BONDS MARKET IN INDIA

MADE PRN BY:-ASHMIT GROVER NO. :-11021021017 :-A SEMESTER:-II SECTION

BONDS MARKET IN INDIA

BONDS DEFINITION:A bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (thecoupon) to use and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals (semi annual, annual, sometimes monthly).[1] Thus a bond is like a loan: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Certificates of deposit (CDs) orcommercial paper are considered to be money market instruments and not bonds. Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity).

BONDS MARKET :The Bond Market in India with the liberalization has been transformed completely. The opening up of the financial market at present has influenced several foreign investors holding upto 30% of the financial in form of fixed income to invest in the bond market in India. The bond market in India has diversified to a large extent and that is a huge contributor to the stable growth of the economy. The bond market has immense potential in raising funds to support the infrastructural development undertaken by the government and expansion plans of the companies. Sometimes the unavailability of funds become one of the major problems for the large organization. The bond market in India plays an important role in fund raising for developmental

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. The Indian financial system is changing fast, marked by strong economic growth, more robust markets, and considerably greater efficiency. But to add to its world-class equity markets, and growing banking sector, the country needs to improve its bond markets. While the government and corporate bond markets have grown in size, they remain illiquid. The corporate market, in addition, restricts participants and is largely arbitrage-driven. To meet the needs of its firms and investors, the bond market must therefore evolve. This will mean creating new market sectors such as exchange traded interest rate and foreign exchange derivatives contracts. It will need a relaxation of exchange restrictions and an easing of investment mandates on contractual savings institutions to attract a greater variety of investors (including foreign) and to boost liquidity. Tax reforms, particularly stamp duties, and a revamping of disclosure requirements for corporate public offers, could help develop the corporate bond market. And streamlining the regulatory and supervisory structure of the local currency bond market could substantially increase efficiency, spurring innovation, economies of scale, liquidity and competition. Such reforms will help level the playing field for investors. In deciding the course for reform, however, the innovations and experiences of markets in the region are also important. Developing markets often mimic more advanced European and North American markets. But complex structures designed for diverse developed markets are sometimes ill-suited to less-developed economies. Instead, looking to neighboring, emerging markets at similar stages of development can be more useful. For example, Indias unique collateralized borrowing and lending obligations (CBLO) system and its successful electronic trading platform could usefully be studied by its neighbors, many of which suffer from limited repo markets or which have (like India) tried unsuccessfully to move bonds on to electronic platforms. India could benefit, by contrast, from the lessons of its neighbors in developing its corporate bond market. This paper reviews these issues and discusses policies that can help further develop Indias debt market. Section II highlights and compares market development and outlook to emerging East Asian economies. Sections III and IV summarize salient characteristics, reforms and obstacles. Section V discusses the development and prospects for Indias securitization market. Section VI looks at the main market participants and the depth of the pool of available investors, arguably the most significant factor in market development. Section VII tackles policy

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

OVERVIEW OF THE BOND MARKET:There are three main segments of debt market in India, viz., Government securities, Public Sector Units (PSU) bonds and private sector corporate bonds. India being a federal state, Government securities are issued by Central Government and all the provincial Governments (India has 28 states), although in case of the latter such securities constitute a relatively small portion of their fiscal deficits. In India, banks are required to maintain statutorily a certain percentage of their liabilities in Government securities and other specified liquid assets which creates a captive demand for Government securities. At present, the Statutory Liquidity Ratio (SLR) for banks is 25 per cent. Similar statutory requirements in varying degrees are there for other type of financial institutions, viz., insurance companies, provident funds, non-banking financial institutions etc. The PSU bonds are generally treated as surrogates of sovereign paper, sometimes due to explicit guarantee of Government, and often due to the comfort of public ownership. Some of the PSU bonds are tax free, a status not enjoyed even by Government securities. Corporate bonds and debentures have maturities beyond 1 year and generally up to 10 years. Corporates also issue short-term commercial paper with maturity ranging from 15 days to one year.

STATE OF BOND MARKET:The Indian financial system is not well developed and diversified. One major missing element is an active, liquid, and large debt market. In terms of outstanding issued amount,Indian debt market ranks as the third largest in Asia, next only to that of Japan and South Korea. Further, in terms of the primary issues of debt instruments, Indian market is quite large. The government continues to be a large borrower unlike South Korea where the private sector is the main borrower. If we compare the size of the Indian GDP with the outstanding size of the debt flotation, Indian debt market is not very much underdeveloped. The gross domestic savings rate in the Indian economy is reasonably satisfactory at around 23%. According to RBIs annual studies on savings, about 78% of the aggregate financial savings of the household sector were invested in fixed income assets. The average Indian household has great appetite for debt instruments provided they are packaged properly. The main financial instruments popular with the households are bank deposits, provident funds, insurance, income-

oriented mutual funds, and postal savings schemes. However, the share of fixed income instruments that could be traded in the secondary markets is negligible. The main reason for this is the absence of an active secondary market in debt instruments. Investors are not willing to invest in tradable instruments as they lack required liquidity. It is thus a typical case of chicken and egg problem. Since there are not enough number of issues and the floating stock in the secondary market is very small there is hardly any trading in them. Currently almost 98% of the secondary market transactions in debt instruments relate to government securities, treasury bills and bonds of public sector companies. The quality of secondary market debt trading is very poor if we compare it with the quality of the secondary market in equities. Debt markets lack the required transparency, liquidity, and depth. With reference to the usual standards or yardsticks of market efficiency the Indian debt markets would not score more than 30% of the marks that the Indian equity markets would score.The US has one of the most active secondary markets in both government and corporate bonds. The trading volume in the US debt market is said to be on an average ten times the size of the equity trading. In India the average daily trading in debt during the last year was about one tenth of the average daily trading in equities. These comparisons bring out the underdeveloped nature of the Indian debt markets. The secondary debt market suffers from several infirmities. It is highly non-transparent compared to the equity market. It is highly fragmented since the ownership titles of government securities are fragmented in 14 offices of the RBI, which acts as a depository for the government debt including the treasury bills. A seller from New Delhi cannot trade in Mumbai market since security held in RBI office in New Delhi cannot be easily transferred to Mumbai office of RBI and vice-versa. Since the current small order book stands fragmented city-wise the price discovery process does not throw up the best possible prices.

Corporate Bond Market

For too long, most of the corporate entities have been depending on loans from banks and institutions and they have not shown any interest to raise at least a small of the required resources from the market through bonds or commercial paper. The cash credit system also made them complacent about cost effective fund management through treasury operations. Under their age-old cash credit system, banks grant credit/borrowing limits to the corporates. They can use bank funds within the granted credit limits at theirconvenience and return the same back to the banks as they receive from their customers. Since the interest is charged by banks only on the average outstanding drawals, the cash management responsibility of the corporates got transferred from the borrowers to the banks. Corporates have been raising funds from the retail markets by way of term deposits just as the banks do. This is an age-old system quite popular with several corporates. The company statute permits corporate entities to raise public deposits within certain limits.

Currently the amount of deposits that a corporate can raise is equal to 50% of its capital and free reserves. Surprisingly even the corporate units which raise funds through public deposits have also not shown interest in issuing bonds although they could raise more money this way than through public deposits. Corporates can raise bond funds so long as their term debt does not exceed twice the amount of paid up capital plus free reserves. Several good credit-rated corporates have been showing interest in raising funds by way of private placement from big lenders/investors but they do not like to tap the public issue market. One of the reasons why they do not like to make public issue of debt is that the regulatory requirements including quality and the type of disclosures are more rigorous or onerous in the case of public issues. Although the interest rates they pay on suchplacements would be equally attractive to retail investors, corporates have not shown much interest in the retail investors. Recently through an amendment to Companies Act government has tried to plug possible misuse of the system by stipulating that the privately placed debt cannot be distributed to more than 50 investors. Market feed back suggests that the corporates are not happy with this amendment and a number of them are trying to find ways for bypassing the legal requirement of distributing debt among not more than 50 investors. One of the possible that is being discussed is to issue the privately place to less than 50 investors in the initial stage and these investors to sell it to larger number of investors at the second stage as if it is a secondary market operation. The US experience clearly bears out that the Indian private corporate sector is adopting a myopic approach by overlooking the advantages of financial disintermediation. Sooner it gets out of the habit of depending excessively on the banks, institutions, and the private placement market, the better it would be for it from a long-term point of view. The problem of asset-liability mismatches is going to catch up with the banks sooner than later and their appetite for term debt will decline. In so far as the DFIs are concerned they are already in a transition phase toying with the idea of commercial/universal banking. Since their access to long-term funds has dwindled they will not be in a position to meet demand for term funds of industry and infrastructure sectors when investment activity picks up from the present low levels. Continued excessive dependence on banks and DFIs is not in the interest good credit-worthy borrowers, as they would end up paying up more than what they would have to pay if they decide to raise funds from the market directly. Initially, before an extensive good retail distribution network is built up, the borrowing costs of good-credit rated borrowers from the primary savers including the hous eholds may turn out to be slightly higher than those charged to them by banks and institutions. There are also those hassles of servicing large number of investors, which the corporates

have been avoiding all these years by either taking loans or tapping the private placement market. A number of significant reforms have taken place in the Indian financial and capital market areas, which make it possible to tap the retail bond market with minimum hassles. During the last five years movement to depository form for ownership and secondary market transactions has made tremendous progress. Currently, 99.7% of the secondary market transactions in equities are settled through book entry transfers in the depository. The National Securities Depository Ltd (NSDL) promoted by the National Stock Exchange (NSE) along with IDBI and UTI has helped in almost getting rid of paperbased settlements in equities. About a year ago through suitable legislative changes the debt instruments have been brought under the ambit of depository. As a result all ownership transfers through the depository have been completely exempted from the payment of stamp duty, which is quite prohibitively costly. NSE now provides direct online connectivity to 430 cities and towns across the whole country through a satellite communication link-up for secondary market trades. The response time for trades from any part of the country is less than 1.5 seconds. NSE has extended its secondary market infrastructure for making primary issues of debt and equity through either direct fixed price mechanism or through the book-building route. The costs of primary issues as also of secondary market trades of debt and equity can be kept at very modest levels by relying on the infrastructure of NSE and NSDL. With the disappearance of paper securities and abolition of stamp duty in depository mode transfers, the costs of secondary market transactions as also the costs and hassles of servicing of large number of investors can be significantly minimised. Banks and the DFIs can earn good returns if they undertake market making in bonds of their choice. Market making will provide liquidity to the bonds and help in popularising them among millions of investors who have natural preference for fixed income securities. Banks can perform this role with minimum level of risk if they hold investors security accounts as depository participants besides holding their cash accounts. Like in most of the well-developed markets all over the world the Indian stock exchanges had also adopted trading systems that relied overwhelmingly on the jobbing or market making mechanism. The Bombay Stock Exchange (BSE), which until November 1994 used to account for about 70% of the trading turnover of all the stock exchanges in India, had adopted jobbing or market makers system of trade. It was in November 1994 that NSE introduced fully screen-based order driven trading system in India. Many market observers had opined that NSE, as an Exchange would not take off since it did not adopt the time-tested market making trading system. For about a year since November 1994 there was a fierce competition between the order driven system adopted by a totally new exchange like NSE and the market making system of a wellentrenched stock exchange like the BSE. Interestingly the market preferred the order driven system as could be noted from the fact that after about a years time, that is by November 1995,

NSE emerged as the largest stock exchange of the country in terms of daily trading turnover. Since the Indian equity market has a history of more than a 120 years investors could quickly discover that the advantages of the order driven trading system in terms of much lower transaction costs and freedom from the stranglehold of the market makers. However, Indian investor is still new to the debt market. As of now, most of the investors in favour of fixed income assets prefer bank deposits, postal savings schemes, etc. To entice these investors to the debt market they will have to be assured of adequate liquidity in the secondary market for debt instruments. In the case of the fixed income assets such as bank deposits or postal savings schemes the investors are protected in regard to both the principle value of investment and the rate of return. However, principal value of the debt instruments traded in the secondary market may not always be equal to their original investment value. Most of the investors are aware that the market value of the bond is likely to fluctuate in response to movements in interest rates. For instance, the market value of the bond may be below its issued price in response to upward movement in interest rates. The opposite would happen if interest rates decline. Most of the investors would be prepared to absorb this price risk. But what they may not be willing to live with is the decline in the bond value merely because there is hardly any liquidity in the secondary market. Until the market provides a mechanism for pricing bonds based on their intrinsic worth and that bonds do not get quoted at a discount merely because there is no liquidity investors may be unwilling to go in for traded debt instruments. Conscious efforts therefore need to be made to create liquidity in the debt instruments by encouraging market makers to give two-way bid and offer quotes with reasonably narrow spreads. Once the investors are convinced that they are assured of liquidity in the market their willingness to shift from the currently popular fixed income assets like bankdeposits to tradable debt instruments like corporate debentures would be greater. As of now the average investors are not yet aware of the advantages of investing in debt instruments that are traded in the market. Tradable debt instruments are yet to catch fancy of most of the average investors although they prefer to invest major part of their savings in the fixed income securities. Therefore, it is more a matter of developing investors tastes for such instruments before the fixed income oriented investors naturally start investing in them. In the early stages of development of the debt market it would be both desirable and necessary to introduce active market making so that investors are assured of liquidity for the debt instruments. The banks and DFIs are best suited to take upon themselves the role of market makers for their clients who enjoy good credit rating. The existence of information asymmetry is actually in favour of the banks and DFIs. They have good access to far more dependable information about their corporate clients than 10 average investors do. Since they can assess credit risk of the debentures of their clients they are in a better position to make bid and offer quotes for such debentures. Instead of extending loans/credits to their corporate clients, banks and institutions should persuade some of their clients to tap the debt market for long-term bonds or commercial

paper. The attractions of such instruments to the investors would be considerable if the banks actively make market in these instruments by making two-way quotes. Banks can offer both cash account and depository account facilities to investors at most of their branches. They are, therefore, in a better position to tempt their depositors to invest in the bonds floated by their good clients. Investors would be better inclined to invest in a debt instrument if they know that their bank would be willing to buy/sell the instrument from them at a preannounced price. This being a fee-based income activity banks will be passing on the credit risk directly to the investors. Banks do not have to raise additional capital to meet the stringent capital adequacy norms if they choose to play the intermediary role in the sale of debenture rather accept deposits to extend credit to their corporate clients.

HISTORY :Towards the eighteenth century, the borrowing needs of Indian Princely States were largely met by Indigenous bankers and financiers. The concept of borrowing from the public in India was pioneered by the East India Company to finance its campaigns in South India (the Anglo French wars) in the eighteenth century. The debt owed by the Government to the public, over time, came to be known as public debt. The endeavours of the Company to establish government banks towards the end of the 18th Century owed in no small measure to the need to raise term and short term financial accommodation from banks on more satisfactory terms than they were able to garner on their own. The incentive to set up Government banks (read central banks), had a lot to do with debt management. Public Debt, today, is raised to meet the Governments revenue deficits (the difference between the income of the government and money spent to run the government) or to finance public works (capital formation). Borrowing for financing railway construction and public works such irrigation canals was first undertaken in 1867. The First World War saw a rise in India's Public Debt as a result of India's contribution to the British exchequer towards the cost of the war. The provinces of British India were allowed to float loans for the first time in December, 1920 when local government borrowing rules were issued under section 30(a) of the Government of India Act, 1919. Only three provinces viz., Bombay, United Provinces and Punjab utilised this sanction before the introduction of provincial autonomy. Public Debt was managed by the Presidency Banks, the Comptroller and Auditor-General of India till 1913 and thereafter by the Controller of the Currency till 1935 when the Reserve Bank commenced operations. Interest rates varied over time and after the uprising of 1857 gradually came down to about 5% and later to 4% in 1871. In 1894, the famous 3 1/2 % paper was created which continued to be in existence for almost 50 years. When the Reserve Bank of India took over the management of public debt from the Controller of the Currency in 1935, the total funded debt of the Central

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. As at the end of March, 2003, it is estimated that the combined outstanding liabilities of the centre and state governments amounted to Rs 18 trillion which worked out to over 75 percent of the country's gross domestic product (GDP). In India and the world over, Government Bonds have, from time to time, have not only adopted innovative methods for rasing resources (legalised wagering contracts like the Prize Bonds issued in the 1940s and later 1950s in India) but have also been used for various innovative schemes such as finance for development; social

engineering like the abolition of the Zamindari system; saving the environment; or even weaning people away from gold (the gold bonds issued in 1993). Normally the sovereign is considered the best risk in the country and sovereign paper sets the benchmark for interest rates for the corresponding maturity of other issuing entities. Theoretically, others can borrow at a rate above what the Government pays depending on how their risk is perceived by the markets. Hence, a well developed Government Securities market helps in the efficient allocation of resources. A countrys debt market to a large extent depends on the depth of the Governments Bond Market. It in in this context that the recent initiatives to widen and deepen the Government Securities Market and to make it more efficient have been taken.

An early debt instrument issued by the East India Company

An early debt instrument issued by the East India Company

A Government Promissory Note issued by the Princely State of Travancore

A Government Stock Certificate Issued by the Princely State of Hyderabad

Premium Prize Bonds issued by Government of India

The Finance Minister inaugurating the Premium Prize Bonds

The Bihar Zamindari Abolition Compensation Bonds represented the use of Government Bonds to help undertake social engineering initiatives.

REGULATORY BODY FOR BONDS IN INDIA:Establishment The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934.

The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies are formulated. Though originally privately owned, since nationalisation in 1949, the Reserve Bank is fully owned by the Government of India. Preamble The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as: "...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage."

TRADING OF BONDS IN INDIA:Bonds generally can trade anywhere in the world that a buyer and seller can strike a deal. There is no central place or exchange for bond trading, as there is for publicly traded stocks. The bond market is known as an "over-the-counter" market, rather than an exchange market. There are some exceptions to this. For example, some corporate bonds in the United States are listed on an exchange. Also, bond futures, and some types of bond options, are traded on exchanges. But the overwhelming majority of bonds do not trade on exchanges. (This article refers to marketable bonds where trading is permitted. Trading is sometimes not permitted for government savings bonds.)

INVESTING IN BONDS:Bonds are bought and traded mostly by institutions like central banks, sovereign wealth funds, pension funds, insurance companies and banks. Most individuals who want to own bonds do so through bond funds. Still, in the U.S., nearly 10% of all bonds outstanding are held directly by households. Sometimes, bond markets rise (while yields fall) when stock markets fall. More relevantly, the volatility of bonds (especially short and medium dated bonds) is lower than that of stocks. Thus bonds are generally viewed as safer investments than stocks, but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks, and bonds' interest payments are often higher than the general level of dividend payments. Bonds are liquid it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks and the comparative certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount),

whereas the company's stock often ends up valueless. However, bonds can also be risky but less risky than stocks:

Fixed rate bonds are subject to interest rate risk, meaning that their market prices will decrease in value when the generally prevailing interest rates rise. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the market interest rate rises, the market price of bonds will fall, reflecting investors' ability to get a higher interest rate on their money elsewhere perhaps by purchasing a newly issued bond that already features the newly higher interest rate. Note that this drop in the bond's market price does not affect the interest payments to the bondholder at all, so long-term investors who want a specific amount at the maturity date do not need to worry about price swings in their bonds and do not suffer from interest rate risk.

Bonds are also subject to various other risks such as call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk and yield curve risk. Price changes in a bond will also immediately affect mutual funds that hold these bonds. If the value of the bonds held in a trading portfolio has fallen over the day, the value of the portfolio will also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers (irrespective of whether the value is immediately "marked to market" or not). If there is any chance a holder of individual bonds may need to sell his bonds and "cash out", interest rate risk could become a real problem (conversely, bonds' market prices would increase if the prevailing interest rate were to drop, as it did from 2001 through 2003.One way to quantify the interest rate risk on a bond is in terms of its duration. Efforts to control this risk are called immunization or hedging.

Bond prices can become volatile depending on the credit rating of the issuer for instance if the credit rating agencies like Standard & Poor's and Moody's upgrade or downgrade the credit rating of the issuer. A downgrade will cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them. A company's bondholders may lose much or all their money if the company goes bankrupt. Under the laws of many countries (including the United States and Canada), bondholders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank) and trade creditors may take precedence.

There is no guarantee of how much money will remain to repay bondholders. As an example, after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications company Worldcom, in 2004 its bondholders ended up being paid 35.7 cents on the dollar In a

bankruptcy involving reorganization or recapitalization, as opposed to liquidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.

Some bonds are callable, meaning that even though the company has agreed to make payments plus interest towards the debt for a certain period of time, the company can choose to pay off the bond early. This creates reinvestment risk, meaning the investor is forced to find a new place for his money, and the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.

The GOI bond market in the 1990s In 1992, the GOI bond market did not use trading on an exchange. It featured bilateral negotiation between dealers. A major consequence of bilateral negotiation is that the market lacks pricetime priority. Further, the lack of anonymity implies that a variety of malpractices can ourish, such as shading prices for favoured counterparties, forming and enforcing cartels, etc. Bilateral transactions impose counterparty credit risk on participants. This tends to narrow down the market into a club which has homogeneous credit risk, and thus throws up entry barriers in the market. The negotiations between dealers took place on telephone, and were effectively restricted to individuals in one square kilometer of south Bombay. The rest of India could not participate in the market. This was similar to the BSE oor, which produced a southBombay domination in the equity market. Bilateral transactions are extremely nontransparent in terms of both pretrade and post trade transparency. Before the trade takes place, trading intentions are not publicly visible. After the trade takes place, information about the trade is not made publicly available in realtime. The settlement of GOI bond trades is done through the database called SGL maintained by RBI. SGL suffered from serious operational problems as of 1991. Partly as a response to these problems, participants took to trading in IOUs called bankers receipts (BRs). The practice of 9bilateral netting ourished, in a dangerous environment of weak back ofce software and internal controls.

These problems were present from the middle 1980s onwards. However, the increase in transaction volume in the early 1990s, and the euphoria on the stock market following the liberalization of 1991, were the triggers which converted these systemic problems into a crisis. Most systemic crises in the nancial sector are rooted in uncontrolled leverage; the Scam of 1992 can be attributed to a twostage leverage one stage at the interbank GOI bond market (using IOUs) and another on the stock market (using badla).

In terms of sheer market size, the equity market saw a drop from 42% of GDP in 199394 to 28.6% of GDP in 2000-01. Over the same period, the GOI bond market saw an increase in market size, fueled by large scal decits, from 28% of GDP in 199394 to 36.7% of GDP in 200001. Other things being equal, this should have generated an improvement in liquidity of the GOI bond market and a reduction in liquidity in the equity market. Instead,changes in market design on the equity market over this period gave the opposite outcome, where the improvement in liquidity on the equity market was superior to that observed on the GOI bond market.

BUSINESS IN THE INDIAN BOND MARKET FROM 1993-2001:Rs. billion Percent of GDP Year 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 Equity 3681 4334 5265 4639 5603 5429 9128 6255 GOI Bond 2457 2665 3079 3445 3890 4597 7143 8045 Equity 42.0 41.8 43.2 32.9 33.8 30.9 46.6 28.6 GOI Bond 28.0 25.7 25.3 24.4 25.7 26.0 36.5 36.7

MAJOR PARTICIPANTS:Market Participants In India the major investors in government securities are the commercial banks, cooperative banks, insurance companies, provident funds, financial institutions includingthe DFIs, mutual funds (including the gilt funds), primary dealers, and non-bank financecompanies. RBI also invests in government securities either through the private placement route or by absorbing the un-subscribed portion of an auction for notified amount. Commercial banks are the dominant investors historically because of the Statutory Liquidity Ratio (SLR) compulsions. But during the last several years banks are investing substantially more than what is required by the SLR compulsions as the demand for funds is not growing or that they prefer investing in government securities in view of the capital adequacy requirements. Given the risk-reward matrix banks find it more attractive to invest in government securities. Life Insurance Corporation (LIC) is another major investor next to the banks. As at end 1999while RBI held 9.1% of the stock of the Central and State Government securities, 59.5% was held by commercial banks,17.9% by LIC, and 13.5% by others. During the last decade the mandatory SLR ratio was brought down by RBI from 38.5% of the total demand time liabilities of the banks to 25% as of now. But banks investment in government securities is around one-third more than what is statutorily required indicating thereby that banks now consider government securities to be a preferred option. From the viewpoint of the debt markets this is a healthy development, as it will help in developing an efficient government securities market that can throw up a meaningful benchmark yield rate. An equally important development has been the growing popularity of the Gilt Funds, which invest all their disposable resources into gilt securities. Slowly but surely many investors are discovering the advantages of gilt securities and the risk-reward matrix. This should help in the development of a retail market in government securities for a class of investors who would invest either through the Gilt Funds or directly. One major attraction of gilt investments is the abolition of the Tax Deducted at Source (TDS) for gilt investments. This will also facilitate in the development of the yield curve that does not contain the noise generated by TDS.

TYPES OF BONDS:-

Government Bonds In general, fixed-income securities are classified according to the length of time before maturity. These are the three main categories: Bills - debt securities maturing in less than one year. Notes - debt securities maturing in one to 10 years. Bonds - debt securities maturing in more than 10 years. Marketable securities from the U.S. government - known collectively as Treasuries - follow this guideline and are issued as Treasury bonds, Treasury notes and Treasury bills (T-bills). Technically speaking, T-bills aren't bonds because of their short maturity. (You can read more about T-bills in our Money Market tutorial.) All debt issued by Uncle Sam is regarded as extremely safe, as is the debt of any stable country. The debt of many developing countries, however, does carry substantial risk. Like companies, countries can default on payments. Municipal Bonds Municipal bonds, known as "munis", are the next progression in terms of risk. Cities don't go bankrupt that often, but it can happen. The major advantage to munis is that the returns are free from federal tax. Furthermore, local governments will sometimes make their debt non-taxable for residents, thus making some municipal bonds completely tax free. Because of these tax savings, the yield on a muni is usually lower than that of a taxable bond. Depending on your personal situation, a muni can be a great investment on an after-tax basis.

Corporate Bonds A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years, and long term is over 12 years. Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixedincome investments because of the risk the investor must take on. The company's credit quality is very important: the higher the quality, the lower the interest rate the investor receives. Other variations on corporate bonds include convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity.

Types of Bonds

1. Classification on the basis of Variability of Coupon I. 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. For better understanding let us consider an example of one such bond from IDBI in 1997. The maturity period of this floating rate bond from IDBI was 5 years. The coupon for this bond used to be reset half-yearly on a 50 basis point mark-up, with reference to the 10 year yield on Central Government securities (as the benchmark). This means that if the benchmark rate was set at X %, then coupon for IDBI s floating rate bond was set at (X + 0.50) %. Coupon rate in some of these bonds also have floors and caps. For example, this feature was present in the same case of IDBIs floating rate bond wherein there was a floor of 13.50% (which ensured that bond holders received a minimum of 13.50% irrespective of the benchmark rate). On the other hand, a cap (or a ceiling) feature signifies the maximum coupon that the bonds issuer will pay (irrespective of the benchmark rate). These bonds are also known as Range Notes. More frequently used in the housing loan markets where coupon rates are reset at longer time intervals (after one year or more), these are well known as Variable Rate Bonds and Adjustable Rate Bonds. Coupon rates of some bonds may even move in an opposite direction to benchmark rates. These bonds are known as Inverse Floaters and are common in developed markets.

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2. Classification on the Basis of Variability of Maturity I. Callable Bonds The issuer of a callable bond has the right (but not the obligation) to change the tenor of a bond (call option). The issuer may redeem a bond fully or partly before the actual maturity date. These options are present in the bond from the time of original bond issue and are known as embedded options. A call option is either a European option or an American option. Under an European option, the issuer can exercise the call option on a bond only on the specified date, whereas under an American option, option can be exercised anytime before the specified date. This embedded option helps issuer to reduce the costs when interest rates are falling, and when the interest rates are rising it is helpful for the holders. 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. 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 pre-specified 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.

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3. Classification on the basis of Principal Repayment I. Amortising Bonds Amortising Bonds are those types of bonds in which the borrower (issuer) repays the principal along with the coupon over the life of the bond. The amortising schedule (repayment of principal) is prepared in such a manner that whole of the principle is repaid by the maturity date of the bond and the last payment is done on the maturity date. For example - auto loans, home loans, consumer loans, etc.

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Bonds with Sinking Fund Provisions Bonds with Sinking Fund Provisions have a provision as per which the issuer is required to retire some amount of outstanding bonds every year. The issuer has following options for doing so: i. ii. By buying from the market By creating a separate fund which calls the bonds on behalf of the issuer

Since the outstanding bonds in the market are continuously retired by the issuer every year by creating a separate fund (more commonly used option), these types of bonds are named as bonds with sinking fund provisions. These bonds also allow the borrowers to repay the principal over the bonds life.

Issuance Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is arranged by bookrunners who arrange the bond issue, have direct contact with investors and act as advisers to the bond issuer in terms of timing and price of the bond issue. The bookrunners' willingness to underwrite must be discussed prior to opening books on a bond issue as there may be limited appetite to do so. In the case of government bonds, these are usually issued by auctions, called a public sale, where both members of the public and banks may bid for bond. Since the coupon is fixed, but the price is not, the percent return is a function both of the price paid as well as the coupon. However, because the cost of issuance for a publicly auctioned bond can be cost prohibitive for a smaller loan, it is also common for smaller bonds to avoid the underwriting and auction process through the use of a private placement bond. In the case of a private placement bond, the bond is held by the lender and does not enter the large bond market. Sometimes the documentation allows the issuer to borrow more at a later date by issuing further bonds on the same terms as before, but at the current market price. This is called a tap issue or bond tap.

A when-issued (grey) market was introduced in May 2006. Initially, it was only permitted when the issue was a re-opening of an existing bond (one that was currently trading). The rules were subsequently relaxed to allow when-issued trading in selected new issuances (bonds that were not re-openings of old bonds). This is a relatively sophisticated tool which, while common in developed markets, is not common in Asia, with few exceptions such as Singapore and Hong Kong, China. Increasingly, issuers of government bonds have come to realize that transparency of issuance allows investors to plan their cash flows and investments more accurately. This prevents the market being distorted by temporary excess supply and ensures better prices. Most issuers now publish some form of timetable of forthcoming issues. In 2001, a published timetable was introduced for Treasury bill auctions but not for longer-dated bonds. In part, this was a consequence of weak control of the budget deficit, leading to frequent revisions in funding requirements during the course of the year. Since September 2006, the RBI has published a yearly issuance timetable for dated bonds. Indian state governments raise finance through omnibus issues organized by the RBI. State issues are not government guaranteed. The omnibus issues are sold at fixed coupons and prices (the same for every state). Potential buyers subscribe at the fixed-coupon rate for the bonds of a particular state (the amount on issue for each state is not announced). The subscription is closed after 2 days even if some issues are under subscribed.

Current government bonds are fixed-coupon with maturities from 1 to 30 years. The RBI has experimented over the years with a number of different types of bonds. These include (i) zerocoupon bonds; (ii) capital-indexed bonds (inflation-linked principal); and (iii) floating-rate bonds. None has generated much interest and all have now been discontinued. The RBI is now working to develop a market for Separate Trading of Registered Interest and Principal of Securities (STRIPS).

RBI AND THE BOND MARKET

The government securities market is a very important segment of the debt market for several reasons. In most of the market economies it is perhaps the largest and very active segment. Being a fairly liquid and large market most of the players in the market use sovereign debt instruments

for their liquidity management as well as a collateral for several types of transactions including the repos and collateralised large payments systems. The yield structure as given by the secondary market in sovereign debt serves asBthe benchmark rate for all the other yield rates in the system. It is a universally acceptedBproposition that the term structure of interest rates cannot be meaningfully estimated inBthe absence of a deep, vibrant, and efficient market in sovereign rated debt instruments. The yield rate structure for all the other debt instruments in any financial system evolves or emerges with reference to the term rate structure of the sovereign instruments. RBI has therefore been laying considerable emphasis on the development of an efficient and vibrant government securities market. The last decade witnessed significant transformation in the government securities markets. These developments were as a result of the joint move by RBI and GOI to gradually align the yield structure to the market expectations. Till then the coupon rates on government securities were administratively determined. Until a few years ago the artificially low rates of government securities in relation to the market expectations had an impact on the entire yield structure in the entire financial system. This also hindered growth of an active secondary market in government bonds. As a first step, RBI introduced in June 1992 an auction system for the issue of government securities. The major objective behind this move was to help the market to understand the niceties of the price discovery process. RBI has used both the auction method and the pre-determined coupon/tap issue for this purpose before fully going in for completely market determined rates. Treasury bills are issued primarily through the auction method. Generally the multiple price auctions method used for issuing the instruments. Apart from the allotment through auction, the practice of non-competitive bids at the cut off yield rates is accepted from certain types of investors. The State Governments generally manage their liquidity through purchase of treasury bills issued by the Central Government; they are allotted these at the weighted average price determined in the auction. Non-competitive bids are accepted outside the notified amount for auction. This practice has been adopted to encourage participants who do not have the expertise needed to participate in the auction.RBI also participates in the non-competitive bids in both dated securities and the treasury bills for part of the issues in case the entire issue is not subscribed. On a number of occasions RBI has accepted private placements of government stocks and released them to the market when the interest rate expectations turned out to be favourable. RBI has to resort to this system whenever the governments needs for funds suddenly spurt and the issue through the auction would result in creating sudden destabilisation in the market rates.

A multiple price auction method is associated with the problem called winners curse. It is therefore suggested that a uniform price auction method would be more equitable. RBI 14 therefore recently introduced the uniform price auction method for 91-day treasury bills. With a view to further the process of consolidation, since 1999-2000 RBI is making mostof the primary issues of dated securities by way of re-issues and price-based auctions,instead of yieldbased auctions. As the secondary market widens and deepens it needs large-sized issues for efficient price discovery process in the secondary market and development of proper benchmark rates. RBI is also planning to develop an active market is Separately Traded Registered Interest and Principal of Securities (STRIPS). RBI announces a fixed calendar for auctions of all types treasury bills. The auctions of 14-day and 91-day treasury bills were so far auctioned on a weekly basis while auctions of 182-day and 364-day treasury bills are held on a fortnightly basis. RBI has decided to discontinue the 14-day and 182-day treasury bills and have auctions only in 91-day and 364-day treasury bills. Henceforth the weekly auction of 91-day Treasury bill amountwill be Rs. 2.5 billion and the fortnightly auction of 364-day Treasury bill will be Rs 7.5 billion. RBI is yet to adopt a fixed pre-announced calendar in respect of the issues ofdated securities.

The major reforms in the bond market in India

The system of auction introduced to sell the government securities. The introduction of delivery versus payment (DvP) system by the Reserve Bank of India to nullify the risk of settlement in securities and assure the smooth functioning of the securities delivery and payment. The computerization of the SGL. The launch of innovative products such as capital indexed bonds and zero coupon bonds to attract more and more investors from the wider spectrum of the populace. Sophistication of the markets for bonds such as inflation indexed bonds. The development of the more and more primary dealers as creators of the Government of India bonds market.

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.