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.

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, government central banks try to manipulate interest rates to stimulate their economies without causing inflation.

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.

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;

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

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.

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 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.

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.

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.

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.

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 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:

Relationship between lenders and borrowers

LendersFinancial

IntermediariesFinancial Markets

Borrowers

IndividualsCompanies

BanksInsurance Companies

Pension FundsMutual Funds

InterbankStock ExchangeMoney MarketBond Market

Foreign Exchange

IndividualsCompanies

Central GovernmentMunicipalities

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.

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 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.

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 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 wide range 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.

Intermediary Market Role

Stock Exchange Capital MarketSecondary Market to

securities

Investment Bankers Capital 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

Conclusion

In India money market is regulated by Reserve bank of India and Securities Exchange Board

of India (SEBI) regulates capital market. Capital market consists of primary market and

secondary market. All Initial Public Offerings comes under the primary market and all

secondary market transactions deals in secondary market. Secondary market refers to a

market where securities are traded after being initially offered to the public in the primary

market and/or listed on the Stock Exchange. Secondary market comprises of equity markets

and the debt markets. In the secondary market transactions BSE and NSE plays a great role in

exchange of capital market instruments.

What is the Debt Market?

The debt market 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 debt market 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 debt market.

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 debt market.

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

debt market 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 debt market 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 debt market offerings are chosen.

Issuers of various bonds, notes, and mortgages also benefit from the structured environment of a debt market. 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 theyields of government bonds, corporate debentures, MIBOR-related commercial papers,and non-convertible debentures.

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 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.

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 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' 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 across the country to trade simultaneously with enormous easeand 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.

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.

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 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 market is that the return is fixed. This means, returns are almost risk-free. This fixed return on the bond is often termed as the 'coupon rate' or the 'interest rate'. Therefore, the buyer (of bond) is giving the seller a loan at a fixed interest rate, which equals to the coupon rate.

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

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

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.

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 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

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.

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

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

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.

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

(i) Callable Bonds

The issuer of a callable bond has the right (but not the obligation) to change

the tenor of a bond (call option). The issuer may redeem a bond fully or partly

before the actual maturity date. These options are present in the bond from the

time of original bond issue and are known as embedded options. A call option

is either a European option or an American option. Under an European option,

the issuer can exercise the call option on a bond only on the specified date,

whereas under an American option, option can be exercised anytime before

the specified date.

This embedded option helps issuer to reduce the costs when interest rates are

falling, and when the interest rates are rising it is helpful for the holders.

(ii) 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.

(iii) 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.

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

A Debenture is a unit of loan amount. When a company intends to raise the loan  amount

from the public it issues debentures. A person holding debenture or  debentures  is called a

debenture holder. A debenture is a document issued under the seal of the company. It is an

acknowledgment of the loan  received by the company equal to the nominal value of the

debenture. It bears the date of redemption and rate and mode of payment of interest. A

debenture holder is the  creditor of the company.

 

As per section 2(12) of Companies Act 1956, “Debenture includes debenture  stock, bond

and  any  other  securities  of  the  company whether constituting a charge on the

company’s assets or not”.

 

TYPES OF DEBENTURES

 

Debenture can be classified as under :

1. F r om security point of

view

(i) Secu r ed or Mortgage debentu r es :

These are the debentures that are secured by a charge on the assets of the

company. These are also called mortgage debentures. The holders of

secured debentures have the right to recover their principal amount with

the unpaid amount of interest on such debentures out of the assets

mortgaged by the company. In India, debentures must be secured.

Secured debentures can be of two types :

 

(a)   First mortgage debentures : The holders of such debentures have a first

claim on the assets charged.

 

(b)   Secon d mortgag e debenture s : The holders of such debentures have a

second claim on the assets charged.

 

(ii)    Unsecu r ed debentu r es : Debentures which do not carry any security with

regard to the principal amount or unpaid interest are called unsecured debentures.

These are called simple debentures.

 

2. On the basis of r edemption

 

(i) Redeemable debentu r es : These are the debentures which are issued for a fixed

period. The principal amount of such debentures is paid off to the debenture holders

on the expiry of such period. These can be redeemed by annual drawings or by

purchasing from the open market.

(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. On the basis of Records

(i) Registe r ed   debentu r es   :  These

are  the  debentures  that  are

registered with the company. The

amount of such debentures is

payable only to those debenture

holders whose name appears in the

register of the company.

(ii)   Bea r er debentu r es : These are the

debentures which are not recorded

in  a  register  of  the  company.

Such  debentures  are transferrable

merely by  delivery. Holder of these

debentures is entitled to get the

interest.

 

4. On the basis of convertibility

(i) Conve r tible debentu r es : These are the debentures that can be converted

into shares of the company on the expiry of predecided period.  The  term  and

conditions  of  conversion  are  generally announced at the time of issue of

debentures.

(ii)Non-convertible debentu r es : The debenture holders of such debentures

cannot convert their debentures into shares of the company.

 

5. On the basis of priority

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

(ii)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.

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.

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.

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?

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)

Security or collateral provided by the issuer

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

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.

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.

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. 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 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

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.

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 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.

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

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

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.

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.

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. 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 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,

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.

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 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 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.

(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 (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

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

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 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 riskappetite.

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.

RECCOMENDATIONS:

Transparency - The market’s functionality needs to be transparent both to the entity issuing the debt security, as also to the intermediary investing his money into it.

Market unification and communication - The current market fragmentation has to be reduced.

Trustworthy and transparent benchmarks - For a debt capital market to function efficiently, the existence of a credible benchmark is critical. In most markets, Government Treasury Notes play this role. It is common practice in most developing markets to use the US Treasuries as a global benchmark.

Liquidity - Liquidity is perhaps one of the most important requirements for

an efficient, developed capital market. Allowing banks to guarantee bonds would lower companies' funding costs and increase

investor confidence in the bond market. Legal system - A functioning legal system that all parties have faith in is another

critical component. Without a viable legal infrastructure in place, it is very difficult to create investor confidence vis-à-vis the risk attributes of debt securities.

Macroeconomic stability - Investor confidence is guided by many factors, one of the most important of which is macroeconomic stability.

Even with these additional reforms, India would have a long way to go. Its outstanding corporate debt is only 3.3 percent of its gross domestic product, vs. 10.6 percent in China.

We have all hung in there in good times and bad. And it may not be too long a wait before the Indian debt market takes on all the proportions of an international debt market.

The bottom line: India needs to develop a more robust corporate bond market if the government's $1 trillion infrastructure program is to succeed.

BIBLIOGRAPHY

Financial Accounting By Marian Powers

Economic Times

Times Of India

Business Today

www.rbi.org

www.economictimes.indiatimes.com

www.bseindia.com

www.google.com

www.investopedia.com

www.businessstandard.com

www.netbank.com

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