Bond market in india fis

Bond market in India

HISTORY

Towards the eighteenth century, the borrowing needs of Indian Princely States were largely
met by Indigenous bankers and financiers. The concept of borrowing from the public in India
was pioneered by the East India Company to finance its campaigns in South India (the Anglo
French wars) in the eighteenth century. The debt owed by the Government to the public,
over time, came to be known as public debt. The endeavors of the Company to establish
government banks towards the end of the 18th Century owed in no small measure to the
need to raise term and short term financial accommodation from banks on more satisfactory
terms than they were able to garner on their own.

Public Debt, today, is raised to meet the Governments revenue deficits (the difference
between the income of the government and money spent to run the government) or to
finance public works (capital formation). Borrowing for financing railway construction and
public works such irrigation canals was first undertaken in 1867. The First World War saw a
rise in India's Public Debt as a result of India's contribution to the British exchequer towards
the cost of the war. The provinces of British India were allowed to float loans for the first time
in December, 1920 when local government borrowing rules were issued under section 30(a)
of the Government of India Act, 1919. Only three provinces viz., Bombay, United Provinces
and Punjab utilised this sanction before the introduction of provincial autonomy. Public Debt
was managed by the Presidency Banks, the Comptroller and Auditor-General of India till
1913 and thereafter by the Controller of the Currency till 1935 when the Reserve Bank
commenced operations.

Interest rates varied over time and after the uprising of 1857 gradually came down to about
5% and later to 4% in 1871. In 1894, the famous 3 1/2 % paper was created which continued
to be in existence for almost 50 years. When the Reserve Bank of India took over the
management of public debt from the Controller of the Currency in 1935, the total funded debt
of the Central Government amounted to Rs 950 crores of which 54% amounted to sterling
debt and 46% rupee debt and the debt of the Provinces amounted to Rs 18 crores.

Broadly, the phases of public debt in India could be divided into the following phases.

Upto 1867: when public debt was driven largely by needs of financing campaigns.

1867- 1916: when public debt was raised for financing railways and canals and other such
purposes.

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

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

1947-1951: represented the interregnum following war and partition and the economy was
unsettled. Government of India failed to achieve the estimates for borrwings for which credit
had been taken in the annual budgets.

1951-1985: when borrowing was influenced by the five year plans.

1985-1991: when an attempt was made to align the interest rates on government securities
with market interest rates in the wake of the recommendations of the Chakraborti Committee
Report.

1991 to date: When comprehensive reforms of the Government Securities market were
undertaken and an active debt management policy put in place. Ad Hoc Treasury bills were
abolished; commenced the selling of securities through the auction process; new
instruments were introduced such as zero coupon bonds, floating rate bonds and capital
indexed bonds; the Securities Trading Corporation of India was established; a system of
Primary Dealers in government securities was put in place; the spectrum of maturities was
broadened; the system of Delivery versus payment was instituted; standard valuation norms
were prescribed; and endeavours made to ensure transparency in operations through
market process, the dissemination of information and efforts were made to give an impetus
to the secondary market so as to broaden and deepen the market to make it more efficient.
In India and the world over, Government Bonds have, from time to time, have not only
adopted innovative methods for rasing resources (legalised wagering contracts like the Prize
Bonds issued in the 1940s and later 1950s in India) but have also been used for various
innovative schemes such as finance for development; social engineering like the abolition of
the Zamindari system; saving the environment; or even weaning people away from gold (the
gold bonds issued in 1993).
Normally the sovereign is considered the best risk in the country and sovereign paper sets
the benchmark for interest rates for the corresponding maturity of other issuing entities.
Theoretically, others can borrow at a rate above what the Government pays depending on

how their risk is perceived by the markets. Hence, a well developed Government Securities
market helps in the efficient allocation of resources. A country‟s debt market to a large extent
depends on the depth of the Government‟s Bond Market. It in in this context that the recent
initiatives to widen and deepen the Government Securities Market and to make it more
efficient have been taken.

INTRODUCTION

Traditionally, the capital markets in India are more synonymous with the equity markets –
both on account of the common investors‟ preferences and the oft huge capital gains it
offered – no matter what the risks involved are. The investor‟s preference for debt market, on
the other hand, has been relatively a recent phenomenon – an outcome of the shift in the
economic policy, whereby the market forces have been accorded a greater leeway in
influencing the resource allocation.

In a developing economy such as India, the role of the public sector and its financial
requirements need no emphasis. Growing fiscal deficits and the policy stance of “directed
investment” through statutory pre emption (the statutory liquidity ratio – SLR - for banks),
ensured a captive but passive market for the Government securities. Besides, participation
of the Reserve Bank of India (RBI) as an investor in the Government borrowing programme
(monetisation of deficits) led to a regime of financial repression. In an eventual administered
interest rate regime, the asset liability mismatches pose no threat to the balance sheets of
financial institutions. As a result, the banking system, which is the major holder of the
Government securities portfolio, remained a dominant passive investor segment and the
market remained dormant.

The Indian Bond Market has been traditionally dominated by the Government securities
market. The reasons for this are

· The high and persistent government deficit and the need to promote an efficient government
securities market to finance this deficit at an optimal cost,

· A captive market for the government securities in the form of public sector banks which are
required to invest in government securities a certain per cent of deposit liabilities as per
statutory requirement1,

· The predominance of bank lending in corporate financing and

· Regulated interest rate environment that protected the banks‟ balance sheets on account of
their exposure to the government securities.

While these factors ensured the existence of a big Government securities market, the market
was passive with the captive investors buying and holding on to the government securities till
they mature. The trading activity was conspicuous by its absence.

The scenario changed with the reforms process initiated in the early nineties. The gradual
deregulation of interest rates and the Government‟s decision to borrow through auction
mechanism and at market related rates

DEBT MARKET

Debt market as the name suggests is where debt instruments or bonds are traded. The most
distinguishing feature of these instruments is that the return is fixed i.e. they are as close to
being risk free as possible, if not totally risk free. The fixed return on the bond is known as
the interest rate or the coupon rate. Thus, the buyer of a bond gives the seller a loan at a
fixed rate, which is equal to the coupon rate. Debt Markets are therefore, markets for fixed
income securities issued by:

· Central and State Governments
· Municipal Corporations
· Entities like Financial Institutions, Banks, Public Sector Units, and Public Ltd. companies.

The money market also deals in fixed income instruments. However, difference between
money and bond markets is that the instruments in the bond markets have a larger time to
maturity (more than one year). The money market on the other hand deals with instruments
that have a lifetime of less than one year.

Segments of Debt Markets

There are three main segments in the debt markets in India,

· Government Securities,
· Public Sector Units (PSU) bonds and
· Corporate securities.

The market for Government Securities comprises the Centre, State and State-Sponsored
securities. The PSU bonds are generally treated as surrogates of sovereign paper,
sometimes due to explicit guarantee and often due to the comfort of public ownership. Some
of the PSU bonds are tax free while most bonds, including government securities are not tax
free. The Government Securities segment is the most dominant among these three
segments. Many of the reforms in pre-1997 period were fundamental, like introduction of
auction systems and PDs. The reform in the Government Securities market which began in
1992, with Reserve Bank playing a lead role, entered into a very active phase since April
1997, with particular emphasis on development of secondary and retail markets

MARKET STRUCTURE

There is no single location or exchange where debt market participants interact for common
business. Participants talk to each other, conclude deals, send confirmations etc. on the
telephone, with clerical staff doing the running around for settling trades. In that sense, the
wholesale debt market is a virtual market.
In order to understand the entirety of the wholesale debt market we have looked at it through
a framework based on its main elements. The market is best understood by understanding
these elements and their mutual interaction. These elements are as follows:

· Instruments - the instruments that are being traded in the debt market.
· Issuers - entity which issue these instruments.
· Investors - entities which invest in these instruments or trade in these instruments.
· Interventionists or Regulators - the regulators and the regulations governing the market.

It is necessary to understand microstructure of any market to identify processes, products
and issues governing its structure and development. In this section a schematic presentation
is attempted on the micro-structure of Indian corporate debt market so that the issues are
placed in a proper perspective. Figure gives a bird‟s eye view of the Indian debt market
structure.

Participants

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

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

corporate, individuals, non-resident Indians and overseas corporate bodies. Foreign
institutional investors are permitted to invest in Treasury Bills and dated Government
Securities in both primary and secondary markets.

Often, the same participants are present in the non-Government debt market also, either as
issuers or investors. For example, banks are issuers in the debt market for their Tier-II
capital. On the other hand, they are investors in PSU bonds and corporate securities.
Foreign Institutional Investors are relatively more active in non-Government debt segment as
compared to the Government debt segment.

· Central Governments, raising money through bond issuances, to fund budgetary deficits
and other short and long term funding requirements.

· Reserve Bank of India, as investment banker to the government, raises funds for the
government through bond and t-bill issues, and also participates in the market through open-
market operations.

· Primary Dealers, who are market intermediaries appointed by the Reserve Bank of India
who underwrite and make market in government securities, and have access to the call
markets and repo markets for funds.

· State Governments, municipalities and local bodies, which issue securities in the debt
markets to fund their developmental projects, as well as to finance their budgetary deficits.

· Public Sector Units are large issuers of debt securities, for raising funds to meet the long
term and working capital needs. These corporations are also investors in bonds issued in the
debt markets.

· Public Sector Financial Institutions regularly access debt markets with bonds for funding
their financing requirements and working capital needs. They also invest in bonds issued by
other entities in the debt markets.

· Banks are the largest investors in the debt markets, particularly the treasury bond and bill
markets. They have a statutory requirement to hold a certain percentage of their deposits
(currently the mandatory requirement is 24% of deposits) in approved securities

· Mutual Funds have emerged as another important player in the debt markets, owing
primarily to the growing number of bond funds that have mobilized significant amounts from
the investors.

· Foreign Institutional Investors FIIs can invest in Government Securities upto US $ 5
billion and in Corporate Debt up to US $ 15 billion.

· Provident Funds are large investors in the bond markets, as the prudential regulations
governing the deployment of the funds they mobilise, mandate investments pre-dominantly
in treasury and PSU bonds. They are, however, not very active traders in their portfolio, as
they are not permitted to sell their holdings, unless they have a funding requirement that
cannot be met through regular accruals and contributions.

· Corporate treasuries issue short and long term paper to meet the financial requirements of
the corporate sector. They are also investors in debt securities issued in the debt market.

· Charitable Institutions, Trusts and Societies are also large investors in the debt markets.
They are, however, governed by their rules and byelaws with respect to the kind of bonds
they can buy and the manner in which they can trade on their debt portfolios.

DEBT MARKET INSTRUMENTS

The instruments traded can be classified into the following segments based on the
characteristics of the identity of the issuer of these securities

Commercial Paper (CP): They are primarily issued by corporate entities. It is compulsory
for the issuance of CPs that the company be assigned a rating of at least P1 by a recognized
credit rating agency. An important point to be noted is that funds raised through CPs do not

represent fresh borrowings but are substitutes to a part of the banking limits available to
them.

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

Treasury Bills (T-Bills): T-Bills are issued by the RBI at the behest of the Government of
India and thus are actually a class of Government Securities. Presently T-Bills are issued in
maturity periods of 91 days, 182 days and 364 days. Potential investors have to put in
competitive bids. Non-competitive bids are also allowed in auctions (only from specified
entities like State Governments and their undertakings, statutory bodies and individuals)
wherein the bidder is allotted T-Bills at the weighted average cut off price.

Long-term debt instruments: These instruments have a maturity period exceeding 1year.
The main instruments are Government of India dated securities (GOISEC), State
Government securities (state loans), Public Sector Undertaking bonds (PSU bonds) and
corporate bonds/debenture. Majority of these instruments are coupon bearing i.e. interest
payments are payable at pre specified dates.

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

State Government Securities (state loans): Although these are issued by the State
Governments, the RBI organizes the process of selling these securities. The entire process,
17 right from selling to auction allotment is akin to that for GOISECs. They also form a part
of the SLR requirements and interest payment and other modalities are analogous to
GOISECs. Although there is no Central Government guarantee on these loans, they are
believed to be exceedingly secure. One important point is that the coupon rates on state

oans are slightly higher than those of GOISECs, probably denoting their sub-sovereign
status.

Public Sector Undertaking Bonds (PSU Bonds): These are long-term debt instruments
issued generally through private placement. The Ministry of Finance has granted certain
PSUs, the right to issue tax-free bonds. This was done to lower the interest cost for those
PSUs who could not afford to pay market determined interest rates.

Bonds of Public Financial Institutions (PFIs): Financial Institutions are also allowed to
issue bonds, through two ways - through public issues for retail investors and trusts and
secondly through private placements to large institutional investors.

Corporate debentures: These are long-term debt instruments issued by private companies
and have maturities ranging from 1 to 10 years. Debentures are generally less liquid as
compared to PSU bonds.

TERMS IN DEBT MARKET

An individual must be aware about the following terms associated with Government
Securities:

· Coupon: The 'Coupon' denotes the rate of interest payable on the security. E.g. a security
with a coupon of 7.40% would draw an interest of 7.40% on the face value.

· Interest Payment Dates (IP dates): The dates on which the coupon (interest) payments
are made are called as the IP dates.

· Last Interest Payment Date (LIP Date): LIP date refers to the date on which the interest
was last paid.

· Accrued Interest: Accrued interest is the interest charged at the coupon rate from the Last
Interest Payment to the date of settlement. Accrued Interest for a security depends upon its
coupon rate and the number of days from its LIP date to the settlement date.

· Day count convention: The market uses quite a few conventions for calculation of the
number of days that has elapsed between two dates. The ultimate aim of any convention is
to calculate (days in a month)/(days in a year). The Fixed Income Instruments in India 18/90

conventions used are as below. We take the example of a bond with Face Value 100,
coupon 12.50%, last coupon paid on 15th June, 2008 and traded for value 5th October,
2008.

– A/360(Actual by 360) :In this method, the actual number of days elapsed between the two
dates is divided by 360, i.e. the year is assumed to have 360 days.

– A/365 (Actual by 365) :In this method, the actual number of days elapsed between the two
dates is divided by 365, i.e. the year is assumed to have 365 days.

– A/A (Actual by Actual): In this method, the actual number of days elapsed between the
two dates is divided by the actual days in the year.

– 30/360-Day Count: A 30/360-day count says that all months consist of 30 days. i.e. the
month of February as well as the month of March is assumed to have thirty days.

· Yield: Yield is the effective rate of interest received on a security. It takes into consideration
the price of the security and hence differs as the price changes, since the coupon rate is
paid on the face value and not the price of purchase. The concept can be best understood
by the following example:

Ø A security with a coupon of 7.40%:
Ø If purchased at Rs. 100 the yield will be 7.40%
Ø If purchased at Rs. 200 the yield becomes 3.70%.
Ø If purchased at Rs. 50 the yield becomes 14.80%
Ø Thus it is seen that higher the price lesser will be the yield and vice-versa.
Ø The yield will be equal to the coupon rate if and only if the security is purchased at the
face value (Par).

· Yield to Maturity (YTM): YTM implies the effective rate of interest received if one holds the
security till its maturity. This is a better parameter to see the effective rate of return as YTM
also takes into consideration the time factor.

· Holding Period Yield (HPY): HPY comes into the picture when an investor does not hold
the security till maturity. HPY denotes the effective Fixed Income Instruments in India 19/90
yield for the period from the date of purchase to the date of sale.

· Clean Price: Clean Price denotes the actual price of the security as determined by the
market.

· Dirty Price: Dirty Price is the price that is obtained when the accrued interest is added to
the Clean Price.

· Shut Period: The government security pays interest twice a year. This interest is paid on
the IP dates. One working day prior to the IP date, the security is not traded in the market.
This period is referred to as the 'Shut Period'.

· Face Value: The Face Value of the securities in a transaction is the number of Government
Security multiplied by Rs.100 (face Value of each Government Security). Say, a transaction
of 5000 Government Security will imply a face value of Rs. 5,00,000 (i.e. 5000 * 100)

· "Cum-Interest" and "Ex-Interest”: Cum-interest means the price of security is inclusive of
the interest accrued for the interim period between last interest payment date and purchase
date. Security with ex-interest means the accrued interest has to be paid separately

· Trade Value: The Trade Value is the number of Government Security multiplied by the price
of each security.

Primary and Satellite Dealers: Primary Dealers can be referred to as Merchant Bankers to
Government of India, comprising the first tier of the government securities market. They
were formed during the year 1994-96 to strengthen the market infrastructure.PDs are
expected to absorb government securities in primary markets, to provide two-way quotes in
the secondary market and help develop the retail market. The capital adequacy
requirements of PDs take into account both credit risk and market risk. They are required to
maintain a minimum capital of 15 per cent of aggregate risk weighted assets, including
market risk capital (arrived at using the Value at Risk method). ALM discipline has been
extended to PDs. RBI is also vested with the responsibility of on-site supervision of PDs.
PDs have now been brought under the purview of the Board for Financial Supervision. The
satellite dealer system was introduced in 1996 to act as a second tier to the Primary Dealers
in developing the market particularly the retail segment. The system which was in operation
for more than six years was discontinued because it did not yield the desired results.

SIZE OF DEBT MARKET

Worldwide debt markets are three to four times larger than equity markets. However, the
debt market in India is very small in comparison to the equity market. This is because the
domestic debt market has been deregulated and liberalized only recently and is at a
relatively nascent stage of development. The debt market in India is comprised of two main
segments, the Government securities market and the corporate securities market.
Government securities form the major part of the debt market-accounting for about 90-95%
in terms of outstanding issues, market capitalization and trading value. In the last few years
there has been significant growth in the Government securities market. The aggregate
trading volumes of Government securities in the secondary market have grown significantly
from 1998-99 to 2008-09.

Turnover in the Government Securities Market (Face
Value)

GOI TURNOVER

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

In terms of size, the Indian debt market is the third largest in Asia after Japan and Korea. It,
however, fairs poorly when compared to other economies like the US and the Euro area.
The Indian debt market also lags behind in terms of the size of the corporate debt market.
The share of corporate debt in the total debt issued had in fact declined.

Market Capitalization - NSE-WDM Segment as on March 31,
2008

REGULATORS

The Securities Contracts Regulation Act (SCRA) defines the regulatory role of various
regulators in the securities market. Accordingly, with its powers to regulate the money and

Government securities market, the RBI regulates the money market segment of the debt
products (CPs, CDs) and the Government securities market. The non Government bond
market is regulated by the SEBI. The SEBI also regulates the stock exchanges and hence
the regulatory overlap in regulating transactions in Government securities on stock
exchanges have to be dealt with by both the regulators (RBI and SEBI) through mutual
cooperation. In any case, High Level Co-ordination Committee on Financial and Capital
Markets (HLCCFCM), constituted in 1999 with the Governor of the RBI as Chairman, and
the Chiefs of the securities market and insurance regulators, and the Secretary of the
Finance Ministry as the members, is addressing regulatory gaps and overlaps.

FACTORS AFFECTING MARKET

• Internal Factors
– Interest rate movement in the system
– RBI economic policies
– Demand for money
– Government borrowings to tide over its fiscal deficit
– Supply of money
– Inflation rate
– Credit quality of the issuer.

• External Factors
– World Economy & its impact
– Foreign Exchange
– Fed rate cut
– Crude Oil prices
– Economic Indicators

BENEFITS OF INVESTING IN A DEBT MARKET

· Safety: The Zero Default Risk is the greatest attraction for investments in Government
Securities. It enjoys the greatest amount of security possible, as the Government of India
issues it. Hence they are also known as Gilt-Edged Securities or 'Gilts'.

· Fixed Income: During the term of the security there is likely to be fluctuations in the
Government Security prices and thus there exists a price risk associated with investment in
Government Security. However, the return on the holding of investment is fixed if the

security is held till maturity and the effective yield at the time of purchase is known and
certain. In other words the investment becomes a fixed income investment if the buyer holds
the security till maturity.

· Convenience: Government Securities do not attract deduction of tax at source (TDS) and
hence the investor having a non-taxable gross income need not file a return only to obtain a
TDS refund.

· Simplicity: To buy and sell Government Securities all an individual has to do is call his / her
Broker and place an order. If an individual does not trade in the Equity markets, he / she has
to open a demat account and then can commence trading through any broker.

· Liquidity: Government Security when actively traded on exchanges will be highly liquid,
since a national trading platform is available to the investors.

· Diversification Government Securities are available with a tenor of a few months up to 30
years. An investor then has a wide time horizon, thus providing greater diversification
opportunities

DEVELOPMENTS IN MARKET INFRASTRUCTURE:

Securities Settlement System: Settlement of government securities and funds is being
done on a gross trade-by-trade Delivery vs. Payments (DvP) basis in the books of Reserve
Bank, since 1995. A Special Funds Facility from Reserve Bank for securities settlement has
also been in operation since October 2000 for breaking gridlock situations arising in the
course of DvP settlement.

With the introduction of Clearing Corporation of India Ltd (CCIL) in February 2002, which
acts as clearing house and a central counterparty, the problem of gridlock of settlements has
been reduced. To enable Constituent Subsidiary General Ledger (CSGL) account holders to
avail of the benefits of dematerialised holding through their bankers, detailed guidelines have
been issued to ensure that entities providing custodial services for their constituents employ
appropriate accounting practices and safekeeping procedures.

Negotiated Dealing System: A Negotiated Dealing System (NDS) (Phase I) has been
operationalised effective from February 15, 2002. In Phase I, the NDS provides on line
electronic bidding facility in primary auctions, daily LAF auctions, screen based electronic
dealing and reporting of transactions in money market instruments, facilitates secondary

market transactions in Government securities and dissemination of information on trades
with minimal time lag. In addition, the NDS enables "paperless" settlement of transactions in
government securities with electronic connectivity to CCIL and the DvP settlement system at
the Public Debt Office through electronic SGL transfer form.

Clearing Corporation of India Limited:The Clearing Corporation of India Limited (CCIL)
commenced its operations in clearing and settlement of transactions in Government
securities (including repos) with effect from February 15, 2002. Acting as a central
counterparty through novation, the CCIL provides guaranteed settlement and has in place
risk management systems to limit settlement risk and operates a settlement guarantee fund
backed by lines of credit from commercial banks. All repo transactions have to be
necessarily put through the CCIL, while all outright transactions up to Rs.200 million have to
be settled through CCIL (Transactions involving larger amounts are settled directly in RBI).

Transparency and Data Dissemination : To enable both institutional and retail investors to
plan their investments better and also to providing further transparency and stability in the
Government securities market, an indicative calendar for issuance of dated securities has
been introduced in 2002. To improve the information flow to the market Reserve Bank
announces auction results on the day of auction itself and all transactions settled through
SGL accounts are released on the same day by way of press releases/on RBI website.
Statistical information relating to both primary and secondary market for Government
securities is disseminated at regular interval to ensure transparency of debt management
operations as well as of secondary market activity. This is done through either press
releases or Bank‟s publications viz., (e.g., RBI monthly Bulletin, Weekly Statistical
Supplement, Handbook of Statistics on Indian Economy, Report on Currency and Finance
and Annual Report).

Fixed Income Auction

INTRODUCTION

The Government of India issues securities in order to borrow money from the market. One
way in which the securities are offered to investors is through auctions. The government
notifies the date on which it will borrow a notified amount through an auction. The investors
bid either in terms of the rate of interest (coupon) for a new security or the price for an
existing security being reissued. Since the process of bidding is somewhat technical, only
the large and informed investors, such as, banks, primary dealers, financial institutions,
mutual funds, insurance companies, etc generally participate in the auctions. This left out a

large section of medium and small investors from the primary market for government
securities which is not only safe and secure but also gives market related rates of return.

The Reserve Bank of India has announced a facility of non-competitive bidding in dated
government securities on December 7th 2001 for small investors.

NON-COMPETITIVE BIDDING

Non-competitive bidding means the bidder would be able to participate in the auctions of
dated government securities without having to quote the yield or price in the bid. Thus, he
will not have to worry about whether his bid will be on or off-the-mark; as long as he bids in
accordance with the scheme, he will be allotted securities fully or partially.

Participation

Participation in the Scheme of non-competitive bidding is open to individuals, HUFs, firms,
companies, corporate bodies, institutions, provident funds, trusts and any other entity
prescribed by RBI. As the focus is on the small investors lacking market expertise, the
Scheme will be open to those who do not have current account (CA) or Subsidiary General
Ledger (SGL) account with the Reserve Bank of India do not require more than Rs.one crore
(face value) of securities per auction

As an exception, Regional Rural Banks (RRBs), Urban Cooperative Banks (UCBs) and Non-
banking Financial Companies (NBFCs) can also apply under this Scheme in view of their
statutory obligations. However, the restriction in regarding the maximum amount of Rs. one
crore per auction per investor will remain applicable.

Silent Features

· Eligible investors cannot participate directly. They have to necessarily come through a
Bank or Primary Dealer (PD) for auction.
· The minimum amount for bidding will be Rs.10,000 (face value) and in multiples in
Rs.10,000.
· An investor can make only a single bid through any bank or PD under this scheme in each
specified auction.
· The bank or PD through whom the investor bids will obtain and keep on record an
undertaking to the effect that the investor is making only a single bid.

Advantages

The non competitive bidding facility will encourage wider participation and retail holding of
government securities. It will enable individuals , firms and other mid segment investors who
do not have the expertise to bid competitively in the auctions. Such investors will have fair
chance of assured allotments at the rate which emerges in the auction.
Scope of the scheme

· Non-competitive bids will be allowed upto 5 percent of the notified amount in the specified
auctions of dated securities.

· Non-competitive bidding will be allowed only in select auctions of dated Government of
India securities which will be announced as and when proposed to be issued.

· The scheme is not applicable for Treasury Bills.

Auction Process

· Each bank or PD will, on the basis of firm orders, submit a single bid for the aggregate
amount of non-competitive bids on the day of the auction. The bank or PD will furnish details
of individual customers, viz., name, amount, etc. along with the application.

· This will be notified at the time of announcement of the specific auction for which non
competitive bids will be invited.

· The Government of India notifies the auction of government securities. It also notifies the
amount and whether it will be a new loan or reissue of an existing loan. It also announces
whether the bidders have to bid for the price or the coupon (interest rate).The competitive
bidders put in competitive bids for the price or the coupon. The cutoff price or the coupon is
then announced by RBI on the basis of the bids received. All successful bidders will be
allotted the security auctioned either in full or in part.

Example
Recently, an auction was held for government of India's 12 year Government Stock in which
the notified amount was Rs.5,000 crore. The coupon rate for cut-off yield was 8.40 per cent.
The weighted average yield was, however, 8.36 per cent since allotments were made to

different successful bidders at the rates quoted by them at or below the cut off rates (i.e.
multiple price auction system).

· The allotment to the non-competitive segment will be at the weighted average rate that will
emerge in the auction on the basis of competitive bidding.

Allotment Process

· The RBI will allot the bids under the non-competitive segment to the bank or PD which, in
turn, will allocate to the bidders.

· In case the aggregate amount bid is more than the reserved amount through non-
competitive bidding, allotment would be made on a pro rata basis.

Example:
Suppose, the amount reserved for allotment in non competitive basis is 10 crore. The total
amount bid at the auction for Non competitive segment is 12 crore. The partial allotment
percentage is =10/12=83.33%. The actual allocation in the auction will be as follows:

· It may be noted that the actual allotment may vary slightly at times from the partial
allotment ratio due to rounding off with a view to ensuring that the allotted amounts are in
multiples of 10,000/-.

· In case the aggregate amount bid is less than the reserved amount all the applicants will be
allotted in full and the shortfall amount will be taken to the competitive portion.

· It will be responsibility of the bank or PD to appropriately allocate securities to their clients
in a transparent manner.

Settlement Process

· In the above example, where the auction was yield based, the cut off rate that emerged in
the auction was 8.40 per cent; while the weighted average cut off rate was 9.36 per cent. At
the weighted average rate of 8.36 per cent the price of the security works out to Rs.100.27.
Therefore, under the Scheme, the investor will get the security at Rs.100.27. Hence, price
payable for every Rs.100 (face value) is Rs. 100.27. Therefore, for securities worth
Rs.10,000, he will have to pay (Price x Face value/100) = 100.27 x 10,000/100=Rs.10,270/-

· Since the bank/PD has to make payment on the date of issue itself , in case payment is
made by the client after date of issue of the security, the consideration amount payable by
the client to the bank or the PD would include accrued interest. For example, if for security
8.40% GOI 2022, the payment is made three days after the date of issue, the accrued
interest component will amount to 8.40/100x3/360x10,000 = Rs.7.83. Hence, if the security
price is Rs.100.27, the total amount payable by the investor for acquiring securities worth
Rs.10,000 after three days will be Rs. 10, 270 + Rs. 7.83 = Rs.10, 277. 83 (if not rounded
off).

· The non competitive bidders will pay the weighted average price which will emerge in the
auction.

· For example, on December 5, 2009 RBI held a price based auction of an existing security
8.20% GOI 2022 maturing on 19 April, 2022. The cut off price emerged in the auction was
Rs. 100.62. The weighted average price was Rs. 100.69. Thus the non competitive bidders
will pay the weighted average price of Rs. 100.69. In addition, they have to pay accrued
interest as indicated below.

· Price payable for every Rs.100 (face value) is Rs.100.69. Therefore, for securities worth
Rs.10,000, he will have to pay (Price x Face value/100) = 100.69 x 10,000/100=Rs.10,069/-.
Since the coupon on dated GOI securities are payable half yearly, the coupon payment
dates for the security are 19 April/ 19 October. Now if the security was paid for (settled) on
December 6, 2009, the accrued interest from the last coupon date to the date of settlement
viz. from 19 October, 2009 to December 6, 2009, i.e. for 47 days will be 8.22/100 x
47/360x10000=Rs 107.31

· Hence, the amount payable by the investor will be price plus accrued interest, i.e. Rs
10069 + 107.31 = 10,176.31/- (if not rounded off). If the payment is not made on December
6, 2009 but, say, on December 9, 2009, the accrued interest component will be for 50 days

instead of 47 days (i.e.3 days more) and it will work out to 8.22/100x50/360
x10,000=Rs.114.16 .The total amount payable by the investor will then be 10069 + 114.16
=10,183.16/-(if not rounded off)

· The transfer of securities to the clients should be completed within five working days from
the date of the auction. Delivery and Form of Holding.

· RBI will issue securities only in demat (SGL) form. It will credit the securities to the CSGL
account of the bank/PD.

· SGL or CSGL are a demat form of holding government securities with the RBI. Just as an
investor can hold shares in demat form with a depository participant, he can also hold
government securities in an account with a bank or a PD. Securities kept on behalf of
customers by banks or PDs are kept in a segregated CSGL A/c with the RBI. Thus, if the
bank or the PD buys security for his client, it gets credited to the CSGL account of bank or
PD with the RBI.

· It will not be mandatory for the retail investor to maintain a constituent subsidiary general
ledger (CSGL) account with a bank or a primary dealer (PD) through whom it proposes to
participate in the auction. It will, however, be convenient for the investor to have such an
account.

· RBI will issue the securities to the bank or PD that has bid on behalf of non-competitive
bidder against payment made by the bank or PD on the date of issue itself.

· The non-competitive bidder will make payment to the bank or the PD through which he has
put the bid and receive his securities from them.

· In other words, the RBI will issue securities to the bank or the PD against payment received
from the bank or the PD on the date of issue irrespective of whether the bank or the PD has
received payment from their clients.

· The bank or the PD can recover upto six paise per Rs.100 as commission for rendering this
service to their clients.

· The bank or the PD can build this cost into the sale price or it can recover separately from
the clients.

· Modalities for obtaining payment from clients towards the cost of securities, accrued
interest, wherever applicable and commission will have to be worked out by the bank or the
PD and clearly stated in the contract made for the purpose with the client.

· The bank or the PD is not permitted to build any other cost, such as funding cost, into the
price. In other words, the bank or the PD cannot recover any other cost from the client other
than accrued interest as indicated.

· PDs and banks will furnish information relating to the Scheme to the Reserve Bank of India
as and when called for. RBI can also review the guidelines. If and when the guidelines are
revised, RBI will notify the modified guidelines.

Fixed Income Instruments

INTRODUCTION

A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending
money to a government, municipality, corporation, federal agency or other entity known as
an issuer. In return for that money, the issuer provides you with a bond in which it promises
to pay a specified rate of interest during the life of the bond and to repay the face value of
the bond (the principal) when it matures, or comes due.

Fixed income instruments constitute a claim on the issuer of a loan. The yield is normally
paid in the form of interest. There are various types of fixed income instruments depending
on which the issuer has issued the instrument, the collateral given by the issuer for the loan,
the maturity until repayment date and the form of disbursement of interest.

TYPES OF FIXED INCOME INSTRUMENTS

· BASED ON COUPON OF A BOND
· BASED ON MATURITY OF A BOND
· BASED ON THE PRINCIPAL REPAYMENT OF A BOND
· ASSET BACKED SECURITIES

BASED ON COUPON OF A BOND

Zero Coupon Bond

In such a bond, no coupons are paid. The bond is instead issued at a discount to its face
value, at which it will be redeemed. There are no intermittent payments of interest. When
such a bond is issued for a very long tenor, the issue price is at a steep discount to the
redemption value. Such a zero coupon bond is also called a deep discount bond. The
effective interest earned by the buyer is the difference between the face value and the
discounted price at which the bond is bought. There are also instances of zero coupon
bonds being issued at par, and redeemed with interest at a premium. The essential feature
of this type of bonds is the absence of intermittent cash flows.

Treasury Strips

In the United States, government dealer firms buy coupon paying treasury bonds, and create
out of each cash flow of such a bond, a separate zero coupon bond. For example, a 7-year
coupon-paying bond comprises of 14 cash flows, representing half-yearly coupons and the
repayment of principal on maturity. Dealer firms split this bond into 14 zero coupon bonds,
each one with a differing maturity and sell them separately, to buyers with varying tenor
preferences. Such bonds are known as treasury strips. (Strips is an acronym for Separate
Trading of Registered Interest and Principal Securities). We do not have treasury strips yet
in the Indian markets. RBI and Government are making efforts to develop market for strips in
government securities.

Floating Rate Bonds

Instead of a pre-determined rate at which coupons are paid, it is possible to structure bonds,
where the rate of interest is re-set periodically, based on a benchmark rate. Such bonds
whose coupon rate is not fixed, but reset with reference to a benchmark rate, are called
floating rate bonds. For example, IDBI issued a 5 year floating rate bond, in July 2009, with
the rates being reset semi-annually with reference to the 10 year yield on Central
Government securities and a 50 basis point mark-up. In this bond, every six months, the 10-
year benchmark rate on government securities is ascertained. The coupon rate IDBI would
pay for the next six months is this benchmark rate, plus 50 basis points. The coupon on a
floating rate bond thus varies along with the benchmark rate, and is reset periodically.

The Central Government has also started issuing floating rate bonds tying the coupon to the
average cut-off yields of last six 364-day T-bills yields.

Some floating rate bonds also have caps and floors, which represent the upper and lower
limits within which the floating rates can vary. For example, the IDBI bond described above
had a floor of 9.5%. This means, the lender would receive a minimum of 9.5% as coupon
rate, should the benchmark rate fall below this threshold. A ceiling or a cap represents the
maximum interest that the borrower will pay, should the benchmark rate move above such a
level. Most corporate bonds linked to the call rates, have such a ceiling to cap the interest
obligation of the borrower, in the event of the benchmark call rates rising very steeply.
Floating rate bonds, whose coupon rates are bound by both a cap and floor, are called as
range notes, because the coupon rates vary within a certain range.

The other names, by which floating rate bonds are known, are variable rate bonds and
adjustable rate bonds. These terms are generally used in the case of bonds whose coupon
rates are reset at longer time intervals of a year and above. These bonds are common in the
housing loan markets.

In the developed markets, there are floating rate bonds, whose coupon rates move in the
direction opposite to the direction of the benchmark rates. Such bonds are called inverse
floaters.

Other Variations

In the mid-eighties, the US markets witnessed a variety of coupon structures in the high yield
bond market (junk bonds) for leveraged buy-outs. In many of these cases, structures that
enabled the borrowers to defer the payment of coupons were created. Some of the more
popular structures were: (a) deferred interest bonds, where the borrower could defer the
payment of coupons in the initial 3 to 7 year period; (b) Step-up bonds, where the coupon
was stepped up by a few basis points periodically, so that the interest burden in the initial
years is lower, and increases over time; and (c) extendible reset bond, in which investment
bankers reset the rates, not on the basis of a benchmark, but after re-negotiating a new rate,
which in the opinion of the lender and borrower, represented the rate for the bond after
taking into account the new circumstances at the time of reset.

BASED ON MATURITY OF A BOND

Callable Bonds

Bonds that allow the issuer to alter the tenor of a bond, by redeeming it prior to the original
maturity date, are called callable bonds. The inclusion of this feature in the bond‟s structure
provides the issuer the right to fully or partially retire the bond, and is therefore in the nature
of call option on the bond. Since these options are not separated from the original bond
issue, they are also called embedded options. A call option can be an European option,
where the issuer specifies the date on which the option could be exercised. Alternatively, the
issuer can embed an American option in the bond, providing him the right to call the bond on
or anytime before a pre-specified date. The call option provides the issuer the option to
redeem a bond, if interest rates decline, and re-issue the bonds at a lower rate. The investor,
however, loses the opportunity to stay invested in a high coupon bond, when interest rates
have dropped.

The call option, therefore, can effectively alter the term of a bond, and carries an added set
of risks to the investor, in the form of call risk, and re-investment risk. As we shall see later,
the prices at which these bonds would trade in the market are also different, and depend on
the probability of the call option being exercised by the issuer. In the home loan markets,
pre-payment of housing loans represent a special case of call options exercised by
borrowers. Housing finance companies are exposed to the risk of borrowers exercising the
option to pre-pay, thus retiring a housing loan, when interest rates fall. The Central
Government has also issued an embedded option bond that gives options to both issuer
(Government) and the holders of the bonds to exercise the option of call/put after expiry of 5
years. This embedded option would reduce the cost for the issuer in a falling interest rate
scenario and helpful for the bond holders in a rising interest rate scenario.

Puttable Bonds

Bonds that provide the investor with the right to seek redemption from the issuer, prior to the
maturity date, are called puttable bonds. The put options embedded in the bond provides the
investor the rights to partially or fully sell the bonds back to the issuer, either on or before
pre-specified dates. The actual terms of the put option are stipulated in the original bond
indenture.

A put option provides the investor the right to sell a low coupon-paying bond to the issuer,
and invest in higher coupon paying bonds, if interest rates move up. The issuer will have to
re-issue the put bonds at higher coupons. Puttable bonds represent a re-pricing risk to the

issuer. When interest rates increase, the value of bonds would decline. Therefore put
options, which seek redemptions at par, represent an additional loss to the issuer.

Convertible Bonds

A convertible bond provides the investor the option to convert the value of the outstanding
bond into equity of the borrowing firm, on pre-specified terms. Exercising this option leads to
redemption of the bond prior to maturity, and its replacement with equity. At the time of the
bond‟s issue, the indenture clearly specifies the conversion ratio and the conversion price.
The conversion ratio refers to the number of equity shares, which will be issued in exchange
for the bond that is being converted. The conversion price is the resulting price when the
conversion ratio is applied to the value of the bond, at the time of conversion. Bonds can be
fully converted, such that they are fully redeemed on the date of conversion. Bonds can also
be issued as partially convertible, when a part of the bond is redeemed and equity shares
are issued in the pre-specified conversion ratio, and the nonconvertible portion continues to
remain as a bond.

BASED ON THE PRINCIPAL REPAYMENT OF A BOND

Amortising Bonds

The structure of some bonds may be such that the principal is not repaid at the end/maturity,
but over the life of the bond. A bond, in which payment made by the borrower over the life of
the bond, includes both interest and principal, is called an amortising bond. Auto loans,
consumer loans and home loans are examples of amortising bonds. The maturity of the
amortising bond refers only to the last payment in the amortising schedule, because the
principal is repaid over time.

Bonds with Sinking Fund Provisions

In certain bond indentures, there is a provision that calls upon the issuer to retire some
amount of the outstanding bonds every year. This is done either by buying some of the
outstanding bonds in the market, or as is more common, by creating a separate fund, which
calls the bonds on behalf of the issuer. Such provisions that enable retiring bonds over their
lives are called sinking fund provisions. In many cases, the sinking fund is managed by
trustees, who regularly retire part of the outstanding bonds, usually at par. Sinking funds also
enable paying off bonds over their life, rather than at maturity. One usual variant is

applicability of the sinking fund provision after few years of the issue of the bond, so that the
funds are available to the borrower for a minimum period, before redemption can
commence.

ASSET BACKED SECURITIES

Asset backed securities represent a class of fixed income securities, created out of pooling
together assets, and creating securities that represent participation in the cash flows from
the asset pool. For example, select housing loans of a loan originator (say, a housing
finance company) can be pooled, and securities can be created, which represent a claim on
the repayments made by home loan borrowers. Such securities are called mortgage–backed
securities. In the Indian context, these securities are known as structured obligations (SO).
Since the securities are created from a select pool of assets of the originator, it is possible to
„cherry-pick‟ and create a pool whose asset quality is better than that of the originator. It is
also common for structuring these instruments, with clear credit enhancements, achieved
either through guarantees, or through the creation of exclusive preemptive access to cash
flows through escrow accounts. Assets with regular streams of cash flows are ideally suited
for creating asset-backed securities. In the Indian context, car loan and truck loan
receivables have been securitized. Securitized home loans represent a very large segment
of the US bond markets, next in size only to treasury borrowings. However, the market for
securitization has not developed appreciably because of the lack of legal clarity and
conducive regulatory environment.

The Securitization and Reconstruction of Financial Assets and Enforcement of Security
Interest Act were approved by parliament in November 2002. The Act also provides a legal
framework for securitization of financial assets and asset reconstruction. The securitization
companies or reconstruction companies shall be regulated by RBI. The security receipts
issued by these companies will be securities within the meaning of the Securities Contract
(Regulation) Act, 1956. These companies would have powers to acquire assets by issuing a
debenture or bond or any other security in the nature of debenture in lieu thereof. Once an
asset has been acquired by the asset reconstruction company, such company would have
the same powers for enforcement of securities as the original lender. This has given the
legal sanction to securitized debt in India.

Bond Investment Strategies

INTRODUCTION

How do you make bonds work for your investment goals? Strategies for bond investing
range from a buy-and-hold approach to complex tactical trades involving views on inflation
and interest rates. As with any kind of investment, the right strategy for you will depend on
your goals, your time frame and your appetite for risk.

Bonds can help you meet a variety of financial goals such as: preserving principal, earning
income, managing tax liabilities, balancing the risks of stock investments and growing your
assets. Because most bonds have a specific maturity date, they can be a good way to make
sure that the money will be there at a future date when you need it.

Your goals will change over time, as will the economic conditions affecting the bond market.
As you regularly evaluate your investments, check back often for information that can help
you see if your bond investment strategy is still on target to meet your financial goals.

As you build your investment portfolio of fixed-income securities, there are various
techniques you and your investment advisor can use to help you match your investment
goals with your risk tolerance.

BOND INVESTMENT STRATEGIES

The way you invest in bonds for the short-term or the long-term depends on your investment
goals and time frames, the amount of risk you are willing to take and your tax status. When
considering a bond investment strategy, remember the importance of diversification.

DIVERSIFICATION

As a general rule, it‟s never a good idea to put all your assets and all your risk in a single
asset class or investment. You will want to diversify the risks within your bond investments
by creating a portfolio of several bonds, each with different characteristics. Choosing bonds
from different issuers protects you from the possibility that any one issuer will be unable to
meet its obligations to pay interest and principal. Choosing bonds of different types
(government, agency, corporate, municipal, mortgage-backed securities, etc.) creates
protection from the possibility of losses in any particular market sector. Choosing bonds of
different maturities helps you manage interest rate risk.

Bond Ladders, barbells, and bullets are strategies that will help the investor diversify and
balance their bond portfolios to achieve their desired result. The terminology of these
strategies actually reflects the character of that strategy. For example, a bond ladder will
enable the bond investor to set up a bond re-investment strategy, in steps. The barbell
approach resembles a barbell in that bonds are purchased heavily in the short end and the
long end. Medium term notes are left out of the mix. Finally, with the bullet strategy, each
bond will share the same maturity date. They will typically start at different intervals, but they
all will mature together

Ladders

Ladders are a popular strategy for staggering the maturity of your bond investments and for
setting up a schedule for reinvesting them as they mature. A ladder can help you reap the
typically higher coupon rates of longer-term investments, while allowing you to reinvest a
portion of your funds every few years.

Example
You buy three bonds with different maturity dates: two years, four years, and six years. As
each bond matures, you have the option of buying another bond to keep the ladder going. In
this example, you buy 10-year bonds. Longer-term bonds typically offer higher interest rates.

Ladders are popular among investors who want bonds as part of a long-term investment
objective, such as saving for college tuition, or seeking additional predictable income for
retirement planning.

Ladders have several potential advantages:

· The periodic return of principal provides the investor with additional income beyond the set
interest payments

· The income derived from principal and interest payments can either be directed back into
the ladder if interest rates are relatively high or invested elsewhere if they are relatively low

· Interest rate volatility is reduced because the investor now determines the best investment
option every few years, as each bond matures

· Investors should be aware that laddering can require commitment of assets over time, and
return of principal at time of redemption is not guaranteed
Barbells

Barbells are a strategy for buying short-term and long-term bonds, but not intermediate-term
bonds. The long-term end of the barbell allows you to lock into attractive long-term interest
rates, while the short-term end insures that you will have the opportunity to invest elsewhere
if the bond market takes a downturn.

Example:
You see appealing long-term interest rates, so you buy two long-term bonds. You also buy
two short-term bonds. When the short-term bonds mature, you receive the principal and
have the opportunity to reinvest it.

Bullets

Bullets are a strategy for having several bonds mature at the same time and minimizing the
interest rate risk by staggering when you buy the bonds. This is useful when you know that
you will need the proceeds from the bonds at a specific time, such as when a child begins
college.

Example:
You want all bonds to mature in 10 years, but want to stagger the investment to reduce the
interest rate risk. You buy the bonds over four years.

BOND SWAPPING

Techniques to lower your taxes and improve the quality of your portfolio.

A bond swap is a technique whereby an investor chooses to sell a bond and simultaneously
purchase another bond with the proceeds from the sale. Fixed-income securities make
excellent candidates for swapping because it is often easy to find two bonds with similar
features in terms of credit quality, coupon, maturity and price.

In a bond swap, you sell one fixed-income holding for another in order to take advantage of
current market and/or tax conditions and better meet your current investment objectives or
adjust to a change in your investment status. A wide variety of swaps are generally available
to help you meet your specific portfolio goals.

Why You Would Consider Swapping

Swapping can be a very effective investment tool to:

1. increase the quality of your portfolio;
2. increase your total return;
3. benefit from interest rate changes; and
4. lower your taxes.

These are just a few reasons why you might find swapping your bond holdings beneficial.
Although this booklet contains general information regarding federal tax consequences of
swapping, we suggest you consult your own tax advisor for more specific advice regarding
your individual tax situation.

1. Swapping for Quality

A quality swap is a type of swap where you are looking to move from a bond with a lower
credit quality rating to one with a higher credit rating or vice versa. The credit rating is
generally a reflection of an issuer‟s financial health. It is one of the factors in the market‟s
determination of the yield of a particular security. The spread between the yields of bonds
with different credit quality generally narrows when the economy is improving and widens
when the economy weakens. So, for example, if you expect a recession you might swap
from lower-quality into higher-quality bonds with only a negligible loss of income.

Standard rating agencies classify most issuers‟ likelihood of repayment of principal and
payment of interest according to a grading system ranging from, say, triple-A to C (or an
equivalent scale), as a quality guideline for investors. Issuers considered to carry good
likelihood of payment are “investment grade” and are rated Baa3 or higher by Moody‟s
Investors Service or BBB- or higher by Standard & Poor‟s Ratings Services and Fitch
Ratings. Those issuers rated below Baa3 or below BBB- are considered “below investment
grade” and the repayment of principal and payment of interest are less certain. Suppose you
own a corporate bond rated BBB (lower-investment-grade quality) that is yielding 7.00% and
you find a triple-A-rated (higher-investment-grade quality) corporate bond that is yielding
6.70%.1 You could swap into the superior-credit, triple-A-rated bond by sacrificing only 30
basis points (one basis point is 1/100th of one percent, or .01%). Moreover, during an
economic downturn, higher-quality bonds, which represent greater certainty of repayment in
difficult market conditions, will typically hold their value better than lower-quality bonds.

Also, if a market sector or a particular bond has eroded in quality, it may no longer meet your
personal risk parameters. You may be willing to sacrifice some current income and/or yield
in exchange for enhanced quality.

2. Swapping to Increase Yield

You can sometimes improve the taxable or tax-exempt returns on your portfolio by
employing a number of different bond-swapping strategies. In general, longer-maturity bonds
will typically yield more than those of a shorter maturity will; therefore, extending the average
maturity of a portfolio‟s holdings can boost yield. The relationship between yields on different
types of securities, ranging from three months to 30 years, can be plotted on a graph known
as the yield curve. The curve of that line is constantly changing, but you can often pick up
yield by extending the maturity of your investments, assuming the yield curve is sloping
upward. For example, you could sell a two-year bond that‟s yielding 5.50% and purchase a
15-year bond that is yielding 6.00%. However, you should be aware that the price of longer-
maturity bonds might fluctuate more widely than that of short-term bonds when interest rates
change.

When the difference in yield between two bonds of different credit quality has widened, a
cautious swap to a lower-quality bond could possibly enhance returns. But sometimes
market fluctuations create opportunities by causing temporary price discrepancies between
bonds of equal ratings. For example, the bonds of corporate issuers may retain the same

credit rating even though their business prospects are varying due to transient factors such
as a specific industry decline, a perception of increased risk or deteriorating credit in the
sector or company. So, suppose you purchased in the past (at par) a 30-year A-rated
$50,000 corporate bond with a 6.25% coupon. Assume that comparable bonds are now
being offered with a 6.50% coupon. Assume that you can replace your bond with another
$50,000 A-rated corporate bond having the same maturity with a 6.50% coupon. By selling
the first bond and buying the second bond you will have increased your annual income by 25
basis points ($125). Discrepancies in yield among issuers with similar credit ratings often
reflect perceived risk in the marketplace. These discrepancies will change as market
conditions and perceptions change.

3. Swapping for Increased Call Protection

Swaps may achieve other investment objectives, such as building a more diversified
portfolio, or establishing better call protection. Call protection is useful for reducing the risk of
reinvestment at lower rates, which may occur if an issuer retires, calls or pre-refunds its
bonds early. Call protection swaps are particularly advantageous in a declining interest rate
environment. For example, you could sell a bond with a short call, e.g., five years, and
purchase a bond with 10 years of call protection. This will enable you to lock in your coupon
for an additional five years and not worry about losing your higher-coupon bonds in the near
future. You may have to sacrifice yield in exchange for the stronger call protection.

Anticipating Interest Rates

If you believe that the overall level of interest rates is likely to change, you may choose to
make a swap designed to benefit or help you protect your holdings.

If you believe that rates are likely to decline, it may be appropriate to extend the maturity of
your holdings and increase your call protection. You will be reducing reinvestment risk of
principal and positioning for potential appreciation as interest rates trend down. Conversely,
if you think rates may increase, you might decide to reduce the average maturity of holdings
in your portfolio. A swap into shorter-maturity bonds will cause a portfolio to fluctuate less in
value, but may also result in a lower yield.

It should be noted that various types of bonds perform differently as interest rates rise or fall,
and may be selectively swapped to optimize performance. Long-term, zero-coupon2 and
discount bonds3 perform best during interest rate declines because their prices are more

sensitive to interest rate changes. Floating-rate, short- and intermediate-term, callable and
premium bonds4 perform best when interest rates are rising because they limit the downside
price volatility involved in a rising yield environment; their price fluctuates less on a
percentage basis than a par or discount bond.

However, you should remember that rate-anticipation swaps tend to be somewhat
speculative, and depend entirely on the outcome of the expected rate change. Moreover,
shorter- and longer-term rates do not necessarily move in a parallel fashion. Different
economic conditions can impact various parts of the yield curve differently. To the extent that
the anticipated rate change does not come about, a decline in market value could occur.

4. Swapping to Lower Your Taxes

Tax swapping is the most common of all swaps. Anyone who owns bonds that are selling
below their amortized purchase price and who has capital gains or other income that could
be partially, or fully, offset by a tax loss can benefit from tax swapping.

You may have realized capital gains from the sale of a profitable capital asset (e.g., real
estate, your business, stocks or other securities). Or you may expect to sell such an asset at
a potential profit in the near future. By swapping those assets that are currently trading
below the purchase price (due to a rise in interest rates, deteriorating credit situation, etc.)
you can reduce or eliminate the capital gains you would otherwise have paid on your other
profitable transactions in the current tax year.

The traditional tax swap involves two steps: (1) selling a bond that is worth less than you
paid for it and (2) simultaneously purchasing a bond with similar, but not identical,
characteristics. For example, assume you own a $50,000, 20-year, triple-A-rated municipal
bond with a 5.00% coupon that you purchased five years ago at par. If interest rates
increase (such that new bonds are now being issued with a 5.50% coupon), the value of
your bond will fall to approximately $47,500. If you sell the bond, you will realize a $2,500
capital loss, which you can use to offset any capital gains you have realized. If you have no
capital gains, you can use the capital loss to offset ordinary income. You then purchase in
the secondary market a replacement triple-A-rated 5.00% municipal bond (from a different
issuer), maturing in 15 years, at an approximate cost of $47,500. Your yield, maturity and
quality of bond will be the same as before, plus you will have realized a loss that will save
you money on taxes in the year of the bond sale. Of course, if you hold the new bond to
maturity, you will realize a $2,500 gain in 15 years, taxable as ordinary income at that time.

By swapping, you have converted a “paper” loss into a real loss that can be used to offset
taxable gain.

ASSET ALLOCATION

Asset allocation describes the percentage of total assets invested in different investment
categories, also known as asset classes. The most common broad financial asset classes
are Fixed Income, Equities, Commodities, Currencies& Real Estate and “alternative
investments” such as hedge funds and commodities can also be viewed as asset classes.

Each broad asset class has various subclasses with different risk and return profiles. In
general, the more return an asset class has historically delivered, the more risk that its value
could fall as well as rise because of greater price volatility. To earn higher potential returns,
investors have to take higher risk.
Asset classes differ by the level of potential returns they have historically generated and the
types of risk they carry. Virtually all investments involve some type of risk that you might lose
money.

Asset subclasses of stocks include:

· Large cap stocksstocks of large, well established and usually well known companies
· Small cap stocksstocks of smaller, less well known companies
· International stocksstocks of foreign companies

Large cap, small cap and international stocks can in turn be considered:

· Value stocks whose prices are below their true value for temporary reasons
· Growth stocks of companies that are growing at a rapid rate.

Asset subclasses of bonds include:

· Different maturities long-term (10 years or longer), intermediate-term (3-10 year) or short-
term (3 years or less)
· Different issuers government and agencies, corporate, municipal, international
· Different types of bonds callable bonds, zero-coupon bonds, inflation-protected bonds,
high-yield bonds, etc.

Stocks are generally considered a risky investment because, among other things, their
values can decline if the stock market goes down (market risk) or the issuing company does
poorly (company risk). As owners of the company, stockholders are paid after all creditors,
including bond holders, are paid. In theory at least, a stock‟s value can go to zero.
Historically, stock prices have been the most volatile of all the different types of investments,
meaning their prices can move up and down quickly, frequently and not always in a
predictable way.

Bonds are considered less risky than stocks because bond prices have historically been
more stable and because bond issuers promise to repay the debt to the bondholders at
maturity. That promise is generally kept unless the issuer falls on hard times; some bonds
have credit risk based on the financial health of their issuer. When a bond issuer goes into
bankruptcy, bondholders are paid off before stockholders. Bonds are also vulnerable to
interest rate risk: when interest rates rise, bond prices fall and vice versa.

Cash investments carry opportunity risk. For example, investing in very safe, short-term
investments like Treasury bills may protect you from loss, but you may miss the opportunity
of more generous returns offered by other investments. Even people who keep their money
under their mattress have the risk that their money will be worth less in the future because of
inflation that reduces the purchasing power of the cash.

Smart investors do not put all their assets in one type of investment or “asset class.” Instead,
they spread or diversify their risk by investing in different types of investments. When one
asset class is performing poorly, another may be doing well and compensating for the poor
performance in the other.

Some studies have shown that overall asset allocation is more important to investment
success than the choice of investments within the allocation.

MARKET SIGNALS

Seven bond market signals in four market-driving categories.

Category: Fundamentals

Two fundamental forces drive bond yields: growth and inflation. If you understand that bond
prices are present values of future cash flows, then you know that forecasts of future growth
and inflation are more important than historical data reports on what has already occurred.

Signal one: Market consensus for year-ahead GDP growth, as measured monthly in the
Blue Chip survey of 50 professional forecasters.

Signal two: Market consensus for year-ahead inflation, as measured monthly in the Blue
Chip survey of 50 professional forecasters.
Trade: Buy the 10-year Treasury note when the consensus lowers its estimate of year-ahead
growth and inflation, suggesting interest rates will go down and bond prices will go up. Sell
the 10-year Treasury note when the consensus raises its estimate of year-ahead growth and
inflation, suggesting rates will rise and prices will fall. Hold for one month until next
consensus figures are released. Roll trade if consensus moves in same direction; reverse if
consensus turns; close if consensus in unchanged.

Category: Value

Presuming that asset prices fluctuate around a stable, long-term equilibrium, extreme
deviations serve as lead indicators of trend reversals.

Signal three: Real (inflation-adjusted) yields.
Trade: Buy the 10-year Treasury note when real yields are more than one standard deviation
above the long-term moving average sell when they are more than one standard deviation
below. Hold the position until real yields cross the opposite threshold.

Signal four: Ratio of the S&P 500 earnings yield to the 30-year Treasury yield.Trade: Buy
bonds when the ratio is more than half a standard deviation below its long-run moving
average (bonds are cheap relative to stocks) sell when it‟s more than half a standard
deviation above its long-run moving average (stocks are cheap relative to bonds).

Category: Risk appetite

Risk appetite refers to investors‟ relative preference for safe and risky assets, prompted by
business cycle fluctuations, policy developments or exogenous events.

Signal five: Credit Appetite Index, where zero represents minimum appetite (widest
spreads, positive for U.S. government bonds) and 100 represents maximum appetite
(tightest spreads, negative for U.S. government bonds).
Trade: Sell U.S. government bonds when credit appetite is high, as signaled by the CAI
being more than one standard deviation above its 50-day moving average, and buy when it
is low, or more than one standard deviation below its 50-day moving average.

Category: Technicals

Technical indicators trace market patterns in price and volume.

Signal six: Price data.
Trade: Buy when the short-term moving average of prices crosses the long-term average
from below sell when it crosses from above. In this momentum measure, the strongest
returns were generated when short-term was 10 days and long-term was 20 days.

Signal seven: Flow data, defined as net purchases of bond market mutual funds, as an
indicator of cash flow into the bond market
Trade: Buy the 10-year Treasury when the flow indicator is more than one standard
deviation above the long-term moving average sell when it‟s more than one standard
deviation below.

CONCLUSION

Diversification pays no single indicator works at all times or in all trading environments. In
the absence of foresight, a diversified strategy that combines different information sources
(fundamentals, value, risk appetite and technicals), trading strategies (momentum and
contrarian) and holding periods (daily, weekly and monthly) far outperforms narrower
approaches over the longer term.

Fixed Income Risks

INTRODUCTION

As an integral part of a well-balanced and diversified portfolio, fixed income securities afford
opportunities for predictable cash flows to match investors‟ individual needs and provide

capital preservation. In addition, they may offset the volatility of the stock market. However,
all investments have some degree of risk. In general, the higher the return potential, the
higher the risk. Safer investments usually offer relatively lower returns.

While the interest payment or coupon on most bonds is fixed and the principal amount,
known as par value, is returned to the investor upon maturity, the market price of a bond
during its life varies as market conditions change. Consequently, if a bond is sold prior to
maturity, the proceeds may be more or less than the original purchase price or the quoted
yield. If a bond is held to maturity, an investor can expect to receive the return or yield at
which the bond was initially purchased, subject to the credit worthiness of the issuer.

There are a number of variables to consider when investing in bonds that may affect the
value of the investment. These variables include changes in interest rates, income
payments, bond maturity, redemption features, credit quality, and priority in the capital
structure, price, yield, tax status and other provisions that are covered in the offering
documents.

In general, investors demand higher yields to compensate for higher risks. Discussed below
are the most common risks associated with fixed income securities.

Interest Rate Risk

The market value of the securities is inversely affected by movements in interest rates.
When rates rise, market prices of existing debt securities fall as these securities become
less attractive to investors when compared to higher coupon new issues. As prices decline,
bonds become cheaper so the overall return, when taking into account the discount, can
compete with newly issued bonds at higher yields. When interest rates fall, market prices on
existing fixed income securities tend to rise because these bonds become more attractive
when compared to newly issued bonds priced at lower rates.

Price Risk

Investors who need access to their principal prior to maturity must rely on the secondary
market to sell their securities. The price received may be more or less than the original
purchase price and may depend, in general, on the level of interest rates, time to term, credit
quality of the issuer and liquidity. Among other factors, prices may also be affected by
current market conditions or by the size of the trade (prices may be different for 10 bonds

versus 1,000 bonds). It is important to note that selling a security prior to maturity may affect
the actual yield received which may be different than the yield at which the bond was
originally purchased. This is because the initially quoted yield assumed holding the bond to
term.

As mentioned above, there is an inverse relationship between interest rates and bond prices.
Therefore, when interest rates decline, bond prices increase, and when interest rates
increase, bond prices decline. Generally, longer maturity bonds are more sensitive to
interest rate changes. Dollar for dollar, a long-term bond should go up or down in value more
than a short-term bond in response to the same change in yield.

Liquidity Risk

Liquidity risk is the risk that an investor will be unable to sell securities due to lack of demand
from potential buyers and thus must sell them at a substantial loss and/or incur substantial
transaction costs in the sale process. Broker-dealers, although not obligated to do so, may
provide secondary markets.

Reinvestment Risk

Downward trends in interest rates also create reinvestment risk, or the risk that the income
and/or principal repayments must be invested at lower rates. Reinvestment risk is an
important consideration for investors who hold callable securities. Some bonds may be
issued with a call feature which allows the issuer to call, or repay, bonds prior to maturity.
Bonds with this feature are generally called when market rates fall low enough for the issuer
to save money by repaying existing higher coupon bonds and issuing new ones at lower
rates. Investors will stop receiving coupon payments if the bonds are called. Generally,

callable fixed income securities do not appreciate in value as much as comparable non-
callable securities.

Prepayment Risk

Similar to call risk, prepayment risk is the risk that the issuer may repay bonds prior to
maturity. This type of risk is generally associated with mortgage-backed securities.
Homeowners who prepay their mortgages in an effort to save money may adversely affect
the holders of the mortgage-backed securities. If the bonds are repaid early, investors face
the risk of reinvesting at lower rates.

Purchasing Power Risk

Fixed income investors often focus on the real rate of return, or the actual return minus the
rate of inflation. Rising inflation has a negative impact on real rates of return because
inflation reduces the purchasing power of both investment income and principal.

Credit Risk

The safety of the fixed income investor's principal depends on the issuer's credit quality and
ability to meet its financial obligations, such as payment of coupon and repayment of
principal at maturity. Rating agencies assign ratings based on their analysis of the issuer‟s
financial condition, economic and debt characteristics, and specific revenue sources
securing the bond. Issuers with lower credit ratings usually must offer investors higher yields
to compensate for additional credit risk. A change in either the issuer's credit rating or the
market's perception of the issuer's business prospects will affect the value of its outstanding
securities. Ratings are not a recommendation to buy, sell or hold, and may be subject to
review, revision, suspension or reduction, and may be withdrawn at any time. If a bond is
insured, attention should be given to the creditworthiness of the underlying issuer or obligor
on the bond as the insurance feature may not represent additional value in the marketplace
or may not contribute to the safety of principal and interest payments.

Default Risk

The risk of default is the risk that the issuer will not be able to make interest payments and/or
return the principal at maturity.

Growth in Outright and repo settlement volumes (in
7000000 Rs. Crore)

6000000

5000000

4000000

3000000

2000000

1000000

0
2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10
G-sec Repo

10
14

12

0
2
4
6
8
Yield %

1997-98

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

Wt. avg yield
2004-05

2005-06

2006-07

2007-08

2008-09 Wt. avg maturity

2009-10
0
2
4
6
8
10
12
14
16
18

years

Holder Profile in Central Govt securities as on
end Mar 2010

1. Commercial Banks
4%
2. Bank- Primary Dealers
12%
3. Non-Bank PDs
4. Insurance Companies
7% 38%
5. Mutual Funds
1% 6. Co-operative Banks
3%
0% 7. Financial Institutions
3%
8. Corporates
1%
9. FIIs
10. Provident Funds
22% 11. RBI
9%
12. Others
0%

Trend in corproate bond trades
80000
70000
60000
50000
40000
30000
20000
10000
0
Sep/07

Sep/08

Sep/09
Jan/07

Jan/08

Jan/09

Jan/10
May/07

May/08

May/09

May/10

Trends in Government Debt-GDP Ratio

90
80
70
60
Per cent

50
40
30
20
10
0
1980-81 1990-91 1996-97 2000-01 2004.05 2006-07
(BE)

Centre States Total

Centre’s Fiscal Responsibility Act

• Enactment of FRBM Act : August 26, 2003
• Came into force from July 5, 2004
• Elimination of RD by 2008-09 (3.6% in 2003-04) and revenue surplus thereafter
• Containment of GFD to 3 % of GDP by 2008-09 (4.5% in 2003-04)
• RD and GFD placed at 2.0% and 3.7% of GDP in 2006-07 (RE)
• RD and GFD budgeted to decline to 1.5% and 3.3% of GDP in 2007-08
• RBI prohibited from Participation in Primary Issuances of G-Secs

Maturity and Yield

• Elongation of Maturity Profile
• General Reduction in Weighted Average Yield

18
16
14
Per cent / Years

12
10
8
6
4
2
0
1995-96

1996-97

1997-98

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06
Weighted Average Yield (per cent) Weighted Average Maturity (years)

Yield Curve

• Development of a Smooth Yield Curve

16
14
12
Per cent

10
8
6
4
2
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Maturity (Years)

Mar-97 Mar-04 Jan-07

Ownership Pattern of Central G-Secs

Chart 5: Ownership Pattern of Central G-Secs:
1991
Reserve B ank o f Ind ia (o wn acco unt )

0% 5%
0%
1% Co mmercial B anks

13% 25%
Lif e Insurance Co rp o rat io n o f Ind ia #

Unit Trust o f Ind ia

NA B A RD

Emp lo yees Pro vid ent Fund Scheme

Co al M ines Pro vid ent Fund Scheme

Primary d ealers
56%
Ot hers

Chart 6: Ownership Pattern of Central G-Secs:
0% 2005
Res erve Bank of India
0% (own account)
7% Com m ercial Banks
2% 16%
Life Ins urance
0% Corporation of India #
Unit Trus t of India
0%
NABARD

Em ployees Provident
20%
Fund Schem e
53% Coal Mines Provident
Fund Schem e
Prim ary dealers

Others

External Borrowings

• Low Share of External Debt
• External Borrowings only from Multilateral and Bilateral Sources

100.0

80.0
Per cent

60.0

40.0

20.0

0.0

Corporate Bond Market

• Corporate Bond markets historically late to develop
• Access to bank credit
• Access to external sources of finance
• Require well developed accounting legal and regulatory systems
• Rating agencies
• Rigorous disclosure standards and effective governance of corporations
• Payment and settlement systems
• Secondary markets

Reforms in Corporate Bond Market

• Four Rating agencies operating in India
• De-materialisation and electronic transfer of securities
• Initial focus – reform of private placement market by encouraging rating of
issues
• Further reforms needed
• Appointment of a High Powered Committee

High-powered committee recom

• Enhance the issuer base and investor base including measures to bring in
retail investors

• Listing of primary issues and creation of a centralized database of primary
issues
• Electronic trading system
• Comprehensive automated trade reporting system
• Safe and efficient clearing and settlement standards
• Repo in corporate bonds
• Promote credit enhancement
• Specialized debt funds to fund infrastructure projects
• Development of a municipal bond market

The Way Ahead

• Build upon the Strong Macroeconomic Performance
– Adherence to FRL
– Stability of Inflation Rate

-external debt management policy

Pension reforms

• Active Consolidation
• Floating Rate Bonds and Inflation-Indexed Bonds
• STRIPS
• Corporate Bonds
– Bond Insurance Institutions
– Institutional Investors: Credit Enhancers
– Securitised paper to be traded on exchanges
– Municipal Bonds, Mortgage Backed Securities, General Securitised
Paper

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