Debt Markets

Introduction

Debt instruments are contracts in which one party lends money to another on pre-determined terms with regard to rate of interest to be paid by the borrower to the lender, the periodicity of such interest payment, and the repayment of the principal amount borrowed (either in installments or in bullet).

Evolution of Debt Market in India

Indian Economic Crisis 1991

Pre-liberalization 1947-1991: Socialism Industrialization under state monitoring Foreign trade restrictions (import tariffs, export taxes and

quantitative restrictions, foreign direct investment (FDI) upper limit, restrictions on technology transfer, export obligations and government approvals)

Economic intervention Elaborate licenses, regulations (commonly referred to

as License Raj)

Debt Market in India before Liberalization: Control on pricing of assets, administered interest rates (Rates

not market related) Segmentation of markets and barriers to entry Limited number of players High transactions cost High Statutory Liquidity Ratio (SLR) requirements The absence of a liquid and transparent secondary market

Economic Crisis 1990’s Large and growing fiscal imbalances over the 1980s Financial Repression Investors withdrew on low sentiments Import bill swelled, exports slumped Balance of payments problems Rupee Depreciation Defending the currency by expending foreign reserves

The economic liberalization in India Opening for international trade and foreign investment (Globalization) Deregulation Initiation of Privatization Inflation-controlling measures Private sector enterprise and competition Setting up of a comprehensive system of primary dealers Adoption of DVP system for settlement of government securities

transactions Abolition of tax deduction at source on government securities (Tax

reforms) Permission for FII’s to Hedge their foreign currency risk in the forward

market Introduction of Treasury bills of varying maturities Placing investments of banks in preference shares/debentures/bonds of

corporate outside the five per cent limit Recommendation that the Government borrowings at market related rates

The main objective of the government was to transform the economic system from socialism to capitalism so as to achieve high economic growth and industrialize the nation.

Financial Markets

A financial market is a market in which people and entities can trade financial securities, commodities, and other fungible items of value at low transaction costs and at prices that reflect supply and demand.

Financial markets facilitate: The raising of capital (in the capital markets) The transfer of risk (in the derivatives markets) Price discovery (Demand and supply equilibrium) The transfer of liquidity (in the money markets) International trade (in the currency markets)

Types of Financial Markets

Money MarketThe money market can be defined as a market for short term money and financial assets that are near substitutes for money.

Money Market Instruments

Call Money or Notice Money Amount borrowed for very short period, more than one day up to 14

days.

Enables banks and institutions to even out their day to day deficits and surpluses of money

Needed to adjust CRR requirement for Banks

Completely inter-bank market, only specified financial institutions & MF’s allowed to access call money market

Interest rates are market determined

Participants of call money market need to maintain current account with RBI

Bill Market

Bills of exchange can be rediscounted by the banks in bills market

RBI introduced the Bills Market Scheme (BMS) in 1952 & New Bill Market Scheme (NBMS) in 1970 to promote the bill market in India

Precaution on bills regarding Accommodation bills, Credibility of the parties, Completeness of the bill, Dishonor of the bill, Stamped bill

Certificate of Deposits

Marketable receipt of funds deposited in a bank for a fixed period issued in form of promissory notes

They are negotiable and marketable bearing specific face value and maturity

CD can be registered or bearer

They are liquid and risk free

Commercial Papers

Short term negotiable unsecured promissory note

Issued by Private sector, public sector and non banking company

Maturity period of a minimum 30 days to max 364 days

Direct commercial papers (without intermediary, issued directly to the investors) or Dealer papers (dealer or merchant banker issues on behalf of the company & advisory service)

Ready Forward Contracts

Agreement to sell and repurchase the same security and vice versa

Sellers perspective of transaction is Repo and buyers perspective is Reverse Repo

Only RBI approved parties and the securities are allowed to repo and reverse repo trade

Highly useful for banks to maintain SLR & CRR

Treasury Bills Market

Short term and lowest risk instrument

Issued at a pre-fixed day (14 & 91-day T Bill every Friday, 182 & 364-day T bill every alternate Wednesday) and a fixed amount

Governments borrowing instrument

Yield is based on bids received at the auction

Money Market Mutual Funds

The fund portfolio consists of various short term market instruments

Small-scale investor actively take part in the money markets

Minimum lock-in period is 15 days

Credit Cards

Monetary instrument that enables the card holder to obtain goods and service without actual payment at the time of purchase

Credit can be availed for a period of 30 to 45 days

The card carried a pre-determined limit up to which the holder can spend

Debt MarketDebt market is where debt instruments or bonds are traded. The most distinguishing feature of these instruments is that the return is fixed i.e. they are as close to being risk free as possible, if not totally risk free. The fixed return on the bond is known as the interest rate or the coupon rate.

Debt Market Instruments

Government Securities / Gilt-edged Securities

Issued by Central Government, State government and Quasi-Government agencies

Government securities have maturities ranging from 3 – 20 years

Typically held by banks, financial institutions, insurance companies, provident funds mainly because of certain statutory compulsions

Savings Bonds

Public Sector Undertaking Bonds

Private Sector Debentures

Instruments raised by the company for raising long term debt

Typically secured by a charge on immovable properties

They carry maturity period and coupon rate

Debentures may have convertible clause (option to convert the debentures into equity shares)

Debentures may have call & put option

Preference Shares

Represent hybrid security (combination of equity shares and debentures)

Carry fixed rate of dividend

Dividend payable only out of distributable profits

Dividend is generally cumulative and tax-exempt

May be redeemable

There are three main segments in the debt markets in India Government Securities

Public Sector Units (PSU) bonds and

Corporate securities

Indian Debt Market Structure

Risks Associated with Fixed Income Securities

Interest Rate Risk - The market value of the securities is inversely affected by movements in interest rates. Price Risk - The price received on secondary market (premature exit) depends on the level of interest rates, time to term, credit quality of the issuer and liquidity. Liquidity Risk - the risk that an investor will be unable to sell securities due to lack of demand and thus must sell them at a substantial loss and/or incur substantial transaction costs in the sale process. Reinvestment Risk – the risk that the income and/or principal repayments must be invested at lower rates, especially with callable securities. Prepayment Risk - Prepayment risk is the risk that the issuer may repay bonds prior to maturity; investor faces the risk of reinvesting at lower rates.

Purchasing Power Risk - Investors often focus on the real rate of return, or the actual return minus the rate of inflation. Rising inflation has a negative impact on real rates of return because inflation reduces the purchasing power of both investment income and principal. Credit Risk - The safety of the fixed income investor's principal depends on the issuer's credit quality and ability to meet its financial obligations, such as payment of coupon and repayment of principal at maturity. A change in either the issuer's credit rating or the market's perception of the issuer's business prospects will affect the value of its outstanding securities. Default Risk - The risk of default is the risk that the issuer will not be able to make interest payments and/or return the principal at maturity.

REGULATORS

The Securities Contracts Regulation Act (SCRA) defines the regulatory role of various regulators in the securities market. The RBI regulates the money market segment of the debt products (CPs, CDs) and the Government securities market. The non Government bond market is regulated by the SEBI. The SEBI also regulates the stock exchanges and hence the regulatory overlap in regulating transactions in Government securities on stock exchanges have to be dealt with by both the regulators (RBI and SEBI) through mutual cooperation.

The RBI’s Regulatory Role Licensing Prescribing capital requirements Monitoring governance Setting prudential regulations to ensure solvency and liquidity of the banks Prescribing lending to certain priority sectors of the economy Regulating interest rates in specific areas Setting appropriate regulatory norms related to income recognition, asset

classification, provisioning, investment valuation, exposure limits and the like

Initiating new regulation

SEBI The regulator for the Indian corporate debt market is the Securities and Exchange Board of India (SEBI). SEBI controls the bond market in cases where entities, especially corporates, raise money from public through public issues.

It regulates the manner in which money is raised and to ensure a fair play for the retail investor. It forces the issuer to make the retail investor aware of the risks inherent in the investment and its disclosure norms. SEBI is also a regulator for the mutual funds and regulates the entry of new mutual funds in the industry. It also regulates the instruments in which these mutual funds can invest. SEBI also regulates the investments of FIIs.