UNDERSTANDING DEBT MARKETS

What is the Debt Market?

The Debt Market is the market Where fixed income securities of various types and features are issued and traded

Securities Issued by:

Central and State Governments, Municipal Corporations, Govt. bodies Financial Institutions Banks Public Sector Units Public Ltd. companies Structured Finance Instruments

What is the Money Market?

Money market instruments are fixed income instruments, generally having maturity less than 1 year and are discounted instruments.

The Money

Market is basically concerned with the issue and trading of securities with short term maturities or quasi-money instruments

Basic of Debt Market

Why should one invest in Fixed Income Securities?

Fixed Income securities offer a predictable stream of payments by way of interest and repayment ofprincipal at the maturity of the instrument. The debt securities are issued by the eligible entitiesagainst the moneys borrowed by them from the investors in these instruments. Therefore, most debtsecurities carry a fixed charge on the assets of the entity and generally enjoy a reasonable degree ofsafety by way of the security of the fixed and/or movable assets of the company.

The investors benefit by investing in fixed income securities as they preserve and increasetheir invested capital and also ensure the receipt of regular interest income.

The investors can even neutralize the default risk on their investments by investing in Govt.securities, which are normally referred to as risk-free investments due to the sovereignguarantee on these instruments.

The prices of Debt securities display a lower average volatility as compared to the prices ofother financial securities and ensure the greater safety of accompanying investments.

Debt securities enable wide-based and efficient portfolio diversification and thus assist inportfolio risk-mitigation.

Basic of Debt Market

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 return sand are referred to as the risk free return in financial theory. The Risk Free rate obtained from the G-sec rates are often used to price the other non-govt. securities in the financial markets.

Importance of Debt markets to the economy

Debt instruments represent contracts whereby one party lends money to another on pre-determined terms with regard to rate of interest to be paid by the borrower to the lender, the periodicity of the said interest payment, and the repayment of the principal amount borrowed

Key Features of a Debt instrument

Coupon Zero Coupon Bonds Treasury STRIPS Floating Rate Bonds Deferred Interest Bonds Step-up Bonds Extendible Reset Bond

Maturity Callable Bonds Putable Bonds Convertible Bonds

Principal Amortising Bonds Bonds with Sinking Funds

What are debt Instruments?

Government Securities

Corporate Bonds

Money Market

Segments in the Debt Market

FINANCIAL MARKET

MONEY MARKET

DEBT MARKET

FOREX MARKET

CAPITAL MARKET

G-SECS BONDS

Corporate Securities

PSU BONDS

FIBONDS

STATE Govt.

CENTRALGovt.

T-BILLSCALL / NOTICE TERMS MONEY CD ICD CP REPOCOMMERCIAL

BILL

Participants and Products in the Debt Markets

Market Segment Issuer Instruments Government Securities

Public Sector Bonds

Public Sector Bonds

Private Sector Bonds

Private Sector Bonds

Central Government

State Government Government Agencies / Statutory Bodies

Public Sector Units

Corporates

Banks

Financial Institutions

Zero Coupon Bonds, Coupon Bearing Bonds, Treasure Bills, STRIPS

Coupon Bearing Bonds.

Govt. Guaranteed Bonds, Debentures

PSU Bonds, Debentures, Commercial Paper

Debentures , Bonds, Commercial Paper, Floating Rate Bonds. Zero CouponBonds, Inter-Corporate Deposits

Certificates of Deposits, Debentures, Bonds

Certificates of Deposits, Bonds

Participants and Products in the Debt Markets

Borrowing by Government of India Categorised as Sovereign Debt thus ZERO Credit Risk Normally available with maturities of 1 yrs to 30 yrsRBI announces the auction of government securities through a press notification, and invites bids.Choices of Treasury Auctions

Discriminatory Price Auctions (French) Uniform Price Auction (Dutch)

Price Based Auction

Yield Based Auction

SGL Accounts*

Constituent SGL Accounts

**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. They may also open a Constituent SGL account with any entity authorised by RBI for this purpose and thus avail of the DVP settlement. Such client accounts are referred to as Constituent SGL accounts.

Long Term (> 1 year) Debt Products Used by Long Term Debt/Income Funds

Government Securities (GSec)

The market for long term corporate debt has two large segments:

Bonds issued by public sector units, including public financial institutions, and Bonds issued by the private corporate sector

Long Term (> 1 year) Debt Products Used by Long Term Debt/Income Funds

Corporate Debt Market

Credit rating is primarily intended to systematically measure credit risk arising from transactions between lender and borrower.

Credit risk is the risk of a financial loss arising from the inability (known in credit parlance as default) of the borrower to meet the financial obligations towards its creditor

Credit Ratings

Independent Opinion on credit worthiness of an issuer, awarded by a registered credit rating agency.Both Quantitative and qualitative researchOnly credit opinions, no guaranteesCan be different grades by different agenciesCredit Rating agency appointed by the issuerAdvantages of Credit rating

Issuer:-Widen investor base Lower cost of funds Higher financial flexibility

Investor Independent assessment of credit worthiness Improved liquidity of the paper help in valuing a security

Credit Ratings

In India, it is mandatory for credit rating agencies to register themselves with SEBI and abide by the SEBI (Credit Rating) Regulations, 1999.

There are 4 SEBI registered credit rating agencies in India, namely:

CRISILLong Term: AAA to DShort term: P1+ to P5

ICRA Long term: LAAA to LDShort term: A1+ to A5

Fitch Long term: AAA to DShort term: F1+ to F5

CARELong term: CARE AAA to CARE DShort term: PR1+ to PR5

Credit Rating

High Investment Grades AAA (Triple A) Highest Safety AA (Double A) High Safety

Investment Grades A Adequate Safety Changes in circumstances can adversely impact

such issue more than higher rated issues BBB (Triple B) Moderate Safety changing circumstances are likely to

lead to weakened capacity

Speculative Grades BB (Double B) Inadequate Safety B -High Risk C Substantial Risk D Default

Credit rating from CRISIL (An example)

What is Commercial Paper (CPs)?

Short-term instrument (less than 12 months), introduced in 1990, to enable non banking companies to borrow short-term funds through liquid money market instruments.

Intended to be part of the working capital finance for a corporate

Mandatory for CPsto be credit rated

What are Certificates of Deposit (CDs)?

Short-term borrowings by banks (Less than 12 months)

Rates are higher than the term deposit rates on account of low costs for bulk mobilization as compared to retail deposits

CPs and CDs

REPOS are better known as Repurchase Agreements, a sale & a Repurchase Agreement has a borrower sell securities for cash to a lender and agree to repurchase to repurchase those securities at a later date for more cash. A reporters the difference between borrowed and paid back cash expressed as a percentage

In Indian Financial System, RBI accepts approved securities from member banks in exchange for cash at a predefined rate called the repo rate. REPO rate thus is the rate at which RBI lends to banks in exchange for securities

Repos are popular because they can virtually eliminate credit problems

Reverse-Repoby the central banks acts as a floor to call money market

Repo and reverse-repo together become corridor for call money market

Worldwide Central Bankers use Repost manage Money Supply in the economy

What are REPOs?

Difference between cash given by RBI & received back is Repo Rate

Repo Transaction

Collateralized Borrowing & Lending Obligation (CBLO) -Money market instrument approved by RBI

Developed by CCIL (Clearing Corporation of India Ltd.) for the benefit of the entities who have either been phased out from inter bank call money market or have been given restricted participation

CBLO is a discounted instrument available in electronic book entry form for the maturity period ranging from 1 day to 90 Days (as per RBI guidelines can be uptoa year).

Dealing System through:

Indian Financial Network (INFINET), a closed user group to the Members of the Negotiated Dealing System (NDS) who maintain Current account with RBI.

Internet gateway for other entities who do not maintain Current account with RBI.

What are CBLOs?

Mutual Funds are major lenders

Primary Dealers are major borrowers

Transaction Denomination INR 5 M

Auction basis Discount rate & Maturity

Unlike REPO, lenders here can call their funds and borrowers can repay before maturity by unwinding their position

Participants Banks, MFs, Co-operative Banks, FIs, Insurance Companies, NBFCs, Corporate, Provident/Pension Funds

CBLOContinued

Short-term debt instruments issued by the Central government.

Currently 3 types of T-bills are issued, 91-day, 182 -day and 364-day.

Sold through an auction at a discount to face value

What are T-Bills?

BOND VALUATION

Fundamentals of Valuation

The valuation model

Principal Amount = Rs.100000

Coupon = 12% p.a.

Installment = Annual

Maturity (n) = 5 yrs

Present Interest rate in the market / Discount Rate(r)= 8% p.a.

Present Value of Cash flow over 5 Years of this Bond = 12000/((1+8%)^1 + 12000/(1+8%)^2.(12000+100000)/(1+8%)^5

Present Value of all Cash flow of this bond = 1,15,970.80

Bond Valuation An Example

Frequently used terms in debt

Markets

Yield

Yield to Maturity (YTM)

Yield Curve

Spread

Duration

Modified duration

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

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

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 Eg: 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

Yield

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

Yield to maturity on a bond is also called the Internal Rate of Return (IRR)

The calculation for YTM is based on the coupon rate, length of time to maturity and market price. It is the Internal Rate of Return on the bond and can be determined by equating the sum of the cash-flows throughout the life of the bond to zero. A critical assumption underlying the YTM is that the coupon interest paid over the life of the bond is assumed to be reinvested at the same rate

The YTM is basically obtained through a trial and error method by determining the value of the entire range of cash-flows for the possible range of YTMsso as to find the one rate at which the cash-flows sum up to zero.

Yield To Maturity

A G-Sec -8.00% GOI Loan 2010 with only 2 cash flows remaining to maturity as under:

Maturity Date: 30th January 2010

Interest Payment Dates: 30th January, 30th July

and trading currently at Rs. 115 for 1 Unit, will have a YTM as follows:

Settlement Date: 17th March 2009 (Date at which ownership is transferred to the Buyer)

Frequency of Interest Payments: 2

Day Count Convention: 30/360 (which in MS-EXCEL is taken as Basis 4)

Yield To Maturity: 4.8626%

The same can be computed from MS-EXCEL through the YIELD Formula by input of the parameters given above. It can be checked by discounting the said cash-flows, i.e., the two coupons of Rs. 8.00 each and the principal repayment of Rs.100/-from the interest payment dates and maturity dates to the date of settlement

Yield to Maturity Sample Calculation

The graphical depiction of the relationship between the interest rates (or yields) on bonds of the same credit quality and different maturities is known as the yield curve

In other words, the yield curve is a depiction of debt market interest rates across maturities, with time being plotted on the X-axis and yields on the Y-axis. The curve graphically demonstrates the rate at which market participants are willing to transact debt capital for short-term, medium-term and long-term periods

The yield curve is generally upward sloping indicating that investors demand a premium for holding securities for a longer period of time.

Yield Curve

Types of yield curveNormal CurveFlat CurveInverted Curve

Yield Curve

The difference between the yield on a corporate bond and government bond is called the credit spread( Also called the yield spread)

Credit Spread

Movement in Credit Spreads of 10 Y AAA Corp Bond V/s 10 Y Govt. Bond10Y

Duration is the weighted average term to maturity

Duration of a bond is less than its maturityexcept for zero coupon bond

Duration is longer the longer the maturityexcept for deep discount bonds

As YTM increases, duration decreases

Duration

The modified duration of a bond measures the percentage change in its price for a given change in interest rates or yields

Modified Duration = Duration/ (1+ytm)

Modified duration measures the risk of the bond with respect to changes in the yield, in other words it is the price risk of the bond with a unit change in yield, in general longer duration bonds carry more price risk for a given change in yield and vice versa

Modified Duration

The basic bond valuation equation shows that the yield and price are inversely related

This relationship is however, not uniform for all bonds, nor is it symmetrical for increases and decreases in yield, by the same quantum

Price-yield relationship between bonds is not a straight line, but is convex.

The sensitivity of price to changes in yield in not uniform across bonds.

Higher the term to maturity of the bond, greater the price sensitivity.

Lower the coupon, higher the price sensitivity. Other things remaining the same, bonds with higher coupon exhibit lower price sensitivity than bonds with lower coupons.

Price-Yield relationship in Bonds A few pointers

Price-Yield relationship in Bonds Graphical Representation Price / Yield Graph (10Y Govt Security)

Overall Return = Interest return + Capital return due to change in interest rates

In a falling interest rate scenario, the overall returns would be high and vice versa in a rising interest rate scenario.

In a falling interest rate scenario, the overall returns would depend on the duration of the bond and the current yield of the bond

Calculation of return from debt instruments

Volatility due to change in Interest rate Change in Bond Price vs Duration for 1% Yield Change-

About Pass Through Certificates (PTCs)

When certain financial asset classes (retail or corporate) are pooled together and undivided interest in the pool is sold, pass-through securities are created

The term 'undivided interest' means that each holder of the security has a proportionate interest in each cash flow generated by the poolThe pass-through securities assure that cash flow from the underlying asset classes would

be passed through to the holders of the securities in the form of regular payments of interest and principal

The entity selling the receivables (also usually the originating entity) to the Trust is called the Originator' and the entity which has borrowed the funds and is responsible for repayment is the obligor

Nature of a Typical PTC transaction:First, a special purpose vehicle (SPV) is created, to de-link the pool assets (cash flows) from the

company that wants to securitise(the `originator'). The SPV is usually a trust and has no borrowings of its own

The SPV then issues tradable debt instruments called `pass through certificates' and sells them to potential investors. Proceeds from the sale of PTCsare then utilized by the SPV to purchase/ buy-out the asset pools from the Originator

In a typical securitization deal, assets in the pool include auto loans, Commercial vehicle (CV) and construction equipment (CE) loans, personal loans OR single corporate loans

Since the SPV is a set up as a bankruptcy remote entity, it is not impacted by bankruptcy of the originator

Background

Schematic Representation of a PTC Transaction

The PTC market in India can be broadly segregated into two categories vizSingle corporate loans. Herein, a loan given by an originator (Bank/ NBFC/ FI etc.) to a single entity (obligor) is converted into pass through certificates and sold to end investors Retail asset pools comprising multiple borrowers and asset classes such as Personal loans, Credit Card receivables, Construction Equipments, Commercial Vehicles, passenger cars and two wheelers

Difference between Retail pool PTC transactions different from Single Loan PTCsUnlike single loan sell-downs, the retail asset pools comprise several different borrowers within multiple asset classes. A transaction may involve either a single asset class (such as CVs or CEs) or a composite pool comprising multiple asset classes In retail pool transactions, the exposure is towards several small ticket borrowers and hence the methodology of analysis (explained later) is different from that followed for single loan PTCs, wherein the exposure is on the corporate borrower Retail pool PTCs in majority of the cases are rated the highest (i.e. AAA) owing to the stipulation of a cash collateral, unlike single loan PTCs, wherein the rating is mostly the same as the stand-alone rating (in the absence of any credit enhancement) enjoyed by the issuer on other instruments such as debentures and bonds

Different Types of PTC transactions

All PTCs are rated by one of the four accredited rating agencies in the country

The rating is based on the financial strength of the obligor, as the end-investors have no recourse to the originator of the loans

Effectively the rating on the PTCs represents the stand-alone credit risk of the obligor

The rating takes into account the relative repayment ability of the obligor

Ratings for PTCs

There is no difference in the credit risk on the exposure taken through a single loan PTC vis--vis a plain vanilla debenture

Credit risk assessment in a PTC investment is based on the analysis of the obligor and not originator of the loan

The methodology adopted to evaluate the credit risk in the case of a single loan PTC is identical to that followed in the case of investment in debentures / CPsor other financial instruments issued by the obligor

Nature of risks in PTCs

Debt Fund Investing - Risk

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

Risks associated with 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

Risks associated with trading in Debt Securities

Probability of default by the borrower

Change in credit ratingdowngrade increases the yield & decreases the price upgrade decreases the yield & increases the price

SpreadThe payoff for assuming credit risk

Credit Risk

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