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Debt

An Overview

History
In most of the countries, the debt market is more popular than the equity market. This is
due to the sophisticated bond instruments that have return-reaping assets as their
underlying. In the US, for instance, the corporate bonds (like mortgage bonds) became
popular in the 1980s. However, in India, equity markets are more popular than the debt
markets due to the dominance of the government securities in the debt markets.
Moreover, the government is borrowing at a pre-announced coupon rate targeting a
captive group of investors, such as banks. This, coupled with the automatic monetization
of fiscal deficit, prevented the emergence of a deep and vibrant government securities
market.

The bond markets exhibit a much lower volatility than equities, and all bonds are priced
based on the same macroeconomic information. The bond market liquidity is normally
much higher than the stock market liquidity in most of the countries. The performance of
the market for debt is directly related to the interest rate movement as it is reflected in the
yields of government bonds, corporate debentures, MIBOR-related commercial papers,
and non-convertible debentures.

Concepts
The debt market is a market where fixed income securities issued by the Central and state
governments, municipal corporations, government bodies, and commercial entities like
financial institutions, banks, public sector units, and public limited companies. Therefore,
it is also called fixed income market. For a developing economy like India, debt markets
are crucial sources of capital funds. The debt market in India is amongst the largest in
Asia. It includes government securities, public sector undertakings, other government
bodies, financial institutions, banks, and companies.

Risks associated with debt securities


The debt market instrument is not entirely risk free. Specifically, two main types of risks
are involved, i.e., default risk and the interest rate risk.

• Default Risk/Credit Risk arises when an issuer of a bond defaults on the interest
or principal obligation.
• Interest Rate Risk can be defined as the risk emerging from an adverse change in
the interest rate prevalent in the market, which would affect the yield on the
existing instruments. For instance, an upswing in the prevailing interest rate may
lead to a situation where the investors' money is locked at lower rates. If they had
waited and invested in the changed interest rate scenario, they would have earned
more.

Other risks associated with trading in debt securities are more generic in nature, such as:
• Counter Party Risk refers to the failure or inability of the opposite party in 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 an adverse movement in the prices.

Indian Debt Market


The Indian debt market is composed of government bonds and corporate bonds.
However, the Central government bonds are predominant and they form most liquid
component of the bond market. In 2003, the National Stock Exchange (NSE) introduced
Interest Rate Derivatives.

The trading platforms for government securities are the ‘Negotiated Dealing System’ and
the Wholesale Debt Market (WDM) segment of NSE and BSE. In the negotiated market,
the trades are normally decided by the seller and the buyer, and reported to the exchange
through the broker, whereas 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.

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

Government Securities

Public Sector Bonds

Private Sector Bonds

Issuer

Central Government

State Governments

Government Agencies / Statutory Bodies

Public Sector Units

Corporates

Banks
Financial Institutions

Instruments

Zero Coupon Bonds, Coupon Bearing Bonds, Treasury Bills, STRIPS

Coupon Bearing Bonds

Govt. Guaranteed Bonds, Debentures

PSU Bonds, Debentures, Commercial Paper

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

Certificates of Deposits, Debentures, Bonds

Certificates of Deposits, Bonds

Price determination in the debt markets


The price of a bond in the markets is determined by the forces of demand and supply, as
is the case in any market. The price of a bond also depends on the changes in:

• Economic conditions
• General money market conditions, including the state of money supply in the
economy
• Interest rates prevalent in the market and the rates of new issues
• Future Interest Rate Expectations
• Credit quality of the issuer

Note: There is, however, a theoretical underpinning to the determination of the price of
the bond based on the measure of the yield of the security.

Debt Instruments are categorized as:

• Government of India dated Securities (G Secs) are 100-rupee face-value units/


debt paper issued by the Government of India in lieu of their borrowing from the
market. They are referred to as SLR securities in the Indian markets as they are
eligible securities for the maintenance of the SLR ratio by the banks.
• Corporate debt market: The corporate debt market basically contains PSU
bonds and private sector bonds. The Indian primary Corporate Debt market is
basically a private placement market with most of the corporate bonds being
privately placed among the wholesale investors, which include banks, financial
Institutions, mutual funds, large corporates & other large investors.

The following debt instruments are available in the corporate debt market:
• Non-Convertible Debentures
• Partly-Convertible Debentures/Fully-Convertible Debentures (convertible into
Equity Shares)
• Secured Premium Notes
• Debentures with Warrants
• Deep Discount Bonds
• PSU Bonds/Tax-Free Bonds

Main participants in the retail debt market include mutual funds, provident funds,
pension funds, private trusts, state-level and district-level co-operative banks, housing
finance companies, NBFCs and RNBCs, corporate treasuries, Hindu Undivided Families
(HUFs), and individual investors.

Interest Rate Derivatives


An interest rate futures contract is "an agreement to buy or sell a package of debt
instruments at a specified future date at a price that is fixed today." The price of debt
securities and, therefore, interest rate futures, is inversely proportional to the prevailing
interest rate. When the interest rate goes up, the price of debt securities and interest rate
futures goes down, and vice versa. Some of the assets underlying interest rate futures
include US Treasuries, Euro-Dollars, LIBOR Swap, and Euro-Yen futures.

Tenure
Interest rate futures contracts can have short-term (less than one year) and long-term
(more than one year) interest bearing instruments as the underlying asset. In the US,
short-term interest rate futures like 90-day T-Bill and 3-month Euro-Dollar time deposits
are more popular. Long-term interest rate futures include the 10-year Treasury Note
futures contract, and the Treasury Bond futures contract.

Hedging with Interest rate futures


Interest rate futures can be used to protect against an increase in interest rates as well as a
decline in interest rates. By selling interest rate futures, also known as short hedging, an
investor can protect himself against an increase in interest rates; and by buying interest
rate futures, also known as long hedging, an investor can protect himself against a decline
in interest rates. Thus, short, medium, and long-term interest rate risks can be managed
with products based on Euro-Dollars, US Treasuries, and Swaps in Europe and the US. In
India, interest rate derivatives would be used for hedging in the near future.

Regulatory Authority
The regulators of the Indian debt market are:

RBI: The Reserve Bank of India is the main regulator for the money market. It controls
and regulates the G-Secs market. Apart from its role as a regulator, it has to
simultaneously fulfill several other important objectives, such as managing the borrowing
programme for the Government of India, controlling inflation, ensuring adequate credit at
reasonable costs to various sectors of the economy, managing the foreign exchange
reserves of the country and ensuring a stable currency environment.
The RBI controls the issuance of new banking licences to banks. It controls the manner in
which various scheduled banks raise money from depositors. Further, it controls the
deployment of money through its policies on CRR, SLR, priority sector lending, export
refinancing, guidelines on investment assets, etc.

The RBI also administers the interest rate policy. Earlier, it used to strictly control
interest rates through a directed system of interest rates. Each type of lending activity was
supposed to be carried out at a pre-specified interest rate. Over the years, the RBI has
moved slowly towards a regime of market-determined controls.

SEBI: The regulator for the Indian corporate debt market is the Securities and Exchange
Board of India (SEBI). SEBI controls bond market in cases where entities esp. corporates
raise money from public through public issues.

It regulates the manner in which money is raised and to ensure a fair play for the retail
investor. It forces the issuer to make the retail investor aware of the risks inherent in the
investment and its disclosure norms. SEBI is also a regulator for the mutual funds and
regulates the entry of new mutual funds in the industry. It also regulates the instruments
in which these mutual funds can invest. SEBI also regulates the investments of FIIs.

To begin from the point of truism, one of the essential elements of a successful
enterprise, among other key factors, is the availability of capital. Even at that, it is the
accessibility and the economy of debt capital that has come to play an important role in
the sustainability and growth of a firm.

Not the least bit to be compared with the significance of equity (owners’) participation,
debt capital helps in mitigating the enterprise risk across the entire capital structure. Other
than that, debt capital also frees up the risk capital for the more vital functions and helps
in leveraging the business potential of the firm.

Given this strategic nature of debt capital, it becomes all the more necessary that students
and practitioners of entrepreneurism have an in-depth understanding of how the market
for debt operates in India.

History of India’s debt market


India was a late entrant into the capitalist form of economy. And we are still in the
transitory phase. Consequently, the evolution and the development of the formal debt
market, as we know it, was initiated much later than other developed economies.
It was only after the financial reforms of 1991-’92 that the bond market in India received
a major push. This era saw the end of the administered interest rate mechanism, and led
to the introduction of the auction system for the sale of gilts and T-bills. Innovative
products like zero coupon bonds, capital indexed bonds, etc., were also introduced during
this period.

Much later, the NDS (Negotiated Dealing Settlement) and the WDM (Wholesale Debt
Market segment) system were launched by the RBI, BSE and NSE to facilitate the trade
settlement. In short, it was in the last two decades that the technical and regulatory
infrastructure was developed to make the debt capital market as we see it today.

The debt market in India is categorized by many standards. But the most important of
them is based on duration. The market that deals with short term debt, which basically
means debt of less than a one-year maturity period, is called the money market. On the
other hand, debt maturity that exceeds the
one-year timeline is considered to be a part of the bond market.

Both these forms of market are dominated by government debt, which is classified under
T-bills and gilt. This categorization is again based entirely on the duration of the maturity
of the paper issued. That is, gilts normally refer to government borrowings whose
maturity is scheduled after one year.

Concurrently, T-bills are government borrowings whose maturity is scheduled within one
year. The dynamics of the corporate bond market are slightly different from the gilt. The
activity and the size of this market are relatively marginal, given the large shadow of
government borrowings under which it has had to operate.

Additionally, the lack of a wide investor base, the opaqueness and information
asymmetry have been some of the reasons for the tepidity in the growth of the corporate
bond market. The depth and the appetite of this segment have started to expand lately,
though. But from the point of view of this article, we shall dwell further on the money
markets.

Money market opportunities for SMEs


To begin with a brief rejoinder, the Indian money market is a market for short term
securities like T-bills, certificates of deposits, commercial papers, repos and others. These
debts are issued by the government, banks, companies and financial institutions,
respectively. The papers traded are almost like a promissory note which usually has a
fixed interest rate and a maturity of less than one year.

Since the securities in this market are less than one year, and the source of these
securities is the government/banks/highly-rated companies, the credit risk involved is
considered to be low (though slightly higher than an FD). Moreover, the tax incidence on
the income from these schemes (depending on the plan) is usually lower than the one that
the interest on savings accounts or FDs invite.
Therefore, from the SME point of view, the leveraging of the debt market can actually
come in two forms. First, as a supplier of debt, and second, as the buyer. The capacity of
the SME to tap the debt market is correlated directly to the growth trajectory of the
corporate debt segment. However, the real and immediate gain potential for SMEs rests
on their ability as the buyer of debt, especially of short term debts.

Now, most of you might have already been doing this unknowingly! That is, your money
—parked in the current, cash or FD accounts—is used by the banks to buy the debt and
the money market securities for you. However, the earning it might be delivering to you
may range from nil to almost nil.

A convenient alternative and yet a potentially enhanced ‘revenue-generative’ method of


parking the surplus is in the liquid, ultra-short term and the bond/gilt schemes of mutual
funds. These schemes usually also invest your money in the money market and debt
market securities, depending on the investment mandate of the fund.

An investor can invest in money market mutual funds for a period of as little as one day.
Avenues are also available for investing for longer horizons according to your risk
appetite.

In conclusion, in my understanding as an entrepreneur, the ability of a continuously


evolving and self-propelling enterprise is its ability to not only learn and adapt to changes
and opportunities, but also to make full use of them as and when possible.

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.

Classification of Indian Debt Market

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.

Advantages

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.

Disadvantages

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 Instruments

There are various types of debt instruments available that one can find in Indian debt
market.

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 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.

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