Presentation on Indian Debt Market. Overview of Financial Markets. The Basic Premise of Financial Markets- As we know, a market is where buyers and sellers meet to exchange goods, services, money, or anything of value. In a financial market,
goods, services, money, or anything of value. In a financial market,
the buyers are investors, or lenders: the sellers are issuers, or
borrowers. An investor / lender is an individual, company, government,
or any entity that owns more funds than it can use.
An issuer / borrower is an entity that has a need for capital. Each
investor and issuer is active in a market that meets its needs. Needs
are based on many factors, including a time horizon (short- or longterm),
a cost / return preference, and type of capital (debt or equity).
intermediaries called brokers and dealers. Brokers facilitate the
buying and selling process by matching investors and issuers
according to their needs. Dealers purchase securities from issuers and
sell them to investors. Brokers and dealers may be referred to as
investment bankers. Investment banking firms specialize in the
a borrower or issuer.
- Debt security or bond – an IOU promising periodic payments
of interest and/or principal from a claim on the issuer's
- Equity or stock – an IOU promising a share in the ownership
and profits of the issuer
debt securities. These securities are often called "cash equivalents"
because of their safety and liquidity. The liquidity of a market refers to
the ease with which an investor can sell securities and receive cash. A
market with many active investors and few ownership regulations
usually is a liquid market; a market with relatively few investors, only a
few securities, and many regulations concerning security ownership is
probably less liquid.
are three general subsets of capital markets: bond (or debt) markets,
equity markets, and derivative markets. Today, we will discuss
debt markets in more detail and will have a cursory glance at equity markets and
illustrate how debt markets look, we will analyze a short example.
operations. Most companies try to match assets and liabilities
according to maturity (time left before the item is no longer useful).
The company expects the new equipment to have a useful life of about 10 years
and, therefore, after consulting with its financial advisors, HT Manufacturing
decides to issue 10-year bonds to pay for the equipment. HT Manufacturing
consults with investment bankers to find out what types of bonds investors are
buying and to decide what interest rate the bonds will pay. The object is to make
them attractive to investors, yet cost-efficient for HT Manufacturing.
bonds to investors using two methods.
1) The investment banks use their brokers to find buyers for the
bonds, and HT Manufacturing sells the bonds directly to the
2) The investment banks also act as dealers by buying some of the
bonds themselves, then selling them to investors.
The original issue of bonds (or bills, or any other debt security) is
called the primary market issue. A secondary market also exists
where debt securities are bought and sold by investors. For example,
suppose an investor who bought HT Manufacturing bonds one year ago
has a change in investment plans and no longer needs 10-year bonds.
S/he can sell the bonds in the secondary market (usually with the
assistance of a broker) to another investor who wants 10-year bonds.
Because this transaction has no effect on HT Manufacturing's finances
or operations, it is considered a secondary market transaction.
selling of equity securities (stocks) of companies. As in the debt
markets, the equity markets have a primary and secondary market.
companies, a process known as an initial public offering — or "taking
the company public." Investment bankers advise a company on the
process and can also act as brokers and dealers for new stock issues.
that reflect the investors' collective view of the future prospects of
each individual firm.
A derivative instrument is a security that derives its value from an
underlying asset, including financial assets such as stocks and bonds
or other assets such as commodities and precious metals. Derivative
instruments include future and forward contracts and options. These
instruments are bought and sold in the market by investors needing to
hedge risk exposure.
7. thePublic Sector Financial Institutions regularly access debt markets with
bonds for funding their financing requirements and working capital
needs. They also invest in bonds issued by other entities in the debt
treasury bond and bill markets. They have a statutory requirement to hold
a certain percentage of their deposits (currently the mandatory
requirement is 25% of deposits) in approved securities (all government
bonds qualify) to satisfy the statutory liquidity requirements. Banks are
very large participants in the call money and overnight markets. They are
arrangers of commercial paper issues of corporates. They are also active
in the inter-bank term markets and repo markets for their short term
funding requirements. Banks also issue CDs and bonds in the debt
markets, owing primarily to the growing number of bond funds that have
mobilised significant amounts from the investors. Most mutual funds also
have specialised bond funds such as gilt funds and liquid funds.
Mutual Funds are not permitted to borrow funds, except for very short-term liquidity
requirements. Therefore, they participate in the debt markets pre-dominantly as
investors, and trade on their portfolios quite regularly.
US $ 5 billion and in Coporate Debt upto US $ 15 billion.
regulations governing the deployment of the funds they mobilise, mandate
investments pre-dominantly in treasury and PSU bonds. They are, however, not
very active traders in their portfolio, as they are not permitted to sell their holdings,
unless they have a funding requirement that cannot be met through regular accruals
markets. They are, however, governed by their rules and byelaws with respect to
the kind of bonds they can buy and the manner in which they can trade on their debt
Participants and Instruments In Debt Markets very short-term liquidity
Instruments very short-term liquidity
Money Market very short-term liquidity
Call / Notice Money
Repo very short-term liquidity
Collateralized Borrowing and Lending Obligation (CBLO) very short-term liquidity
Treasury Bills very short-term liquidity
Commercial Paper (CP) very short-term liquidity
Certificate of Deposit (CD) very short-term liquidity
Bills Rediscounting Scheme very short-term liquidity
Cash Reserve Ratio (CRR) very short-term liquidity
Repo Rate very short-term liquidity
Statutory Liquidity Ratio (SLR)
Derived Instruments very short-term liquidity
Pass Through Certificate
Certificate of Participation
Hedging Mechanism very short-term liquidity
Interest Rate Swaps
Interest Rate Options very short-term liquidity
These are bonds for which the coupon payment in a particular period is
linked to the inflation rate at that time - the base coupon rate is fixed with the
inflation rate (consumer price index-CPI) being added to it to arrive at the
total coupon rate. Investors are often loath to invest in longer dated securities
due to uncertainty of future interest rates. The idea behind these bonds is to
make them attractive to investors by removing the uncertainty of future
inflation rates, thereby maintaining the real value of their invested capital.
These are bonds for which there is no coupon payment. They are issued at a discount to face value with the discount providing the implicit interest payment. In effect, these can be construed as long duration T - Bills or as bonds with cumulative interest payment.
These are issued by the respective state governments but the RBI coordinates the actual process of selling these securities. Each state is allowed to issue securities up to a certain limit each year. State Government issue such securities to fund their developmental projects and finance their budgetary defictis
These are long term debt instruments issued by Public Sector Undertakings
(PSUs). The term usually denotes bonds issued by the central PSUs (ie
PSUs funded by and under the administrative control of the Government of
India). The issuance of these bonds began in a big way in the late eighties
when the central government stopped/reduced funding to PSUs through the
general budget. Typically, they have maturities ranging between 5-10 years
and they are issued in denominations (face value) of Rs.1,000 each. Most of
these issues are made on a private placement basis to a targeted investor
base at market determined interest rates.
These PSU bonds are transferable by endorsement and delivery and no tax
is deductible at source on the interest coupons payable to the investor (TDS
Apart from public sector undertakings, Financial Institutions are also
allowed to issue bonds, that too in much higher quantum. They issue
bonds in 2 ways - through public issues targeted at retail investors and trusts
and also through private placements to large institutional investors. Usually,
transfers of the former type of bonds are exempt from stamp duty while only
part of the bonds issued privately have this facility. On an incremental basis,
bonds of PFIs are second only to GOISECs in value of issuance.
These are long term debt instruments issued by private sector companies.
These are issued in denominations as low as Rs.1,000 and have maturities
ranging between one and ten years. Long maturity debentures are rarely
issued, as investors are not comfortable with such maturities. Generally,
debentures are less liquid as compared to PSU bonds and the liquidity is
inversely proportional to the residual maturity.
A key feature that distinguishes debentures from bonds is the stamp duty
payment. Debenture stamp duty is a state subject and the quantum of
incidence varies from state to state. There are two kinds of stamp duties
levied on debentures viz issuance and transfer. Issuance stamp duty is paid
in the state where the principal mortgage deed is registered. Over the years,
issuance stamp duties have been coming down and are reasonably uniform.
Stamp duty on transfer is paid to the state in which the registered office of
the company is located. Transfer stamp duty remains high in many states
and is probably the biggest deterrent for trading in debentures resulting in
lack of liquidity.
Bond Basics & Valuation of very short-term liquidity
investor purchases a certificate from the issuer in exchange for a stream
of interest payments and the return of a principal amount at the end of
the contract. In this section we will discuss the terminology of the bond
market and the methodology for calculating the price (present value) of
There are several terms that are commonly used by investors and
issuers when dealing with bonds.
Coupon The periodic interest payment made by the issuer.
When bonds were first developed, the bond certificate had detachable
coupons that the investor would send to the issuer to receive each
interest payment. The term still applies to payments, even though coupons
are no longer used to redeem them.
Coupon rate The interest rate used to calculate the coupon
amount the bond will pay. This rate is multiplied by the face value of the bond
to arrive at the coupon amount.
Face (par) value contract, theThe amount printed on the certificate. The face
value represents the principal in the loan agreement, which is
the amount the issuer pays at maturity of the bond.
Maturity date The date the loan contract ends. At this time, the
issuer pays the face value to the investor who
owns the bond.
Bonds are often referred to as fixed income securities because they
have a fixed payout to the investor. Since the coupon rate is set before
the sale of the bond, the investor knows the amount of the interest
A simple example will illustrate the process for issuing bonds.
Example ABC Company needs capital to purchase a new piece of
equipment for its operations. The company meets with financial advisors and
investment bankers to discuss the possibilities of raising the necessary
capital. They decide that a bond issue is the least expensive method for the
The process is as follows:
1. ABC Company sets the maturity date and face value of the bonds.
The bonds will have a maturity date of ten years from the date of
issue and a face value of Rs.1,000. The company will issue as many
bonds as it needs for the equipment purchase – if the equipment
costs Rs.10,000,000 fully installed, then the company will issue
2. Investment bankers set the coupon rate for the bonds. contract, the
The investment bankers attempt to gauge the interest rate environment and set the
coupon rate commensurate with other bonds with similar risk and maturity. The
coupon rate dictates whether the bonds will be sold in the secondary market at face
value or at a discount or premium. If the coupon rate is higher than the prevailing
interest rate, the bonds will sell at a premium; if the coupon rate is lower than the
prevailing interest rate, the bonds will sell at a discount.
3. Investment bankers find investors for the bonds and issue them in
the primary market.
The investment bankers use their system of brokers and dealers to find investors to
buy the bonds. When investment bankers complete the sale of the bonds to
investors, they turn over the proceeds of the sale (less the fees for performing their
services) to the company to use for the purchase of equipment. The total face
value of the bonds appears as a liability on the company's balance sheet.
4. The bonds become available in the secondary market. contract, the
Once the bonds are sold in the primary market to investors, they
become available for purchase or sale in the secondary market.
hese transactions usually take place between two investors – one
investor who owns bonds that are no longer needed for his/her
investment portfolio and another investor who needs those same
Pricing Bonds contract, the
from the bond throughout its life. The formula for calculating the
present value of a bond is:
V = Present value of the bond
C = Coupon payment (coupon rate multiplied by face value)
R = Discount rate (current prevailing rate)
F = Face value of the bond
T = Number of compounding periods until maturity
Example: contract, the
value of Rs.1,000, and a coupon rate of 6%? The current prevailing rate for
similar issues is 5%. To apply the formula,
C = Rs.60 (Rs.1,000 x 0.06), R = 0.05, T = 2, and F = Rs.1,000.
V = C[1 / (1+R)]1 + C[1 / (1+R)]2 + F[1 / (1+R)]2
V = Rs.60[1 / (1+0.05)] + Rs.60[1 / (1+0.05)]2 + Rs.1,000[1 / (1+0.05)]2
V = Rs.60[0.95238] + Rs.60[0.90703] + Rs.1,000[0.90703]
V = Rs.57.14 + Rs.54.42 + Rs.907.03
V = Rs.1,018.59
in the secondary bond market. You will notice that the price is higher
than the face value of Rs.1,000. In the time since these bonds were
issued, interest rates have fallen from 6% to 5%. Investors are willing
to pay more for the Rs.60 interest payments when compared with new
bond issues that are only paying Rs.50 in interest per Rs.1,000 face value.
This inverse relationship is important.
As interest rates fall, bond prices rise;
As interest rates rise, bond prices fall.
face value. A bond with a coupon rate that is higher than the prevailing
interest rate sells at a premium to par value; a bond with a lower rate
sells at a discount.
Current Yield, YTM & Duration of a Bond will trade for
Name of bond
e.g. GOI 2020
12 ¼ % pa.
e.g. Dec 2020
Current Yield will trade for, in contrast to the Coupon Yield or Nominal Yield, is a Bond Yield that is determined by dividing the fixed coupon amount (that is paid as a percentage on the face or original value of the specific bond) by the current price value of the particular bond. In other words, Current Bond Yield = Coupon amount / current price of a bond.
The market price for a 8.24% G-Sec 2018 is Rs.118.85. The current yield on the security will be 0.0824 x 100 / 118.85 = 6.93 percent.
Yield to Maturity is the most popular measure of yield in the Debt Markets. YTM refers
to the percentage rate of return paid on a bond, note or other fixed income security if
the investor buys and holds the security till its maturity date.
The calculation for YTM is based on the coupon rate, the length of time to maturity and
the market price of the bond. YTM is basically the Internal Rate of Return on the bond.
It can be determined by equating the sum of the cash-flows throughout the life of the
bond to zero. One of the major assumptions underlying the YTM is that the coupon
interest paid over the life of the bond is assumed to be reinvested at the same rate.
The concept of Yield to Maturity assumes that the future cash flows are reinvested at the same rate at which the original investment was made.
Market price =
I/2 I/2 I/2 I/2+FV
---- + ---- + ---- ........... ------
(1+r) (1+r)2 (1+r)3 (1+r)n
where I/2 = annual interest rate payable half yearlyr = discount rate or YTMn = number of half years remaining to maturity
The approximate Yield to Maturity (YTM) can be computed as per the formula given below:
where I = Annual interest RateF = Face value of bondM = Market price of the bondN = Number of years to maturity
---------- = ---------
Suppose Ramesh buys 12% GOI-2008 at Rs 102 and Suresh buys the same instrument at Rs 104 then the yield to maturity using approximation is For Ramesh,
YTM = --------------- = 11.59%
For Suresh, per the formula given below:
YTM = -------------- = 11.20%
YTM = 10%
Coupon = 10%
Bond price = Rs100
Flat yield = 10%
YTM = 12%
Bond price = Rs83
Flat yield = 12 %
YTM = 12%
Coupon = 10%
Bond price = Rs 83
Flat yield = 12%
YTM = 12%
Bond price = Rs100
Flat yield = 10 %
Price Interest rate relationship: per the formula given below:
The price of a government security is inversely related to the market interest rate. As the interest rate increases price decreases and therefore, the yield increases. However, if the interest rates fall the G-Sec become expensive and therefore, the yield falls.
Coupon rate = Yield to maturity if, Market price = Face value
Coupon rate < Yield to maturity if, Market price < Face value
Coupon rate > Yield to maturity if, Market price > Face value
Average Maturity- per the formula given below:
Average Maturity is the weighted Average of the maturities of all the instruments in a portfolio.
Duration of a Bond-
a bond's cash flows. It represents the weighted average life of the
bond, where the weights are based on the present value of the
individual cash flows relative to the present value of the total cash
flows (current price of the bond).
- A three year duration portfolio will approximately rise ( fall ) 3% if interest rates fall (rise) by 100 bps (1%)
- A six year duration portfolio will rise (fall) 6% if interest rates fall (rise) by 100 bps (1%)
Relation of Duration with Maturity Date,YTM and Coupon Rate: per the formula given below:
holding the coupon rate constant.
maturity is lower.
Term Structure of Interest Rates per the formula given below:
Normal Yield Curve: Remember that as general current interest rates increase, the price of a bond will decrease and its yield will increase.
Flat Yield Curve: Sends mixed signalsthat short-term interest rates will rise and other signals that long-term interest rates will fall.
Inverted Yield Curve :The inverted yield curve indicates that the market currently expects interest rates to decline as time moves farther into the future, which in turn means the market expects yields of long-term bonds to decline.
Remember, also, that as interest rates decrease, bond prices increase and yields decline.
The Credit Spread per the formula given below:
the economy is expanding in the long run, so the risk associated with investing in a long-term corporate bond is also generally lower.
Yield Curve Analysis per the formula given below:
- Argues that yields differ with maturities because of market expectations of future changes in interest rates.
- For example, the 2-year yield is higher than the 1-year yield because the expectations about the 1-year yield 1-year from now, is factored in the 2-year yield is ruling now.
- If YTMs were equal across maturities, investors will prefer shorter maturity bonds because longer the maturity, greater the uncertainties, about the future inflation and interest rates.
- As compensation for the higher uncertainties, investors demand a higher yield (or liquidity premium) to invest in longer term securities.
-Weakness of the theory is that, on first principles, liquidity premium should go up with maturity.
preference and asset liability management needs, and the yields are independent of each other.
Risks in Bond Investing per the formula given below:
- Impact on price of a bond due to changes in interest rate changes
- Impact due to credit migration or default risk
- Coupons get reinvested at different rates, impacting the total return of the portfolio
- Yield curve shifts may not be parallel