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INDIAN BOND MARKET An Overview

INDIAN BOND MARKET An Overview. The Structure of the Indian Debt Market. Market Segment Issuers Instruments. The Sovereign Issuer. Central Govt. GOI dated securities, T/Bs, State Govt. securities, zero coupon bonds. State Govt. Govt. Agencies and Stat. Bodies.

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INDIAN BOND MARKET An Overview

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  1. INDIAN BOND MARKET An Overview www.pptmart.com

  2. The Structure of the Indian Debt Market • Market Segment Issuers Instruments The Sovereign Issuer Central Govt. GOI dated securities, T/Bs, State Govt. securities, zero coupon bonds State Govt Govt. Agencies and Stat. Bodies Govt. Guaranted Bonds The Public Sector PSUs PSU Bonds, CP Com. Banks/DFIs Certificate of deposit, Bond Debenture, CP, ZCBs, Floating rate Notes Corpotares The Private sector Pvt. Sect. banks Bonds, CPs, and CDs www.pptmart.com

  3. Security wise Distribution of trades on WDM in percentage terms www.pptmart.com

  4. The corporate bond market, in the sense of private corporate sector raising debt through public issuance in capital market, is only an insignificant part of the Indian debt market. • About 90 per cent of the private corporate sector debt has been raised through private placement in the recent past. www.pptmart.com

  5. TYPE OF DEBT INSTRUMENTS They may be classified into two groups according to maturity. Money Market Instruments: Maturity of one year or less than one year. Capital Market Instruments:Bonds (Debenture):Maturity of more than one year. www.pptmart.com

  6. MONEY MARKET INSTRUMENTS T/Bs: 91 days, 364 days T/B. They are sold at a discount and redeemed at par value. Yield rate is low; Risk free; Liquidity is very high, Secondary market is very active. (Discount and Finance House of India (DFHI) , and RBI play active role). Certificates of Deposit (CD):A negotiable receipt of funds deposited in a bank for a fixed period. CDs are sold at a discount and redeemed at par value. Interest rate is higher than T/B rates. www.pptmart.com

  7. Commercial Paper: Short-term unsecured promissory notes issued by firms (financially strong). Maturity period: 90-180 days. It is sold at a discount and redeemed at par. Interest rate of CP>Interest on CD> Interest on T/B. Secondary market is not developed. www.pptmart.com

  8. Capital Market Instruments: Bonds (Debenture) Straight Bond (Plain Vanilla Bond): The most popular bond. It pays a fixed periodic coupon over its life and return the principal on the maturity date. www.pptmart.com

  9. Zero Coupon Bonds: It is issued at a discount over its face value and redeemed at par on maturity. IDBI issued deep discount bond in 1996, face value Rs.2,00,000, maturity period 25 years, issued at Rs.5,300. Floating Rate Bond: Interest rate is linked to a benchmark rate such as T/B rate. www.pptmart.com

  10. Bonds with Options: Convertible Bonds: It gives the bond holder the right (Option) to convert into equity shares. Callable Bonds:It gives the issuer the right (Option) to redeem them pre-maturely on certain terms. Puttable Bonds:It gives the investor the right to pre-maturity sells them back to the issuer on certain terms. www.pptmart.com

  11. Market Design • Primary Market • Secondary Market www.pptmart.com

  12. Primary Market Government issues securities through the following modes • Issue of securities through auction • Issue of securities with pre-announced coupon rates • Issue of securities through tap sale. • Issue of securities in conversion of maturing T.Bs / dated securities www.pptmart.com

  13. Issue of securities through auction • The securities are issued through auction either on price basis or on yield basis. • Where the issue is on price basis, the coupon is predetermined and the bidders quote price per Rs 100 face value of the security, at which they desire to purchase the security. • Where the issue is on yield basis, the coupon of the security is decided in an auction and the security carries the same coupon till maturity. • On the basis of the bids received, RBI determines the maximum rate of yield or the minimum offer price as the case may be at which offers for purchase of securities would be accepted at the auction. www.pptmart.com

  14. Issue of securities with pre-announced coupon rates • The coupon on such securities is announced before the date of floatation and the securities are issued at par. In case the total subscription exceeds the aggregate amount offered for sale, RBI may make partial allotment to all the applicants. www.pptmart.com

  15. Issue of securities through tap sale. • No aggregate amount is indicated in the notification in respect of securities sold on tap. Sale of such securities may be extended to more than one day and the sale may be closed at any time on any day. www.pptmart.com

  16. Issue of securities in conversion of maturing T.Bs / dated securities • The holders of T/Bs of certain specified maturities and holders of specified dated securities are provided an option to convert their holding at specified prices into new securities offered for sale. The new securities could be issued on an auction / pre-announced coupon basis. www.pptmart.com

  17. Secondary Market • Most of the secondary markets trades in government securities are negotiated between participants (Banks, FIs, MFs) having SGL accounts with RBI. These may be negotiated directly between counter parties or negotiated through brokers. • Trades are executed on • Negotiated Dealing System (NDS) of RBI • Electronic platform of the Wholesale Debt Market Of NSE www.pptmart.com

  18. Constituent SGL Account • SGL stands for 'Subsidiary General Ledger' account. It is a facility provided by RBI to large banks and financial institutions to hold their investments in Government securities and Treasury bills in the electronic book-entry form. • As all investors in Government securities do not have an access to the SGL accounting system, RBI has permitted such investors to hold their securities in physical stock certificate form. www.pptmart.com

  19. Negotiated Dealing System (NDS) of RBI • NDS facilitates screen based negotiated dealing for secondary market transactions in government securities and money market instruments. www.pptmart.com

  20. Wholesale Debt Market (WDM) of NSE • WDM segment of NSE has been providing a platform for trading of a wide range of debt securities. • The WDM trading system, known as NEAT (National Exchange for Automated Trading), is a fully automated screen based trading system, which enables members across the country to trade simultaneously with enormous ease and efficiency. www.pptmart.com

  21. Trading system provides two market sub-types: continuous market and negotiated market • In continuous market, the buyer and seller do not know each other and they put their best buy/sell orders, which are stored in order book with price / time priority. If the order match, it results into a trade. • In the negotiated market, the trades are normally decided by the seller and the buyer outside the exchange, and reported to the Exchange through the broker. Thus deals negotiated outside the exchange are disclosed to the market through NEAT-WDM system. www.pptmart.com

  22. BOND VALUATION Coupon Rate: It is the nominal rate of interest fixed and printed on the bond certificate. Current Yield: A bond of face value Rs.100 may be selling at a discount, at say Rs.80 or may be selling at a premium Rs.120. If the coupon rate is 12%, Current Yield = 12/80 x 100 = 15% (sell at discount) or 12/120 x 100 = 10% (sell at premium) The current yield would be higher than the coupon rate when the bond is selling at a discount. Current yield would be lower than the coupon rate for a bond selling at a premium. www.pptmart.com

  23. Zero Coupon Bond: Zero coupon bond is a special type of bond which does not pay annual interest. The return on this bond is in the form of a discount on issue of the bond. For example, a 3 month treasury bills of face value Rs.100 may be issued at a discount for Rs.97. The investor who purchases this bond for Rs.97 would receive Rs.100 three months later. This type of bond is also called Pure Discount Bond or Deep Discount Bond. www.pptmart.com

  24. Spot interest rate. The return received from a zero coupon bond or a pure discount bond expressed on an annualized basis is the spot interest rate. In the above example, the spot interest rate: = (100 - 97)/97 x 4 x 100 = (3 x 4)/97 x 100 = 12.37 www.pptmart.com

  25. Mathematically, the spot interest rate is the discount rate that makes the present value of the single cash inflow to the investor equal to the cost of the bond. Thus, in the case of a two year bond of face value Rs.1,000, issued at a discount for Rs.797.19, the spot interest rate is calculated as follows: 797.19 = 1000/(1+k)2 or (1+k)2 = 1000/797.19 = 1.2544 (1+k) = 1.2544 = 1.12 or k = 0.12 or 12% The spot interest rate is 12% per annum. www.pptmart.com

  26. Yield to Maturity (YTM): This is the most widely used measure of return on bonds. It is the internal rate of return earned from holding a bond till maturity. YTM is the discount rate that makes the present value of cash inflows from the bond equal to the cash outflow for purchasing the bond. The relation between the cash outflow, the cash inflow and the YTM of a bond can be expressed as: n Ct TV MP =  -------------------- + ------------------------ t=1 (1+YTM)t (1+YTM)n Where, MP = Current market price of the bond Ct = Cash inflow from the bond throughout the holding period. TV = The terminal cash inflow received at the end of the holding period. www.pptmart.com

  27. Example I: Let us consider a bond of face value of Rs.1,000 and a coupon rate of 15%. The current market price of the bond is Rs.900. Five years remain to maturity and the bond is repaid at par. Then: 5 150 1000 900 =  -------------------- + ------------------------ t=1 (1+Y)t (1+Y)5 Since, the market price is lower than the face value, it indicates that Y would be higher than the coupon rate. let Y = 20% at 20% , PV annuity factor = 2.9906 at 20%, PV factor at 5th year = 0.4019 www.pptmart.com

  28. Therefore, PV = 150 x 2.9906 + 1000 x 0.4019 = 448.59 + 401.90 = Rs.850.49 Since the value obtained < market price, a lower discount rate has to be tried. If Y = 18% at Y = 18% PV = 150 x 3.1272 + 1000 x 0.4371 = 469.08 + 437.1 = 906.18 The value obtained is higher than the required amount of Rs.900. Hence, Y lies between 18% and 20%. (906.18 - 900) Thus, Y = 18% + --------------------------------- x (20-18) (906.18 - 850.49) = 18% + [(6.18/55.69) x 2] = 18% + 0.22 = 18.22% www.pptmart.com

  29. Example: II If, MP = 1000 TV = 1000 Y = 20% Ct = 200 (Interest rate 20%) 5 200 1000 1000 =  -------------------- + ------------------------ t=1 (1+Y)t (1+Y)5 = 200 x 2.9906 + 1000 x 0.4019 = 598.12 + 401.9 = 1000.02 Therefore, Y = 20% (at 20% PV of an annuity for 5 years = 2.9906 and PV of Re 1 received at the end of 5th year = 0.4019) www.pptmart.com

  30. Bond Pricing and Yield Rate: The interest rate for a given time interval is called the short interest rate for that period. Suppose that all participants in the bond market are convinced that the short rates for the next four years will follow the pattern in the following table. Table 1: Interest rate on one year bonds in coming year Year Interest Rate (ri) 1 (Today) 8% 2 10% 3 11% 4 11% Given this pattern of rates, what prices might we observe on various maturity bonds? www.pptmart.com

  31. A zero coupon bond paying Rs.1000 in one year would sell today for Rs.1000/1.08 = Rs.925.93. Similarly, a two year maturity bond would sell today at price P = 1000/[(1.08) ( 1.1)] = Rs.841.75 This is nothing but the present value of the future today. www.pptmart.com

  32. In general we may write the present value of Re1 to be received after n periods as PV = 1/[(1+r1) (1+r2) ……… (1+rn) where, ri is the one year interest rate that will prevail in year i. Continuing in this manner, we find the values of the three and four year bonds as shown in the middle column of Table 2. www.pptmart.com

  33. Table 2: Prices and Yields of Zero-Coupon Bonds Time to Maturity Price (Rs.) Yield to Maturity 1 925.93 8.00% 2 841.75 8.995% 3 758.33 9.660% 4 683.18 9.993% From the bond price we can calculate the yield to maturity on each bond. The yield is the single interest rate that equates the present value of the bond’s payment to the bond’s price. Yield on one year zero coupon bond: 925.93 = 1000/(1+Y1) = 1000/1.08 or Y1 = 0.08 www.pptmart.com

  34. Yield on two year zero coupon bond 841.75 = 1000/(1+Y2)2 = 1000/[(1+r1) (1+r2)] or (1+Y2) = [(1+r1) (1+r2)] = [(1+r1) (1+r2)]1/2 or Y2 = [(1+r1) (1+r2)]1/2 - 1 We repeat the process for the two other bonds, with results as reported in the above table. www.pptmart.com

  35. When the yield rates are plotted against different maturity of the bond, in the following figure, we get the yield curve. • Yield Rate • Yield curve • Maturity • Figure 1: Yield Curve www.pptmart.com

  36. Figure-2(a) shows a positively sloped yield curve This yield curve indicates that borrowers who wish to borrow for long periods of time pay a higher rate of interest than medium-term borrowers who in turn pay, higher rate of interest than short-term borrowers. www.pptmart.com

  37. Figure-2(b) shows a negatively sloped yield curve • This indicates that borrowers who wish to borrow in short-term pay a higher rate of interest than short-term borrowers. www.pptmart.com

  38. Figure-2(c ) depicts a hump shaped yield curve Borrowers that borrow medium terms paying higher interest than those that borrow short-term or long-term. www.pptmart.com

  39. Figure-2(d) depicts a relatively flat yield curve with Borrowers at the short, medium and long term all borrowing at approximately the same rate of interest. www.pptmart.com

  40. Spot rate • The yield to maturity on zero-coupon bonds is sometimes called the spot rate that prevails today for a period corresponding to the maturity of the zero coupon bond. • The yield curve, or, equivalently, the last column of Table 2, thus presents the spot rates for four maturities. • Note that the spot rates, or yields to maturity, do not equal the 1-year interest rates for each year. www.pptmart.com

  41. Bond Stripping and Pricing of Coupon Bonds • Consider a 3-year bond with par value Rs1,000, paying an annual coupon rate of 8%. • Using the spot rates from table 2, the price of this bond is • P = 80/(1.08) + 80/(1.08995)2+ 1080/(1.09660)3 • = Rs960.41 www.pptmart.com

  42. In other words, we can treat each of the bond’s payments as in effect a stand-alone zero-coupon security that can be valued independently. The total value of the bond is just the sum of the values of each of its cash flows. • Here the strips have been created by breaking down the bond’s coupons and ultimate repayment of par value into a series of independent zero-coupon bonds. www.pptmart.com

  43. Holding-Period Return • What is the rate of return on each of the four bonds in table 2 over 1-year holding period? • In our simple world with no uncertainty all bonds must offer identical rates of return over any holding period. www.pptmart.com

  44. Holding period return on Zero-Coupon Bonds • The 1-year bond is bought today for Rs925.93 and matures in 1 year to its par value of Rs1000. • Thus the rate of return = (1,000-925.93)/925.93 • = 74.07/925.93 = .08 = 8% www.pptmart.com

  45. The 2-year bond is bought today for Rs841.75. • Next year the interest rate will be 10%, and the bond will have 1 year left to mature. • It will then sell for Rs1000/1.10 = Rs909.09. • Thus the holding period return= • 909.09-841.75/841.75 = .08 = 8%. www.pptmart.com

  46. Similarly the 3-year bond will be purchased for Rs758.33 and will be sold at year end for Rs1,000/(1.10)(1.11) = Rs819 for a rate of return = (819-758.33) /758.33 = .08 =8% • When interest rate movements are known with certainty, and all bonds are properly priced, all will provide with equal 1-year rates of return. www.pptmart.com

  47. Forward Rates • Suppose we are interested in interest rate that will prevail during year 3, and we have access only to the data in Table 2. • Table 2: Prices and Yields of Zero-Coupon Bonds • Time to Maturity Price (Rs.) YTM • 1 925.93 8.00% • 2 841.75 8.995% • 3 758.33 9.660% • 4 683.18 9.993% www.pptmart.com

  48. We start by comparing two alternatives: • Invest in a 3 year zero-coupon bond. • Invest in a 2-year zero-coupon. After 2 years reinvest the proceeds in a 1-year bond www.pptmart.com

  49. Assuming an investment of Rs100, under strategy 1, with YTM of 9.66% on 3-year zero-coupon bonds,our investment would grow to 100(1.0966)3=Rs131.87. Under strategy 2, Rs100 would grow after 2 years to Rs100(1.08995)2 = Rs118.80. Then in the third year it would grow by an additional factor of 1+r3. www.pptmart.com

  50. In a world of certainty both of these strategies must yield exactly the same final payoff. WHY? • Thus, • Rs131.87 = Rs118.80(1+r3) • Or (1+r3) = 1.11 or r3=11% • This is in fact the rate that will prevail in year 3, as Table 1 indicates. www.pptmart.com

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