Introduction to Government Bond, Corporate Bond and Money Markets

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1 Introduction to Government Bond, Corporate Bond and Money Markets Fixed income market in India can be categorized into five segments, Money Market, Government Bond Market, Corporate Bond Market, Interest Rate Derivative Market and Credit Derivative Market. The markets cover different types of issuers and the tenors of the instruments traded. The primary characteristics of Government Bond, Corporate Bond and Money Market are outlined. Government Bond Market in India Fixed income securities issued by the Government of India and by State Governments in India are traded in the government bond market. The tenor of the securities traded varies from one year to thirty years. The RBI regulates the government bond market. Bonds issued by the Government of India are called GOI (Government of India) bonds and bonds issued by State Governments are called State Development Loans (SDL). The traded yields on GOI bonds are the benchmark yields for all other bonds including SDLs. GOI bonds are deemed risk free, as the Government of India will not default on its local currency obligations. All other bonds including SDL carried credit risk or risk of default. The Government of India is the single largest borrower in the country. The government runs a fiscal deficit where expenditure is higher than revenues and the resultant deficit is financed by the government issuing bonds to investors. Government has a captive investor base for its bonds. Banks have to compulsorily invest a percentage of their net deposits in bonds issued by the government. Insurance companies and pension and provident funds are required by law to invest in government bonds. The RBI (Reserve Bank of India) manages the government debt issue and also regulates and manages the government bond market. RBI appoints Primary Dealers (PDs) to underwrite government bond issuances. PDs bring in investors to invest in government bonds and this process ensures that all government bond issues are fully subscribed. The government bond market is largely accessible to the institutional segment of the market and retail investors access to the market is indirect through mutual funds. The RBI, which runs and regulates the market, is selective in its approach to give electronic trading platforms. The electronic bond trading platform NDS-OM (Negotiated Dealing Screen-Order Matching) is given only to institutional participants in the market. Hence unlike equity screens given by NSE or BSE, only a few have access to the NDS-OM screen. Government bond trades are settled through a centralized clearing system run by the CCIL (Clearing Corporation of India Limited). Trades are settled on a T+1 basis.

2 Government bonds also trade off the screen through telephones. Telephonic trades are settled on a NDS (Negotiated Dealing System) platform run by the RBI. Telephonic trades are settled on a T+1 basis. Government bonds are also traded on stock exchanges in India. Volumes in the government bond market average around Rs crores to Rs 20,000 crores on a daily basis when market sentiment is negative. Volumes average Rs 45,000 crores to Rs 50,000 crores when market sentiment is positive. Liquidity in government bonds is high as government bonds can be used as collateral for borrowing funds from the RBI. Government issues bonds through government bond auctions. PDs underwrite the bond auctions and they bid in each bond auction at market prices/yields. Government bond auctions are conducted on a regular (weekly, fortnightly) basis depending on the size of the total government borrowing program for a fiscal year (April-March). The government and the RBI consult with each other on the schedule of the government borrowing program. The RBI releases a borrowing calendar at the beginning of each fiscal year, which give details of the schedule of government borrowing for one half year. The second calendar is released on the completion of the first half borrowing. Corporate Bond Market in India Fixed income securities that are issued by public and private sector companies are traded in the corporate bond market. The corporate bond market is regulated by SEBI (Securities Exchange Board of India). Corporate bond issuers include government owned companies. Corporate bonds carry credit risk. Corporate bond tenors vary from one year to fifteen years. There are banks that issue perpetual bonds but these come with options to redeem the bonds at an earlier date by the issuer. The credit rating of corporate bonds traded in the corporate bond market varies from highest safety to default category. Corporate bonds are priced off the government bond yield curve. Corporate bonds are listed on the stock exchanges in India. The corporate bond market is the only market that is not electronically traded though technically electronic trading is available on the stock exchange platform. It is largely a telephonic market where buyers and sellers conclude trades over the telephone with or without the services of a debt market broker. The concluded trades are reported on the BSE (Bombay Stock Exchange) or NSE (National Stock Exchange) stock exchange and are settled through a centralised clearing system, which is the NSDL (National Securities Depository Limited run by the NSE) and the CDSL (Central Depository Securities Limited run by the BSE). The trades are settled on a T+1 or T+2 basis. Except for the telephonic trading, the settlement is similar to equity and government bond settlement. Corporate bonds are held in electronic form in Demat accounts. The market is regulated by SEBI. Corporate bonds in India are rated by credit rating agencies and are listed on the NSE or BSE. It is not necessary for corporate bonds to be rated and listed but as investors prefer to buy rated and listed bonds rather than unrated and unlisted bonds, most of the issuers go in for rating and listing. Unrated and unlisted bonds carry higher interest rates due to lack of liquidity and it proves to be expensive for issuers to issue unrated and unlisted bonds.

3 There are four established and well recognised rating agencies in India. They are CRISIL, ICRA, CARE and Fitch. Other rating agencies include Brickworks and India Ratings and Research. The rating agencies rate bonds as per the standard rating scales from AAA to D. Issuers go in for dual rating of corporate bonds i.e. ratings by two rating agencies as many investors including the provident funds require dual rating to invest in corporate bonds. Corporate bonds in India have annual coupons rather than semiannual coupons. Corporate bonds are traded on yield terms rather than price terms. On the other hand government bonds carry semiannual coupons and are traded on price terms. Trading in corporate bonds is largely restricted to AAA to AA issuers (almost 95% of traded volumes). There is very low trading in issuers below AA. Issuers who have rating of below AA go to banks to borrow in the form of loans. Corporate bond trading volumes are just about 10% of government bond trading volumes and the market is dwarfed by the government bond market. Government owned institutions such as IRFC (Indian Railway Finance Corporation), REC (Rural Electrification Corporation), PFC (Power Finance Corporation) and banks including SBI (State Bank of India), PNB (Punjab National Bank), BOI (Bank of India) etc are prominent issuers of corporate bonds. All these entities are rated AAA by rating agencies. The private sector issuers include Reliance, L&T, Tata Motors and HDFC. The ratings of these issuers are AAA except for Tata Motors which is AA-. Non Banking Finance Companies (NBFC) are active issuers of bonds as the bond market is an important source of funding for these companies. The investors in corporate bonds include mutual funds, provident and pension funds, insurance companies, banks, primary dealers, FIIs and corporate entities. Retail participation in the corporate bond market is negligible. Money Market in India The money market trades all instruments that are less than 365 days in maturity. The tenors traded vary from one day to 364 days and instruments traded include inter bank borrowing and lending, treasury bills (T-bill), commercial papers (CP), certificate of deposits (CD), bills rediscounting scheme (BRDS) and corporate debentures (Non Convertible Debentures or NCDs) with less than 365 day maturity. The inter bank borrowing and lending instruments include overnight call money, term money, Repo (Repurchase Agreement) and CBLO (Collateralized Borrowing and Lending). Treasury bills, Repo and CBLO are risk free instruments while all other money market instruments carry credit risk. The money market is regulated by the RBI (Reserve Bank of India) The Money market securities are issued at a discount to face value and carry no coupon. Money market securities issued by governments are called treasury bills (T-Bills) while money market securities issued by banks are called Certificate of Deposits (CDs). Money market securities issued by corporates are called Commercial Papers (CPs). Apart from the nature of the issuer, there is no difference between T-bills, CDs and CPs in terms of pricing.

4 Treasury bills The Government of India (GOI) issues treasury bills (T-Bills) in maturities of 91 days, 182 days and 364 days. T-Bills qualify for SLR (Statutory Liquidity Ratio), where banks are required to maintain a certain minimum percentage of their aggregate deposits in government securities. T-Bills are traded on the NDS (Negotiated Dealing System) electronic trading platform, over telephone and on stock exchanges and are settled on a T+1 basis. T-Bills are issued at a discount to face value. Commercial Papers and Certificate of Deposits Commercial Papers (CPs) are money market securities issued by non bank entities. CPs can have maturities of 7 days to one year. CPs carry credit risk given that the issuers can default on their obligations to debt holders. CPs are traded in the voice market i.e. CPs are bought and sold by counterparties by closing trades over the telephone. CPs are settled on a T+0 or T+1 basis. CP trades are reported on a reporting platform run by the Fixed Income Money Market Dealers Association (FIMMDA) or are reported to the stock exchanges. CP trades are settled by clearing houses. Certificate of Deposits (CDs) are securities issued by banks or financial institutions permitted by the RBI to issue CDs. CDs issued by banks are money market securities with maturity of seven days to one year. Financial institutions can issues CDs of maturity of one year to three years and such CDs can also be issued on a floating rate basis. CDs are bought and sold by counterparties by closing trades over the telephone. CDs are settled on a T+0 or T+1 basis. CD trades are reported on a reporting platform run by the FIMMDA or are reported to the stock exchanges. CD trades are settled by clearing houses. Interest Rate Derivative Market in India Interest rate derivatives (IRD) are priced off the government bond yield curve or the money market yield curve. The most prominent IRD market is the Interest Rate Swap (IRS) market. The IRS is priced off the overnight call money benchmark and is called the OIS (Overnight Index Swap). The OIS is traded on an OTC (Over the Counter) platform and the market comes under the purview of the RBI. The OIS tenor varies from one month to ten years. The other IRDs include CMT (Constant Maturity Swap), INBMK swaps or swaps priced off the government bond yield curve and FRA (Forward Rate Agreement). The Interest Rate Futures (IRF) market is traded on the Stock Exchanges. The IRF market is regulated by SEBI and tenors vary from three months to ten years. Credit Derivative Market

5 The CDS (Credit Default Swap) market is technically active in India but there has been no trading in this market. The market is yet to come to terms with the CDS regulations. Participants of the Fixed Income Market in India The participants in the fixed income market include banks, primary dealers (PDs), insurance companies, mutual funds, non banking finance companies (NBFC), development institutions, foreign institutional investors (FII), pension and provident funds, trusts and public and private sector companies. There is very low individual investor participation as the market lot is typically Rs 50 million (Rs 5 crores). The lack of individual investor participation limits the depth of the market and hence fixed income market in India has not taken off as well as equity markets, which see large scale individual investor participation. Arjun Parthasarathy is dedicating his experience of over twenty years in financial markets to guide investors to the path of informed decision making on their investments. The more informed the investor, the more money the investor will make is the guiding principle of Arjun. The fact that he has worked across markets including equities, interest rates, credits and currencies and across market platforms of fund management, proprietary trading and research, gives Arjun the extra edge that is required to guide investors to make the right investments in the globalized nature of markets

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