Bonds & Debentures:- FAQ’s

(Click over Questions to get Answer)

What is the Debt Market?

The Debt Market is the market where fixed income securities of various types and features are issued and traded. Debt Markets are therefore, markets for fixed income securities issued by Central and State Governments, Municipal Corporations, Govt. bodies and commercial entities like Financial Institutions, Banks, Public Sector Units, Public Ltd. companies and also structured finance instruments.

What are the different types of instruments, which are normally traded in this market?

The instruments traded can be classified into the following segments based on the characteristics of the identity of the issuer of these securities:

What is the importance of the Debt Market to the economy?

The key role of the debt markets in the Indian Economy stems from the following reasons:

• Efficient mobilization and allocation of resources in the economy
• Financing the development activities of the Government
• Transmitting signals for implementation of the monetary policy

Facilitating liquidity management in tune with overall short term and long term objectives. Since the Government Securities are issued to meet the short term and long term financial needs of the government, they are not only used as instruments for raising debt, but have emerged as key instruments for internal debt management, monetary management and short term liquidity management. The returns earned on the government securities are normally taken as the benchmark rates of returns and are referred to as the risk free return in financial theory. The Risk Free rate obtained from the G-sec rates is often used to price the other non-govt. securities in the financial markets.

What are the benefits of an efficient Debt Market to the financial system and the economy?

• Reduction in the borrowing cost of the Government and enable mobilization of resources at a reasonable cost.
• Provide greater funding avenues to public-sector and private sector projects and reduce the pressure on institutional financing.
• Enhanced mobilization of resources by unlocking illiquid retail investments like gold.
• Development of heterogeneity of market participants.
• Assist in development of a reliable yield curve and the term structure of interest rates.

What are the different types of risks with regard to debt securities?

The following are the risks associated with debt securities:

Default Risk:

This can be defined as the risk that an issuer of a bond may be unable to make timely payment of interest or principal on a debt security or to otherwise comply with the provisions of a bond indenture and is also referred to as credit risk.

Interest Rate Risk:

Can be defined as the risk emerging from an adverse change in the interest rate prevalent in the market so as to affect the yield on the existing instruments. A good case would be an upswing in the prevailing interest rate scenario leading to a situation where the investors' money is locked at lower rates whereas if he had waited and invested in the changed interest rate scenario, he would have earned more.

Reinvestment Rate Risk:

Can be defined as the probability of a fall in the interest rate resulting in a lack of options to invest the interest received at regular intervals at higher rates at comparable rates in the market.

The following are the risks associated with trading in debt securities:

Counter Party Risk:

Is the normal risk associated with any transaction and refers to the failure or inability of the opposite party to the contract to deliver either the promised security or the sale-value at the time of settlement.

Price Risk:

Refers to the possibility of not being able to receive the expected price on any order due to a adverse movement in the prices.

Who regulates the fixed income markets?

The issue and trading of fixed income securities by each of these entities are regulated by different bodies in India. For eg: Government securities and issues by Banks, Institutions are regulated by the RBI. The issue of non-government securities comprising basically issues of Corporate Debt is regulated by SEBI.

What are the segments in the secondary debt market?

The segments in the secondary debt market based on the characteristics of the investors and the structure of the market are:

Wholesale Debt Market - where the investors are mostly Banks, Financial Institutions, the RBI, Primary Dealers, Insurance companies, MFs, Corporate and FIIs.

Retail Debt Market - involving participation by individual investors, provident funds, pension funds, private trusts, NBFCs and other legal entities in addition to the wholesale investor classes.

What is the structure of the Wholesale Debt Market?

The Debt Market is today in the nature of a negotiated deal market where most of the deals take place through telephones and are reported to the Exchange for confirmation. It is therefore in the nature of a wholesale market.

Who are the most prominent investors in the Wholesale Debt Market in India?

The Commercial Banks and the Financial Institutions are the most prominent participants in the Wholesale Debt Market in India. During the past few years, the investor base has been widened to include Co-operative Banks, Investment Institutions, cash rich corporate, Non-Banking Finance companies, Mutual Funds and high net-worth individuals. FIIs have also been permitted to invest 100% of their funds in the debt market, which is a significant increase from the earlier limit of 30%. The government also allowed in 1998-99 the FIIs to invest in T-bills with a view towards broad basing the investor base of the same.

What are the types of trades in the Wholesale Debt Market?

There are normally two types of transactions, which are executed in the Wholesale Debt Market:

• An outright sale or purchase and
• A Repo trade

What is a Repo trade and how is it different from a normal buy or sell transaction?

An outright Buy or sell transaction is a one where there is no intended reversal of the trade at the point of execution of the trade. The Buy or sell transaction is an independent trade and is in no way connected with any other trade at the same or a later point of time.

A Ready Forward Trade (which is normally referred to as a Repo trade or a Repurchase Agreement) is a transaction where the said trade is intended to be reversed at a later point of time at a rate which will include the interest component for the period between the two opposite legs of the transactions.

So in such a transaction, one participant sells securities to other with an agreement to purchase them back at a later date. The trade is called a Repo transaction from the point of view of the seller and it is called a Reverse Repo transaction from point of view of the buyer.

Repos therefore facilitate creation of liquidity by permitting the seller to avail of a specific sum of money (the value of the repo trade) for a certain period in lieu of payment of interest by way of the difference between the two prices of the two trades.

Repos and reverse repos are commonly used in the money markets as instruments of short-term liquidity management and can also be termed as a collateralized lending and borrowing mechanism. Banks and Financial Institutions usually enter into reverse repo transactions to manage their reserve requirements or to manage liquidity.

What is Yield?

Yield refers to the percentage rate of return paid on a stock in the form of dividends, or the effective rate of interest paid on a bond or note. There are many different kinds of yields depending on the investment scenario and the characteristics of the investment.

Yield To Maturity (YTM) is the most popular measure of yield in the Debt Markets and is the percentage rate of return paid on a bond, note or other fixed income security if you buy and hold the security till its maturity date.

Current Yield is the coupon divided by the Market Price and gives a fair approximation of the present yield.

Therefore, Current Yield = Coupon of the Security (in %) x Face Value of the Security (viz. 100 in case of G-Secs.)/Market Price of the Security

E.g.: Suppose the market price for a 10.18% G-Sec 2012 is Rs.120. The current yield on the security will be (0.1018 x 100)/120 = 8.48%

The yield on the government securities is influenced by various factors such as level of money supply in the economy, inflation, future interest rate expectations, borrowing program of the government & the monetary policy followed by the government.

Who are the participants in the Retail Debt Market?

The following are the main investor segments who could participate in the Retail Debt Market:

• Mutual Funds
• Provident Funds
• Pension Funds
• Private Trusts
• Religious Trusts and charitable organizations having large investible corpus
• State Level and District Level Co-operative Banks
• Housing Finance Companies
• NBFCs and RNBCs
• Corporate Treasuries
• Hindu-Undivided Families (HUFs)
• Individual Investors

What are the main points to be kept in mind by the investor while investing in the Debt Markets?

The main features which you need to check for any debt security is:

• Coupon (or the discount implied by the price as in the case of zero coupon bonds) and the frequency of interest payments. The securities can also be chosen in such a manner so that the interest payments coincide with any requirements of funds at that point of time.

• Timing of Cash Flows - In case the interest and redemption proceeds, at one single point or at different points of time, are planned to be used for meeting certain planned expenses in the future.

• Information about the Issuer and the Credit Rating - It is essential to obtain enough information about the background, the business operations, the financial position, the use of the funds being collected and the future projections to satisfy oneself of the suitability of the investment. As per the regulations in force in the capital markets, it is essential for any corporate debt security to obtain a credit rating from any of the major credit rating agencies. A proper analysis of the background and the financials of the issuer of any non-govt. debt instrument and especially the credit rating would lend greater safety to your investments.

• Other Terms of particular Issue - It is also advisable to check on certain terms of the issue like the use of the issue proceeds, the monitoring agency, the formation of trustees, the secured or unsecured nature of the bonds, the assets underlying the security and the credit-worthiness of the organization.

Most of the said information can be available from the prospectus of the said issue (In case of and any required and relevant details can also be obtained on demand from the lead manager of the issue:

• Obtain all the relevant knowledge on the debt security like the coupon, maturity, interest payments, put and call options (if any), Yield To Maturity (at the particular price at which the trade is intended to be carried out) and the Duration of the Instrument.

• Check the Yield To Maturity (YTM) of the debt security with the YTMs of other comparable debt securities of the same class and features.

• Remember that the Yield and the Price are inversely related. So, you will be able to obtain a higher yield at a lower price.

• It is desirable to check on the liquidity of any corporate debt instrument before investing in it so as to ensure the availability of satisfactory exit options.

The investor should be well aware of the set of risks associated with the Debt Markets like the default risk (non-receipt or delay in receipt of interest or principal), price risk, interest rate risk (risk of rates moving adversely after investment), settlement risk (or risk of non-delivery of securities and funds in the secondary market) and the re-investment risk (interest payments fetching a lower return when re-invested). Investors in the Debt Markets should follow a process of judicious investing after a careful study of the economic and money market condition, various instruments available for investment, the desired returns and its compatibility with existing investment opportunities, alternative modes available for investments and the relevant transaction costs.