appoint a Debenture Trustee (DT) for each issuance of the NCDs. 9.2 Any entity that is registered as a DT with the SEBI under SEBI (Debenture Trustees) Regulations, 1993, shall be eligible to act as DT for issue of the NCDs only subject to compliance with the requirement of these Directions. 9.3 The DT shall submit to the Reserve Bank of India such information as required by it from time to time.
Investors (FIIs). 10.2 Investments in NCDs by Banks/PDs shall be subject to the approval of the respective regulators. 10.3 Investments by the FIIs shall be within such limits as may be set forth in this regard from time to time by the SEBI
12.7 The DTs shall report the information called for under para 12.4, 12.5 and 12.6 of these Directions as per the format notified by the Reserve Bank of India, Financial INSTRUMENTs Department, Central Office, Mumbai from time to time. (c) Credit Rating Agencies (CRAs) 12.8 Code of Conduct prescribed by the SEBI for the CRAs for undertaking rating of capital INSTRUMENT instruments shall be applicable to them (CRAs) for rating the NCDs. 12.9 The CRA shall have the discretion to determine the validity period of the rating depending upon its perception about the strength of the issuer. Accordingly, CRA shall, at the time of rating, clearly indicate the date when the rating is due for review. 12.10 While the CRAs may decide the validity period of credit rating, they shall closely monitor the rating assigned to corporates vis--vis their track record at regular intervals and make their revision in the ratings public through their publications and website.
CASE STUDY
CONCLUSION
For a developing economy like India, debt instruments are crucial sources of capital funds. The debt instrument in India is amongst the largest in Asia. It includes government securities, public sector undertakings, other government bodies, financial institutions, banks, and companies. An investor can invest in money market mutual funds for a period of as little as one day. Avenues are also available for investing for longer horizons according to your risk appetite. In conclusion, the ability of a continuously evolving and self-propelling enterprise is its ability to not only learn and adapt to changes and opportunities, but also to make full use of them as and when possible.
RECCOMENDATIONS:
Transparency - The markets functionality needs to be transparent both to the entity issuing the debt security, as also to the intermediary investing his money into it. Market unification and communication - The current market fragmentation has to be reduced. Trustworthy and transparent benchmarks - For a debt capital market to function efficiently, the existence of a credible benchmark is critical. In most markets, Government Treasury Notes play this role. It is common practice in most developing markets to use the US Treasuries as a global benchmark. Liquidity - Liquidity is perhaps one of the most important requirements for an efficient, developed capital market. Allowing banks to guarantee bonds would lower companies' funding costs and increase investor confidence in the bond market. Legal system - A functioning legal system that all parties have faith in is another critical component. Without a viable legal infrastructure in place, it is very difficult to create investor confidence vis--vis the risk attributes of debt securities. Macroeconomic stability - Investor confidence is guided by many factors, one of the most important of which is macroeconomic stability. Even with these additional reforms, India would have a long way to go. Its outstanding corporate debt is only 3.3 percent of its gross domestic product, vs. 10.6 percent in China. We have all hung in there in good times and bad. And it may not be too long a wait before the Indian debt market takes on all the proportions of an international debt market. The bottom line: India needs to develop a more robust corporate bond market if the government's $1 trillion infrastructure program is to succeed.
BIBLIOGRAPHY
Financial Accounting By Marian Powers Economic Times Times Of India Business Today www.rbi.org
www.economictimes.indiatimes.com
www.bseindia.com
References
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13. www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt.htm).