fixed income primer for india
TRANSCRIPT
17 August 2010
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Woon Khien Chia
Emerging Markets Strategy
+65 6518 5169
Teck Wee Yeo
Emerging Markets Strategy
+65 6518 6160
www.rbsm.com/strategy
Top View | India A primer on India’s fixed income market The Indian fixed income market has developed rapidly since the structural
changes made in the 1990s. These changes included technological and
regulatory changes such as the electronic screen-based trading, the
establishment of Clearing Corporation of India Ltd. (CCIL) and new instruments
and initiatives to broaden the investor base. This primer provides a full spectrum
of India’s fixed income market, describing the different market instruments and
the roles, objectives and choice of instruments of the central bank, banks, non-
banks and foreign investors. A brief listing of settlement, pricing and taxation
issues is also contained in this primer.
Monetary Policy Framework
- Policy decision making, policy targets, policy tools. Pages 2-5
Markets and instruments
- Money market instruments, long-term instruments, derivatives. Pages 5-10
Supply
- Issuers, issuance patterns. Pages 10-12
Demand
- Primary dealers, banks, insurance companies, pension funds, FII, retail investors. Pages 12-14
Settlement, pricing and taxation. Pages 15-16
Conclusion. Page 16
List of tables
- Table 1: Cash instruments’ basic features. Page 9 - Table 2: Derivative instruments’ basic features. Page 10 - Table 3: Cash instruments’ supply and demand. Page 14 - Table 4: Settlement and FII regulation and taxation. Page 16 Glossary. Pages 17-19
Appendix
- Lists of credit rating agencies, primary dealers, custodians and countries with double taxation avoidance agreement (DTAA). Pages 20-22
The Royal Bank of Scotland
Monetary Policy Framework
The Reserve Bank of India (RBI) is the monetary authority, regulator and
supervisor of the financial system, manager of foreign exchange, issuer of
currency and a banker to the banks. In setting its monetary policy, the RBI
balances growth and price and financial stability.
The RBI uses a multiple-indicator approach to achieve its multiple objectives,
monitoring the movements of interest rates, inflation rate, money supply, credit,
exchange rate, capital flows along with trends in output. As the economy is
heavily dependent on agriculture, weather factors such as monsoon sometimes
influence the RBI’s decisions, compelling the central bank to adopt both price
and quantitative instruments for implementing the policy.
Policy decision-making
The process of monetary policy formulation has largely been an internal process.
At the very apex of the policy process is the governor, assisted by a maximum of
four deputy governors and guided by the Central Board of Directors (see below).
The RBI’s Monetary Policy Department (MPD) formulates the monetary policy in
consultation with banks, insurance companies, pension funds and industry and
trade associations. In parallel, a Technical Advisory Committee (TAC) reviews
the macroeconomic conditions and advises the RBI. The final decision is solely
that of the governor who seeks consensus from a 12-member (5 internal/ 7
external) Monetary Policy Committee (MPC) who sits on the board of directors.
As announced at the 27 July 2010 policy meeting, monetary policy reviews are
now conducted mid-quarter in addition to the quarterly reviews. The intention is
to reduce the element of surprise to market participants from the inter-policy
moves which have occurred quite often in the past.
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The central board of directors
The Board is appointed by the government comprising 19 members divided into
official and non-official directors. The official directors include the governor and
the four deputy governors. The non-official directors include four directors
nominated by the government to represent each local board, 10 directors
nominated by the government possessing expertise in various segments of the
economy and 1 representative of the central government.
Policy targets
Within its policy toolkit, the cash reserve ratio (CRR) and repo/reverse repo rates
are the most commonly used tools by the RBI. Tools like Statutory Liquidity Ratio
(SLR) and bank rate are used for long-term planning and are seldom adjusted.
Repo/Reverse repo rates
These are the rates used for the RBI’s repo and reverse repo auctions with
scheduled commercial banks and primary dealers under its Liquidity Adjustment
Facility (LAF, see section below). Through the LAF, the RBI indirectly aims to
keep the market overnight call rate within the corridor set by its targeted repo/
reverse repo rates. Oftentimes the market overnight call breaches this policy rate
corridor due to a combination of reasons such as a shortage of eligible
government securities among banks and dislocations in interbank credit risks.
The current repo rate is at 5.75 % while the reverse repo rate is at 4.5% giving a
spread of 125 bps. On a hiking cycle, the operational or effective policy rate is
the repo rate as the interbank market as a whole would be generally short of
2
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liquidity and would need to be net borrowing from the RBI at the repo rate. Vice
versa, on an easing cycle, the operational rate is the reverse repo rate. At the
beginning of a turning point in the policy cycle, the RBI tends to maintain a
tighter policy rate corridor so as to guide the market towards the desired
operational rate while towards the end of a policy cycle, it tends to broaden the
policy rate corridor to provide the scope for the market to trade away from the
operational rate towards the other rate. Over the past ten years, the spread has
varied from 100bp to 700bp averaging around 175bp (see Figure 1).
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Bank rate
Bank rate is the rate at which the RBI is ready to either buy back or rediscount
bills of exchange or other commercial papers with banks. The bank rate is used
to signal the medium to long-term stance of monetary policy. The rate has not
changed since April 2003 and currently stands at 6%.
3
Source: RBI
Figure 1: RBI’s targets on reverse repo rate, repo rate and bank rate (%)
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Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10
Reverse Repo Repo Bank Rate
Source: RBI
Figure 2: RBI’s policy tools CRR and SLR (%)
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Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
CRR SLR
Policy tools
Cash reserve ratio (CRR)
The RBI requires banks to maintain a fraction of their net demand and time
liabilities (NDTL) in the form of cash with the central bank so that they have
sufficient cash to cover customer withdrawals. The ratio is applied to Scheduled
Commercial Banks (SCB) but excludes regional rural banks.
Under it the RBI Act, the RBI can raise CRR to a maximum of 20% and a
minimum of 3% of NDTL. CRR reached a peak of 9 % in July 2008 before it was
brought down sharply to 5% after the breakout of the global credit crisis in
2008/09. Currently, the CRR stands at 6% (see Figure 2).
Statutory liquidity ratio (SLR)
The SLR is the percentage a commercial bank needs to maintain in the form of
cash, gold or government approved securities against its total credit
outstanding. As borrowing from the open market forms a critical part of the
government’s financing over the years, this tool has become an important
support for the government’s fiscal financing programme.
The Royal Bank of Scotland
SLR has remained at 25 % since November 1997 except at the peak of the
2008/09 crisis period when it was reduced to 24% for a year from November
2008 to November 2009. The ratio can be increased to a maximum of 40%.
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Bonds which are eligible for SLR include the central and local government
securities, T-bills and cash management bills. All other bonds are not eligible for
SLR, including Public Sector Undertaking (PSU) bonds, corporate bonds and
Government securities issued for special purposes like Oil Bonds, Food Bonds,
Fertilizer Bonds, etc.
Liquidity adjustment facility (LAF)
This is a facility extended by the RBI to allow banks to park their funds with the
central bank in case of an excess or borrow from it in case of a shortage. It is
done on an overnight basis against the collateral of eligible securities, including
all the SLR-eligible securities as well as selected government securities issued
for special purposes. Repo auction operations facilitate liquidity injection
whereas reverse repo auctions are used to absorb the liquidity (see Figure 3).
Open market operations (OMO)
In addition to LAF, the RBI also makes outright sale and purchase of government
securities in the market. RBI soaks the liquidity from the market by selling
government securities and vice versa it injects liquidity into the system by buying
securities from the market. However, more often than not, he RBI uses the
window to smooth out fluctuations in the bond market rather than to manage
liquidity.
Market stabilization scheme (MSS)
The MSS was introduced in 2004 to absorb the surplus cash generated due to
the central bank’s dollar buying intervention in the FX market. It is thus essentially
an FX sterilization tool. Under the MSS, the government issues treasury bills
and/or dated securities on top of its normal fiscal borrowing requirements for
absorbing the excess liquidity from the market which resulted from the RBI’s FX
intervention. These securities are issued and serviced like existing bills and
dated securities by way of the RBI’s weekly auction. The amount raised under
MSS is held in a separate cash account which is maintained and operated by the
RBI. This amount is appropriated only for the purpose of redemption or to buy
back treasury bills and dated securities issued under this scheme. Payments for
interest and discount are not made from the MSS account and the receipts due
to premium and/or accrued interest are not credited to the MSS account. Such
payments or receipts are dealt through the government’s account with the RBI.
During the 2008/09 global credit crisis, the government held back from issuing
MSS bonds to allow outstanding MSS bonds to roll off and release liquidity back
into the market to support the government’s fiscal stimulus spending. In addition,
the RBI also de-sequestered some MSS bonds to the government’s account. As
a result of these actions, MSS balances came down from INR1.7trn in March
2008 to INR880bn in March 2009 and further to INR27.4bn by March 2010. As at
June 2010, the MSS balance stood at INR3.17bn (see Figure 4).
After the global credit crunch subsided, the RBI has restarted issuing MSS
bonds, with a INR500bn limit set for FY2010/11 which is substantially lower than
the INR2.5trn limit for FY2007/08.
4
The Royal Bank of Scotland
Refinance facilities
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0 The RBI provides refinance facilities to banks for lending to specific sectors, with
the most important being the export sector. All scheduled banks which are
authorized dealers in foreign exchange and have extended export credit are
eligible to avail of the export credit refinance facility. The government increases
the ceiling for these loan facilities when it wishes to pump in liquidity to specific
sectors. The refinance facility is available at the RBI’s repo rate and is allocated
in multiples of hundred thousand rupees. As at April 2010, the RBI has
INR99.38bn in export credit refinance facility.
5
* negative refers to liquidity withdrawal. Source: Bloomberg, RBS
Figure 3: Net reverse repo outstanding under LAF* (INR trn)
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Source: CEIC, RBS
Figure 4: MSS bonds outstanding (INR trn)
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Markets and instruments
The Indian fixed income market is one of the most actively traded markets in Asia
with its size and depth comparable to those of the developed markets. As is the
case with the developed world, the Indian fixed income market is also dominated
by the government securities, commonly known as GSecs or gilts. The GSec
market is characterized by an efficient auction process and a liquid secondary
market. Areas for future development would be to deepen the retail investor base
on the demand side and the corporate bond market on the supply side.
Money market instruments (reference Table 1, page 9)
Treasury bills (T-Bills)
Treasury bills are short-term debt instruments issued by the RBI on behalf of the
government. They are issued as discount (zero coupons) securities in three
tenors namely, 91 days, 182 days and 364 days. The RBI conducts T-bill
auctions every Wednesday.
Call money/ notice money/ term money
Call money market is a market for uncollateralized lending and borrowing of
funds. This market is predominantly overnight and is open for participation only
to scheduled commercial banks and primary dealers. If the money lent exceeds
The Royal Bank of Scotland
one day but is less than 15 days, it is called notice money market. If it exceeds
15 days but doesn’t exceed 1 year, it is referred to as term money market.
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Repo
In addition to engaging in repo transactions with the RBI under LAF, interbank
market participants also engage in repos among themselves. The daily turnover
of the interbank market repo is generally higher than the call market but lower
than LAF. The list of eligible collaterals for market repos are more wide-ranging
than that for LAF, including GSecs, T-bills, special securities and state
development loans (SDL). As of 1 March 2010, even corporate bonds rated AA
or above can be used for repo borrowing with an initial margin of 25%.
Predominantly, the repos are undertaken on an overnight basis although there is
no restriction on term repos.
Certificates of deposit (CD)
Certificates of deposits are the certificates issued by banks and financial
institutions. The tenor ranges from 7 days to 1 year for banks and from 1 year to
3 years for financial institutions.
Commercial paper (CP)
Commercial paper is issued in the form of a promissory note which is essentially
an unsecured money market instrument. Corporate, primary dealers and all
financial institutions are permitted to issue them to raise short-term financing of
funds under an umbrella limit set by the RBI. Main investors are banks, insurance
companies and mutual funds. Mandatory credit rating by an RBI approved
credit rating agency has to be attained by the issuer for its commercial paper.
Maturities of CPs can range from 7 days to 1 year.
Collateralized borrowing and lending obligation (CBLO)
This money market instrument is operated by the Clearing Corporation of India
Limited (CCIL) for the benefit of entities which have no access to interbank call
money market or have restricted access in terms of ceiling on call borrowing and
lending. Securities eligible as collateral can be GSecs or securities specified by
the CCIL. It is available in electronic book entry form as a discounted instrument
with maturities ranging from 1 day to 1 year. In terms of turnover volume, CBLOs
are the most traded money market instrument behind RBI’s LAF.
Cash management bills (CMB)
In August 2009, the government decided to introduce a new short-term
instrument known as cash management bills to meet its temporary cash flow
mismatches. These bills are non-standardized and the tenor which can be no
more than 91 days, amount and date of issue depend on the temporary cash
requirement of the government. The bills are sold at a discount. The
announcement of the auction is made by the RBI one day prior to the auction.
Thus far, the government has auctioned CMB twice, once on 11 May 2010 and a
second time on 18 May 2010 for a notified amount of INR60bn with the same
maturity date on 16 June 2010.
Long-term securities
Dated government securities (GSecs)
6
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Dated government securities are issued by the government to finance its fiscal
deficit or infrastructure development programmes. These are long-term
securities, with maturities ranging from 2 years to 30 years. The yields are driven
by factors such as policy rates, domestic inflation and sometimes follow the
direction of the US treasuries (see Figures 5 and 6).
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Source: Bloomberg, RBS
Figure 5: 10y GSec yield vs. WPI YoY (%)
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2y Gsec WPI (yoy)
Source: Bloomberg, RBS
Figure 6: 10y GSec yield vs. 10y UST yield (%)
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Special securities
The government issues special securities to companies like oil marketing
companies, fertilizer companies, the Food Corporation of India as compensation
in lieu of cash subsidies. These are usually long-dated bonds about 20-25 basis
points higher than regular GSecs of similar maturity to compensate for the
illiquidity.
As the companies given these special GSecs are usually state-owned (e.g. oil
bonds are given to Indian Oil Corp), these bonds can be kept off the
government’s budget. The government pays out approximately INR100bn a year
as interest payments on oil bonds alone. Since 2005, the government has issued
special securities mainly to oil and fertilizer companies apart from a small
handful of issues to the Food Corporation of India, a state bank and a non-bank
FI.
A conscious effort is now being made to avoid issuing new oil and fertilizer
bonds so that the government now extends its subsidy in cash thereby bringing
all subsidy-related liabilities onto the balance sheet for fiscal accounting. Except
for interest payments and redemption for FY 2008/09, no new oil and fertilizer
bonds were issued in FY 2009/10. Special securities are not SLR-eligible but
some are selectively eligible as collateral under LAF.
Capital Indexed Bonds
The principal of these bonds are linked to an accepted index of inflation with a
view to protecting the holder from inflation. One variant of capital indexed bonds
was issued in December 1997 linked to the wholesale price index. It was not too
successful as it offered inflation hedging only against the principal while the
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coupons were unprotected. Steps are now being taken to come up with new
capital indexed bonds which have both the coupon and principal linked to the
wholesale price index.
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Bonds with call/put options
GSecs with put/call options up to a maturity of 10 years were issued on 18 July
2002. The optionality on the bond could be exercised after the completion of five
years from the date of issuance on any coupon date thereafter. Out of the
INR30bn issued then, INR 5.5bn worth of bonds are currently still outstanding.
Separate trading for registered interest and principal of securities (STRIPS)
The guidelines for stripping/reconstitution of the securities came into effect on 1
April 2010, allowing participants to strip/reconstitute eligible GSecs through the
Negotiated Dealing System (NDS) subject to terms and conditions. STRIPS are
tradable only in the OTC market and is reported to the NDS for clearing and
settlement through the CCIL. STRIPS give rise to sovereign zero coupon bonds
which will gradually lead to the development of a market-determined zero
coupon yield curve. As STRIPS do not have any reinvestment risk, they can be
attractive to retail/non-institutional investor.
State development loans (SDL)
State governments issue dated securities called State Development Loans (SDL)
to directly raise funds from the market. Generally the yields on SDLs are slightly
higher than the yields on GSecs of similar maturities. They are eligible for SLR
and for borrowing from the RBI through repo under LAF.
Public sector undertaking (PSU) bonds
Public sector undertaking (PSU) bonds are medium to long-term bonds issued
by public sector organizations (e.g. State Electricity boards, improvement trusts,
metropolitan authorities etc). Some of the bonds are guaranteed by the central or
state government. Typical maturities for PSU bonds are 3-10 years. These bonds
might carry a call/put option.
Corporate bonds
A well developed corporate bond market may enable the corporates to tap the
market for their financial needs thereby reducing the systemic stress on banks.
The RBI has every now and then initiated measures to develop the corporate
bond market, which as of now stands barely a fraction of the government bond
market. Nevertheless, there has been a significant growth in the secondary
market activity for the corporate bond markets. Corporate bonds tend to have a
maturity of up to 20 years and often come with call or put options and sometimes
in the form of convertibles.
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The Royal Bank of Scotland
Table 1 : Cash instruments’ basic features
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0 Issuer(s) Tenor(s) Coupon Day Count LAF Eligible SLR eligible
Central government 91,182 and 364 days Zero. Discounted Instrument Actual/365 Yes Yes Treasury Bills
Cash Management Bills
Central government Up to 91 days Zero. Discounted Instrument Actual/365 Yes Yes
GSecs Central government 2-30 years Mostly fixed, with semi annual payments
30/360 Yes Yes
State Govt Loans
State governments 2-15 years Mostly fixed with semi annual payments
30/360 Yes Yes
Commercial Paper
Indian companies, supranaturals
7 days -1 year Zero. Discounted Instrument Actual/365 No No
Certificates of Deposit
Banks and financial institutions
7 days-1 year Zero. Discounted Instrument Actual/365 No No
Corporate Bonds Public limited companies 1-20 years Mostly fixed. Annual or specific issuance
Actual/365 No No
PSU bonds Public sector organisations
1-15years Mostly fixed with semi annual payments
Actual/365 No No
Special Securities
Central government 1-20years Mostly fixed with semi annual payments
30/360 Yes selectively No
Source: RBI, Bloomberg, RBS
Derivatives (reference Table 2, page 10)
Interest rate swaps (IRS)
In the INR swap market, several alternative floating rate benchmarks have
evolved over time, among which the most commonly traded one is the OIS. One
main reason for the innovation of the different floating rate benchmarks is
because of the ban on the use of optionality in interest rate swaps.
- Overnight Index Swaps (OIS) – The floating benchmark used is the overnight
call money rate, MIBOR, which is a daily fixing set by the national stock
exchange using inputs provided by the market makers. The market is highly
liquid up to the 5-year tenor.
- MIFOR Swaps – The floating rate in this case is the implied INR offer rate
derived from USD/INR FX forward exchange rate. A large number of Indian
corporates regularly use MIFOR to manage their interest rate risk.
- Swaps with floating rates linked to GSec yields - These swaps allow banks and
corporates to take views on the relative movements of GSec yields and
corporate spreads without any underlying positions in the securities.
Currency swaps
These are interest rate derivatives where the INR payments can be swapped into
another currency or vice versa. USD and JPY are the two most common second
currencies for a currency swap in INR.
Interest rate futures
Interest rate futures were re-launched in 2009 by the RBI. An earlier edition
launched in 2003 failed due to faulty benchmarks and the fact that the futures
could only be used for hedging and not for trading.
New contracts on 10y notional coupon-bearing GSecs were issued in August
2009, with a notional coupon of 7% per annum with semi-annual compounding.
A proposal is underway to introduce interest rate futures on 5y and 2y notional
coupon-bearing securities and 91-day treasury bills.
9
The Royal Bank of Scotland
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Table 2: Derivative instruments’ basic features
Tenors Liquidity Day Count Fixing Rate Participants Non-resident access Effective Date
2m-10y (liquid 1y-5y) 10-30bp for <1y Actual/365 Overnight rate T+1 Interbank, corporates
Not allowed Onshore OIS 2-4bp up to 1y 5-15bp for >5y
1y-10y (liquid up to 5y) 3-4bp up to 5y Offshore NDIRS 5-10bp for >5y
Actual/365 Overnight rate T+1 Interbank, corporates
Allowed
MIFOR Swaps 1y-10y (liquid up to 5y) 30bp up to 5y 30-50bp for >5y
Actual/365 6m implied USD/INR swap offer rate
T+1 Interbank, corporates
Not allowed
Onshore CCS 1m-10y (liquid up to 5y) ≥30bp Actual/360 6m mifor T+2 Interbank, corporates
Principal hedging allowed
Offshore CCS 1m-10y (liquid up to 5y) ≥20bps Actual/360 6m libor T+2 Interbank, corporates
Allowed
Source: FIMMDA, RBS
Credit Default Swap (CDS)
The RBI has drafted rules proposing the introduction of plain vanilla over-the-
counter single-name CDS for corporate bonds. Infrastructure bonds will be the
first bonds which can be hedged using CDS. The plan of launching CDS has
been deferred twice in the past in 2003 and 2007. No timeline has been set yet
for the latest proposal.
Supply
Apart from the central and local governments, banks and financial institutions are
the next biggest group of bond issuers in the market (see Figure 7). As said,
corporate issuance has not been keeping apace with the average market growth
over the years. The average issue size of corporate bonds is also the smallest in
the market at INR1bn compared to the average GSec issue size of INR150bn.
By maturity, the GSec market offers the longest maturity up to 30 years while
corporate bonds have tenors stretching into 20y. The maturity profile of the GSec
market is bunched up heavily in the 4y to 8y segment (see Figure 8). Table 3 on
page 14 lists the supply and demand picture by instruments and primary and
secondary market participants.
10
Source: CEIC, RBS
Figure 7: Market share of bonds listed on NSE by instrument type/ issuer (INR trn)
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Figure 8: Maturity profile of outstanding GSecs (INR bn)
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GSec T-bill Special securities
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Issuers
Central government
For FY 2010/11, the government has set a target fiscal deficit of 5.5% of GDP or
close to INR 3.8trn. To finance approximately 90% of this deficit, the government
has set a borrowing program targeting net INR3.45trn to be raised mostly
through the issuance of new GSecs. The tentative targets for fiscal deficit are set
at 4.8% and 4.1% of GDP for FY 2011/12 and 2012/13 respectively. In the 12
five-year plan, the government has set a target of USD1trn for infrastructure
spending and will allow private companies to issue infrastructure bonds.
State governments
State governments fund their budget through both transfers from the central
government and issuing their own bonds, known as state development loans
(SDL). In FY2009/10, state governments in total raised INR1.3trn of SDLs. This
compares to INR4.2trn of GSecs and INR3.8trn of T-bills issued in the same year.
Corporates
Corporate bonds include bonds issued by PSUs, banks and private sector
companies, with PSU bonds holding the largest share. One reason for
corporates’ preference to rely on bank borrowing to raise funds rather than
issuing bonds is that they have to get a credit rating to determine the premium of
their bonds over GSecs.
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Issuance patterns
GSecs
The RBI announces the half-yearly auction calendar of GSecs in March and
September each year. Usually, close to 60% of the annual fiscal borrowing is
completed in the first half of the year.
There are 15 to 18 benchmarks on the GSec curve, depending on how many
issues qualified as benchmarks at any point in time. On average, each
benchmark issue stays on the benchmark curve for about a year except for the
5y and 10y tenors which sometimes get revised more than once a year.
Changes are decided by the Fixed Income Money Market and Derivatives
Association of India (FIMMDA) based on size, trading volume and market
consensus during its meeting towards the end of each month. Observing that the
government usually stops tapping into a particular issue when its outstanding
size gets too large to avoid bunching its liability into a single maturity date, the
FIMMDA replaces a benchmark when it gets close to the government’s
undisclosed ceiling, observed to be around INR650bn. The issue with the
highest trading volume close to the outgoing benchmark is usually selected as
the new benchmark. A new issue by the government thus does not automatically
come in as a new benchmark.
T-bills
Treasury bills are auctioned on every Wednesday. 91-day bills are issued every
Wednesday while 182-day and 364-day bills are issued on alternate
Wednesdays. 364-day bills are auctioned on the Wednesday preceding the
Friday when the banks are required to report their reserve requirements to the
RBI. 182-day bills are auctioned prior to non-reporting Fridays. The settlements
for the T-bills are made on the following Friday.
11
The Royal Bank of Scotland
State development loans (SDL)
SDLs are issued through an auction similar to that for GSecs i.e. multiple-price
competitive bidding and typically, 5 to 6 state bonds are being auctioned
together. There are usually 6 to 8 auctions conducted a year.
Quasi-government/ Corporates
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PSU bonds are privately placed with the major investors, being banks, insurance
companies, mutual funds, financial institutions, state-run pension funds and
cash-rich corporates. Other corporate bonds are usually sold through a book-
building process.
Special securities
Special securities are directly issued to corporates or state agencies to
subsidise their operations. There is therefore no open market auction. The
number of issues also varies from year to year and as aforesaid, the government
is gradually phasing out the issuance of special securities.
Demand
The major investors of the GSec market include banks, pension funds and
insurance companies, with banks accounting for just below 70% of the total
market (see Figure 9). Most GSec investors are fairly stable investors including
even foreign institutional investors which have gradually shifted their asset
allocations from equity into debt from less than 1% a decade ago to nearly 15%
now (Figure 10). Mutual funds are by comparison relatively volatile. Quite
understandably, the RBI’s GSec holdings are also fairly unstable given its
conduct of daily open market operations and having entered into quantitative
easing (QE) during 2007/08 to help ease the government’s then fiscal funding
pressure.
12
Source: CEIC, SEBI, RBS
Source: CEIC, RBS
Figure 9: GSec holdings by banks, mutual funds, FII and RBI (INR trn)
0
2
4
6
8
10
12
14
16
00 01 02 03 04 05 06 07 08 09 10-0.5
0.0
0.5
1.0
1.5
2.0
2.5
Banks M utual funds (RHS)RBI (RHS) FII (RHS)
Figure 10: Cumulative net FII flows into debt vs. equity (USD bn)
0
2
4
6
8
10
12
14
16
98 99 00 01 02 03 04 05 06 07 08 09 100
10
20
30
40
50
60
70
80
90
debt (LHS) equity (RHS)
Primary Dealers (PD)
Primary dealers are either banks (presently 12 of them, see list in Appendix) or
specialized financial firms (presently 8). For auctions, bids are invited from PDs
The Royal Bank of Scotland
one day before the GSec auction wherein the PDs indicate the amount to be
underwritten by them and the underwriting fees. PDs have to meet two
commitments for underwriting.
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- Minimum underwriting commitment (MUC) per PD: This is computed in a way
that ensures that at least 50% of each issue is covered by the aggregate of all
MUCs. Each PD has a uniform MUC irrespective of the size of its balance
sheet or capital.
- Additional competitive underwriting (ACU) per PD: The remaining portion of
the notified amount is opened to competitive underwriting through underwriting
auctions. Each PD is required to bid for a minimum of 3%. The auction could
be uniform price based or multiple price-based.
PDs do not have to underwrite fully subscribed issues unless they want to bid. If
there is a devolvement, the successful bids put in by the PDs are set off against
the amount underwritten by them when deciding the amount of devolvement.
Banks
The banking sector is the single largest subscriber of Gsecs largely as a result of
having to fulfil the statutory liquidity ratio. Scheduled Urban Co-operative banks
(UCB) are supposed to hold 25% of their SLR requirement in Government and
approved securities (Gsecs, T-bills and SDL). Non-scheduled urban co-
operative banks with NDTL more than INR250mn have to hold 15% of their SLR
requirement in government approved securities. Those with less than INR100mn
NDTL have to hold 10% of their SLR requirement
Regional rural banks are supposed to maintain their entire SLR requirement
(which is 25% of NDTL) in GSecs and other approved securities. Rural co-
operative banks can maintain their SLR requirement in cash, gold or approved
securities. Non-government provident funds, superannuation funds and gratuity
funds are required to invest 40% of their incremental accretions in central and
state government securities.
Insurance companies and pension funds
The other key bond investors are pension funds, insurance companies and
mutual funds. Life insurance companies tend to hold a large amount of GSecs,
the largest one being the Life Insurance Corporation. Among pension funds, the
largest investor in GSecs is the Employee Provident Fund. Life insurance
companies and pension funds tend to hold close to 50% and 25 % of their
liabilities against GSecs. Insurance companies, provident funds and banks have
restrictions on private sector securities and hence the demand for the corporate
bonds is low. Even if they do purchase corporate bonds, their tendency to hold
them to maturity will only further reduce the trading volume of these bonds.
Funds are allowed to invest only up to 10% into corporate bonds and up to 40%
in PSU bonds.
Foreign Institutional Investors (FII)
The key restriction on foreign institutional investors (FII) is in the form on
aggregate ceilings on how much they can hold in the GSecs and corporate bond
markets. An earlier restriction on a 70:30 investment ratio between equity and
debt was removed in 2008. In the same year, the ceiling for investments in
GSecs was lifted from USD3.2bn to USD5bn. In March 2009, the FII ceiling for
investments in corporate bonds was lifted from USD6bn to USD15bn. There are
currently talks about further increasing the ceilings.
13
The Royal Bank of Scotland
Registered FIIs are eligible to invest in all securities issued by the central and
state governments as well as quasi-government entities as long as the
organisation is more than 51% owned by the central or a state government.
They are also allowed to invest in corporate bonds or debentures as long as they
are listed in the national stock exchange. FIIs are not permitted to invest in
certificates of deposit. FIIs have recently become a driving force in the
secondary market for corporate bonds, accounting for almost half of the overall
volumes in the first four months of 2010. Their ceiling for the GSec market has
also been hit.
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For a list of FAQs on FII investments, please see the following SEBI’s website
link: http://investor.sebi.gov.in/faq/foreign%20institutional%20investor.html.
Not to be confused with the FII limits, there is another limit set by the RBI on local
corporates’ external commercial borrowings (ECB) to restrict their overseas
borrowing. To promote the country’s infrastructure development plans, rules
governing prior approvals and spreads over USD Libor have been relaxed for
infrastructure firms in 2008.
Retail Investors
Retail investors have very low participation but over the past few years, they
have gradually increased their participation in mutual funds and bond funds. To
enable small and medium-sized retail investors to participate in the auction
process, the RBI has introduced non-competitive bidding in GSecs.
Table 3: Cash instruments’ supply and demand
Issuance Cycle Issuer Auction Style Primary Market Participants
Secondary Market Participants
Outstanding Amount (as at
Jun 2010)
Average Auction Size
(number of issues
outstanding)
Central government Multiple Price 10-80bn(51)
1.3trn 91d every Wednesday 182d-364d alternate
Wednesday
Institutions, banks, mutual funds
Fund managers, insurance companies,
banks
Treasury Bills
Cash Mgmt Bills (CMB)
Central government Multiple Price 60bn 0 Ad hoc Institutions, banks, mutual funds
Fund managers, insurance companies,
banks (0)
Central government Multiple Price 20-60bn 20.2trn 2-4 auctions per month Institutions, banks, mutual funds
GSecs (96)
Fund managers, insurance companies,
banks
State Govt Loans (SDL)
State governments Multiple Price 20-60bn (1342)
5.55trn 6-8 auctions per year Institutions, banks Fund managers, insurance companies,
banks
Commercial Paper (CP)
Indian companies, supranaturals
Bilateral Issuance 1-2bn 1trn Ad hoc Institutions, banks, mutual funds
Fund managers, insurance companies,
banks
Certificates of Deposit (CD)
Banks Bilateral Issuance 1-2bn 3.2trn Ad hoc Institutions, banks, mutual funds
Fund managers, insurance companies,
banks
Corporate Bonds
Public listed companies
Mainly book-building
1-2bn (1049)
1.46trn Ad hoc Institutions, banks, corporates, mutual funds
Fund managers, insurance companies,
banks
PSU Public sector organisations
Private placement 3-5bn for tenors <=5y
1-2bn for tenors >=10y
(850)
1.78trn Ad hoc Institutions, banks, mutual funds
Fund managers, insurance companies,
banks
Special securities
Central government Bilateral placement INR10-200bn (31)
2trn Ad hoc Corporations receiving subsidies in strategic
sectors including oil, food & fertilizer or for bank
recapitalisation
Insurance companies, fund managers
Source: Bloomberg, RBI, RBS
14
The Royal Bank of Scotland
Settlement, Pricing and Taxation
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Settlement
Government securities
GSecs are held in security accounts maintained by interbank counterparties with
the RBI. All the deals are settled through CCIL using the DvP (Delivery vs.
Payment) mechanism. This mechanism ensures that on settlement date, transfer
of securities by the seller occurs simultaneously with transfer of funds from the
buyer. In the secondary market, CCIL guarantees settlement of trades on the
settlement date by becoming a central counter-party to every trade. All outright
secondary market transactions in GSecs are settled on T+1 basis. However, in
case of repo transactions in GSecs, market participants have the choice of
settling the first leg on T+0 basis or T+1 basis while the second leg has to be
settled on a T+1 basis.
Corporate securities
As decided by SEBI in 2009, all trades in corporate bonds between mutual
funds, foreign institutional investors or their sub-accounts, venture capital funds,
foreign venture capital investors, portfolio managers and RBI-regulated entities
are cleared and settled through the NSSCL (National Securities Clearing
Corporation Limited) or the Indian Clearing Corporation Limited (ICCL). This is
applicable to all corporate bonds traded after 1 December 2009 on OTC or on
the debt segment of the stock exchange. This arrangement facilitates the
settlement of secondary market trades on corporate bonds on a DvP basis.
Pricing Sources
Negotiated Dealing system (NDS)
The price and other information of a trade are stored under NDS on the RBI
website or on the CCIL website through NDS Order matching (NDS-OM).Since
NDS-OM is a live and anonymous platform where the trades are disseminated as
they are struck and where counterparties to the trades are not revealed, NDSOM
is the safest and most transparent pricing source.
Transactions undertaken between market participants in the OTC market or
through the telephone are expected to be reported on the NDS platform within
15 minutes after the deals are put through. All OTC trades are required to be
reported on the secondary market module of the NDS for settlement.
Fixed Income Money Market and Derivatives Association of India (FIMMDA)
FIMMDA is also a source of price information, especially for securities that are
not traded frequently. FIMMDA releases rates of various GSec issues that are
used by market participants for valuation purposes.
For benchmark, liquid securities, the prices are polled from various active market
participants between 3pm and 4pm every working day. The collected data gets
automatically transferred to Bloomberg’s valuation system for generating the
prices of all outstanding securities.
For the illiquid securities, the various market participants are polled for different
illiquidity premiums on different maturity buckets. These illiquidity premiums are
then added to the liquid yield curve and an illiquid yield curve is established by
15
The Royal Bank of Scotland
the FIMMDA. There is no mathematical way of deriving the illiquidity premium – it
is generally estimated by market makers who would base it on maturity, coupon
rate, issue size and distribution of the illiquid bonds.
Taxation
Currently the interest income tax on FIIs is 20% subject to double taxation
agreement (DTA) whereas the capital gains tax is 30% and 10% for short-term
and long-term respectively. The capital gains tax is also subject to double tax
agreement. India has entered into a Double Taxation Avoidance Agreement
(DTAA) with numerous countries (see Appendix). If the capital asset is held for
more than 36 months prior to its transfer, the gains are long term gains. However,
the qualifying period of holding is 12 months in the case of GSecs and listed
corporate bonds. The government is the midst of streamlining the tax rates for all
holding periods of bonds by FIIs.
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Table 4: Settlement and FII Regulation and Taxation
Settlement primary market
Settlement secondary market
Restrictions for FII Interest Income Tax Capital gains tax
Treasury Bills T+2 T+2 Subject to USD5bn limit on GSec 20% subject to DTA 30% subject to DTA
Cash Management Bills
T+1 or T+2 T+1 Subject to USD5bn limit on GSec 20% subject to DTA 30% subject to DTA
T+1 T+1 Subject to USD5bn limit on GSec 20% subject to DTA 10% for long-term,30% for short-term subject to
DTA
GSecs
State Development Loans
T+1 or T+2 T+1 Subject to USD5bn limit on GSec 20% subject to DTA 10% for long-term,30% for short-term subject to
DTA
T+0 or T+2 T+1 Subject to USD15bn limit on corporate bonds
- 30% for short-term subject to DTA
Commercial Paper
Certificates of Deposit
T+0 or T+2 T+1 Not permitted - 30% for short-term subject to DTA
T+0 or T+2 T+0 to T+2 Subject to USD15bn limit on corporate bonds
20% subject to DTA 10% for long-term,30% for short-term subject to
DTA
Corporate Bonds
Public Sector Undertaking (PSU)
T+0 or T+1 T+2 Subject to USD15bn limit on corporate bonds
20% subject to DTA 10% for long-term,30% for short-term subject to
DTA
Source: RBI, CCIL, SEBI, RBS
Conclusion
While the Indian fixed income is characterised by a well-defined set of rules and
regulations and a deep matured GSec market, the slow growth of the corporate
bond market as well as retail investors’ participation are areas for future
development. Although credit rating and issuer knowledge are generally quite
well developed relative to other emerging markets, an active secondary market
and credit curve have not fully evolved. Addressing these deficiencies are
acknowledged priorities of the SEBI.
16
The Royal Bank of Scotland
Glossary Broad Based Funds – This refers to a fund established or incorporated outside
India having at least twenty investors with no single investor holding more than
10% of the shares or units of the fund. The exceptions to the requirements
arise when the fund has institutional investors, then it is not required to have
twenty investors. In the case that the institutional investor is holding more than
10 % of the shares, the institutional investor itself must be a broad based fund.
BSE – Bombay Stock Exchange
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CCIL – Clearing Corporation of India Limited (CCIL) is the clearing agency for
government securities. It acts as a central counterparty for all transactions of
the government securities. CCIL guarantees the settlement of all the trades of
all trades in the government securities.
CMB – Cash management bills were introduced in August 2009 to allow the
government to meet temporary cash flow mismatches. Their tenors can be no
more than 91 days. The government issued two such bills in H1 2010 which
had since matured.
CSGL – Constituent’s Subsidiary General Ledger Account also known as SGL
II account is an account in which a bank or primary dealer acting as a
custodian of gilt accounts can hold its constituents.
Depositories – Investors can hold government securities in dematerialized
account with a depository. The most prominent depositories are NSDL and
CDSL.
DvP – Delivery versus Payment is the mode of settlement wherein the transfer
of securities and funds happens simultaneously. There are three types of DvP
settlements: DvP I, where the securities and the funds legs of the transactions
are settled on a gross basis; DvP II, where the securities are settled on a gross
basis whereas the funds are settled on a net basis; and DvP III, where both
securities and funds legs are settled on a net basis.
ECB – External commercial borrowing limit is set by the RBI on local
corporates’ to restrict their overseas borrowing. To promote the country’s
infrastructure development plans, rules governing prior approvals and spreads
over USD Libor have been relaxed for infrastructure firms in 2008.
FII – Foreign institutional investor refers to a non-resident investor which has
been licensed by the Securities Exchange Board of India (SEBI) to trade and
invest in the Indian equity and debt markets.
FIMMDA – Fixed income money market and derivatives association of India
Gilt Account – Since registration of SGL accounts with RBI is restricted,
investors have the option of opening a Gilt Account with a bank of primary
dealer which has a CSGL account.
LAF – Liquidity adjustment facility is the repo/ reverse repo window provided
by the RBI for overnight borrowing or lending by the banks with the central
bank.
MIBOR – Mumbai inter-bank offered rate
17
The Royal Bank of Scotland
MIFOR – Mumbai inter-bank forward offered rate
MSS – Market stabilization scheme was introduced in 2004 for the RBI to issue
GSecs to sterilize its USD buying intervention in the FX market where the
proceeds of these GSec issuance would be kept in a MSS account set up at
the RBI, withheld from the government so that the proceeds cannot be used
for fiscal funding.
NDS – The negotiated dealing system was introduced in 2002 for electronic
dealing and reporting of the transactions of government securities. NDS
members can send in bids for primary issuance of GSecs. Membership is
restricted to members holding SGL or Current accounts with RBI. NDS also
facilitates settlement of transactions for GSecs in the secondary market.
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NDS-OM – An order driven electronic system was introduced where the
participants can trade anonymously by matching their orders with other market
participants. Direct access to NDS-OM is available to selected commercial
banks, primary dealers, insurance companies and mutual funds while others
can only access this system through their custodians.
NDTL – Net demand and time liabilities are the base used by scheduled
commercial banks to compute their required cash reserves to be placed with
the RBI.
NSE – National stock exchange
Participatory Notes (PN) – These are notes issued to foreign funds with no FII
licence by FII-registered institutions to trade in the domestic markets on their
behalf.
PSU – Public sector undertaking
SEBI – Securities exchange board of India
SGF – CCIL guarantees settlement of all the trades in the government
securities and provides funds/securities by its own means in case the
participant fails. To hedge this risk, the CCIL collects margins from all
participants and this maintained margin is called the settlement guarantee
fund (SGF). It can be in the form of cash or securities (minimum 10% cash).
Eligible securities for SGF are specific issues of central government securities
and treasury bills listed by the CCIL through notification where the list is
reviewed periodically.
SGL – Subsidiary General Ledger Account (SGL) facility is provided by RBI to
select entities who can maintain their securities in SGL accounts with the
Public Debt Office of RBI
Shut Period – Shut period is the period for which securities can not be
delivered or settled. This shut period serves the purpose of facilitating the
servicing of the security e.g. payment of coupon and redemption proceeds
and to avoid any change in ownership during this process. Example if the
coupon payments dates are 26th August and 26th February then the shut
period will fall on 25th August and 25th February and trading in this security for
settlement on these two days is not allowed. Currently the shut period for
securities held in SGL accounts is one day.
18
The Royal Bank of Scotland
Sub accounts (FII) – Sub accounts refer to foreign corporates, foreign
individuals and institutions, funds or portfolios established or incorporated
outside India on whose behalf a registered FII can make investments.
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19
The Royal Bank of Scotland
Appendix
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List of Credit Rating Agencies, Primary Dealers and Custodians
Credit Rating Agencies
CRISIL limited
Fitch Ratings India Private Ltd.
ICRA Limited
Credit Analysis & Research Ltd. (CARE)
Brickwork Ratings India Pvt ltd.
Bank Primary Dealers Standalone Primary Dealers
Royal Bank of Scotland N.V. Deutsche Securities (India) Pvt. Ltd.
Bank of America ICICI Securities Primary Dealership Limited
Bank of Baroda IDBI Gilts Ltd.
Canara Bank Morgan Stanley India Primary Dealer Pvt. Ltd.
Citibank N.A. Nomura Fixed Income Securities Pvt. Ltd.
Corporation Bank PNB Gilts Ltd.
HDFC Bank Ltd. SBI DFHI Ltd
Hongkong and Shanghai Banking Corpn. Ltd STCI Primary Dealer Limited
J.P Morgan Chase N.A., Mumbai Branch
Kotak Mahindra Bank Ltd.
Standard Chartered Bank
Registered Custodian of Securities Entities where in-principal approval has been granted
Royal Bank of Scotland N.V. India Infoline Ltd.
AXIS BANK DSP Merril Lynch Limited
BNP Paribas MF Global Sify Securities India Pvt. Ltd.
Citibank N.A. Globe Capital market Ltd.
DBS Bank Ltd. India Edelweiss Custodial Services Limited
Deutsche Bank AG
HDFC Bank Ltd.
Hongkong and Shanghai Banking Corpn. Ltd
ICICI Bank Ltd.
IL&FS Securities Services Ltd.
JPMorgan Chase Bank, N.A.
Kotak Mahindra Bank Limited
Orbis Financial Corporation Ltd.
SBI Custodial Services Pvt. Ltd.
Standard Chartered Bank
Source: See list below
20
The Royal Bank of Scotland
List of Countries with Double Taxation Avoidance Agreement (DTAA)
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0 Dividends Interest Country Royalties
15 Australia 15 15
Austria 20 20 30
21
15 10 10 Bangladesh
15 Belarus 10 15
Belgium 15 15 20
15 15 15 Brazil
15 15 20 Bulgaria
25 15 15 Canada
10 10 10 China
15 10 15 Cyprus
20 15 30 Czechoslovakia
10 10 10 Czech Republic
20 15 20 Denmark
20 20 30 Egypt
15 10 20 Finland
10 15 20 France
10 10 10 Germany
20 20 30 Greece
15 15 30 Hungary
15 10 15 Indonesia
10 10 10 Israel
20 15 20 Italy
15 15 20 Japan
10 10 20 Jordan
10 10 10 Kazakhstan
15 15 20 Kenya
20 15 15 Korea
10 10 15 Kyrgyzstan
20 20 30 Libya
20 20 30 Malaysia
15 10 15 Malta
15 20 15 Mauritius
15 15 15 Mongolia
10 10 10 Morocco
10 10 10 Namibia
15 15 15 Nepal
10 10 10 Netherlands
15 10 10 New Zealand
15 15 30 Norway
12.5 10 15 Oman
20 15 15 Philippines
15 15 22.5 Poland
15 10 10 Portugal
10 10 10 Qatar
20 15 22.5 Romania
10 10 10 Russian Federation
15 15 15 Singapore
10 10 10 South Africa
15 15 20 Spain
15 10 10 Sri Lanka
10 10 10 Sweden
15 15 20 Switzerland
0 7.5 10 Syria
15 12.5 20 Tanzania
The Royal Bank of Scotland
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22
20 20 15 Thailand
10 10 10 Trinidad and Tobago
15 15 15 Turkey
10 10 10 Turkmenistan
15 12.5 10 United Arab Emirates
15 15 15 United Kingdom
20 15 15 United States
15 15 15 Uzbekistan
10 10 10 Vietnam
15 10 10 Zambia
Source: MOF
Sources
www.rbi.org.in
www.sebi.gov.in
www.bseindia.com
www.fimmda.org
www.finmin.nic.in
www.commerce.nic.in
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