DEBT INSTRUMENT

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EXECUTIVE SUMMARY

Understanding and measuring the liquidity of government bond markets

is important to various market participants. Primarily, these markets serve to

governments for financing purposes. Market participants use government bonds

as collateral, as benchmarks for pricing other financial instruments and as

hedging or investment instruments. Central banks extract from these markets

information on future interest rates and use government bonds as monetary

policy instrument. Liquidity directly affects the usability of government bonds

for these purposes.

Until recently, most research articles focused on stock or foreign

exchange markets and only few were dedicated to government bond markets.

Researchers and regulators started to focus on the liquidity of government bond

markets after the financial market turmoil in 1998, which had an impact even on

such liquid markets like the U.S. Treasury market.

Through the efforts of this project, we understood in depth the various

instruments used by individuals as well as by organizations for raising and using

debt. Earlier we were under the impression that we have limited scope to the

debt markets but after this study, we are aware of the various opportunities in

the debt instrument market.

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Introduction

The debt market is a bigger source of borrowed funds than the banking

system. The market for debt is larger than the market for equities (i.e., is larger

than the stock market). The debt market is commonly divided into the so-called

money market (short-term debt, maturity of one year or less) and the so-called

capital market (long-term debt). Both of these terms are misnomers. All

productive assets are capital (including equities). The terminology may be

rationalized by the convention that capitalized expenses are amortized over

periods in excess of one year. "Money market" instruments are debt and

although they can be used as a store of value they can only be regarded as a

medium of exchange in the sense that they are readily sold at a price which is

usually predictable within a short time frame. Moreover, it is hard to base a

conceptual distinction between money & non-money based on a one-year

maturity dividing line.

Most debt instruments are not traded through exchanges, but are traded

over-the-counter (OTC) in a telephone/electronic network market where dealers

or brokers frequently act as direct intermediaries. Money-market instruments

usually have such large denominations that they are not accessible to small

investors except through mutual funds.

The market for debt can be viewed as a market for money in the sense

that sellers of debt (lenders) have a supply of money which is demanded by

would-be buyers (borrowers). In this model, interest rates are the "price" of

money. An increase in demand to borrow money due to increased economic

opportunity increases interest rates (everything else being equal). The market

for debt is influenced by term-to-maturity, credit-worthiness of borrowers,

security for loan and many other factors. By their control of money supply,

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government central banks try to manipulate interest rates to stimulate their

economies without causing inflati

FINANCIAL SYSTEM

Financial System of any country consists of financial markets, financial

intermediation and financial instruments or financial products. This paper

discusses the meaning of finance and Indian Financial System and focus on the

financial markets, financial intermediaries and financial instruments. The brief

review on various money market instruments are also covered in this study.

 

The term "finance" in our simple understanding it is perceived as

equivalent to 'Money'. We read about Money and banking in Economics, about

Monetary Theory and Practice and about "Public Finance". But finance exactly

is not money, it is the source of providing funds for a particular activity. Thus

public finance does not mean the money with the Government, but it refers to

sources of raising revenue for the activities and functions of a Government.

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INDIAN FINANCIAL SYSTEM

  The economic development of a nation is reflected by the progress of the

various economic units, broadly classified into corporate sector, government

and household sector.  While performing their activities these units will be

placed in a surplus/deficit/balanced budgetary situations.

There are areas or people with surplus funds and there are those with a

deficit.  A financial system or financial sector functions as an intermediary and

facilitates the flow of funds from the areas of surplus to the areas of deficit.  A

Financial System is a composition of various institutions, markets, regulations

and laws, practices, money manager, analysts, transactions and claims and

liabilities.

The word "system", in the term "financial system", implies a set of

complex and closely connected or interlined institutions, agents, practices,

markets, transactions, claims, and liabilities in the economy.  The financial

system is concerned about money, credit and finance-the three terms are

intimately related yet are somewhat different from each other. Indian financial

system consists of financial market, financial instruments and financial

intermediation. These are briefly discussed below;

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Constituents of a Financial System

FINANCIAL INSTRUMENTS & ITS CLASSIFICATION

Definition:

“A real or virtual document representing a legal agreement involving some sort

of monetary value” In today's financial marketplace, financial instruments can

be classified generally as equity based, representing ownership of the asset, or

debt based, representing a loan made by an investor to the owner of the asset.

Foreign exchange instruments comprise a third, unique type of

instrument. Different subcategories of each instrument type exist, such as

preferred share equity and common share equity, for example

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Money Market Instruments

The money market can be defined as a market for short-term money and

financial assets that are near substitutes for money. The term short-term means

generally a period upto one year and near substitutes to money is used to denote

any financial asset which can be quickly converted into money with minimum

transaction cost.

Some of the important money market instruments are briefly discussed below;

1.Call/Notice Money

2. Treasury Bills

3.Term Money

4.Certificate of Deposit

5.Commercial Papers

1. Call /Notice-Money Market

Call/Notice money is the money borrowed or lent on demand for a very

short period. When money is borrowed or lent for a day, it is known as Call

(Overnight) Money. Intervening holidays and/or Sunday are excluded for this

purpose. Thus money, borrowed on a day and repaid on the next working day,

(irrespective of the number of intervening holidays) is "Call Money". When

money is borrowed or lent for more than a day and up to 14 days, it is "Notice

Money". No collateral security is required to cover these transactions.

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2. Inter-Bank Term Money

Inter-bank market for deposits of maturity beyond 14 days is referred to

as the term money market. The entry restrictions are the same as those for

Call/Notice Money except that, as per existing regulations, the specified entities

are not allowed to lend beyond 14 days.

3. Treasury Bills

Treasury Bills are short term (up to one year) borrowing instruments of

the union government. It is an IOU of the Government. It is a promise by the

Government to pay a stated sum after expiry of the stated period from the date

of issue (14/91/182/364 days i.e. less than one year). They are issued at a

discount to the face value, and on maturity the face value is paid to the holder.

The rate of discount and the corresponding issue price are determined at each

auction.

4. Certificate of Deposits

Certificates of Deposit (CDs) is a negotiable money market instrument

and issued in dematerialised form or as a Usance Promissory Note, for funds

deposited at a bank or other eligible financial institution for a specified time

period. Guidelines for issue of CDs are presently governed by various directives

issued by the Reserve Bank of India, as amended from time to time. CDs can be

issued by (i) scheduled commercial banks excluding Regional Rural Banks

(RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial

Institutions that have been permitted by RBI to raise short-term resources within

the umbrella limit fixed by RBI. Banks have the freedom to issue CDs

depending on their requirements. An FI may issue CDs within the overall

umbrella limit fixed by RBI, i.e., issue of CD together with other instruments

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viz., term money, term deposits, commercial papers and inter corporate deposits

should not exceed 100 per cent of its net owned funds, as per the latest audited

balance sheet.

5. Commercial Paper

CP is a note in evidence of the debt obligation of the issuer. On issuing

commercial paper the debt obligation is transformed into an instrument. CP is

thus an unsecured promissory note privately placed with investors at a discount

rate to face value determined by market forces. CP is freely negotiable by

endorsement and delivery. A company shall be eligible to issue CP provided -

(a) the tangible net worth of the company, as per the latest audited balance

sheet, is not less than Rs. 4 crore; (b) the working capital (fund-based) limit of

the company from the banking system is not less than Rs.4 crore and (c) the

borrowal account of the company is classified as a Standard Asset by the

financing bank/s. The minimum maturity period of CP is 7 days. The minimum

credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies.

Capital Market Instruments

The capital market generally consists of the following long term period

i.e., more than one year period, financial instruments; In the equity segment

Equity shares, preference shares, convertible preference shares, non-convertible

preference shares etc and in the debt segment debentures, zero coupon bonds,

deep discount bonds etc.

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Hybrid Instruments

Hybrid instruments have both the features of equity and debenture. This

kind of instruments is called as hybrid instruments. Examples are convertible

debentures, warrants etc.

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FINANCIAL MARKET & ITS CLASSIFICATION

A financial market is a mechanism that allows people to buy and sell

(trade) financial securities (such as stocks and bonds), commodities (such as

precious metals or agricultural goods), and other fungible items of value at low

transaction costs and at prices that reflect the efficient-market hypothesis.

Both general markets (where many commodities are traded) and

specialized markets (where only one commodity is traded) exist. Markets work

by placing many interested buyers and sellers in one "place", thus making it

easier for them to find each other. An economy which relies primarily on

interactions between buyers and sellers to allocate resources is known as a

market economy in contrast either to a command economy or to a non-market

economy such as a gift economy.

In finance, financial markets facilitate:

The raising of capital (in the capital markets)

The transfer of risk (in the derivatives markets)

International trade (in the currency markets)

– and are used to match those who want capital to those who have it.

Typically a borrower issues a receipt to the lender promising to pay back

the capital. These receipts are securities which may be freely bought or sold. In

return for lending money to the borrower, the lender will expect some

compensation in the form of interest or dividends.

In mathematical finance, the concept of a financial market is defined in

terms of a continuous-time Brownian motion stochastic process.

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Definition

Typically, the term market means the aggregate of possible buyers and

sellers of a certain good or service and the transactions between them.

The term "market" is sometimes used for what are more strictly

exchanges, organizations that facilitate the trade in financial securities, e.g., a

stock exchange or commodity exchange. This may be a physical location (like

the NYSE) or an electronic system (like NASDAQ). Much trading of stocks

takes place on an exchange; still, corporate actions (merger, spinoff) are outside

an exchange, while any two companies or people, for whatever reason, may

agree to sell stock from the one to the other without using an exchange.

Trading of currencies and bonds is largely on a bilateral basis, although

some bonds trade on a stock exchange, and people are building electronic

systems for these as well, similar to stock exchanges.

Financial markets can be domestic or they can be international.

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Types of Financial Markets

The financial markets can be divided into different subtypes:

Capital markets which consist of:

o Stock markets, which provide financing through the issuance of

shares or common stock, and enable the subsequent trading thereof.

o Bond markets, which provide financing through the issuance of

bonds, and enable the subsequent trading thereof.

Commodity markets, which facilitate the trading of commodities.

Money markets, which provide short term debt financing and investment.

Derivatives markets, which provide instruments for the management of

financial risk.

Futures markets, which provide standardized forward contracts for

trading products at some future date; see also forward market.

Insurance markets, which facilitate the redistribution of various risks.

Foreign exchange markets, which facilitate the trading of foreign

exchange.

The capital markets consist of primary markets and secondary markets.

Newly formed (issued) securities are bought or sold in primary markets.

Secondary markets allow investors to sell securities that they hold or buy

existing securities.

Raising the capital

To understand financial markets, let us look at what they are used for, i.e. what

Without financial markets, borrowers would have difficulty finding lenders

themselves. Intermediaries such as banks help in this process. Banks take

deposits from those who have money to save. They can then lend money from

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this pool of deposited money to those who seek to borrow. Banks popularly lend

money in the form of loans and mortgages.

More complex transactions than a simple bank deposit require markets

where lenders and their agents can meet borrowers and their agents, and where

existing borrowing or lending commitments can be sold on to other parties. A

good example of a financial market is a stock exchange. A company can raise

money by selling shares to investors and its existing shares can be bought or

sold. The following table illustrates where financial markets fit in the

relationship between lenders and borrowers

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Relationship between lenders and borrowers

LendersFinancial

Intermediaries

Financial

MarketsBorrowers

Individuals

Companies

Banks

Insurance Companies

Pension Funds

Mutual Funds

Interbank

Stock Exchange

Money Market

Bond Market

Foreign

Exchange

Individuals

Companies

Central

Government

Municipalities

Public

Corporations

Lenders

Individuals

Many individuals are not aware that they are lenders, but almost everybody

does lend money in many ways. A person lends money when he or she:

puts money in a savings account at a bank;

contributes to a pension plan;

pays premiums to an insurance company;

invests in government bonds; or

invests in company shares.

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Companies

Companies tend to be borrowers of capital. When companies have

surplus cash that is not needed for a short period of time, they may seek to make

money from their cash surplus by lending it via short term markets called

money markets.

There are a few companies that have very strong cash flows. These

companies tend to be lenders rather than borrowers. Such companies may

decide to return cash to lenders (e.g. via a share buyback.) Alternatively, they

may seek to make more money on their cash by lending it (e.g. investing in

bonds and stocks.)

Borrowers

Individuals borrow money via bankers' loans for short term needs or

longer term mortgages to help finance a house purchase.

Companies borrow money to aid short term or long term cash flows. They also

borrow to fund modernization or future business expansion.

Governments often find their spending requirements exceed their tax

revenues. To make up this difference, they need to borrow. Governments also

borrow on behalf of nationalised industries, municipalities, local authorities and

other public sector bodies. In the UK, the total borrowing requirement is often

referred to as the Public sector net cash requirement (PSNCR).

Governments borrow by issuing bonds. In the UK, the government also

borrows from individuals by offering bank accounts and Premium Bonds.

Government debt seems to be permanent. Indeed the debt seemingly expands

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rather than being paid off. One strategy used by governments to reduce the

value of the debt is to influence inflation.

Municipalities and local authorities may borrow in their own name as well as

receiving funding from national governments. In the UK, this would cover an

authority like Hampshire County Council.

Public Corporations typically include nationalised industries. These may

include the postal services, railway companies and utility companies.

Many borrowers have difficulty raising money locally. They need to borrow

internationally with the aid of Foreign exchange markets.

Derivative products

During the 1980s and 1990s, a major growth sector in financial markets is

the trade in so called derivative products, or derivatives for short.

In the financial markets, stock prices, bond prices, currency rates, interest

rates and dividends go up and down, creating risk. Derivative products are

financial products which are used to control risk or paradoxically exploit risk. It

is also called financial economics.

Currency markets

Seemingly, the most obvious buyers and sellers of currency are importers

and exporters of goods. While this may have been true in the distant past, when

international trade created the demand for currency markets, importers and

exporters now represent only 1/32 of foreign exchange dealing, according to the

Bank for International Settlements.

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The picture of foreign currency transactions today shows:

Banks/Institutions

Speculators

Government spending (for example, military bases abroad)

Importers/Exporters

Tourists

Analysis of financial markets

Much effort has gone into the study of financial markets and how prices

vary with time. Charles Dow, one of the founders of Dow Jones & Company

and The Wall Street Journal, enunciated a set of ideas on the subject which are

now called Dow Theory. This is the basis of the so-called technical analysis

method of attempting to predict future changes. One of the tenets of "technical

analysis" is that market trends give an indication of the future, at least in the

short term. The claims of the technical analysts are disputed by many

academics, who claim that the evidence points rather to the random walk

hypothesis, which states that the next change is not correlated to the last change.

FINANCIAL INTERMEDIATION

Having designed the instrument, the issuer should then ensure that these

financial assets reach the ultimate investor in order to garner the requisite

amount.  When the borrower of funds approaches the financial market to raise

funds, mere issue of securities will not suffice.  Adequate information of the

issue, issuer and the security should be passed on to take place.  There should be

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a proper channel within the financial system to ensure such transfer. To serve

this purpose, Financial intermediaries came into existence. Financial

intermediation in the organized sector is conducted by a widerange of

institutions functioning under the overall surveillance of the Reserve Bank of

India. In the initial stages, the role of the intermediary was mostly related to

ensure transfer of funds from the lender to the borrower.  This service was

offered by banks, FIs, brokers, and dealers.  However, as the financial system

widened along with the developments taking place in the financial markets, the

scope of its operations also widened. Some of the important intermediaries

operating in the financial markets include; investment bankers, underwriters,

stock exchanges, registrars, depositories, custodians, portfolio managers, mutual

funds, financial advertisers financial consultants, primary dealers, satellite

dealers, self regulatory organizations, etc. Though the markets are different,

there may be a few intermediaries offering their services in more than one

market e.g. underwriter.  However, the services offered by them vary from one

market to another.

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Intermediary Market Role

Stock Exchange Capital MarketSecondary Market to

securities

Investment BankersCapital Market, Credit

Market

 Corporate advisory

services, Issue of

securities

UnderwritersCapital Market, Money

Market

Subscribe to unsubscribed

portion of securities

Registrars, Depositories,

CustodiansCapital Market

Issue securities to the

investors on behalf of the

company and handle

share transfer activity

Primary Dealers Satellite

DealersMoney Market

Market making in

government securities

Forex Dealers Forex MarketEnsure exchange ink

currencies

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What is the Debt Market?

The debtmarket is any market situation where the trading debt

instruments take place. Examples of debt instruments include mortgages,

promissory notes, bonds, and Certificates of Deposit. A debtmarket establishes

a structured environment where these types of debt can be traded with ease

between interested parties.

Individual investors as well as groups or corporate partners may

participate in a debtmarket. Depending on the regulations imposed by

governments, there may be very little distinction between how an individual

investor versus a corporation would participate in a debtmarket. However, there

are usually some regulations in place that require that any type of investor in

debtmarket offerings have a minimum amount of assets to back the activity.

This is true even with situations such as bonds, where there is very little chance

of the investor losing his or her investment.

One of the advantages to participating in a debtmarket is that the degree

of risk associated with the investment opportunities is very low. For investors

who are focused on avoiding riskier ventures in favor of making a smaller but

more or less guaranteed return, going with bonds and similar investments

simply makes sense. While the returns will never be considered spectacular, it is

possible to earn a significant amount of money over time, if the right

debtmarket offerings are chosen.

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Issuers of various bonds, notes, and mortgages also benefit from the structured

environment of a debtmarket. By offering the instruments on a market that is

regulated and has a solid working process, it is possible to interact with a larger

base of investors who could be attracted to the type of debt instrument offered.

Because most markets have at least some basic requirements for participation

on the market, the issuers can spend less time qualifying potential buyers and

more time spreading the word about the debt instruments they have to offer.

In most of the countries, the debt market is more popular than the equity

market. This is due to the sophisticated bond instruments that have return-

reaping assets as their underlying. In the US, for instance, the corporate bonds

(like mortgage bonds) became popular in the 1980s. However, in India, equity

markets are more popular than the debt markets due to the dominance of the

government securities in the debt markets.

Moreover, the government is borrowing at a pre-announced coupon rate

targeting a captive group of investors, such as banks. This, coupled with the

automatic monetization of fiscal deficit, prevented the emergence of a deep and

vibrant government securities market.

The bond markets exhibit a much lower volatility than equities, and all

bonds are priced based on the same macroeconomic information. The bond

market liquidity is normally much higher than the stock market liquidity in most

of the countries. The performance of the market for debt is directly related to

the interest rate movement as it is reflected in the

yields of government bonds, corporate debentures, MIBOR-related commercial

papers,and non-convertible debentures.

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INDIAN DEBT MARKET

Debt market refers to the financial market where investors buy and sell

debt securities, mostly in the form of bonds. These markets are important source

of funds, especially in a developing economy like India. India debt market is

one of the largest in Asia. Like all other countries, debt market in India is also

considered a useful substitute to banking channels for finance.

Wholesale Debt Market

The Wholesale Debt Market segment deals in fixed income securities and

is fast gaining ground in an environment that has largely focussed on equities.

The Wholesale Debt Market (WDM) segment of the Exchange commenced

operations on June 30, 1994. This provided the first formal screen-based trading

facility for the debt market in the country.

This segment provides trading facilities for a variety of debt instruments

including Government Securities, Treasury Bills and Bonds issued by Public

Sector Undertakings/ Corporates/ Banks like Floating Rate Bonds, Zero Coupon

Bonds, Commercial Papers, Certificate of Deposits, Corporate Debentures,

State Government loans, SLR and Non-SLR Bonds issued by Financial

Institutions, Units of Mutual Funds and Securitized debt by banks, financial

institutions, corporate bodies, trusts and others.

Large investors and a high average trade value characterize this segment. Till

recently, the market was purely an informal market with most of the trades

directly negotiated and struck between various participants. The commencement

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of this segment by NSE has brought about transparency and efficiency to the

debt market.

Retail Debt Market

With a view to encouraging wider participation of all classes of investors

across the country (including retail investors) in government securities, the

Government, RBI and SEBI have introduced trading in government securities

for retail investors.

Trading in this retail debt market segment (RDM) on NSE has been introduced

w.e.f. January 16, 2003. Trading shall take place in the existing Capital Market

segment of the Exchange.

In the first phase, all outstanding and newly issued central government

securities would be traded in the retail segment. Other securities like state

government securities, T-Bills etc. would be added in subsequent phases.

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IMPORTANCE & SIGNIFICANCE OF DEBT

The debt market is a market where fixed income securities issued by the

Central and state governments, municipal corporations, government bodies, and

commercial entities like financial institutions, banks, public sector units, and

public limited companies. Therefore, it is also called fixed income market.

The key role of the debt markets in the Indian Economy stems from the

following reasons:

Efficient mobilization and allocation of resources in the economy

Financing the development activities of the Government

Transmitting signals for implementation of the monetary policy

Facilitating liquidity management in tune with overall short term and

long term objectives.

Since the Government Securities are issued to meet the short term and long term

financial needs of the government, they are not only used as instruments for

raising debt, but have emerged as key instruments for internal debt

management, monetary management and short term liquidity management.

The returns earned on the government securities are normally taken as the

benchmark rates of returns and are referred to as the risk free return in financial

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theory. The Risk Free rate obtained from the G-sec rates are often used to price

the other non-govt. securities in the financial markets.

Advantages of debt instruments:

Reduction in the borrowing cost of the Government and enable

mobilization of resources at a reasonable cost.

Provide greater funding avenues to public-sector and private sector

projects and reduce the pressure on institutional financing.

Enhanced mobilization of resources by unlocking illiquid retail

investments like gold.

Development of heterogeneity of market participants

Assist in development of a reliable yield curve and the term structure of

interest rates.

Risks associated with debt securities

The debt market instrument is not entirely risk free. Specifically, two main

types of risks are involved, i.e., default risk and the interest rate risk. The

following are the risks associated with debt securities:

Default Risk: This can be defined as the risk that an issuer of a bond may

be unable to make timely payment of interest or principal on a debt

security or to otherwise comply with the provisions of a bond indenture

and is also referred to as credit risk.

Interest Rate Risk: can be defined as the risk emerging from an adverse

change in the interest rate prevalent in the market so as to affect the yield

on the existing instruments. A good case would be an upswing in the

prevailing interest rate scenario leading to a situation where the investors'

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money is locked at lower rates whereas if he had waited and invested in

the changed interest rate scenario, he would have earned more.

Reinvestment Rate Risk: can be defined as the probability of a fall in

the interest rate resulting in a lack of options to invest the interest

received at regular intervals at higher rates at comparable rates in the

market.

The following are the risks associated with trading in debt securities:

Counter Party Risk: is the normal risk associated with any transaction and

refers to the failure or inability of the opposite party to the contract to

deliver either the promised security or the sale-value at the time of

settlement.

Price Risk: refers to the possibility of not being able to receive the

expected price on any order due to a adverse movement in the prices.

Significance

The Indian debt market is composed of government bonds and corporate bonds.

However, the Central government bonds are predominant and they form most

liquid component of the bond market. In 2003, the National Stock Exchange

(NSE) introduced Interest Rate Derivatives.

The trading platforms for government securities are the ‘Negotiated

Dealing System’ and the Wholesale Debt Market (WDM) segment of NSE and

BSE. In the negotiated market, the trades are normally decided by the seller and

the buyer, and reported to the exchange through the broker, whereas the WDM

trading system, known as NEAT (National Exchange for Automated Trading),

is a fully automated screen-based trading system, which enables members

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across the country to trade simultaneously with enormous ease

and efficiency.

Price determination of debt instruments

The price of a bond in the markets is determined by the forces of demand and

supply, as is the case in any market. The price of a bond also depends on the

changes in:

• Economic conditions

• General money market conditions, including the state of money supply in the

economy

• Interest rates prevalent in the market and the rates of new issues

• Future Interest Rate Expectations

• Credit quality of the issuer

Debt Instruments are categorized as:

• Government of India dated Securities: (G Secs) are 100-rupee face-value

units/ debt paper issued by the Government of India in lieu of their borrowing

from the market. They are referred to as SLR securities in the Indian markets as

they are eligible securities for the maintenance of the SLR ratio by the banks.

• Corporate debt market: The corporate debt market basically contains PSU

bonds and private sector bonds. The Indian primary Corporate Debt market is

basically a private placement market with most of the corporate bonds being

privately placed among the wholesale investors, which include banks, financial

Institutions, mutual funds, large corporates& other large investors.

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The following debt instruments are available in the corporate debt market:

• Non-Convertible Debentures

• Partly-Convertible Debentures/Fully-Convertible Debentures (convertible into

Equity Shares)

• Secured Premium Notes

• Debentures with Warrants

• Deep Discount Bonds

• PSU Bonds/Tax-Free Bonds

Interest Rate Derivatives

An interest rate futures contract is "an agreement to buy or sell a package

of debt instruments at a specified future date at a price that is fixed today." The

price of debt securities and, therefore, interest rate futures, is inversely

proportional to the prevailing interest rate. When the interest rate goes up, the

price of debt securities and interest rate futures goes down, and vice versa.

Some of the assets underlying interest rate futures include US Treasuries, Euro-

Dollars, LIBOR Swap, and Euro-Yen futures.

Tenure

Interest rate futures contracts can have short-term (less than one year) and

long-term (more than one year) interest bearing instruments as the underlying

asset. In the US, short-term interest rate futures like 90-day T-Bill and 3-month

Euro-Dollar time deposits are more popular. Long-term interest rate futures

include the 10-year Treasury Note futures contract, and the Treasury Bond

futures contract.

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Hedging with Interest rate futures

Interest rate futures can be used to protect against an increase in interest

rates as well as a decline in interest rates. By selling interest rate futures, also

known as short hedging, an investor can protect himself against an increase in

interest rates; and by buying interest rate futures, also known as long hedging,

an investor can protect himself against a decline in interest rates. Thus, short,

medium, and long-term interest rate risks can be managed with products based

on Euro-Dollars, US Treasuries, and Swaps in Europe and the US. In India,

interest rate derivatives would be used for hedging in the near future.

Money market opportunities for SMEs

To begin with a brief rejoinder, the Indian money market is a market for

short term securities like T-bills, certificates of deposits, commercial papers,

repos and others. These debts are issued by the government, banks, companies

and financial institutions, respectively. The papers traded are almost like a

promissory note which usually has a fixed interest rate and a maturity of less

than one year.

Since the securities in this market are less than one year, and the source

of these securities is the government/banks/highly-rated companies, the credit

risk involved is considered to be low (though slightly higher than an FD).

Moreover, the tax incidence on the income from these schemes (depending on

the plan) is usually lower than the one that the interest on savings accounts or

FDs invite.

Therefore, from the SME point of view, the leveraging of the debt market

can actually come in two forms. First, as a supplier of debt, and second, as the

buyer. The capacity of the SME to tap the debt market is correlated directly to

the growth trajectory of the corporate debt segment. However, the real and

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DEBT INSTRUMENT

immediate gain potential for SMEs rests on their ability as the buyer of debt,

especially of short term debts.

A convenient alternative and yet a potentially enhanced ‘revenue-

generative’ method of parking the surplus is in the liquid, ultra-short term and

the bond/gilt schemes of mutual funds. These schemes usually also invest your

money in the money market and debt market securities, depending on the

investment mandate of the fund.

.Debt market refers to the financial market where investors buy and sell debt

securities, mostly in the form of bonds. These markets are important source of

funds, especially in a developing economy like India. India debt market is one

of the largest in Asia. Like all other countries, debt market in India is also

considered a useful substitute to banking channels for finance. The most

distinguishing feature of the debt instruments of Indian debt marketis that the

return is fixed. This means, returns are almost risk-free. This fixed return onthe

bond is often termed as the 'coupon rate' or the 'interest rate'. Therefore, the

buyer (ofbond) is giving the seller a loan at a fixed interest rate, which equals to

the coupon rate.

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DEBT INSTRUMENT

Classification of Indian Debt Market

Indian debt market can be classified into two categories:

Government Securities Market (G-Sec Market): It consists of central and

state government securities. It means that, loans are being taken by the central

and state government. It is also the most dominant category in the India debt

market.

Bond Market: It consists of Financial Institutions bonds, Corporate bonds and

debentures and Public Sector Units bonds. These bonds are issued to meet

financial requirements at a fixed cost and hence remove uncertainty in financial

costs.

Advantages

The biggest advantage of investing in Indian debt market is its assured

returns. The returns that the market offer is almost risk-free (though there is

always certain amount of risks, however the trend says that return is almost

assured). Safer are the government securities. On the other hand, there are

certain amounts of risks in the corporate, FI and PSU debt instruments.

However, investors can take help from the credit rating agencies which rate

those debt instruments. The interest in the instruments may vary depending

upon the ratings.

Another advantage of investing in India debt market is its high liquidity. Banks

offer easy loans to the investors against government securities.

Disadvantages

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DEBT INSTRUMENT

As there are several advantages of investing in India debt market, there

are certain disadvantages as well. As the returns here are risk free, those are not

as high as the equities market at the same time. So, at one hand you are getting

assured returns, but on the other hand, you are getting less return at the same

time.

Retail participation is also very less here, though increased recently. There are

also some issues of liquidity and price discovery as the retail debt market is not

yet quite well developed.

GOVERNMENT SECURITIES

Government Securities are securities issued by the Government for

raising a public loan or as notified in the official Gazette. They consist of

Government Promissory Notes, Bearer Bonds, Stocks or Bonds held in Bond

Ledger Account. They may be in the form of Treasury Bills or Dated

Government Securities.

Government Securities are mostly interest bearing dated securities issued

by RBI on behalf of the Government of India. GOI uses these funds to meet its

expenditure commitments. These securities are generally fixed maturity and

fixed coupon securities carrying semi-annual coupon. Since the date of maturity

is specified in the securities, these are known as dated Government Securities,

e.g. 8.24% GOI 2018 is a Central Government Security maturing in 2018,

which carries a coupon of 8.24% payable half yearly.

Features of Government Securities

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DEBT INSTRUMENT

1. Issued at face value

2. No default risk as the securities carry sovereign guarantee.

3. Ample liquidity as the investor can sell the security in the secondary

market

4. Interest payment on a half yearly basis on face value

5. No tax deducted at source

6. Can be held in Demat form.

7. Rate of interest and tenor of the security is fixed at the time of issuance

and is not subject to change (unless intrinsic to the security like FRBs -

Floating Rate Bonds).

8. Redeemed at face value on maturity

9. Maturity ranges from of 2-30 years.

10.Securities qualify as SLR (Statutory Liquidity Ratio) investments (unless

otherwise stated).

The dated Government securities market in India has two segments:

1. Primary Market: The Primary Market consists of the issuers of the

securities, viz., Central and Sate Government and buyers include

Commercial Banks, Primary Dealers, Financial Institutions, Insurance

Companies & Co-operative Banks. RBI also has a scheme of non-

competitive bidding for small investors (see SBI DFHI Invest on our

website for further details).

2. Secondary Market: The Secondary Market includes Commercial banks,

Financial Institutions, Insurance Companies, Provident Funds, Trusts,

Mutual Funds, Primary Dealers and Reserve Bank of India. Even

Corporates and Individuals can invest in Government Securities. The

eligibility criteria is specified in the relative Government notification.

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DEBT INSTRUMENT

Auctions:Auctions for government securities are either multiple- price auctions

or uniform price auction - either yield based or price based.

Yield Based: In this type of auction, RBI announces the issue size or notified

amount and the tenor of the paper to be auctioned. The bidders submit bids in

term of the yield at which they are ready to buy the security. If the Bid is more

than the cut-off yield then its rejected otherwise it is accepted

Price Based:In this type of auction, RBI announces the issue size or notified

amount and the tenor of the paper to be auctioned, as well as the coupon rate.

The bidders submit bids in terms of the price. This method of auction is

normally used in case of reissue of existing Government Securities. Bids at

price lower then the cut off price are rejected and bids higher then the cut off

price are accepted. Price Based auction leads to a better price discovery then the

Yield based auction.

Underwriting in Auction: One day prior to the auction, bids are received from

the Primary Dealers (PD) indicating the amount they are willing to underwrite

and the fee expected. The auction committee of RBI then examines the bid on

the basis of the market condition and takes a decision on the amount to be

underwritten and the fee to be paid. In case of devolvement, the bids put in by

the PD’s are set off against the amount underwritten while deciding the amount

of devolvement and in case the auction is fully subscribed, the PD need not

subscribe to the issue unless they have bid for it.

G-Secs, State Development Loans & T-Bills are regularly sold by RBI through

periodic public auctions. SBI DFHI Ltd. is a leading Primary Dealer in

Government Securities. SBI DFHI Ltd gives investors an opportunity to buy G-

Sec / SDLs / T-Bills at primary market auctions of RBI through its SBI DFHI

Invest scheme (details available on website ). Investors may also invest in high

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DEBT INSTRUMENT

yielding Government Securities through “SBI DFHI Trade” where “buy and sell

price” and a buy and sell facility for select liquid scrips in the secondary

markets is offered.

BOND MARKET IN INDIA

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 different types of bond market in India

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DEBT INSTRUMENT

Corporate Bond Market

Municipal Bond Market

Government and Agency Bond Market

Funding Bond Market

Mortgage Backed and Collateral Debt Obligation Bond Market

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.

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DEBT INSTRUMENT

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.

Types of Debt Instruments

The various instruments of debt can be classified into long term and short term

debt depending on the tenure for which the amount has been raised or the period

of repayment. The various instruments under each category are mentioned

below.

Types of Debt Instruments

Long Term Debt

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DEBT INSTRUMENT

1. Bond: A bond, also sometimes called a fixed-income security, is a type of

debt instrument that memorializes a loan made by an investor to a corporate or

government entity. The loan is to be paid back over a period of time with a

fixed interest rate and is often secured to fund projects.  Bonds refer to debt

instruments bearing interest on maturity. In simple terms, organizations may

borrow funds by issuing debt securities named bonds, having a fixed maturity

period (more than one year) and pay a specified rate of interest (coupon rate) on

the principal amount to the holders. Bonds have a maturity period of more than

one year which differentiates it from other debt securities like commercial

papers, treasury bills and other money market instruments.

Terminology

Used in Bond Market Meaning in General Terms

Bonds Loans (in the form of a security)

Issuer of Bonds Borrower

Bond Holder Lender

Principal Amount Amount at which issuer pays interest and which is

repaid on the maturity date

Issue Price Price at which bonds are offered to investors

Maturity Date Length of time (More than one year)

Coupon Rate of interest paid by the issuer on the par/face value

of the bond

Coupon Date The date on which interest is paid to investors

Types of Bonds

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DEBT INSTRUMENT

1. Classification on the basis of Variability of Coupon

Zero Coupon Bonds

Zero Coupon Bonds are issued at a discount to their face value and at the time

of maturity, the principal/face value is repaid to the holders. No interest

(coupon) is paid to the holders and hence, there are no cash inflows in zero

coupon bonds. The difference between issue price (discounted price) and

redeemable price (face value) itself acts as interest to holders. The issue price

of Zero Coupon Bonds is inversely related to their maturity period, i.e. longer

the maturity period lesser would be the issue price and vice-versa. These

types of bonds are also known as Deep Discount Bonds.

Treasury Strips

Treasury strips are more popular in the United States and not yet available in

India. Also known as Separate Trading of Registered Interest and Principal

Securities, government dealer firms in the United States buy coupon paying

treasury bonds and use these cash flows to further create zero coupon bonds.

Dealer firms then sell these zero coupon bonds, each one having a different

maturity period, in the secondary market.

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DEBT INSTRUMENT

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.

1. Classification on the Basis of Variability of Maturity

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.

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DEBT INSTRUMENT

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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DEBT INSTRUMENT

2. 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.

(ii)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:

1. By buying from the market

2. By creating a separate fund which calls the bonds on

behalf of the issuer

DEBENTURES

ADebentureisaunitofloanamount.Whenacompanyintendstoraise theloan

amountfromthepublicitissuesdebentures.Apersonholding debentureor

debentures iscalledadebentureholder.Adebentureisa

documentissuedunderthesealofthecompany.Itisanacknowledgment oftheloan

receivedbythecompanyequaltothenominalvalueofthe

debenture.Itbearsthedateofredemptionandrateandmodeofpayment

ofinterest.Adebentureholderisthe  creditorofthecompany.

 

Aspersection2(12)ofCompaniesAct1956,“Debentureincludes debenture  stock,

bond and  any  other  securities  of  the  company

whetherconstitutingachargeonthecompany’sassetsornot”.

 

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DEBT INSTRUMENT

TYPES OF DEBENTURES

 

Debenturecanbeclassifiedasunder:

1. F r omsecuritypointofview

(i) Secu r edorMortgagedebentu r es:

Thesearethedebenturesthat

aresecuredbyachargeontheassetsofthecompany.Theseare

alsocalledmortgagedebentures.Theholdersofsecureddebentures

havetherighttorecovertheirprincipalamountwiththeunpaid

amountofinterestonsuchdebenturesoutoftheassetsmortgaged

bythecompany.InIndia,debenturesmustbesecured.Secured

debenturescanbeoftwotypes:

 

(a)Firstmortgagedebentures:Theholdersofsuchdebentures

haveafirstclaimontheassetscharged.

 

(b)  Secon d mortgag e debenture s: Theholdersofsuchdebentures

haveasecondclaimontheassetscharged.

 

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DEBT INSTRUMENT

(ii)Unsecu r eddebentu r es: Debentureswhichdonotcarryany

securitywithregardtotheprincipalamountorunpaidinterestare called

unsecured debentures. These are called simple debentures.

(iii)

 

2. Onthebasisof r edemption

 

(i) Redeemabledebentu r es: Thesearethedebentureswhichare

issuedforafixedperiod.Theprincipalamountofsuchdebentures

ispaidofftothedebentureholdersontheexpiryofsuchperiod.

Thesecanberedeemedbyannualdrawingsorbypurchasingfrom

theopenmarket.

(ii)Non-redeemable debentures : These are the debentures which are not

redeemed  in the life time of the company. Such debentures are paid back

only when the company goes into liquidation.

3. OnthebasisofRecords

(i)Registe r ed   debentu r es   :  These  are  the

registered with

ecompany.Theamountofsuchdebenturesis

payableonlytothosedebentureholderswhose

nameappearsin theregisterofthecompany.

(ii)  

Bea r erdebentu r es: Thesearethedebenturesw

hicharenot recorded  in  a  register  of  the

company.  Such  debentures are

transferrablemerelyby

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DEBT INSTRUMENT

delivery.Holderofthesedebenturesis

entitledtogettheinterest.

 

4. Onthebasisofconvertibility

(i)Conve r tibledebentu r es: Thesearethedebenturesthatcanbe

convertedintosharesofthecompanyontheexpiryofpredecided period.  The

term and  conditions  of  conversion  are  generally

announcedatthetimeofissueofdebentures.

(ii)Non-convertibledebentu r es: Thedebentureholdersofsuch debentures

cannotconverttheirdebenturesintosharesofthe company.

 

5. Onthebasisofpriority

(i)First debentures : These debentures are redeemed before other debentures.

Second debentures : These debentures are redeemed after the redemption of

first debentures

TERM LOAN

Definition:A loan for equipment, real estate and working capital that's paid off

like a mortgage for between one year and ten years

Term loans are your basic vanilla commercial loan. They typically carry fixed

interest rates, and monthly or quarterly repayment schedules and include a set

maturity date. The range of funds typically available is $25,000 and greater.

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DEBT INSTRUMENT

Bankers tend to classify term loans into two categories:

Intermediate-term loans: Usually running less than three years, these loans are

generally repaid in monthly installments (sometimes with balloon payments)

from a business's cash flow. According to the American Bankers Association,

repayment is often tied directly to the useful life of the asset being financed.

Long-term loans:. These loans are commonly set for more than three years.

Most are between three and 10 years, and some run for as long as 20 years.

Long-term loans are collateralized by a business's assets and typically require

quarterly or monthly payments derived from profits or cash flow. These loans

usually carry wording that limits the amount of additional financial

commitments the business may take on (including other debts but also

dividends or principals' salaries), and they sometimes require that a certain

amount of profit be set-aside to repay the loan.

Term loans are most appropriate for established small businesses that can

leverage sound financial statements and substantial down payments to minimize

monthly payments and total loan costs. Repayment is typically linked in some

way to the item financed. Term loans require collateral and a relatively rigorous

approval process but can help reduce risk by minimizing costs. Before deciding

to finance equipment, borrowers should be sure they can they make full use of

ownership-related benefits, such as depreciation, and should compare the cost

with that leasing.

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DEBT INSTRUMENT

The best use of a term loan is for construction; major capital

improvements; large capital investments, such as machinery; working capital;

purchases of existing businesses. Fortunately, the cost of such a loan is

relatively inexpensive if the borrower can pass the financial litmus tests. Rates

vary, making it worthwhile to shop, but generally run around 2.5 points over

prime for loans of less than seven years and 3.0 points over prime for longer

loans. Fees totaling up to 1 percent are common (though this varies greatly,

too), with higher fees on construction loans.

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DEBT INSTRUMENT

What do banks look for when making decisions about term loans? Well,

the "five C's" continue to be of utmost importance.

Character. How have you managed other loans (business and personal)?

What is your business experience?

Credit capacity. The bank will conduct a full credit analysis, including a

detailed review of financial statements and personal finances to assess

your ability to repay.

Collateral. This is the primary source of repayment. Expect the bank to

want this source to be larger than the amount you're borrowing.

Capital. What assets do you own that can be quickly turned into cash if

necessary? The bank wants to know what you own outside of the

business-bonds, stocks, apartment buildings-that might be an alternate

repayment source. If there is a loss, your assets are tapped first, not the

bank's. Or, as one astute businessman puts it, "Banks like to lend to

people who already have money." You will most likely have to add a

personal guarantee to all of that, too.

Comfort/confidence with the business plan. How accurate are the

revenue and expense projections? Expect the bank to make a detailed

judgment. What is the condition of the economy and the industry--hot,

warm or cold?

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DEBT INSTRUMENT

Mortgage

A mortgage is a secured lien or loan on residential property. The loan is

secured by the associated property. More specifically, if the borrower fails to

pay, the lender can take the property to fulfill the outstanding debt.

Lease

A lease is an agreement between an owner of property and a tenant or

renter. A lease is a type of loan instrument because it secures a regular rent

payment from the tenant to the owner, thereby creating a secured long-term

debt.

Debt Instruments in India

Traditionally when a borrower takes a loan from a lender, he enters into an

agreement with the lender specifying when he would repay the loan and what

return (interest) he would provide the lender for providing the loan. This entire

structure can be converted into a form wherein the loan can be made tradable by

converting it into smaller units with pro rata allocation of interest and principal.

This tradable form of the loan is termed as a debt instrument.   Therefore, debt

instruments are basically obligations undertaken by the issuer of the instrument

as regards certain future cash flows representing interest and principal, which

the issuer would pay to the legal owner of the instrument. Debt instruments are

of various types. The key terms that distinguish one debt instrument from

another are as follows:  

Issuer of the instrument

Face value of the instrument

Interest rate

Repayment terms (and therefore maturity period/tenor)

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DEBT INSTRUMENT

TYPES OF DEBT INSTRUMENTS

There are various types of debt instruments available that one can find in Indian

debt market.

Government Securities

It is the Reserve Bank of India that issues Government Securities or G-

Secs on behalf of the Government of India. These securities have a maturity

period of 1 to 30 years. G-Secs offer fixed interest rate, where interests are

payable semi-annually. For shorter term, there are Treasury Bills or T-Bills,

which are issued by the RBI for 91 days, 182 days and 364 days.

Advantages of Government Securities

Greater safety and lower volatility as compared to other financial

instruments.

Variations possible in the structure of instruments like Index linked

Bonds, STRIPS

Higher leverage available in case of borrowings against G-Secs.

No TDS on interest payments

Tax exemption for interest earned on G-Secs. up to Rs.3000/- over and

above the limit of Rs.12000/- under Section 80L (as amended in the latest

Budget).

Greater diversification opportunities

Adequate trading opportunities with continuing volatility expected in

interest rates the world over

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DEBT INSTRUMENT

Corporate Bonds

These bonds come from PSUs and private corporations and are offered

for an extensive range of tenures up to 15 years. There are also some perpetual

bonds. Comparing to G-Secs, corporate bonds carry higher risks, which depend

upon the corporation, the industry where the corporation is currently operating,

the current market conditions, and the rating of the corporation. However, these

bonds also give higher returns than the G-Secs.

Advantages of Corporate Bonds:

They are provide a fixed stream of income so they are safer than stocks.

Bond holders get paid by companies before stock holders. For example,

companies are required to make interest payments to bondholders, but are

not required to make dividend payments to stock holders. Another

example of this is that if the company went bankrupt, the bond holders

would be the ones to get the proceeds from auctioning off the company's

assets and the stock holders would get nothing.

Another advantage of corporate bonds over government bonds is that they

provide higher interest. The reason for this is because interest rates are

made up of a few ingredients. First is the real interest rate (the actual

money you are receiving simply for loaning money), then the inflation

premium (bonds have to pay extra interest so that bond holders don't have

the value of their payments decline due to inflation), then is the liquidity

premium (this is extra interest bond issuers have to pay if their bond is

not easily bought and sold.

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DEBT INSTRUMENT

Disadvantages of Corporate Bonds:

As we said earlier, bonds are considered safer than stocks because they

offer a steady flow of income while there is no guaranteed income from

stocks. However, stocks offer greater potential returns if its price

increases. So in this way, bonds and stocks obey a fundamental rule of

economics: with greater risk there is greater reward. So in periods of slow

economic growth, bonds may look more attractive because it is unlikely

stocks will provide good returns. In a period of expansion, however,

stocks look much more attractive than bonds because you could make a

lot more in much less time if your stocks go up.

Another disadvantage of corporate bonds over government bonds is that

corporate bonds have more risk. While this does offer a higher yield in

return, if you are risk averse, you would view this as a disadvantage of

corporate bonds. This is where the biggest difference between corporate

and government bonds lies. Government bonds are considered to be the

safest investments having basically no risk that the government will

default on its loans. On the other hand, corporations can and do go

bankrupt. Because of this, corporate bonds are considered riskier than

government bonds.

Because bonds are a fixed investment, they may not offer protection

against inflation changes within an economy. If the interest rates on a

bond investment are low and inflation increases more than average or

expected, the investor has the potential to lose purchasing power within

their portfolio.

The prices of bonds are affected by fluctuations in interest rates within

the economy. Bond prices move inversely to interest rates; when interest

rates rise, bond rates fall and vice versa.

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DEBT INSTRUMENT

Some bonds are callable, meaning that the Issuer can redeem the bonds

issued. This is common when interest rates decline, making it more

favorable for the Issuer to refinance their debts. If this occurs, the investor

would be forced to redeem their bond and replace it with a new one that

potentially would have lower coupon rates. For an investor who is relying

on this income for their lifestyle, this can be a substantial disadvantage.

Certificate of Deposit

These are negotiable money market instruments. Certificate of Deposits

(CDs), which usually offer higher returns than Bank term deposits, are issued in

demat form and also as a Usance Promissory Notes. There are several

institutions that can issue CDs. Banks can offer CDs which have maturity

between 7 days and 1 year. CDs from financial institutions have maturity

between 1 and 3 years. There are some agencies like ICRA, FITCH, CARE,

CRISIL etc. that offer ratings of CDs. CDs are available in the denominations of

Rs. 1 Lac and in multiple of that.

Advantages of Certificate of Deposit:

CDs typically offer a higher rate of interest than Treasury bills and

savings account due to the higher risk associated with them.

As the rate of interest is fixed, your return on investment is ensured

despite the rate fluctuations in the market.

CDs are insured by Federal Deposit Insurance Corporation and hence are

a good investment option for single income households and retired folks.

CDs are a risk-free investment.

The return on CDs is assured and helps in financial planning.

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DEBT INSTRUMENT

It’s very easy to set up a CD. One needs to just walk to their local bank

and request for purchase of CD. Money from the existing savings account

will be ear-marked against the CD that has been purchased. The only

thing to be made sure that the bank is FDIC ensured.

CDs can be purchased and sold through a brokerage firm. This way you

can encash the CD before the maturity term without paying the penalty.

Disadvantages of Certificate of Deposit :

Money is tied down for long durations of time. Though the investor can

withdraw money, he has to generally incur penalty in terms of some

amount of loss of interest on the deposit amount. You can get a waiver on

the penalty in case of special circumstances like disability, death or

retirement.

As the rate of interest is fixed, it is difficult to change or to take

advantage of the market situation when the market rates are favorable.

You will not be able to get an interest rate that favors inflation.

Though the return rate is higher on CDs than savings account, it is much

lower than other money market instruments where you can make possible

investments.

Commercial Papers

In the global money market, commercial paper is a unsecured promissory

note with a fixed maturity of 1 to 270 days. Commercial Paper is a money-

market security issued (sold) by large banks and corporations to get money to

meet short term debt obligations (for example, payroll), and is only backed by

an issuing bank or corporation's promise to pay the face amount on the maturity

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date specified on the note. Since it is not backed by collateral, only firms with

excellent credit ratings from a recognized rating agency will be able to sell their

commercial paper at a reasonable price. Commercial paper is usually sold at a

discount from face value, and carries higher interest repayment dates than

bonds. Typically, the longer the maturity on a note, the higher the interest rate

the issuing institution must pay. Interest rates fluctuate with market conditions,

but are typically lower than banks' ratesThere are short term securities with

maturity of 7 to 365 days. CPs are issued by corporate entities at a discount to

face value.

Advantage of commercial paper:

High credit ratings fetch a lower cost of capital.

Wide range of maturity provide more flexibility.

It does not create any lien on asset of the company.

Tradability of Commercial Paper provides investors with exit options.

Disadvantages of commercial paper:

Its usage is limited to only blue chip companies.

Issuances of Commercial Paper bring down the bank credit limits.

A high degree of control is exercised on issue of Commercial Paper.

Stand-by credit may become necessary

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Non-Convertible Debentures

Non-convertible debentures, which are simply regular debentures, cannot be

converted into equity shares of the liable company. They are debentures without

the convertibility feature attached to them. As a result, they usually carry higher

interest rates than their convertible counterparts.

Advantages of Non-Convertible Debentures:

The advantage of issuing corporate bonds can be seen in achieving a

higher degree of company capital structure flexibility, and a company is

thus more able to react promptly to constantly changing conditions,

which consequently leads to generating larger financial sources.

Another advantage means that corporate bonds emissions can make up a

considerable amount of money provided by a large number of creditors.

As a consequence of a risk distribution among a large number of creditors

the bond emission is a lower costs alternative in comparison to bank

loans under a certain debt level condition.

Companies first accept bank loans, and that is to the degree to which the

loan is cheaper and otherwise more advantageous than bonds emissions.

Then they issue bonds and use a part of the gained finance to paying

loans and other liabilities off, which increases the ability to accept other

bank loans. After reaching the top limit of bank loans a company issues

bonds again and the cycle repeats itself.

In the third cycle a company issues shares and a part of sources is used

for paying off the bank loans, paying off the bonds and the rest is used to

finance a further development. Then a company increases bank loans and

the cycle repeats itself again.

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A significant advantage rests in the fact that returns of corporate bonds

represent a tax base and in case of a company profitability an interest tax

shield can be used.

Furthermore shareholders do not lose a company activity control when

issuing corporate bonds, while issuing them often does not even need a

collateral in a form of a property pledge.

It is due to say that as a consequence of an obligation to pay back the

principal and returns of bonds managers get a clearer view of rate of

returns and that successful issuing of corporate bonds (especially their

placement) is considered a prestigious thing helping the company to gain

respect by the public and business partners.

Disadvantages of Non-Convertible Debentures:

On the other hand, the disadvantage of corporate bonds rests in the fact

that investors require a lot from credit issuer credibility, while returns and

principal must be always paid in time regardless the company profit.

A substantial disadvantage of bonds emissions lies in considerable

emission costs created by costs of issue (costs directly connected with

issuing corporate bonds) and costs of bonds life cycle (costs connected

with the particular emission, arising in course of the life cycle and in

connection to paying back the emission).

On the top of it creditors may restrict the issuing company in various

ways and have a right to express their opinions on problem issues the

solution of which may affect setting up claims to the bonds themselves.

The bond holder meeting decides common concerns of bond holders and

expresses opinions on problem issues that may affect setting up claims to

a bond, especially on suggestions of changes in terms of bond emission

conditions, on suggestions regarding: issuer exchanges, issuer takeover

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bids by another subject, conclusions of a contract to control a company

or contracts on the profit transfer, a sale of a company, a hire of a

company or its part - all this in the meaning of a Commercial Code;

further on suggestions regarding a bond programme, however also on

problem issues of a common process providing a bond issuer delays in

discharging the bond engagements.

If a bond holder meeting does not agree on any of the suggestions, they

can decide an issuer obligation to pay back bond holders a nominal bond

value or an emission rate (in case of zero coupon bonds) including a

proportionate return. An issuer must do so before one-month time from

the date of this decision at the very latest.

Partly-Convertible Debentures/Fully-Convertible Debentures (convertible

in to Equity Shares)

Convertible debenture is basically is a type of commercial loan or a

debenture. A convertible debenture, as the name suggests gives a lender the

option of converting a loan into stock. So the company who has issued the

debentures can convert these into equity shares after, during or on certain dates,

making the debenture holder, a share holder. This conversion factor also

depends upon the type of convertible debenture the company has issued and the

exact agreement between company and debenture holders. The 'convertible'

factor is often added to the commercial loan so as to attract the buyers as they

can be the share holders later.

Advantages of Convertible Debenture:

Convertible bonds are usually issued offering a higher yield than

obtainable on the shares into which the bonds convert.

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Convertible bonds are safer than preferred or common shares for the

investor. They provide asset protection, because the value of the

convertible bond will only fall to the value of the bond floor. At the same

time, convertible bonds can provide the possibility of high equity-like

returns.

Also, convertible bonds are usually less volatile than regular shares.

Indeed, a convertible bond behaves like a call option.

The simultaneous purchase of convertible bonds and the short sale of the

same issuer's common stock is a hedge fund strategy known as

convertible arbitrage. The motivation for such a strategy is that the equity

option embedded in a convertible bond is a source of cheap volatility,

which can be exploited by convertible arbitrageurs.

In limited circumstances, certain convertible bonds can be sold short, thus

depressing the market value for a stock, and allowing the debt-holder to

claim more stock with which to sell short. This is known as death spiral

financing

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Disadvantages of Convertible Debenture:

To convert the debentures into shares, if these are new:

They don’t pass immediately through the quotations.

The securities have a less quotation price due that temporarily they have

lesser rights.

They are less liquid, due that there is a lesser amount of them.

You can’t dispose of money soon due to the former explanation. Usually

the type of interests that they offer is inferior to that of the ordinary

debentures due that they offer the additional advantage of placing them as

shares on the markets

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COMPARISON BETWEEN A MONEY INSTRUMENT AND A DEBT

INSTRUMENT

Both debt and money instruments are popular financial instruments on

which large amounts of money are traded between different businesses and

investors; however, they each deal with a different type of funding. The

instruments give businesses different types of obligations and investors different

perks when they deal in one or the other. Both, however, are used by public

businesses to raise money.

1. Debt Instrument

Debt instruments are used to trade debt instruments. In other words, the

business issues a debt instrument, and an investor buys it. In a specific period of

time, the investor is paid back for the debt, along with interest. Interest rates and

time frames can vary according to the instrument. Bonds are one of the most

widely trade debt instruments on the debt instrument. Both large corporations

and governments use the debt instrument to raise money or to change economic

conditions.

2. Money Instrument

On the money instrument, equity is traded instead of debt. this instrument

is more commonly known as the stock instrument. In the stock instrument,

stocks are sold as securities that give investors the right to a certain amount of

the company's earnings and assets. There are many different types of stock

shares sold to different types of investors, but they do not exist as a debt to be

paid off.

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3. Business Differences

To the business, the difference between a money and debt instrument is

important. Every bond that the business issues must be paid back over time--it is

a loan, and the business is borrowing from investors. Eventually the loan comes

due. Businesses should only sell bonds when they are confident they will have

enough money in the future to meet their debt obligations. Stocks, on the other

hand, do not incur debt, but they do divide ownership of the company among

investors.

4. Holder Difference

To the investor holding the bond or stock, the difference deals mostly with

the return on his investment. When an investor buys stock, he is buying

ownership of the business and can claim the right to vote on matters the

directors of the business decide. Investors do not have any ownership of the

business when they buy bonds; they receive only an obligation from the

business to repay the loan.

5. Risk

Traditionally, the debt instrument is more secure than the money

instrument. Stock dividends can be reduced or suspended when a business

suffers, but bond obligations must be paid as the contract stipulates. This also

means that stocks have a greater chance for growth than bonds because their

success depends on the success of the company.

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RBI/SEBI GUIDELINES FOR DEBENTURES

SEBI GUIDELINES

Issue of FCDs having a conversion period more than 36 months will not be

permissible, unless conversion is made optional with “put” and “call” option.

Compulsory credit rating will be required if conversion is made for FCDs

after 18 months.

Premium amount on conversion, the conversion period, in stages, if any,

shall be pre-determined and stated in the prospectus.

The interest rate for above debentures will be freely determinable by the

issuer.

Issue of debenture with maturity of 18 months or less are exempt from the

requirement of appointing Debenture Trustees or creating a Debenture

Redemption Reserve (DRR).

In other cases, the names of the debenture trustees must be stated in the

prospectus and DRR will be created in accordance with guidelines laid down

by SEBI.

The trust deed shall be executed within six months of the closure of the

issue.

Any conversion in part or whole of the debenture will be optional at the

hands of the debenture holder, if the conversion takes place at or after 18

months from the date of allotment, but before 36 months.

In case of NCDs/ PCDs credit rating is compulsory where maturity exceeds

18 months.

Premium amount at the time of conversion for the PCD, redemption amount,

period of maturity, yield on redemption for the PCDs/NCDs shall be

indicated in the prospectus.

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The discount on the non-convertible portion of the PCD in case they are

traded and procedure for their purchase on spot trading basis must be

disclosed in the prospectus.

In case, the non-convertible portions of PCD/NCD are to be rolled over, a

compulsory option should be given to those debenture holders who want to

withdraw and encash from the debenture programme.

Roll over shall be done only in cases where debenture holders have sent

their positive consent and not on the basis of the non-receipt of their negative

reply.

Before roll over of any NCDs or non-convertible portion of the PCDs, fresh

credit rating shall be obtained within a period of six months prior to the due

date of redemption and communicated to debenture holders before roll over

and fresh trust deed shall be made.

Letter of information regarding roll over shall be vetted by SEBI with

regard to the credit rating, debenture holder resolution, option for conversion

and such other items, which SEBI may prescribe from time to time.

The disclosures relating to raising of debentures will contain, amongst other

things, the existing and future equity and long term debt ratio, servicing

behavior on existing debentures, payment of due interest on due dates on

terms loans and debentures, certificate from a financial institution or bankers

about their no objection for a second or pari-passu charge being created in

favour of the trustees to the proposed debenture issues.

And any other additional disclosure requirement SEBI may prescribe from

time to time.

Most of the listing requirements are common for both equity and debt

instruments in terms of disclosures with some additional provisions specified

for the debt instruments.

Until recently only infrastructure and municipal corporations could list debt

before equity, subject to certain requirements. SEBI now permits listing of

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debt before equity subject to the condition that the debt instrument is rated

not below a minimum rating of ‘A’ or equivalent thereof.

RBI GUIDELINES

1. Short title and commencement of the directions

These directions may be called the Issuance of Non-Convertible Debentures

(Reserve Bank) Directions, 2010 and they shall come into force with effect

from August 02, 2010.

2. Definition

For the purposes of these Directions,

Non-Convertible Debenture (NCD) means a debt instrument issued by a

corporate (including NBFCs) with original or initial maturity up to one year and

issued by way of private placement;

“Corporate” means a company as defined in the Companies Act, 1956

(including NBFCs) and a corporation established by an act of any Legislature

3. Eligibility to issue NCDs

A corporate shall be eligible to issue NCDs if it fulfills the following criteria,

namely,

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the corporate has a tangible net worth of not less than Rs.4 crore, as per the

latest audited balance sheet;

the corporate has been sanctioned working capital limit or term loan by bank/s

or all-India financial institution/s; and

the borrowal account of the corporate is classified as a Standard Asset by the

financing bank/s or institution/s.

4. Rating Requirement

4.1 An eligible corporate intending to issue NCDs shall obtain credit rating for

issuance of the NCDs from one of the rating agencies, viz., the Credit Rating

Information Services of India Ltd. (CRISIL) or the Investment Information and

Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research

Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd or such other agencies

registered with Securities and Exchange Board of India (SEBI) or such other

credit rating agencies as may be specified by the Reserve Bank of India from

time to time, for the purpose.

4.2 The minimum credit rating shall be P-2 of CRISIL or such equivalent rating

by other agencies.

4.3 The Corporate shall ensure at the time of issuance of NCDs that the rating

so obtained is current and has not fallen due for review.

5. Maturity

5.1 NCDs shall not be issued for maturities of less than 90 days from the date of

issue.

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5.2 The exercise date of option (put/call), if any, attached to the NCDs shall not

fall within the period of 90 days from the date of issue.

5.3 The tenor of the NCDs shall not exceed the validity period of the credit

rating of the instrument.

6. Denomination

NCDs may be issued in denominations with a minimum of Rs.5 lakh (face

value) and in multiples of Rs.1 lakh.

7. Limits and the Amount of Issue of NCDs

7.1 The aggregate amount of NCDs issued by a corporate shall be within such

limit as may be approved by the Board of Directors of the corporate or the

quantum indicated by the Credit Rating Agency for the rating granted,

whichever is lower.

7.2 The total amount of NCDs proposed to be issued shall be completed within

a period of two weeks from the date on which the corporate opens the issue for

subscription.

8. Procedure for Issuance

8.1 The corporate shall disclose to the prospective investors, its financial

position as per the standard INSTRUMENT practice.

8.2 The auditors of the corporate shall certify to the investors that all the

eligibility conditions set forth in these directions for the issue of NCDs are met

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by the corporate.

8.3 The requirements of all the provisions of the Companies Act, 1956 and the

Securities and Exchange Board of India (Issue and Listing of Debt Securities)

Regulations, 2008, or any other law, that may be applicable, shall be complied

with by the corporate.

8.4 The Debenture Certificate shall be issued within the period prescribed in the

Companies Act, 1956 or any other law as in force at the time of issuance.

8.5 NCDs may be issued at face value carrying a coupon rate or at a discount to

face value as zero coupon instruments as determined by the corporate.

9. Debenture Trustee

9.1 Every corporate issuing NCDs shall appoint a Debenture Trustee (DT) for

each issuance of the NCDs.

9.2 Any entity that is registered as a DT with the SEBI under SEBI (Debenture

Trustees) Regulations, 1993, shall be eligible to act as DT for issue of the NCDs

only subject to compliance with the requirement of these Directions.

9.3 The DT shall submit to the Reserve Bank of India such information as

required by it from time to time.

10. Investment in NCD

10.1 NCDs may be issued to and held by individuals, banks, Primary Dealers

(PDs), other corporate bodies including insurance companies and mutual funds

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registered or incorporated in India and unincorporated bodies, Non-Resident

Indians (NRIs) and Foreign Institutional Investors (FIIs).

10.2 Investments in NCDs by Banks/PDs shall be subject to the approval of the

respective regulators.

10.3 Investments by the FIIs shall be within such limits as may be set forth in

this regard from time to time by the SEBI

11. Preference for Dematerialisation

While option is available to both issuers and subscribers to issue/hold NCDs in

dematerialised or physical form, they are encouraged to issue/ hold NCDs in

dematerialised form. However, banks, FIs and PDs are required to make fresh

investments in NCDs only in dematerialised form.

12. Roles and Responsibilities

12.1 The role and responsibilities of corporates, DTs and the credit rating

agencies (CRAs) are set out below:

(a) Corporates

12.2 Corporates shall ensure that the guidelines and procedures laid down for

issuance of NCD are strictly adhered to.

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(b) Debenture Trustees

12.3 The roles, responsibilities, duties and functions of the DTs shall be guided

by these regulations, the Securities and Exchange Board of India (Debenture

Trustees) Regulations,1993, the trust deed and offer document.

12.4 The DTs shall report, within three days from the date of completion of the

issue, the issuance details to the Chief General Manager, Financial

INSTRUMENTs Department, Reserve Bank of India, Central Office, Fort,

Mumbai-400001.

12.5 DTs should submit to the Reserve Bank of India (on a quarterly basis) a

report on the outstanding amount of NCDs of maturity up to year.

12.6 In order to monitor defaults in redemption of NCDs, the DTs are advised to

report immediately, on occurrence, full particulars of defaults in repayment of

NCDs to the Financial INSTRUMENTs Department, Reserve Bank of India,

Central Office, Fort, Mumbai-400001, Fax: 022-22630981/22634824.

12.7 The DTs shall report the information called for under para 12.4, 12.5 and

12.6 of these Directions as per the format notified by the Reserve Bank of India,

Financial INSTRUMENTs Department, Central Office, Mumbai from time to

time.

(c) Credit Rating Agencies (CRAs)

12.8 Code of Conduct prescribed by the SEBI for the CRAs for undertaking

rating of capital INSTRUMENT instruments shall be applicable to them

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(CRAs) for rating the NCDs.

12.9 The CRA shall have the discretion to determine the validity period of the

rating depending upon its perception about the strength of the issuer.

Accordingly, CRA shall, at the time of rating, clearly indicate the date when the

rating is due for review.

12.10 While the CRAs may decide the validity period of credit rating, they shall

closely monitor the rating assigned to corporates vis-à-vis their track record at

regular intervals and make their revision in the ratings public through their

publications and website.

13. Documentary Procedure

13.1 Issuers of NCDs of maturity up to one year shall follow the Disclosure

Document brought out by the Fixed Income Money INSTRUMENT and

Derivatives Association of India (FIMMDA), in consultation with the Reserve

Bank of India as amended from time to time.

CASE STUDY

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NCD Issue Of Larsen & Turbo Limited

Engineering major Larsen & Toubro group firm L&T Finance on Tuesday

opened its debentures issue to raise up to Rs 1,000 crore to fund its financing

activities, including lending and investments.

L&T Finance along with L&T Capital Holdings would offer 50 lakh secured

non-convertible debentures (NCD), debentures that cannot be converted into

equity, at Rs 1,000 each, totaling to Rs 500 crore, with an option to raise an

additional Rs 500 crore if the subscription is over subscribed, the company

said.

The NCD issue is with various investment options and yield on redemption

of up to 10.5 per cent. The issue would close on September 4, 2009.

The NCDs have been rated AA+ by rating agency CARE and LAA+ by

ICRA, which indicate low credit risk.

Talking on L&T Finance's growth plans, L&T Executive Vice-President

(Finance) R Shankar Raman said, "We have asset base of Rs 5,500 crore as

of March 31,2009. We plan to grow that by about 25 to 30 per cent in the

current fiscal."

He further said indications in the first three months of the current fiscal have

been encouraging and L&T Finance hopes to do better in the coming month

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Larsen & Toubro arm L&T Finance has opted for the non-convertible

debentures (NCDs) route to raise funds for the second time in the past six

months. It has also applied for a preliminary application for receiving a licence

from the Insurance Regulatory & Development Authority (IRDA) to enter the

general insurance business.

“We have learnt from our earlier issue that the NCD route is the best option to

raise funds. So we are going for it without giving a second thought and we

intend to raise up to Rs 500 crore through this issue where the maturity period is

36 months from the date of allotment,” L&T Finance senior vice president

(financial services) N Sivaraman said.

It will offer 25 lakh secured non-convertible debentures of Rs 1,000 each,

totalling Rs 250 crore. “The company has retained the option to raise the

additional Rs 250 crore if the issue is over-subscribed,” Sivaraman said. It will

sell two series of bonds with a maximum yield of 8.58 per cent — the first

series has a coupon rate of 8.40 per cent payable half-yearly and the second

option pays a coupon of 8.50 per cent payable annually. The issue is priced

based on the company’s borrowing costs, which currently stand at a weighted

average of around 8.25 per cent.

CONCLUSION

For a developing economy like India, debt instruments are crucial sources

of capital funds. The debt instrument in India is amongst the largest in Asia. It

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includes government securities, public sector undertakings, other government

bodies, financial institutions, banks, and companies.

An investor can invest in money market mutual funds for a period of as little as

one day.

Avenues are also available for investing for longer horizons according to your

risk

appetite.

In conclusion, the ability of a continuously evolving and self-propelling

enterprise is its ability to not only learn and adapt to changes and opportunities,

but also to make full use of them as and when possible.

.

BIBLIOGRAPHY

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Financial Accounting By Marian Powers

Economic Times

Times Of India

Business Today

www.rbi.org

www.economictimes.indiatimes.com

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