CHAPTER 1

OVERVIEW OF FINANCIAL SYSTEM

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 [1.1] INTRODUCTION ON FINANCIAL SYSTEM

Economic growth and development of any country depends upon a well-knit

financial system. Financial system comprises a set of sub-systems of financial institutions
financial markets, financial instruments and services which help in the formation of
capital. Thus a financial system provides a mechanism by which savings are transformed
into investments and it can be said that financial system play an significant role in
economic growth of the country by mobilizing surplus funds and utilizing them
effectively for productive purpose.
The financial system is characterized by the presence of integrated, organized and
regulated financial markets, and institutions that meet the short term and long term
financial needs of both the household and corporate sector. Both financial markets and
financial institutions play an important role in the financial system by rendering various
financial services to the community. They operate in close combination with each other.

Financial System:

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 The word "system", in the term "financial system", implies a set of complex and
closely connected or interlined institutions, agents, practices, markets, transactions,
claims, and liabilities in the economy. The financial system is concerned about money,
credit and finance-the three terms are intimately related yet are somewhat different from
each other. Indian financial system consists of financial market, financial instruments and
financial intermediation.

Components Of Indian Financial System:

The following are the four main components of Indian Financial system are:

 Financial Institutions.
 Financial Markets.
 Financial Instruments/Assets/Securities.
 Financial Services.

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 Financial Institutions.
Financial institutions are the intermediary who facilitates smooth
functioning of the financial system by making investors and borrowers meet.
They mobilize savings of the surplus units and allocate them in productive
activities promising a better rate of return. Financial institutions also provide a
service to entities seeking advises on various issues ranging from restructuring to
diversification plans. They provide whole range of services to the entities who
want to raise funds from the markets elsewhere. Financial institutions act as
financial intermediaries because they act as middlemen between savers and
borrowers. Were these financial institutions may be of Banking or Non-Banking
institutions.

 Financial Markets:
Finance is a prerequisite for modern business and financial institutions play
a vital role in economic system. It's through financial markets the financial system
of an economy works. The main functions of financial markets are:
 To facilitate creation and allocation of credit and liquidity.
 To serve as intermediaries for mobilization of savings.
 To assist process of balanced economic growth.
 To provide financial convenience.
 Financial Instruments/Assets/Securities:
Another important constituent of financial system is financial instruments.
They represent a claim against the future income and wealth of others. It will be a
claim against a person or an institution, for the payment of the some of the money
at a specified future date.
 Financial Services:
Efficiency of emerging financial system largely depends upon the quality
and variety of financial services provided by financial intermediaries. The term
financial services can be defined as "activities, benefits and satisfaction connected
with sale of money that offers to users and customers, financial related value".

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 [1.2] INDIAN FINANCIAL MARKET

A Financial Market can be defined as the market in which financial assets are
created or transferred. As against a real transaction that involves exchange of money for
real goods or services, a financial transaction involves creation or transfer of a financial
asset. Financial Assets or Financial Instruments represents a claim to the payment of a
sum of money sometime in the future and /or periodic payment in the form of interest or
dividend. Financial market is broadly divided into 4 parts:

 Money Market:
The money market ifs a wholesale debt market for low-risk, highly-liquid,
short-term instrument. Funds are available in this market for periods ranging
from a single day up to a year. This market is dominated mostly by government,
banks and financial institutions.

 Capital Market:
The capital market is designed to finance the long-term investments. The
transactions taking place in this market will be for periods over a year.

 Forex Market:
The Forex market deals with the multicurrency requirements, which are
met by the exchange of currencies. Depending on the exchange rate that is
applicable, the transfer of funds takes place in this market. This is one of the most
developed and integrated market across the globe.

 Credit Market:

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 Credit market is a place where banks, FIs and NBFCs purvey short,
medium and long-term loans to corporate and individuals.

[1.3] FEATURES OF FINANCIAL MARKET

 India Financial Indices - BSE 30 Index, various sector indexes, stock quotes,
Sensex charts, bond prices, foreign exchange, Rupee & Dollar Chart.

 Indian Financial market news.

 Stock News - Bombay Stock Exchange, BSE Sensex 30 index, S&P CNX-Nifty,
company information, issues on market capitalization, corporate earning
statements.

 Fixed Income - Corporate Bond Prices, Corporate Debt details, Debt trading
activities, Interest Rates, Money Market, Government Securities, Public Sector
Debt, External Debt Service.

 Foreign Investment - Foreign Debt Database composed by BIS, IMF, OECD,&

World Bank, Investments in India & Abroad.

 Global Equity Indexes - Dow Jones Global indexes, Morgan Stanley Equity
Indexes.

 Currency Indexes - FX & Gold Chart Plotter, J. P. Morgan Currency Indexes.

 National and Global Market Relations.

 Mutual Funds.

 Insurance.

 Loans.

 Forex and Bullion.

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 [1.4] SCOPE OF FINANCIAL MARKET

The financial market in India at present is more advanced than many other sectors
as it became organized as early as the 19th century with the securities exchanges in
Mumbai, Ahmedabad and Kolkata. In the early 1960s, the number of securities
exchanges in India became eight - including Mumbai, Ahmedabad and Kolkata. Apart
from these three exchanges, there was the Madras, Kanpur, Delhi, Bangalore and Pune
exchanges as well. Today there are 23 regional securities exchanges in India.

The Indian stock markets till date have remained stagnant due to the rigid
economic controls. It was only in 1991, after the liberalization process that the India
securities market witnessed a flurry of IPOs serially. The market saw many new
companies spanning across different industry segments and business began to flourish.

The launch of the NSE (National Stock Exchange) and the OTCEI (Over the
Counter Exchange of India) in the mid 1990s helped in regulating a smooth and
transparent form of securities trading. The regulatory body for the Indian capital markets
was the SEBI (Securities and Exchange Board of India). The capital markets in India
experienced turbulence after which the SEBI came into prominence. The market
loopholes had to be bridged by taking drastic measures.

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 CHAPTER 2
OVERVIEW OF DEBT MARKET

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 [2.1] INTRODUCTION OF DEBT MARKET

The capital market comprises of equities market and 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. Debt market is a market for the
issuance, trading and settlement in fixed income securities of various types. The debt
market is any market situation where trading debt instruments take place. Examples of
debt instruments include mortgages, promissory notes, bonds, and Certificates of Deposit.
A debt market establishes a structured environment where these types of debt can be
traded with ease between interested parties.
The debt market often goes by other names, based on the types of debt
instruments that are traded. In the event that the market deals mainly with the trading of
municipal and corporate bond issues, the debt market may be known as a bond market. If
mortgages and notes are the main focus of the trading, the debt market may be known as
a credit market. When fixed rates are connected with the debt instruments, the market
may be known as a fixed income market.
Debt market refers to the financial market where investors buy and sell debt
securities, mostly in the form of bonds. These markets are important source of funds,
especially in a developing economy like India. India debt market is one of the largest in
Asia. Like all other countries, debt market in India is also considered a useful substitute
to banking channels for finance. The most distinguishing feature of the debt instruments
of Indian debt market is that the return is fixed. This means, returns are almost risk-free.
This fixed return on the bond is often termed as the 'coupon rate' or the 'interest rate'.
Therefore, the buyer (of bond) is giving the seller a loan at a fixed interest rate, which
equals to the coupon rate.

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 Indian debt market can be broadly classified into two categories, namely debt
instruments issued by Central or State Governments and debt instruments issued by
Public and Private Sector. Different instruments issued have some prominent features in
respect of period of maturity and the investors for such instruments.

A gist of the structure of Indian debt market is given below:-

Who Issues Type of Instruments Maturity Periods Who Invests

Banks, Insurance and

Zero Coupon Bonds;
Central PF Trusts, RBI,
Coupon Bearing GOI 1 year to 30 years
Government Mutual Funds,
securities.
Individuals
Banks, Insurance and
Central 91 days and 364 PF Trusts, RBI,
Treasury Bills
Government days Mutual Funds,
Individuals
Coupon Bearing State Banks, Insurance and
State Government 5 years to 10 years
Govt securities PF Trusts
Government Banks, Insurance, PF
Enterprises & PSU Govt guaranteed bonds 5 years to 10 years Trusts and
Bonds Individuals
Banks, Insurance, PF
PSU Bonds, Zero
PSU 5 years to 10 years Trusts, Corporate
coupon bonds
amd, Individuals
Banks, Corporate,
Private Sector
Debentures and Bonds 1 year to 12 years Mutual Funds and
Corporates
Individuals
Banks, Corporate,
Private and Public Mutual Funds,
Commercial Paper 15 days to 1 year
Sector Corporates Financial Institutions
and Individuals
Banks and FIs Certificate of Deposits 15 days to 3 years Banks and Corporate

[2.2] HISTORY OF DEBT MARKET

In the post reforms era, a fairly well segmented debt market has emerged
comprising:

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  Private corporate debt market.
 Public sector undertaking bond market.
 Government securities market.

The government securities market accounts for more than 90 percent of the turnover
in the debt market. It constitutes the principal segment of the debt market. The Indian
debt market has traditionally been a wholesale market with participation restricted to few
institutional players – mainly banks. The banks were the major participants in the
government securities market due to statutory requirements. The turnover in the debt
market too was quite low a few hundred crores till the early 1990s. The debt market was
fairly underdeveloped due to the administrated interest rate regime and the availability of
investment avenues which gave a higher rate of return to investors.
In the early 1990s, the government needed a large amount of money for investment in
development and infrastructure projects. The government realized the need of a vibrant,
efficient and healthy debt market and undertook reform measures. The Reserve Bank put
in substantial efforts to develop the government securities market but its two segments,
the private corporate debt market and public sector undertaking bond market, have not
yet fully developed in terms of volume and liquidity.
It is debt market which can provide returns commensurate to the risk, a variety of
instruments to match the risk and liquidity preferences of investors, greater safety and
lower volatility. Hence the debt market has a lot of potential for growth in the future. The
debt market is critical to the development of a developing country like India which
requires a large amount of capital for achieving industrial and infrastructure growth.

[2.3] CLASSIFICATION OF DEBT MARKET

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

Market Segment Issuer Instruments

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Government Central Government Zero Coupon Bonds, Coupon Bearing Bonds, Treasury
Securities Bills, STRIPS
State Governments Coupon Bearing Bonds.
Public Sector Government Agencies / Govt. Guaranteed Bonds, Debentures
Bonds Statutory Bodies
Public Sector Units PSU Bonds, Debentures, Commercial Paper
Private Sector Corporates Debentures, Bonds, Commercial Paper, Floating Rate
Bonds Bonds, Zero Coupon Bonds, Inter-Corporate Deposits
Banks Certificates of Deposits, Debentures, Bonds
Financial Institutions Certificates of Deposits, Bonds

Indian debt market can be classified into two categories:

 Government Securities Market (G-Sec Market): It consists of central and
state government securities. It means that, loans are being taken by the central and
state government. It is also the most dominant category in the India debt market.

 Bond Market: It consists of Financial Institutions bonds, Corporate bonds and

debentures and Public Sector Units bonds. These bonds are issued to meet
financial requirements at a fixed cost and hence remove uncertainty in financial
costs.

[2.4] IMPORTANCE 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.
 Reduction in the borrowing cost of the Government and enable mobilization of
resources at a reasonable cost.

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  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.

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.

[2.5] ADVANTAGES OF DEBT MARKET

The following are the advantages of debt market:

 The biggest advantage of investing in Indian debt market is its assured returns.
The returns that the market offer is almost risk-free (though there is always certain
amount of risks, however the trend says that return is almost assured).

 Safer are the government securities. On the other hand, there are certain amounts
of risks in the corporate, FI and PSU debt instruments. However, investors can
take help from the credit rating agencies which rate those debt instruments. The
interest in the instruments may vary depending upon the ratings.

 Another advantage of investing in India debt market is its high liquidity. Banks
offer easy loans to the investors against government securities.

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  Greater safety and lower volatility as compared to other financial instruments.

 Variations possible in the structure of instruments like Index linked Bonds,

STRIPS.

 Higher leverage available in case of borrowings against G-Secs.

 No TDS on interest payments.

Example: Tax exemption for interest earned on G-Secs. up to Rs.3000/- over and
above the limit of Rs.12000/- under Section 80L (as amended in the latest
Budget).

 Greater diversification opportunities adequate trading opportunities with

continuing volatility expected in interest rates the world over.

[2.6] DISADVANTAGES OF DEBT MARKET

As there are several advantages of investing in India debt market, there are certain
disadvantages as well.
 As the returns here are risk free, those are not as high as the equities market at the
same time. So, at one hand you are getting assured returns, but on the other hand,
you are getting less return at the same time.

 Retail participation is also very less here, though increased recently. There are
also some issues of liquidity and price discovery as the retail debt market is not
yet quite well developed.

 Debt securities usually have much smaller relative price changes than stocks or
commodities. Traders in debt securities must take larger positions to achieve the
same level of profits. It is not uncommon for individual stocks or even stock
indexes to move two percent or more during a trading day. Debt securities may
move two percent over several weeks or a month. Even with ten-to-one leverage,
trading debt securities requires the trader to use much larger position sizes than a
stock market trader.

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  The debt trading markets are dominated by hedge funds and the trading desks of
large financial institutions. These traders have access to information and capital
that is difficult or impossible for the individual trader to obtain. By the time the
small trader gets the news that these large players are trading on, it may be too
late to profit from the news.

 Traders in corporate debt securities trade high-yield or junk bonds to earn the
higher interest rates these bonds pay. The trader can also achieve capital gains if
the issuing corporation gets an upgrade in its credit rating. The downside of high
yield bonds is a bankruptcy and total loss of the principal invested.

[2.7] INSTRUMENTS OF DEBT MARKET

There are various types of debt instruments available that one can find in Indian
debt market. They are as follows:
 Government Securities:
It is the Reserve Bank of India that issues Government Securities or G-
Secs on behalf of the Government of India. These securities have a maturity
period of 1 to 30 years. G-Secs offer fixed interest rate, where interests are
payable semi-annually. For shorter term, there are Treasury Bills or T-Bills, which
are issued by the RBI for 91 days, 182 days and 364 days.

 Corporate Bonds:
These bonds come from PSUs and private corporations and are offered for
an extensive range of tenures up to 15 years. There are also some perpetual bonds.
Comparing to G-Secs, corporate bonds carry higher risks, which depend upon the
corporation, the industry where the corporation is currently operating, the current
market conditions, and the rating of the corporation. However, these bonds also
give higher returns than the G-Secs.

 Certificate of Deposit:
These are negotiable money market instruments. Certificate of Deposits
(CDs), which usually offer higher returns than Bank term deposits, are issued in
demat form and also as a Usance Promissory Notes. There are several institutions

15
 that can issue CDs. Banks can offer CDs which have maturity between 7 days and
1 year. CDs from financial institutions have maturity between 1 and 3 years.
There are some agencies like ICRA, FITCH, CARE, CRISIL etc. that offer ratings
of CDs. CDs are available in the denominations of Rs 1 Lac and in multiple of
that.

 Commercial Papers:
There are short term securities with maturity of 7 to 365 days. CPs are
issued by corporate entities at a discount to face value.

 Treasury Bills:
Treasury bills are short-term instruments issued by the RBI on behalf of
the government to tide over short term liquidity shortfalls. The instruments are
issued by government to raise short term funds to bridge seasonal or temporary
gaps between its receipts (revenue & capital) and expenditure. They form the
most important segment of the money market not only in India but all over the
world as well.

 Bonds:
A bond is a debt security in which authorized issuer owes the holder a debt
and it is obligated to repay the principle and interest rate (coupon) at a later date
or maturity date. It is a financial contract which pledge to repay a specified or
fixed amount of money with the interest paid to the lender upon maturity of the
contract.

[2.8] PLAYERS IN DEBT MARKET

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 Players in debt market are similar to players in most financial markets and are
essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often
both.

Players include:

 Institutional investors
 Governments
 Traders
 Individuals
 Banks

Because of the specificity of individual bond issues, and the lack of liquidity in many
smaller issues, the majority of outstanding bonds are held by institutions like pension
funds, banks and mutual funds. In the United States, approximately 10% of the market is
currently held by private individuals.

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 CHAPTER 3
OVERVIEW OF BONDS

[3.1] INTRODUCTION OF BONDS

In finance, a bond is a debt security, in which the authorized issuer owes the
holders a debt and, depending on the terms of the bond, is obliged to pay interest (the
coupon) and/or to repay the principal at a later date, termed maturity. A bond is a formal
contract to repay borrowed money with interest at fixed intervals. Thus a bond is like a
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loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the
coupon is the interest. Bonds provide the borrower with external funds to finance long-
term investments, or, in the case of government bonds, to finance current expenditure.
Certificates of deposit (CDs) or commercial paper are considered to be money market
instruments and not bonds. Bonds must be repaid at fixed intervals over a period of time.

Bonds and stocks are both securities, but the major difference between the two is
that (capital-) stockholders have an equity stake in the company (i.e., they are owners),
whereas bondholders have a creditor stake in the company (i.e., they are lenders).
Another difference is that bonds usually have a defined term, or maturity, after which the
bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a
consol bond, which is a perpetuity (i.e., bond with no maturity).

A number of bond indices exist for the purposes of managing portfolios and
measuring performance, similar to the S&P 500 or Russell Indexes for stocks. The most
common American benchmarks are the (ex) Lehman Aggregate, Citigroup BIG and
Merrill Lynch Domestic Master. Most indices are parts of families of broader indices that
can be used to measure global bond portfolios, or may be further subdivided by maturity
and/or sector for managing specialized portfolios.

[3.2] PLAYERS OF BOND MARKET

The bond market can essentially be broken down into three main groups:
 Issuers: The issuers sell bonds or other debt instruments in the bond market to
fund the operations of their organizations. This area of the market is mostly made
up of governments, banks and corporations. The biggest of these issuers is
the government, which uses the bond market to fund a country's operations, such
as social programs and other necessary expenses. The government segment also
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 includes some of its agencies such as Fannie Mae, which offers mortgage-
backed securities. Banks are also key issuers in the bond market and they can
range from local banks up to supranational banks such as the European
Investment Bank, which issues debt in the bond market. The final major issuer is
the corporate bond market, which issues debt to finance corporate operations.

 Underwriters: The underwriting segment of the bond market is traditionally

made up of investment banks and other financial institutions that help the issuer to
sell the bonds in the market. In general, selling debt is not as easy as just taking it
to the market. In most cases, millions - if not billions - of dollars are being
transacted in one offering. As a result, a lot of work needs to be done - such as
creating a prospectus and other legal documents - in order to sell the issue. In
general, the need for underwriters is greatest for the corporate debt market
because there are more risks associated with this type of debt.

 Purchasers: The final players in the market are those who buy the debt that is
being issued in the market. They basically include every group mentioned as well
as any other type of investor, including the individual. Governments play one of
the largest roles in the market because they borrow and lend money to other
governments and banks. Furthermore, governments often purchase debt from
other countries if they have excess reserves of that country's money as a result
of trade between countries.
Example: Japan is a major holder of U.S. government debt.

[3.3] FEATURES OF BOND

The most important features of a bond are:

 Nominal, principal or face amount:

The amount on which the issuer pays interest, and which, most commonly,
has to be repaid at the end of the term. Some structured bonds can have a
redemption amount which is different to the face amount and can be linked to
performance of particular assets such as a stock or commodity index, foreign

20
 exchange rate or a fund. This can result in an investor receiving less or more than
his original investment at maturity.

 Issue price:
The price at which investors buy the bonds when they are first issued,
which will typically be approximately equal to the nominal amount. The net
proceeds that the issuer receives are thus the issue price, less issuance fees.

 Maturity date:
The date on which the issuer has to repay the nominal amount. As long as
all payments have been made, the issuer has no more obligations to the bond
holders after the maturity date. The length of time until the maturity date is often
referred to as the term or tenor or maturity of a bond. The maturity can be any
length of time, although debt securities with a term of less than one year are
generally designated money market instruments rather than bonds. Most bonds
have a term of up to thirty years. Some bonds have been issued with maturities of
up to one hundred years, and some even do not mature at all. In the market there
are three groups of bond maturities:

 Short term (bills): maturities up to one year;

 Medium term (notes): maturities between one and ten years;
 Long term (bonds): maturities greater than ten years.

 Coupon:
The interest rate that the issuer pays to the bond holders. Usually this rate
is fixed throughout the life of the bond. It can also vary with a money market
index, such as LIBOR, or it can be even more exotic. The name coupon originates
from the fact that in the past, physical bonds were issued which had coupons
attached to them. On coupon dates the bond holder would give the coupon to a
bank in exchange for the interest payment.

 Indentures and Covenants:

An indenture is a formal debt agreement that establishes the terms of a
bond issue, while covenants are the clauses of such an agreement. Covenants
specify the rights of bondholders and the duties of issuers, such as actions that the

21
 issuer is obligated to perform or is prohibited from performing. In the U.S.,
federal and state securities and commercial laws apply to the enforcement of these
agreements, which are construed by courts as contracts between issuers and
bondholders. The terms may be changed only with great difficulty while the
bonds are outstanding, with amendments to the governing document generally
requiring approval by a majority (or super-majority) vote of the bondholders.

 Coupon dates:
The dates on which the issuer pays the coupon to the bond holders. In the
U.S. and also in the U.K. and Europe, most bonds are semi-annual, which means
that they pay a coupon every six months.

 Optionality:
Occasionally a bond may contain an embedded option; that is, it grants
option-like features to the holder or the issuer.

 Callability:
Some bonds give the issuer the right to repay the bond before the
maturity date on the call dates; see call option. These bonds are referred to as
callable bonds. Most callable bonds allow the issuer to repay the bond at par. With
some bonds, the issuer has to pay a premium, the so called call premium. This is
mainly the case for high-yield bonds. These have very strict covenants, restricting
the issuer in its operations. To be free from these covenants, the issuer can repay
the bonds early, but only at a high cost.

 Putability:
Some bonds give the holder the right to force the issuer to repay the bond before
the maturity date on the put dates; see put option. (Note: "Putable" denotes an
embedded put option; "Puttable" denotes that it may be put.)

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 [3.4] TYPES OF BOND

After you decide to invest in bonds, you then need to decide what kinds of bond
investments are right for you. Most people don’t realize it, but the bond market offers
investors a lot more choices than the stock market.
Depending on your goals, your tax situation and your risk tolerance, you can
choose from municipal, government, corporate, mortgage-backed or asset-backed
securities and international bonds. Within each broad bond market sector you will find
securities with different issuers, credit ratings, coupon rates, maturities, yields and other
features. Each one offers its own balance of risk and reward.

1. DOMESTIC BONDS:

 Municipal bonds:

Municipal bonds are debt obligations issued by states, cities, counties and
other governmental entities, which use the money to build schools, highways, hospitals,
sewer systems, and many other projects for the public good. When you purchase a
municipal bond, you are lending money to a state or local government entity, which in
turn promises to pay you a specified amount of interest (usually paid semiannually) and
return the principal to you on a specific maturity date.

Not all municipal bonds offer income exempt from both federal and state taxes. There is
an entirely separate market of municipal issues that are taxable at the federal level, but

23
still offer a state—and often local—tax exemption on interest paid to residents of the state
of issuance. Most of this municipal bond information refers to munis which are free of
federal taxes.

 Fixed Rate Bonds:

Bonds have a coupon that remains constant throughout the life of the
bond.

 Floating Rate Notes (FRNs):

Bonds have a variable coupon that is linked to a reference rate of interest,

such as LIBOR or Euribor. For example the coupon may be defined as three
month USD LIBOR + 0.20%. The coupon rate is recalculated periodically,
typically every one or three months.

 High Yield Bonds:

Bonds that are rated below investment grade by the credit rating agencies.
As these bonds are more risky than investment grade bonds, investors expect to
earn a higher yield. These bonds are also called junk bonds.

 Zero-Coupon Bond:

A debt security that doesn't pay interest (a coupon) but is traded at a deep
discount, rendering profit at maturity when the bond is redeemed for its full face
value. Also known as an "accrual bond". Zero coupon bonds are sold at a
substantial discount from the face amount.

 Government Bonds:

It is the Reserve Bank of India that issues Government Securities or G-

Secs on behalf of the Government of India. These securities have a maturity
period of 1 to 30 years. G-Secs offer fixed interest rate, where interests are

24
 payable semi-annually. For shorter term, there are Treasury Bills or T-Bills, which
are issued by the RBI for 91 days, 182 days and 364 days..

 Inflation Linked Bonds:

Bonds in which the principal amount and the interest payments are
indexed to inflation. The interest rate is normally lower than for fixed rate bonds
with a comparable maturity. However, as the principal amount grows, the
payments increase with inflation. The United Kingdom was the first sovereign
issuer to issue inflation linked Gilts in the 1980s. Treasury Inflation-Protected
Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the
U.S. government.

 Other Indexed Bonds:

For example equity-linked notes and bonds indexed on a business

indicator (income, added value) or on a country's GDP.

 Asset-backed Securities:

Bonds whose interest and principal payments are backed by underlying

cash flows from other assets. Examples of asset-backed securities are mortgage-
backed securities (MBS's), collateralized mortgage obligations (CMOs) and
collateralized debt obligations (CDOs).

 Subordinated Bonds:

Bonds are those that have a lower priority than other bonds of the issuer in
case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First
the liquidator is paid, then government taxes, etc. The first bond holders in line to
be paid are those holding what is called senior bonds. After they have been paid,
the subordinated bond holders are paid. As a result, the risk is higher. Therefore,
subordinated bonds usually have a lower credit rating than senior bonds. The main

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 examples of subordinated bonds can be found in bonds issued by banks, and
asset-backed securities.

 Perpetual Bonds:

Bonds are also often called perpetuities or 'Perps'. They have no maturity
date. The most famous of these are the UK Consols, which are also known as
Treasury Annuities or Undated Treasuries. Some of these were issued back in
1888 and still traded today.

2. INTERNATIONAL BONDS:

Some companies, banks, governments, and other sovereign entities may decide to
issue bonds in foreign currencies as it may appear to be more stable and predictable than
their domestic currency. Issuing bonds denominated in foreign currencies also gives
issuers the ability to access investment capital available in foreign markets. The proceeds
from the issuance of these bonds can be used by companies to break into foreign markets,
or can be converted into the issuing company's local currency to be used on existing
operations through the use of foreign exchange swap hedges. Foreign issuer bonds can
also be used to hedge foreign exchange rate risk. Some foreign issuer bonds are called by
their nicknames, such as the "samurai bond." These can be issued by foreign issuers
looking to diversify their investor base away from domestic markets. These bond issues
are generally governed by the law of the market of issuance, e.g., a samurai bond, issued
by an investor based in Europe, will be governed by Japanese law. Not all of the
following bonds are restricted for purchase by investors in the market of issuance.

 Eurodollar bond, a U.S. dollar-denominated bond issued by a non-U.S. entity

outside the U.S.
 Yankee bond, a US dollar-denominated bond issued by a non-US entity in the US
market.
 Kangaroo bond, an Australian dollar-denominated bond issued by a non-
Australian entity in the Australian market.

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 Maple bond, a Canadian dollar-denominated bond issued by a non-Canadian
entity in the Canadian market.
 Samurai bond, a Japanese yen-denominated bond issued by a non-Japanese
entity in the Japanese market.
 Uridashi bond, a non-yen-denominated bond sold to Japanese retail investors.
 Shibosai Bond is a private placement bond in Japanese market with distribution
limited to institutions and banks.

[3.5] ISSUERS OF BONDS

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 Many entities issue bonds. The bond market separates bond issuers into
categories based on the similarities of these issuers and their characteristics. These major
categories are: supranational agencies (i.e. World Bank), national governments (i.e.
Government of Canada), provincial or state governments (i.e. Province of Ontario),
municipal governments (i.e. City of Edmonton) and corporate bonds (i.e. General
Motors). Bonds are issued by public authorities, credit institutions, companies and
supranational institutions in the primary markets. The most common process of issuing
bonds is through underwriting. In underwriting, one or more securities firms or banks,
forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to
investors. The security firm takes the risk of being unable to sell on the issue to end
investors. Primary issuance is arranged by book runners who arrange the bond issue, have
the direct contact with investors and act as advisors to the bond issuer in terms of timing
and price of the bond issue.

The book runners' willingness to underwrite must be discussed prior to opening

books on a bond issue as there may be limited appetite to do so. In the case of
Government Bonds, these are usually issued by auctions, where both members of the
public and banks may bid for bond. Since the coupon is fixed, but the price is not, the
percent return is a function both of the prices paid as well as the coupon.

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 [3.6] BOND CREDIT RATING

In investment, the bond credit rating assesses the credit worthiness of a

corporation's debt issues. It is analogous to credit ratings for individuals and countries.
The credit rating is a financial indicator to potential investors of debt securities such as
bonds. These are assigned by credit rating agencies such as Moody's, Standard & Poor's,
and Fitch Ratings to have letter designations (such as AAA, B, CC) which represent the
quality of a bond. Bond ratings below BBB/Baa are considered to be not investment
grade and are colloquially called junk bonds.

Moody's S&P Fitch GRADE

Long-term Short-term Long-term Short-term Long-term Short-term
Aaa AAA AAA Prime
Aa1 AA+ AA+
A-1+ F1+
Aa2 AA AA High grade
P-1
Aa3 AA- AA-
A1 A+ A+
A-1 F1
A2 A A Upper medium grade
A3 A- A-
P-2 A-2 F2
Baa1 BBB+ BBB+
Baa2 BBB BBB Lower medium grade
P-3 A-3 F3
Baa3 BBB- BBB-
Ba1 BB+ BB+
Non-investment grade
Ba2 BB BB
speculative
Ba3 BB- BB-
B B
B1 B+ B+
B2 B B Highly speculative
B3 B- B-
Caa1 Not prime CCC+ Substantial risks
Caa2 CCC Extremely speculative
Caa3 CCC- C CCC C
In default with little
CC
Ca prospect for recovery
C
C DDD
D / / In default
 /  DD

CREDIT RATING AGENCIES:

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 Credit rating agencies registered as such with the SEC are known as “Nationally
Recognized Statistical Rating Organizations.” The following firms are currently
registered as NRSROs: A.M. Best Company, Inc.; DBRS Ltd.; Egan-Jones Rating
Company; Fitch, Inc.; Japan Credit Rating Agency, Ltd.; LACE Financial Corp.;
Moody’s Investors Service, Inc.; Rating and Investment Information, Inc.; Real
point LLC; and Standard & Poor’s Ratings Services. Under the Credit Rating
Agency Reform Act, an NRSRO may be registered with respect to up to five
classes of credit ratings: (1) financial institutions, brokers, or dealers; (2)
insurance companies; (3) corporate issuers; (4) issuers of asset-backed securities;
and (5) issuers of government securities, municipal securities, or securities issued
by a foreign government.
 S&P, Moody's, and Fitch dominate the market with approximately 90-95 percent
of world market share.
 The Development of Bond market in In Credit Rating Tiers
 Moody's assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, with
WR and NR as withdrawn and not rated. Standard & Poor's and Fitch assign bond
credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, D.
As of October 16, 2009, there were 4 companies rated AAA by S&P:

Automatic Data Processing (NYSE:ADP)

Johnson & Johnson (NYSE:JNJ)

Microsoft (NASDAQ:MSFT)

ExxonMobil (NYSE:XOM)

 Moody's, S&P and Fitch will all also assign intermediate ratings at levels
between AA and CCC (e.g., BBB+, BBB and BBB-), and may also choose to
offer guidance (termed a "credit watch") as to whether it is likely to be
upgraded (positive), downgraded (negative) or uncertain (neutral).

Moody's Standard Credit worthiness

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 & Poor's
Aaa AAA Triple A = Credit risk almost zero
Aa1 AA+ Safe investment, low risk of failure
Aa2 AA "
Aa3 AA- "
A1 A+ Safe investment, unless unforeseen events should occur in the
economy at large or in that particular field of business
A2 A "
A3 A- "
Baa1 BBB+ Medium safe investment. Occurs often when economy has
deteriorated. Problems may arise
Baa2 BBB "
Baa3 BBB- "
Ba1 BB+ Speculative investment. Occurs often in deteriorated
circumstances, usually problematic to predict future
development
Ba2 BB "
Ba3 BB- "
B1 B+ Speculative investment. -Deteriorating situation expected
B2 B "
B3 B- "
Caa CCC High likelihood of bankruptcy or other business interruption
Ca CC "
C C "
D Bankruptcy or lasting inability to make payments most likely
WR Rating withdrawn[2]
NR Not rated[2]

Investment grade:

 A bond is considered investment grade or IG if its credit rating is BBB- or higher

by Standard & Poor's or Baa3 or higher by Moody's or BBB(low) or higher by
DBRS. Generally they are bonds that are judged by the rating agency as likely
enough to meet payment obligations that banks are allowed to invest in them.
 Ratings play a critical role in determining how many companies and other entities
that issue debt, including sovereign governments; have to pay to access credit
markets, i.e., the amount of interest they pay on their issued debt. The threshold

31
 between investment-grade and speculative-grade ratings has important market
implications for issuers' borrowing costs.
 Bonds that are not rated as investment-grade bonds are known as high yield bonds
or more derisively as junk bonds.
 The risks associated with investment-grade bonds (or investment-grade corporate
debt) are considered noticeably higher than in the case of first-class government
bonds. The difference between rates for first-class government bonds and
investment-grade bonds is called investment-grade spread. It is an indicator for
the market's belief in the stability of the economy. The higher these investment-
grade spreads (or risk premiums) are, the weaker the economy is considered.
 The debt market is much more popular than the equity markets in most parts of
the world. In India
 The reverse has been true. Nevertheless, the Indian debt market has transformed
itself into a much
 More vibrant trading field for debt instruments from the rudimentary market
about a decade ago.
 The sections below encompass the transformation of government and corporate
debt markets in
 India along with a comparison of the developments in equity market.

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 CHAPTER 4
VALUATION OF BONDS

[4.1] BOND VALUATION

At the time of issue a level coupon bond is usually sold for a price which is close
to its par value. After issue a bond is traded on the market at a price which reflects the

33
current level of interest rates and the degree of risk associated with the bond. Typically
we are interested in calculating either the market price that a bond should sell for, given
that the investor wants to obtain a particular market yield; or the effective yield (a.k.a. the
yield to maturity), given the price at which the bond is trading the value of a financial
security is the PV of expected future cash flows to value bonds we need to estimate future
cash flows (size and timing) and discount at an appropriate rate.

 At par: When a bond is selling at price = Par Value = $1,000 ]

This would happen when the coupon rate = YTM.

 Discount Bond: When a bond is selling at price < Face Value

-- Coupon Rate < YTM.

 Premium Bond: When a bond is selling at price > Face Value

-- Coupon rate > YTM.

[4.2] YIELD TO MATURITY

The yield to maturity is the discount rate which returns the market price of
the bond; it is identical to (required return) in the above equation. YTM is thus the
internal rate of return of an investment in the bond made at the observed price. Since
YTM can be used to price a bond, bond prices are often quoted in terms of YTM. 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

34
depending on the investment scenario and the characteristics of the investment. The
calculation of YTM helps the investor in rational decision making. YTM serves as a cut
off point to the investor and enables him to determine whether he should or should not
invest in the given debt instrument. YTM represents the yield on bond, provided the bond
id held to maturity and the intermittent coupons are reinvested at the same YTM rate. In
other words, YTM assumes that investor can reinvest the coupon received at same rate as
YTM over the investment horizon.

To achieve a return equal to YTM, i.e. where it is the required return on the bond, the
bond owner must:

 Buy the bond at price P0,

 Hold the bond until maturity, and
 Redeem the bond at par.

Coupon yield:

The coupon yield is simply the coupon payment (C) as a percentage of the face value (F).

Coupon yield = C / F

Coupon yield is also called nominal yield.

Current yield:

The current yield is simply the coupon payment (C) as a percentage of the (current) bond
price (P).

Current yield = C / P0.

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Relationship:

The concept of current yield is closely related to other bond concepts, including yield to
maturity, and coupon yield. The relationship between yield to maturity and the coupon
rate is as follows:

 When a bond sells at a discount, YTM > current yield > coupon yield.
 When a bond sells at a premium, coupon yield > current yield > YTM.

 When a bond sells at par, YTM = current yield = coupon yield amt.

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 CHAPTER 5
STATISTICAL DATA

[5.1] STATISTICAL DATA ON DEBT MARKET

The following table gives us the information of last ten years bonds issued by Public
Sector Undertakings.

Bonds Issued by Public Sector Undertakings (Rupees crore)

37
 Year Tax-free Bonds Taxable Bonds Total (2+3)
1 2 3 4

2000-01 662.2 15969.4 16631.6

2001-02 274.2 14161.5 14435.7

2002-03 286.0 7243.0 7529.0

2003-04 5443.2 5443.2

2004-05 7590.6 7590.6

2005-06 4845.5 4845.5

2006-07 10325.1 10325.1

2007-08 13404.4 13404.4

2008-09 12839.8 12839.8

2009-10 29937.8 29937.8

It is analyzed that since 2003 till date there is no Tax Free Bonds issued by public
sector undertakings. It is also been interpreted that the value of taxable bonds are
increasing on yearly basis.

Debt-to-GDP and the Market:

Decades from now, when historians write about the current era, the relationship between
the stock market and the debt ratio will likely be a hot topic — one that will encompass
politics, economics, demographics and cultural history. The first few decades after World
War II witnessed an inverse relationship between a rising market and shrinking debt ratio.
But after the decade of stagflation, the 18-year bull market that started in 1982 was
accompanied by a change in the debt relationship from inverse to tandem, as the overlay
below suggests. Those good times came at a cost — one that was increasingly covered by
debt.

38
39
40
Note that I've changed the color of the ratio from red (my usual color for debt) to black to
avoid any suggestion of political responsibly. Ultimately politics is but one factor in the
debt equation, which is driven by larger historical forces (World Wars, the Great
Depression and the Cold War) as well as profound social, economic and cultural changes
(e.g., trickle-down economics meets the Boomer era of conspicuous consumption).

41
I've interpolated monthly values for the debt data in the market overlay so it aligns
properly with the monthly market data for the S&P Composite. Thus the Office of
Management and Budget (OMB) dot estimates in the top chart are shown as a smooth
rosy line in the second. That line represents the White House OMB's six-year debt and
GDP forecasts. Note that the curve becomes less steep from 2012-2015. Let's hope this
isn't a wishful view through rosy colored glasses.

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CHAPTER 6
CONCLUSION

43
 [6.1] CONCLUSION

After you decide to invest in bonds, you then need to decide what kinds of
bond investments are right for you. Most people don’t realize it, but the bond market
offers investors a lot more choices than the stock market.
Depending on your goals, your tax situation and your risk tolerance, you can
choose from municipal, government, corporate, mortgage-backed or asset-backed
securities and international bonds. Within each broad bond market sector you will find
securities with different issuers, credit ratings, coupon rates, maturities, yields and other
features. Each one offers its own balance of risk and reward.
Individual investors as well as groups or corporate partners may participate in a
debt market. Depending on the regulations imposed by governments, there may be very
little distinction between how an individual investor versus a corporation would
participate in a debt market. However, there are usually some regulations in place that
require that any type of investor in debt market offerings have a minimum amount of
assets to back the activity. This is true even with situations such as bonds, where there is
very little chance of the investor losing his or her investment.
One of the advantages to participating in a debt market is that the degree of risk
associated with the investment opportunities is very low. For investors who are focused
on avoiding riskier ventures in favor of making a smaller but more or less guaranteed
return, going with bonds and similar investments simply makes sense. While the returns
will never be considered spectacular, it is possible to earn a significant amount of money
over time, if the right debt market offerings are chosen.

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CHAPTER 7
BIBLOGRAPHY

45
 [7.1] BIBLOGRAPHY

 BOOKS REFERRED:

DEBT MARKETS – SANDEEP GUPTA & SACHIN BHANDARKAR

 WEBSITE:

www.google.com
www.investopedia.com
www.wikipedia.com
www.rbi.org.com

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