inflation indexed bonds

The Study of Inflation Indexed Bonds

SIP-Sashank Ashok Choughule 1

Chapter 1

Introduction to Capital Market

1.1 Capital Market

Capital markets are financial markets for the buying and selling of long-term debt- or equity-

backed securities over one year is traded. Security includes- shares, debentures, bonds etc.

A key division within the capital markets is between the primary markets and secondary

markets. In primary markets, new stock or bond issues are sold to investors, often via a

mechanism known as underwriting. The main entities seeking to raise long-term funds on the

primary capital markets are governments (which may be municipal, local or national) and

business enterprises (companies). Governments tend to issue only bonds, whereas companies

often issue either equity or bonds. The main entities purchasing the bonds or stock

include pension funds, hedge funds, sovereign wealth funds, and less commonly wealthy

individuals and investment banks trading on their own behalf. In the secondary markets,

existing securities are sold and bought among investors or traders, usually on a securities

exchange, over-the-counter, or elsewhere.

Capital market can be broadly divided into two parts

1. Debt Markets (where investors become creditors)

2. Stock Markets (for equity securities, also known as shares, where investors acquire

ownership of companies)

1.2 Debt Market

It is a market meant for trading (i.e. buying or selling) fixed income instruments. Fixed

income instruments could be securities issued by Central and State Governments, Municipal

Corporations, Govt. Bodies or by private entities like financial institutions, banks, corporates,

etc.

Debt instruments are contracts in which one party lends money to another on predetermined

terms with regard to rate of interest to be paid by the borrower to the lender, periodicity of



such interest payment, and the repayment of the principal amount borrowed (either in

instalment or in bullet).

1.3 Current Scenario of Indian Debt Market

The bond market in India is typically classified into three categories viz. the government, the

corporate and the financial. Of these three the government bond market constitutes 85% of

total Debt Market followed by the financial10% and corporate market 5%. The issuers of

these securities are mostly the central and state government, government agencies, corporate

and private sector banks. The investors mostly consist of RBI, banks, individuals, PFs and

MFs with the whole system coming under the purview of SEBI, RBI and the Ministry of

Corporate affairs. The government bond market, at present is quite established and has almost

reached its point of critical mass. However the most under-developed part remains the

corporate debt market, where even today more than 95% of the debt being issued in the form

of private placements. Also the non-uniform stamp duty prices and long gestation periods to

bring the bond issuances into the market remain other deterrent factors which have retarded

the growth in this sector.

1.4 Debt Market Securities

Securities can be classified based on various parameters. One can classify then as floating

rate or fixed rate depending on their coupon type. However the classification can also be done

based on type of issuer. On that basis bonds can be classified as

1. Government Securities or SLR securities

2. Non-SLR Securities

SLR securities can be further classified as

1. Government of India securities

2. State development loans

3. Other approved securities



Chapter 2

Fundamentals of Government Securities

2.1 Government Securities

A Government security is a tradable instrument issued by the Central Government or the

State Governments. It acknowledges the Governments debt obligation. Such securities are

short term (usually called treasury bills, with original maturities of less than one year) or long

term (usually called Government bonds or dated securities with original maturity of one year

or more). In India, the Central Government issues both, treasury bills and bonds or dated

securities while the State Governments issue only bonds or dated securities, which are called

the State Development Loans (SDLs). Government Securities are mostly interest bearing

dated securities issued by RBI on behalf of the Government of India. These types of

securities are fully tradable and eligible to be SLR securities

Government issues such security to support government spending, most often issued in the

country's domestic currency. Before investing in government bonds, investors need to assess

several risks associated with the country such as: country risk, political risk, inflation risk,

and interest rate risk.

Government securities carry practically no risk of default and, hence, are called risk-free gilt-

edged instruments. Government of India also issues savings instruments (Savings Bonds,

National Saving Certificates (NSCs), etc.) or special securities (oil bonds, Food Corporation

of India bonds, fertiliser bonds, power bonds, etc.). They are, usually not fully tradable and

are, therefore, not eligible to be SLR securities.

2.1.1 Treasury Bills (T-bills)

Treasury bills or T-bills, which are money market instruments, are short term debt

instruments issued by the Government of India and are presently issued in three tenors,

namely, 91 day, 182 day and 364 day. Treasury bills are zero coupon securities and pay no

interest. They are issued at a discount and redeemed at the face value at maturity. The

Reserve Bank of India conducts auctions usually every Wednesday to issue T-bills. Payments

for the T-bills purchased are made on the following Friday. The 91 day T-bills are auctioned

on every Wednesday. The Treasury bills of 182 days and 364 days tenure are auctioned on



alternate Wednesdays. T-bills of 364 days tenure are auctioned on the Wednesday preceding

the reporting Friday while 182 T-bills are auctioned on the Wednesday prior to a non-

reporting Fridays. The Reserve Bank releases an annual calendar of T-bill issuances for a

financial year in the last week of March of the previous financial year. The Reserve Bank of

India announces the issue details of T-bills through a press release every week.

2.1.2 Cash Management Bills (CMBs)

Government of India, in consultation with the Reserve Bank of India, has decided to issue a

new short-term instrument, known as Cash Management Bills (CMBs), to meet the temporary

mismatches in the cash flow of the Government. The CMBs have the generic character of T-

bills but are issued for maturities less than 91 days. The tenure, notified amount and date of

issue of the CMBs depend upon the temporary cash requirement of the Government. The

announcement of their auction is made by RBI through a Press Release which will be issued

one day prior to the date of auction. The settlement of the auction is on T+1 basis. However,

these instruments are tradable and also eligible for SLR purpose

2.1.3 Dated Government Securities

Dated Government securities are long term securities and carry a fixed or floating coupon

(interest rate) which is paid on the face value, payable at fixed time periods (usually half-

yearly). The tenor of dated securities can be up to 30 years. Most of the dated securities are

fixed coupon securities.

The nomenclature of a typical dated fixed coupon Government security contains the

following features - coupon, name of the issuer, maturity and face value. For example,

8.21% GS 2020 would mean

Coupon 8.21% paid on face value

Name of Issuer Government of India

Date of Issue April 16, 2010

Maturity April 16, 2020

Coupon Payment Dates Half-yearly (October 16 and April 16) every year

Minimum Amount of issue/ sale Rs.10,000



If the coupon payment date falls on a Sunday or a holiday, the coupon payment is made on

the next working day. However, if the maturity date falls on a Sunday or a holiday, the

redemption proceeds are paid on the previous working day itself.

2.2 Types of Instruments

Fixed Rate Bonds These are bonds on which the coupon rate is fixed for the entire

life of the bond. Most Government bonds are issued as fixed rate bonds.

Floating Rate Bonds Floating Rate Bonds are securities which do not have a fixed

coupon rate. The coupon is re-set at pre-announced intervals (say, every six months or

one year) by adding a spread over a base rate. In the case of most floating rate bonds

issued by the Government of India so far, the base rate is the weighted average cut-off

yield of the last three 364- day Treasury bill auctions preceding the coupon re-set date

and the spread is decided through the auction.

Zero Coupon Bonds Zero coupon bonds are bonds with no coupon payments. Like

Treasury Bills, they are issued at a discount to the face value. The Government of

India issued such securities in the nineties; it has not issued zero coupon bond after

that.

Capital Indexed Bonds These are bonds, the principal of which is linked to an

accepted index of inflation with a view to protecting the holder from inflation. A

capital indexed bond, with the principal hedged against inflation, was issued in

December 1997.

Bonds with Call/ Put Options Bonds can also be issued with features of

optionality wherein the issuer can have the option to buy-back (call option) or the

investor can have the option to sell the bond (put option) to the issuer during the

currency of the bond.

Special Securities - In addition to Treasury Bills and dated securities issued by the

Government of India under the market borrowing programme, the Government of

India also issues, from time to time, special securities to entities like Oil Marketing



Companies, Fertilizer Companies, the Food Corporation of India, etc. These securities

are usually long dated securities carrying coupon with a spread of about 20-25 basis

points over the yield of the dated securities of comparable maturity. These securities

are, however, not eligible SLR securities

2.3 State Development Loans (SDLs)

State Governments also raise loans from the market. SDLs are dated securities issued through

an auction similar to the auctions conducted for dated securities issued by the Central

Government. Interest is serviced at half-yearly intervals and the principal is repaid on the

maturity date. Like dated securities issued by the Central Government, SDLs issued by the

State Governments qualify for SLR.

2.4 Indenture

An indenture is a legal contract reflecting a debt or purchase obligation. Bond

indenture (also trust indenture or deed of trust) is a legal document issued to lenders and

describes key terms such as the interest rate, maturity date, convertibility, pledge, promises,

representations, covenants, and other terms of the bond offering. When the offering

memorandum is prepared in advance of marketing a bond, the indenture will typically be

summarised in the "description of notes" section.

2.5 Underwriting

It is the arrangement by which investment bankers undertake to acquire any unsubscribed

portion of a primary issuance of a security.



Chapter 3

Method of Issuing Government Securities

3.1 Issuance of Government Securities

Government securities are issued through auctions conducted by the RBI. Auctions are

conducted on the electronic platform called the NDS Auction platform. Commercial banks,

scheduled urban co-operative banks, Primary Dealers, insurance companies and provident

funds, who maintain funds account (current account) and securities accounts (SGL account)

with RBI, are members of this electronic platform. All members of PDO-NDS can place their

bids in the auction through this electronic platform.

The RBI, in consultation with the Government of India, issues an indicative half-yearly

auction calendar which contains information about the amount of borrowing, the tenor of

security and the likely period during which auctions will be held. A Notification and a Press

Communique giving exact particulars of the securities, viz., name, amount, and type of issue

and procedure of auction are issued by the Government of India about a week prior to the

actual date of auction. RBI places the notification and a Press Release on its website and also

issues an advertisement in leading English and Hindi newspapers.

3.2Types of Auction

1. Method of Issue

Yield Based Auction: A yield based auction is generally conducted when a new

Government security is issued. Investors bid in yield terms up to two decimal places.

Bids are arranged in ascending order and the cut-off yield is arrived at the yield

corresponding to the notified amount of the auction. The cut-off yield is taken as the

coupon rate for the security. Successful bidders are those who have bid at or below

the cut-off yield. Bids which are higher than the cut-off yield are rejected

Yield Based Auction of A New Security

Maturity Date: September 8, 2018

Coupon: It is determined in the auction (8.22% as shown in the illustration below)



Auction date: September 5, 2008

Auction settlement date: September 8, 2008

Notified Amount : Rs. 1000 crore

Details of Bids Received In the Increasing Order of Bid Yields

Bid No. Bid Amount of bid

(Rs. crore)

Cumulative

amount (Rs.Cr)

Price* with

coupon as 8.22%

1 8.19% 300 300 100.19

2 8.20% 200 500 100.14

3 8.20% 250 750 100.13

4 8.21% 150 900 100.09

5 8.22% 100 1000 100

6 8.22% 100 1100 100

7 8.23% 150 1250 99.93

8 8.24% 100 1350 99.87

The issuer would get the notified amount by accepting bids up to 5. Since the bid

number 6 also is at the same yield, bid numbers 5 and 6 would get allotment pro-rata

so that the notified amount is not exceeded. In the above case each would get Rs. 50

crore. Bid numbers 7 and 8 are rejected as the yields are higher than the cut-off yield.

Price Based Auction: It is conducted when Government of India re-issues securities

issued earlier. Bidders quote in terms of price per Rs.100 of face value of the security

Bids are arranged in descending order and the successful bidders are those who have

bid at or above the cut-off price. Bids which are below the cut-off price are rejected.

Price Based Auction of an Existing Security

Maturity Date: April 22, 2018

Coupon: 8.24%

Auction date: September 5, 2008

Auction settlement date: September 8, 2008*

Notified Amount: Rs.1000 crore



Details of Bids Received In The Decreasing Order of Bid Price

Bid No. Price of bid Amount of bid

(Rs. crore)

Implicit

yield

Cumulative

amount

1 100.31 300 8.1912% 300

2 100.26 200 8.1987% 500

3 100.25 250 8.2002% 750

4 100.21 150 8.2062% 900

5 100.20 100 8.2077% 1000

6 100.20 100 8.2077% 1100

7 100.16 150 8.2136% 1250

8 100.15 100 8.2151% 1350

The issuer would get the notified amount by accepting bids up to 5. Since the bid

number 6 also is at the same price, bid numbers 5 and 6 would get allotment in

proportion so that the notified amount is not exceeded. In the above case each would

get Rs. 50 crore. Bid numbers 7 and 8 are rejected as the price quoted is less than the

cut-off price.

2. Method of Allocation

Uniform Price auction - All the successful bidders are required to pay for the allotted

quantity of securities at the same rate, i.e., at the auction cut-off rate, irrespective of

the rate quoted by them.

Multiple Price auction - The successful bidders are required to pay for the allotted

quantity of securities at the respective price / yield at which they have bid. 4.3 An

investor may bid in an auction under either of the following categories:

3.3 Types of Bidding

Competitive Bidding: In a competitive bidding, an investor bids at a specific price /

yield and is allotted securities if the price / yield quoted is within the cut-off price /

yield. Competitive bids are made by well informed investors such as banks, financial



institutions, primary dealers, mutual funds, and insurance companies. The minimum

bid amount is Rs.10,000 and an investor may put in several bids at various price/ yield

levels.

Non-Competitive Bidding: With a view to providing retail investors, who may lack

skill and knowledge to participate in the auction directly, an opportunity to participate

in the auction process, the scheme of non-competitive bidding in dated securities was

introduced in January 2002. Non-competitive bidding is open to individuals, HUFs,

RRBs, co-operative banks, firms, companies, corporate bodies, institutions, provident

funds, and trusts. Under the scheme, eligible investors apply for a certain amount of

securities in an auction without mentioning a specific price / yield. Such bidders are

allotted securities at the weighted average price / yield of the auction.

In every auction of dated securities, a maximum of 5 per cent of the notified amount is

reserved for such non-competitive bids. In case the total applications received for non-

competitive bids exceed the ceiling of 5 per cent of the notified amount of the auction for

dated securities, the bidders are allotted securities on a pro-rata basis.

3.4 Open Market Operations (OMOs)

OMOs are the market operations conducted by the RBI by way of sale/ purchase of

Government securities to/ from the market with an objective to adjust the rupee liquidity

conditions in the market on a durable basis. When the RBI feels there is excess liquidity in

the market, it resorts to sale of securities thereby sucking out the rupee liquidity. Similarly,

when the liquidity conditions are tight, the RBI will buy securities from the market, thereby

releasing liquidity into the market.

3.5 Buyback of Government Securities

Buyback of Government securities is a process whereby the Government of India and State

Governments buy back their existing securities from the holders. The objectives of buyback

can be reduction of cost, reduction in the number of outstanding securities and improving

liquidity in the Government securities market and infusion of liquidity in the system.

Governments make provisions in their budget for buying back of existing securities. Buyback



can be done through an auction process or through the secondary market route, i.e.,

NDS/NDS-OM. Securities are purchased back at current market price.

3.6 Liquidity Adjustment Facility (LAF)

LAF is a facility extended by the Reserve Bank of India to the scheduled commercial banks

and primary dealers to avail of liquidity in case of requirement or park excess funds with the

RBI in case of excess liquidity on an overnight basis against the collateral of Government

securities including State Government securities. Basically LAF enables liquidity

management on a day to day basis. The operations of LAF are conducted by way of

repurchase agreements with RBI being the counter-party to all the transactions. The interest

rate in LAF is fixed by the RBI from time to time. Currently the rate of interest on repo under

LAF is 6.25% and that of reverse repo is 5.25%. LAF is an important tool of monetary policy

and enables RBI to transmit interest rate signals to the market.

3.7 Format of Holding

The Public Debt Office (PDO) of the Reserve Bank of India, Mumbai acts as the registry and

central depository for the Government securities. Government securities with the effect from

May 20, 2002, it is mandatory for all the RBI regulated entities to hold and transact in

dematerialized form.

3.8 Major Players in the Government Securities Market

Major players in the Government securities market include commercial banks and primary

dealers besides institutional investors like insurance companies. Primary Dealers play an

important role as market makers in Government securities market. Other participants include

co-operative banks, regional rural banks, mutual funds, provident and pension funds. Foreign

Institutional Investors (FIIs) are allowed to participate in the Government securities market

within the quantitative limits prescribed from time to time. Corporates also buy/ sell the

government securities to manage their overall portfolio risk.



Chapter 4

Trading In Government Securities

4.1 Trading In Government Securities

There is an active secondary market in Government securities can be bought / sold in the

secondary market either Over the Counter (OTC) or Negotiated Dealing System (NDS) or

Negotiated Dealing System-Order Matching (NDS-OM).

4.1.1 Over The Counter (OTC)/ Telephone Market

In this market, a participant, who wants to buy or sell a government security, may contact a

bank / PD / financial institution either directly or through a broker registered with SEBI &

negotiate for a certain amount of a particular security at a certain price. This is usually done

on telephone & deal may be struck if both counterparties agree on the amount and rate

4.1.2 Negotiated Dealing System

The Negotiated Dealing System (NDS) for electronic dealing and reporting of transactions in

government securities was introduced in February 2002. It facilitates the members to submit

electronically, bids or applications for primary issuance of Government Securities when

auctions are conducted. NDS also provides an interface to the Securities Settlement System

(SSS) of the PDO, RBI, and Mumbai thereby facilitating settlement of transactions in

Government Securities conducted in the secondary market. Membership to the NDS is

restricted to members holding SGL and/or Current Account with the RBI, Mumbai.

4.1.3 Negotiated Dealing System - OM

In August, 2005, RBI introduced an anonymous screen based order matching module on

NDS, called NDS-OM. This is an order driven electronic system, where the participants can

trade anonymously by placing their orders on the system or accepting the orders already

placed by other participants. It is operated by the Clearing Corporation of India Ltd. (CCIL)

on behalf of the RBI. Direct access to the NDS-OM system is currently available only to

select financial institutions like Commercial Banks, PDs, Insurance Companies, Mutual

Funds, etc. The advantages of NDS-OM are price transparency & better price discovery.



4.1.4 E-Kuber

The funds transfer through Centralized Funds Management System (a system set up, operated

& maintained by the RBI to enable operations on current accounts maintained at various

offices of the Bank, through standard message formats in a secure manner) has been

discontinued with effect from January 1, 2013. The chief reason for discontinuation of CFMS

is the launch by RBI of its Core Banking Solution i.e. (E-Kuber) system.

Features of E-Kuber are as follows

E-Kuber has enabled cooperative banks to be part of the e-Payment revolution in India, as

the cooperative banks can hold direct accounts in RBI.

Provision of a single account for each bank across the country, decentralised access to this

account from anywhere, anytime usage using the portal based services in a safe manner.

Government users can view their balances of all types including the Ways & Means

Advances, drawings, funds positions in consolidated manner for better funds management.

4.2 Benefits of Investing in Bonds

Providing a return in the form of coupons (interest), Government securities offer the

maximum safety as they carry the Sovereigns commitment for payment of interest and

repayment of principal.

They can be held in book entry, i.e., dematerialized form

Government securities are available in a wide range of maturities from 91 days to as long

as 30 years to suit the duration of a bank's liabilities.

Government securities can be sold easily in the secondary market to meet cash

requirements & can also be used as collateral to borrow funds in the repo market.

The settlement system for trading in Government securities, which is based on Delivery

versus Payment (DvP), is a very simple, safe and efficient system of settlement.

4.3 Types of Interest Rate Theories

4.3.1 Pure Expectations Theory (PET)

The pure expectation theory is the most straightforward and easy to understand, and is also

the most intuitive for traders. It simply assumes that qualitatively there's no difference

between a three-month maturity interest rate contract, and one with a maturity of three years.



All that matters is the expected interest rate over the maturity term, as perceived by market

participants on the basis of real and predicted interest rates. In sum, longer term yields are

merely a projection of short term rates to the future without any specific properties setting

long term rates apart from short-term ones with respect to risk or predictability. Today's

assumptions by market participants are perfect predictors of future rates, so there's no need

for any premium when buying or selling debt securities on longer maturities.

4.3.2 Liquidity Preference Theory (LPT)

The pure expectations theory has a clear deficiency in that market participants are not always

right about the future. Also, the geometric mean of short term yields across the term structure

is rarely a perfect indicator of the future rates over the long term. We often observe that

longer-term yields incorporate a premium over the geometric mean, termed the liquidity

premium, which is the subject of the liquidity preference theory for the most part. In

mathematical terms, LPT differs in its calculation of the yield curve only with respect to an

additional risk premium component added to the expected rate of the PET.

4.3.3 Market Segmentation Theory (MST)

This theory takes LPT and drives it one step further away from PET by stating interest rate

contracts across the term structure are not substitutable. The dynamics creating the interest

rate equilibrium for each maturity term are born of independent factors, and as such, the PET

is invalid. An investor deciding to purchase a bond, whether public or private, does not regard

the short-term/long-term paradigm merely as a matter of convenience, but as a fundamental

factor influencing investment strategy, liquidity needs, and of course supply and demand.

This approach to the term structure can explain the sloping nature of the yield curve. But

since it assumes that term structures depend on independent, it fails to explain why rates

across different maturities move simultaneously, albeit often by differing quantities

4.4 Role of the Clearing Corporation of India Limited (CCIL)

The CCIL is the clearing agency for Government securities. It acts as a Central Counter Party

(CCP) for all transactions in Government securities by interposing itself between two

counterparties. In effect, during settlement, the CCP becomes the seller to the buyer and

buyer to the seller of the actual transaction. All outright trades undertaken in the OTC market

and on the NDS-OM platform are cleared through the CCIL. Once CCIL receives the trade

information, it works out participant-wise net obligations on both the securities and the funds



leg. The payable / receivable position of the constituents is reflected against their respective

custodians. CCIL forwards the settlement file containing net position of participants to the

RBI where settlement takes place by simultaneous transfer of funds and securities under the

Delivery versus Payment system. CCIL also guarantees settlement of all trades in

Government securities. That means, during the settlement process, if any participant fails to

provide funds, CCIL will make the same available from its own means. For this purpose,

CCIL collects margins from all participants and maintains Settlement Guarantee Fund.

4.5 Role and Functions of FIMMDA

FIMMDA is a voluntary market body for the bond, money and derivatives markets.

FIMMDA has members representing all major institutional segments of the market. The

membership includes Nationalized Banks; Private sector banks; Foreign Banks, Financial

institutions, Insurance Company and all Primary Dealers.

The FIMMDA represents market participants and aids the development of the bond, money

and derivatives markets. It acts as an interface with the regulators on various issues that

impact the functioning of these markets. It also undertakes developmental activities, such as,

introduction of benchmark rates and new derivatives instruments, etc. FIMMDA releases

rates of various Government securities that are used by market participants for valuation

purposes. FIMMDA also plays a constructive role in the evolution of best market practices by

its members so that the market as a whole operates transparently as well as efficiently.

4.6 Reasons for Changes in Price of Government Security

The price of a Government security, like other financial instruments, keeps fluctuating in the

secondary market. The price is determined by demand and supply of the securities.

Specifically, the prices of Government securities are influenced by the level and changes in

interest rates in the economy and other macro-economic factors, such as, expected rate of

inflation, liquidity in the market, etc. Developments in other markets like money, foreign

exchange, credit and capital markets also affect the price of the Government securities.

Further, developments in international bond markets, specifically the US Treasuries affect

prices of Government securities in India. Policy actions by RBI (e.g., announcements

regarding changes in policy interest rates like Repo Rate, Cash Reserve Ratio, Open Market

Operations, etc.) can also affect the prices of Government securities.



Chapter 5

Fundamentals of Yield

5.1.1 Yield

Yield is a critical concept in bond investing, because it is the tool used to measure the return

of one bond against another. It enables one to make informed decisions about which bond to

buy. In essence, yield is the rate of return on bond investment. However, it is not fixed, like a

bond's stated interest rate. It changes to reflect the price movements in a bond caused by

fluctuating interest rates.

Although the buyer will receive the same amount of interest as you did and will also have the

same amount of returned at maturity, the buyer's yield, or rate of return, will be higher than

yours, because the buyer paid less for the bond.

Yield is commonly measured in two ways, current yield and yield to maturity.

5.1.2 Current Yield

The current yield is the annual return on the amount paid for a bond, regardless of its

maturity. If you buy a bond at par, the current yield equals its stated interest rate. Thus, the

current yield on a par-value bond paying 6% is 6%.

However, if the market price of the bond is more or less than par, the current yield will be

different. For example, if you buy a Rs. 1,000 bond with a 6% stated interest rate at Rs. 900,

your current yield would be 6.67% (Rs. 1,000 x .06/Rs.900).

5.1.3 Yield to maturity

It tells the total return you will receive if you hold a bond until maturity. It also enables you

to compare bonds with different maturities and coupons. Yield to maturity includes all your

interest plus any capital gain you will realize (if you purchase the bond below par) or minus

any capital loss you will suffer (if you purchase the bond above par).

5.2 Relationship between Yield and Price of a Bond

If interest rates or market yields rise, the price of a bond falls. Conversely, if interest rates or

market yields decline, the price of the bond rises. In other words, the yield of a bond is



inversely related to its price. The relationship between yield to maturity and coupon rate of

bond may be stated as follows:

When the market price of the bond is less than the face value, i.e., the bond sells at a

discount, YTM > current yield > coupon yield.

When the market price of the bond is more than its face value, i.e., the bond sells at a

premium, coupon yield > current yield > YTM.

When the market price of the bond is equal to its face value, i.e., the bond sells at par,

YTM = current yield = coupon yield.

5.3 Day Count Conventions Used in Calculating Bond Yields

Day count convention refers to the method used for arriving at the holding period

(number of days) of a bond to calculate the accrued interest. As the use of different

day count conventions can result in different accrued interest amounts, it is

appropriate that all the participants in the market follow a uniform day count

convention.

Bond market: The day count convention followed is 30/360, which means that

irrespective of the actual number of days in a month, the number of days in a month is

taken as 30 and the number of days in a year is taken as 360.

5.4 Types of Yield Curve

The term structure of interest rates, also known as the yield curve, is a very common bond

valuation method. Constructed by graphing the yield to maturities and the respective maturity

dates of benchmark fixed-income securities, the yield curve is a measure of the market's

expectations of future interest rates given the current market conditions. Treasuries, issued by

the federal government, are considered risk-free, and as such, their yields are often used as

the benchmarks for fixed-income securities with the same maturities. The term structure of

interest rates is graphed as though each coupon payment of a noncallable fixed-income

security were a zero-coupon bond that "matures" on the coupon payment date. The exact

shape of the curve can be different at any point in time. So if the normal yield curve changes

shape, it tells investors that they may need to change their outlook on the economy.

There are three main patterns created by the term structure of interest rates:



5.4.1 Normal Yield Curve:

As its name indicates, this is the yield curve shape that forms during normal market

conditions, wherein investors generally believe that there will be no significant changes in the

economy, such as in inflation rates, and that the economy will continue to grow at a normal

rate. During such conditions, investors expect higher yields for fixed income instruments with

long-term maturities that occur farther into the future. In other words, the market expects

long-term fixed income securities to offer higher yields than short-term fixed income

securities. This is a normal expectation of the market because short-term instruments

generally hold less risk than long-term instruments; the farther into the future the bond's

maturity, the more time and, therefore, uncertainty the bondholder faces before being paid

back the principal. To invest in one instrument for a longer period of time, an investor needs

to be compensated for undertaking the additional risk.

Remember that as general current interest rates increase, the price of a bond will decrease and

its yield will increase.

5.4.2 Flat Yield Curve:

These curves indicate that the market environment is sending mixed signals to investors, who

are interpreting interest rate movements in various ways. During such an environment, it is

difficult for the market to determine whether interest rates will move significantly in either

direction farther into the future. A flat yield curve usually occurs when the market is making

a transition that emits different but simultaneous indications of what interest rates will do. In

other words, there may be some signals that short-term interest rates will rise and other

signals that long-term interest rates will fall. This condition will create a curve that is flatter



than its normal positive slope. When the yield curve is flat, investors can maximize

their risk/return trade off by choosing fixed-income securities with the least risk, or highest

credit quality. In the rare instances wherein long-term interest rates decline, a flat curve can

sometimes lead to an inverted curve.

5.4.3 Inverted Yield Curve:

These yield curves are rare, and they form during extraordinary market conditions wherein

the expectations of investors are completely the inverse of those demonstrated by the normal

yield curve. In such abnormal market environments, bonds with maturity dates further into

the future are expected to offer lower yields than bonds with shorter maturities. The inverted

yield curve indicates that the market currently expects interest rates to decline as time moves

farther into the future, which in turn means the market expects yields of long-term bonds to

decline. Remember, also, that as interest rates decrease, bond prices increase and yields

decline.



Chapter 6

Bond Mathematics

6.1 Compounding & Discounting

6.1.1 Compounding: - Government security makes payments semi-annually, so that instead

of receiving 8.66 % interest once in a year, bondholders receives 4.33% interest every half

year. The face value of bond is Rs. 100, so the six monthly payment on each bond is

0.0433*100 Rs = 4 Rs. Because interest is semi-annual, yields on Indian G-Secs are usually

quoted as semi-annually compounded yields.

6.1.2 Discounting: - Treasury bills are typically issued at a discount from the par amount

(face value). For example, if you buy a Rs.1,000 bill at a price per Rs.100 of Rs.99.986111,

then you would pay Rs.999.86 (Rs.1,000 x .99986111 = Rs.999.86111).* When the bill

matures, you would be paid its face value, Rs.1,000. Your interest is the face value minus the

purchase price. It is possible for a bill auction to result in a price equal to par, which means

that Treasury will issue and redeem the securities at par value.

6.2 Duration

Duration of a bond is also known as Macaulay Duration. Duration is a measure of riskiness of

bond. It is the rate of change of slope of price YTM curve. Duration is the weighted average

time to maturity on a financial security using the relative present values of the cash flows as

weights.

Duration measures the period of time required to recover the initial investment in a bond.

D = ((CFt * t)/(1+R)^t) / CFt/(1+R)^t (where t = 1 to N)

For semi-annual coupon bonds,

D = ((CFt * t)/(1+R/2)^2t) / CFt/(1+R/2)^2t (t = 1/2 to N)

Duration of zero-coupon bond is equal to the maturity of the bond.

6.2.1 Features of Duration

The higher the coupon rate, the lower is a bonds duration.



Duration decreases as yield to maturity increases.

Duration increases with the maturity of a bond but at a decreasing rate.

Will the price sensitivity of a 5-year maturity coupon bond having duration of 4.5 yrs

be same when compared to a 4.5 yrs zero coupon bond

6.2.2 Economic Importance of Duration

It is a direct measure of its interest rate sensitivity. It can be used as a strategic tool in trying

to earn a higher rate of return, or to minimize the risk associated with earning the promised

yield to maturity. Given the individual bond durations, the duration of a portfolio is a simple

linear weighted average of the durations of the bonds in the portfolio.

6.3 Modified Duration (MD)

Modified duration (MD) is a modified version of Macaulay Duration. It refers to the change

in value of the security to one per cent change in interest rates (Yield)

dP/P = MD * dR (where MD = D/(1+R) )

6.3.1 Calculation for Duration

1. Each of the future cash flows is discounted to its respective present value for each

period. Since the coupons are paid out every six months, a single period is equal to six

months and a bond with two years maturity will have four time periods.

2. The present values of future cash flows are multiplied with their respective time

periods (these are the weights). That is the PV of the first coupon is multiplied by 1,

PV of second coupon by 2 and so on.

3. The above weighted PVs of all cash flows is added and the sum is divided by the

current price (total of the PVs in step 1) of the bond. The resultant value is the

duration in no. of periods. Since one period equals to six months, to get the duration

in no. of year, divide it by two. This is the time period within which the bond is

expected to pay back its own value if held till maturity.

6.3.2 Applications of Duration

Interest rate risk management (Immunization)

Management of portfolio of bonds



6.4 Fisher equation

The Fisher equation in financial mathematics and economics estimates the relationship

between nominal and real interest rates under inflation. It is named after Irving Fisher, who

was famous for his works on the theory of interest. In finance, the Fisher equation is

primarily used in YTM calculations of bonds or IRR calculations of investments. Economists

generally use the Greek letter as the inflation rate, not the mathematical irrational number

pi (3.14159....)

Letting denote the real interest rate, denote the nominal interest rate, and let denote

the inflation rate, the Fisher equation is:

This is a linear approximation, but as here, it is often written as an equality:

The Fisher equation can be used in either ex-ante (before) or ex-post (after) analysis. Ex-post,

it can be used to describe the real purchasing power of a loan:

Rearranged into an expectations augmented Fisher equation and given a desired real rate of

return and an expected rate of inflation over the period of a loan, , it can be used ex-ante

version to decide upon the nominal rate that should be charged for the loan:

This equation existed before Fisher, but Fisher proposed a better approximation which is

given below. The approximation can be derived from the exact equation:

6.4.1 Applications

The Fisher equation has important implications in the trading of inflation-indexed bonds,

where changes in coupon payments are a result of changes in break-even inflation, real

interest rates and nominal interest rates.



Chapter 7

Risk associated with Government Securities

7.1 Risk associated with Government Securities

Government securities are generally referred to as risk free instruments as sovereigns are not

expected to default on their payments. However, as is the case with any financial instrument,

there are risks associated with holding the Government securities. Hence, it is important to

identify and understand such risks and take appropriate measures for mitigation of the same.

The following are some potential pitfalls and risks to holding government securities that all

investors should be aware of.

7.1.1 Market risk

Market risk arises out of adverse movement of prices of the securities that are held by an

investor due to changes in interest rates. Interest rates and bond prices carry an inverse

relationship; as interest rates fall, the price of bonds trading in the marketplace generally

rises. Conversely, when interest rates rise, the price of bonds tends fall. This will result in

booking losses on marking to market or realizing a loss if the securities are sold at the

adverse prices. Small investors, to some extent, can mitigate market risk by holding the bonds

till maturity so that they can realize the yield at which the securities were actually bought.

7.1.2 Reinvestment risk

Cash flows on a Government security includes fixed coupon every half year and repayment

of principal at maturity. These cash flows need to be reinvested whenever they are paid.

Hence there is a risk that the investor may not be able to reinvest these proceeds at profitable

rates due to changes in interest rate scenario.

7.1.3 Liquidity risk

Liquidity risk refers to the inability of an investor to liquidate (sell) his holdings due to non-

availability of buyers for the security, i.e., no trading activity in that particular security.

Usually, when a liquid bond of fixed maturity is bought, its tenor gets reduced due to time

decay. Due to illiquidity, the investor may need to sell at adverse prices in case of urgent

funds requirement.



Chapter 8

Liquidity in Secondary Market of Government Securities

8.1.1 Indian Government Bond Yield

Source - http://www.tradingeconomics.com/india/government-bond-yield

8.1.2 Wholesale Debt Market Capitalisation

Source-http://blog.securities.com/2012/11/india-a-glance-at-the-national-stock-exchanges-

wholesale-debt-market/



8.1.3 Average Daily Government Bond Market Volume

Source - http://capitalmind.in/2013/05/bond-market-volumes-at-highest-ever-yields-at-3-

year-low/

8.1.4 Daily Volume in Government Bond Market

Source - http://capitalmind.in/2013/05/bond-market-volumes-at-highest-ever-yields-at-3-

year-low/



8.1.5 Comparison of G-Sec and Corporate Debt Market

Source - http://www.ifmr.co.in/blog/2012/08/08/indian-corporate-debt-market-current-status/



Chapter 9

Bond Market Terminologies

Arbitrage

Arbitrage involves buying and selling the same security, more or less simultaneously, to

profit from a price disparity. In the forex market, Arbitrage trades capitalize on forward

exchange rates being out of line with the interest differential.

Accrued Interest

Accrued interest is the amount of interest that has been earned since the last interest payment

date. When a bond trades, the buyer pays the seller the accrued interest - a pro rata portion of

the next interest payment, which will be paid to the buyer of the bond.

Basis Point

A basis point is simply 1/100th of one percent.

Bid(s)

The price(s) at which market makers/buyers want to buy securities or foreign exchange from

the market.

Call Date

When a bond is issued, the issuer may have the option to call (redeem) the bond on specified

dates and prices prior to maturity. The list of dates on which a specified bond can be called is

shown in a call schedule.

Clearing

The process of exchanging securities and funds through a Clearing house after a trade/deal is

concluded.

Clean Price/ Dirty Price

The price of a debt instrument excluding interest for the period elapsed since the last coupon

was paid is called the clean price .Market price are clean prices. Dirty price includes interest

from the last coupon date to the settlement date.



Coupon

A coupon is the stated interest rate for a bond. Most bonds have a fixed coupon that does not

change during the life of the bond. Most bonds have two coupon payments per year. For

example, a bond with a 5.0% coupon will pay $25 twice per year, for total interest of $50

which is 5.0% of the face value of the bond (almost all bonds have a face value of $1,000).

Current Yield

Current yield is the rate of return an investor will get, without taking into account the value of

the premium or discount of the purchase price. It is calculated by dividing the coupon by

the price. The current yield is not a good indication of your return on investment. Yield to

maturity and yield to call take into account the value of the discount or premium paid for the

bond, and as such they offer a much better indication of the value of the bond.

FIMMDA

Acronym For Fixed Income Money Market and Derivatives Association of India, a body

comprising representative of the treasury department of banks and entrusted with the

responsibility of self-regulation of money markets and fixed income and derivative market.

Hedging

Insulating (for example) interest rate exposures from market fluctuations, mostly using

derivative instrument like swaps and futures.

Interest

Interest is the money the issuer pays to the bondholder at specified times throughout the life

of the bond. The stated interest rate of a bond is usually referred to as the coupon rate. Most

bonds pay interest semi-annually (twice per year).

Issue Description

This is the name of the issuer of the bond, and sometimes a brief description of the purpose of

the bond. Think of this as the bond's name.

IPO

Short for Initial Public Offering, the first offer of its share to the public by a company.



Liquidity

Capacity of a market to absorb a reasonable level of selling without significant losses.

Maturity Date

The maturity date of a bond is the date on which the bond will be repaid. Note that many

bonds have features such as puts and calls which may cause the principal to be repaid on an

earlier date.

Redemption

When the principal of the bond is paid off, the bond is said to be redeemed. Bonds can be

redeemed at maturity, or on a call date or put date.

Settlement Date

When a bond trade takes place, the buyer and seller agree on a date when the buyer will pay

for the bonds and the seller will deliver the bonds. For municipal bonds and corporate bonds,

the settlement date is typically 3 business days after the trade date. For Treasury and zero

coupon bonds the settlement date is typically the next business day after the trade.

Yield to Maturity

Yield to maturity is the calculated return on investment that an investor will get if they hold

the bond to maturity. It takes into account the present value of all future cash flows, as well as

any premium or discount to par that the investor pays.



Chapter 10

Inflation Indexed Bonds

10.1.1 Introduction

Inflation-indexed bonds (also known as inflation-linked bonds) are bonds where the principal

is indexed to inflation. They are thus designed to cut out the inflation risk of an investment.

The first known inflation-indexed bond was issued by the Massachusetts Bay Company in

1780.The market has grown dramatically since the British government began issuing

inflation-linked Gilts in 1981. Till 2008, government-issued inflation-linked bonds comprise

over $1.5 trillion of the international debt market. The inflation-linked market primarily

consists of sovereign bonds, with privately issued inflation-linked bonds constituting a small

portion of the market.

10.1.2 Structure

Inflation-indexed bonds pay a periodic coupon that is equal to the product of the inflation

index and the nominal coupon rate. The relationship between coupon payments, breakeven

inflation and real interest rates is given by the Fisher equation. A rise in coupon payments is a

result of an increase in inflation expectations, real rates, or both.

10.1.3 Global Issuance

The most liquid instruments are Treasury Inflation-Protected Securities (TIPS), a type of US

Treasury security, with about $500 billion in issuance. The other important inflation-linked

markets are the UK Index-linked Gilts with over $300 billion outstanding and the French

OATi/OATi market with about $200 billion outstanding. Germany, Canada, Greece,

Australia, Italy, Japan, Sweden and Iceland also issue inflation-indexed bonds, as well as a

number of Emerging Markets, most prominently Brazil.

Country Issue Issuer Inflation Index

United States

Treasury Inflation-

Protected

Securities (TIPS)

US Treasury US Consumer Price

Index



United States

Series I Inflation-

Indexed Savings

Bonds (I-Bonds -

domestic retail

bonds)

US Treasury US Consumer Price

Index

United Kingdom Index-linked Gilt UK Debt

Management Office

Retail Price

Index (RPI)

United Kingdom

Index-linked Savings

Certificates (domestic

retail bonds)

National Savings and

Investments

Retail Price

Index (RPI)

France OATi and OATi Agence France

Trsor

France CPI ex-

tobacco (OATi),

EU HICP ex-tobacco

(OATi)

Canada Real Return Bond

(RRB) Bank of Canada

Canada All-

Items CPI

Australia Capital Indexed

Bonds (CAIN series)

Department of the

Treasury (Australia)

Weighted Average of

Eight Capital Cities:

All-Groups Index

Germany Bund index. and BO

index.

Bundesrepublik

Deutschland

Finanzagentur

EU HICP ex

Tobacco

Greece EU HICP ex

Tobacco

Hong Kong iBond (domestic

retail bonds)

Hong Kong

Government

Composite Consumer

Price Index

Italy BTPi Department of the

Treasury

EU HICP ex

Tobacco

India Reserve Bank of

India

Wholesale Price

Index

Italy BTP Italia (domestic

retail bonds)

Department of the

Treasury Italy CPI ex tobacco

Japan JGBi Ministry of Finance

(Japan)

Japan CPI

(nationwide, ex-

fresh-food)

Sweden Index-linked treasury

bonds

Swedish National

Debt Office Swedish CPI



10.2 Introduction of IIB in India

In Budget 2013, the finance minister has announced a proposal to introduce inflation-indexed

bonds (IIB) or inflation-indexed national security certificates. The Government of India has

decided to issue inflation-indexed bonds (IIB), starting from June, in an effort to broaden the

menu of investment choices available for investors. The government had announced plans to

issue IIBs with 10 years maturity worth Rs 12,000-15,000 crore during the current fiscal

(2013-14).

The government has made an announcement regarding the launch of the inflation-indexed

bonds that finance minister P Chidambaram had first promised in his Budget speech.

However, there is complete discordance between what Chidambaram had said in his Budget

speech and what RBI has now launched. What the Budget speech said: "...in consultation

with RBI, I propose to introduce instruments that will protect savings from inflation,

especially the savings of the poor and the middle classes. These could be inflation-indexed

bonds or inflation-indexed National Security Certificates. The structure and tenor of the

instruments will be announced in due course.

After reading these noble thoughts about saving the poor from the vagaries of inflation, any

reasonable person would expect that the bonds would:

Be linked to the consumer price inflation index; and

Be available to retail customers (and retail customers alone) in a simple manner,

perhaps through bank branches and post offices.

Nothing of that sort is happening. Firstly, the bonds are linked to the wholesale price index

(WPI). This in itself makes a joke out of all these pious statements about saving the poor and

the middle class from inflation.

Central bank says: "Pursuant to the announcement made in the Union Budget for 2013-14

to introduce instruments that will protect savings of the poor and the middle classes from

inflation and incentivise household sector to save in financial instruments rather than buy

gold, RBI, in consultation with the government of India, has decided to launch inflation-

indexed bonds."



For investors who run after gold to hedge their investments against the menace of runaway

inflation, a good investment avenue has opened up. After a long wait, the Reserve Bank of

India has finally come out with inflation-indexed bonds (IIBs) a popular instrument in

developed markets like the US and the UK that will safeguard the capital and returns of

investors in an era of high inflation.

Normally, countries launch such bonds to safeguard the capital of investors at a time when

inflation is ruling the roost. Investors who seek safe returns, which is above the inflation

level, can go for such bonds. Another aim of the Reserve Bank of India and the government

is to incentivise household sector to save in financial instruments rather than buy gold, which

is now the favourite hedge of Indian consumers against inflation.

First series of the IIBs will help in determining the coupon rate for the bonds through auction.

This will help in benchmarking IIBs. Based on the experience in the initial issuances, second

series of IIBs for the retail investors is proposed to be issued around October.

A normal government security bond carries an inflation risk which the inflation indexed

bonds are free from.

10.3.1 Salient Features of Inflation Indexed Bonds Are As Under:-

1. Fixed real coupon rate: and a nominal principal value that is adjusted against

inflation.; Periodic coupon payments are paid on adjusted principal.; Thus these bonds

provide inflation protection to both principal and coupon payment.; At maturity, the

adjusted principal or the face value, whichever is higher, will be paid.

2. Index ratio (IR): will be computed by dividing reference index for the settlement

date by reference index for issue date (i.e., IR set date = Ref. Inflation Index Set Date

/ Ref Inflation Index Issue Date).

3. Final Wholesale Price Inflation (WPI): will be used for providing inflation

protection in this product. In case of revision in the base year for WPI series, base

splicing method would be used to construct a consistent series for indexation.



4. Indexation Lag: Final WPI with four months lag will be used, i.e. Sept 2012 and Oct

2012 final WPI will be used as reference WPI for 1st Feb 2013 and 1st March 2013,

respectively.

5. Retail Participation: Non-competitive portion will be increased from extant 5

percent to up to 20 percent of the notified amount in order to encourage participation

of retail and other eligible investors.

6. Maturity: Issuance would target various points of the maturity curve in order to have

benchmarks. To begin with, these bonds will be issued for tenor of 10 years.

7. Issuance method: These bonds will be issued by auction method.

8. Issuance Size: Each tranche of IIBs will be for `1,000 - 2000 crore and total issuance

would be for about `12,000-15,000 crore in 2013-14.

9. Issuance Date: First tranche will be issued on June 4th 2013 and the same would be

issued regularly through auctions on the last Tuesday of each subsequent month

during 2013-14.

10.3.2 Eligibility Criteria

IIB will also be considered in the statutory liquidity ratio requirements of banks

Inflation bonds will also be eligible for short-selling, repo transactions.

10.3.3 Foreign Investors

Foreign investors can buy these bonds, but within the existing total investment limits of USD

25 billion of government debt.

10.4 Tax Treatment

The maturity value received on redemption is subjected of bond would be subjected to tax as

per the existing Income Tax laws. There is no special treatment for the capital gains/interest

earned on these bonds.

(Capital Gain = Sale Value Purchase Price)



If the capital gain is short term in nature, the entire gain would be added to your taxable

income and levied as per your slab rate. If the capital gain is long term in nature then it will

be taxed at 10% or 20% with indexation benefit, whichever is lower. Accordingly, the capital

gain tax would come near to zero if the bond trades at clean price (without any premium) on

redemption.

10.5 RBI's Previous Experience in Inflation Bonds

The RBI launched an IIB styled as Capital Indexed Bonds (CIB) in December 1997.

However, there was no further issuance of CIB mainly due to lack of an enthusiastic response

of market participants. CIB only offered inflation hedging for the principal, while the

coupons of the bond were left unprotected against inflation and complexities involved in

pricing of the instrument. The latest inflation-indexed bond scheme has addressed these

concerns to a great extent.

10.6 Issues Related with IIB

10.6.1 Timing of IIB Launching

The latest IIB scheme was on the RBI drawing board for quite some time. Finally, when it is

due for launch, inflation rate has started coming down in India. The latest data shows that

WPI inflation fell 4.89 per cent in April as against 5.96 in March, which is very much in the

comfort zone of the RBI. This means investor appetite may wane if inflation falls further as

bank fixed deposit rates are still high. But, as the saying goes, "it's better late than never."

There's no guarantee that inflation won't rise again in the future.

10.6.2 Benchmark @ WPI or CPI:

The gap between the wholesale price index and consumer price index inflation has widened.

In India, what matters is the CPI which is still around 9.39 per cent. Critics argue that linking

inflation-indexed bonds to WPI may not be the best idea. By calculating the return based on

prices at the wholesale level, consumers/investors still end up losing money, Many countries

use CPI to calculate the returns. With a higher CPI here, it will be a costly exercise for the

RBI. Besides, there's apprehension that retail investors who are not active in government

securities market will not be enthused by IIBs. Currently inflation indexed bonds are linked

to WPI. Instead of WPI, the consumer price index (CPI) stands as a better representative of



the purchase power of individuals. But in their current form, the bonds provide only a partial

hedge against inflation and not a perfect one.

10.6.3 Reason for WPI Used With Four Months Lag

Final monthly WPI will be used as reference WPI for 1st day of the calendar month. The

reference WPI for intermittent days, i.e. dates between 1st days of the two consecutive

months will be computed through interpolation.

For interpolation, two months final WPI should be available throughout the month. As final

WPI is available with a lag of about two and half months (e.g. final WPI February 2013 will

be released in mid-May 2013), two months final WPI could be available only with a lag of

four months.

In view of above, the four months lag has been chosen for final WPI to be considered as

reference WPI for 1st day of the calendar month. For example, December 2012 final WPI

will be taken as reference WPI for 1st of May 2013 and January 2013 final WPI will be taken

as reference WPI for 1st of June 2013.



10.6.4 Inflation Indexed Bonds v/s Gold as a Hedging Instrument

Gold for long has been used as a hedge against inflation. Till recently, gold has produced

some good returns for the Indian investors. However, owing to volatility in the prices,

investment in gold will not offer any capital protection. Inflation indexed bonds offer capital

protection and can also be used as a hedge against inflation rates.

10.7.1 Calculation of Inflation Indexed Bonds

Inflation component on principal will not be paid with interest but the same would be

adjusted in the principal by multiplying principal with index ratio (IR). At the time of

redemption, adjusted principal or the face, whichever is higher, would be paid.

Interest rate will be provided protection against inflation by paying fixed coupon rate on the

principal adjusted against inflation.

An example of cash flows on IIBs is furnished below.

Year Period

Real

Coupon

Inflation

Index

Index

Ratio

Inflation

Adjusted

Principal

Coupon

Payments

Principal

Repayment

I II III IV Vti=

(IVti/IVt0)

VI=

(FV*V)

VII=

(VI*III)

VIII

0 28-May-

13 1.50% 100 1.00 100.0

1 28-May-

14 1.50% 106 1.06 106.0 1.59

2 28-May-

15 1.50% 111.8 1.12 111.8 1.68

3 28-May-

16 1.50% 117.4 1.17 117.4

1.76

4 28-May-

17 1.50% 123.3 1.23 123.3 1.85

5 28-May-

18 1.50% 128.2 1.28 128.2 1.92



6 28-May-

19 1.50% 135 1.35 135.0 2.03

7 28-May-

20 1.50% 138.5 1.39 138.5 2.08

8 28-May-

21 1.50% 142.8 1.43 142.8 2.14

9 28-May-

22 1.50% 150.3 1.50 150.3 2.25

10 28-May-

23 1.50% 160.2 1.60 160.2 2.40 160.2

10.7.2 Formula for Calculating Index Ratio

Index ratio (IR) will be calculated by dividing the reference WPI on the settlement date with

the reference WPI on the issue date.

The formula for the same is as under:

10.7.3 Formula for Interpolation of Daily Reference WPI

For calculating the index ratio for a specific date, daily reference WPI values would be

linearly interpolated using Ref WPI for the first day of the calendar month and the first day

of the following calendar month.

The formula for computing the reference WPI for a particular day is as under:

[Ref WPIM = Ref WPI for the first day of the calendar month in which Date falls, Ref

WPIM+1 = Ref WPI for the first day of the calendar month following the settlement date, D

= Number of days in month (e.g. 31 days in August), and t= settlement date (e.g. August 6)]



An example of daily reference WPI computed through interpolation is furnished below.

Date Ref WPI (given)

T-1 D Ref WPI

(interpolation)

1 May 13 168.8

2 May 13 1 31 168.85

3 May 13 2 31 168.90

4 May 13 3 31 168.95

5 May 13 4 31 168.99

6 May 13 5 31 169.04

7 May 13 6 31 169.09

8 May 13 7 31 169.14

9 May 13 8 31 169.19

10 May 13 9 31 169.24

11 May 13 10 31 169.24

12 May 13 11 31 169.28

13 May 13 12 31 169.33

14 May 13 13 31 169.38

15 May 13 14 31 169.43

16 May 13 15 31 169.48

17 May 13 16 31 169.53

18 May 13 17 31 169.57

19 May 13 18 31 169.62

20 May 13 19 31 169.67

21 May 13 20 31 169.72

22 May 13 21 31 169.77

23 May 13 22 31 169.82

24 May 13 23 31 169.86

25 May 13 24 31 169.91

26 May 13 25 31 169.96

27 May 13 26 31 170.01

28 May 13 27 31 170.06

29 May 13 28 31 170.11

30 May 13 29 31 170.15

31 May 13 30 31 170.20

1 June 13 170.3



10.8 Inflation Indexed Bonds Returns Simplified With 3 Scenarios

Face Value INR 1000 (Coupon Rate -1.44%) Interest Payment Semi Annually

Scenarios Scenario 1 Scenario 2 Scenario 3

Deflation

Inflation Rate 4% 5% -2%

Adjusted Face Value

(INR) 1000*(1+4%)=1040 1000*(1+5%)=1050 1000*(1-2%)=980

Interest Amount

(INR)

1040*1.44%=14.98

1050*1.44%=15.12

980*1.44%=14.11

Semi Annual

Payment 14.98/2 = 7.49 15.12/2 = 7.56 14.11/2 = 7.05

Maturity Value

(Face Value or

Adjusted Price

whichever is higher )

1040.00 1050.00 1000.00

In the above table, the holder gets the real interest as payout and the inflation part gets

adjusted to the face value is repaid to the investor.

On the contrary, if there is a deflation of 2.0% the indexed principal would be INR 980 and

the coupon payment would be INR 14.11 only. In this case capital protection would be

provided by paying higher of adjusted principal and face value at redemption. Thus the

investor would get the higher of INR 1000 on redemption.

10.9 Auction of First Tranche

June 04, 2013

Government's first issue of the 10-year inflation indexed bonds, which aims at

discouraging gold investments, was oversubscribed by more than four times, though

only bids worth Rs 1,000 crore were accepted.

As per the RBI, which auctioned the '10 Years Inflation Indexed Government Stock,

2023', there were 167 competitive bids worth Rs 4,616 crore of which only 26



amounting to Rs 985.94 crore were accepted. Also all the eight non-competitive bids

by retail and mid-segment investors totaling Rs 14.06 crore were accepted, it said,

adding the cut off-yield for the auction was fixed at 1.44 per cent.

June 25, 2013

Another 1,000 cr. auctioned at a yield of 1.9855%, which means a price of 95.10.

Effect

The bond has not traded much recently but after this auction, it witness trading of 155 cr.

in the open market. The bond closed at 94.9, which is a yield of over 2% on 25th June

2013.

Trading in the IIB on 25 Jun 2013



10.10 Future plans

The IIBs will be issued on last Tuesday of every month.

First series of the bonds was open for all class of investors, the second series issue

beginning October will be reserved exclusively for retail investors.

The RBI has indicated that in the future when the CPI stabilises, it may consider

launching inflation indexed bonds linked to it. Till such time, these bonds are likely to

be linked to WPI.

These bonds may come with maturity period of 7- 15 years

10.11 Disadvantages of Inflation Indexed Bonds

Inflation indexed bonds are currently linked to WPI and not CPI. The CPI linked

bonds will have a better advantage over WPI linked bonds.

Periods of deflation will often lead to adjusted principal, which is less than the

original principal. However, deflation in India's scenario is just a theoretical risk. As

per the current state of economic affairs, deflation is not practically possible in India.

10.12 L&T First Domestic Company to Issue IIB

After Reserve Bank of India announced that it will issue the first tranche of inflation-

indexed bonds on June 4, Infrastructure major Larsen & Toubro (L&T) announced to

raise Rs 100 crore in 10-year inflation-linked bonds at 1.65% over wholesale price

inflation.

IDFC is the sole arranger of the deal.

The sale has not been made public yet.



Conclusion

There is a shortage of good assets for investment in many developing economies including

India, which can hedge against inflation. The issue of IIBs is a welcome development in this

context of Indian economy. IIB can be proved a useful financial instrument for domestic as

well as foreign investor despite of uncertainty in economic and political conditions of the

country.

RBI is launching IIB to divert investments from gold into these bonds. The objective can be

achieved only if RBI comes up with an attractive structure. Further liquidity in these bonds

has to be ensured to attract retail investors. Investors may get a higher interest during high

inflation scenario as well as a higher principal on maturity. If inflation falls, the investor may

lose out on interest. However, the principal is protected. In other words, you get back what

you had originally invested when the bond matures.

IIB worth Rs 12,000- 15,000 crores this year is small in relation to the size of the existing

market for usual bonds, which is very big. The gross and net market borrowing requirements

of the Government for the financial year 2013-2014 are set at Rs 5,69,616 crores.

Banks demand for government bonds is large, which keeps the yields low. Hence, retail

investors are not interested in these. It is this differential behaviour on the part of banks and

retail investors that is of interest in understanding how the market for IIBs may evolve in

future.

It is true that there will be an exclusive issue for retail investors in October 2013. But if yields

in the monthly issues from June to October are to be used as a guide for setting interest rates

in October, then these are likely to be low. This will further deter retail investors to

participate.

If the RBI were to settle on a low return in monthly issues from June to October and a high

return in the October issue, then retail investors are not likely to participate in the monthly

issues prior to the October issue. They will apply and get bonds in October but they may not

hold them for long because there can be an arbitrage opportunity. Banks can bid up the prices

of these bonds (and bid down the yields) in the secondary market. They will buy IIBs from

retail investors who may go back to buy and hold assets like gold



To make the IIBs more attractive, the RBI has to soon issue bonds which are linked to CPI

index. This will by itself act as a disciplinary measure for the Government to take steps in

time to rein in the CPI.

Liquidity is the major challenge for IIB as in the past product like (Capital Indexed

Bond) could not perform well as per the market expectations.

Inflation-Indexed Bonds caters to the investors with a long term investment horizon.

Investors can include inflation-indexed bonds in their debt portfolios, as this provides

a hedge against inflation.

Bond market gives an alternative for investment, in India bond market is still in

developing stage which needs to be enhanced for the development of economy.



Bibliography

Books

Theory and Practices of Treasury and Risk Management in Banks: By Taxman

Foreign Exchange, International Finance and Risk Management: By A.V. Rajwade

Newspaper

Economic Times

Hindustan Times

Internet Sites

www.rbi.org.in

www.fimmda.com

www.ccil.com

www.investopodia.com

www.sebi.gov.in

inflation indexed bonds

Documents

debt markets

corporate market

corporate debt market

capital market capital

government bond market

total debt market

stock markets

financial markets