Description
The documentation explains on Debt Markets and also Bond markets in India.
AN INTRODUCTION TO DEBT MARKETS (Bond Markets in India)
TABLE OF CONTENT
1. DEBT INSTRUMENTS: FUNDAMENTAL FEATURES..............................................3 2. INSTRUMENT FEATURES..............................................................................................3 3. MODIFYING THE COUPON OF A BOND.....................................................................4 4. MODIFYING THE TERM TO MATURITY OF A BOND............................................6 5. MODIFYING THE PRINCIPAL REPAYMENT OF A BOND.....................................7 DEBT MARKET IN INDIA....................................................................................................8
6.1 Historical development ........................................................................................8 6.2 Market Segments:.................................................................................................8 Corporate bond market.............................................................................................10 6.5 Participants in Indian bond market.....................................................................12 6.6 Secondary Market for Debt Instruments.............................................................13
7. EUROBOND MARKETS .................................................................................................15
7.1 7.2 7.3 7.4 Historical development of the Eurobond Market ................................................16 Characteristics of Eurobonds .............................................................................16 Organization of a Traditional Eurobond Syndicate..............................................17 Eurobond secondary market...............................................................................19
8. FOREIGN BOND MARKET............................................................................................21
8.1 8.2 8.3 8.4 8.5 8.6 8.7 Yankee Bonds.....................................................................................................21 DEM Foreign Bonds.............................................................................................22 Samurai Bonds....................................................................................................22 Swiss Franc International Bonds.........................................................................22 Bulldog Bond.......................................................................................................23 Why Do Investors Care About International Bonds?............................................23 Differences among Bond Markets.......................................................................23
9. BOND MARKET INDICES AND BENCHMARKS......................................................26
9.3 THE FIMMDA NSE MIBID-MIBOR...........................................................................28
10. OTHER DEBT INSTRUMENTS...................................................................................28
10.1 Central Government Securities: T-Bills..............................................................28 10.2 Commercial Paper & Certificate of Deposits.....................................................30 10.3 Certificate of Deposits (CDs).............................................................................31
11. REFERENCES................................................................................................................32
11.1 Websites...........................................................................................................32 11.2 Books/Manuals..................................................................................................32
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1. DEBT INSTRUMENTS: FUNDAMENTAL FEATURES
Debt instruments are contracts in which 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 such interest payment, and the repayment of the principal amount borrowed (either in instalments or in bullet). In the Indian securities markets, we generally use the term ‘bond’ for debt instruments issued by the Central and State governments and public sector organisations, and the term ‘debentures’ for instruments issued by private corporate sector.
2. INSTRUMENT FEATURES
The principal features of a bond are: a) Maturity b) Coupon c) Principal In the bond markets, the terms maturity and term-to-maturity, are used quite frequently. Maturity of a bond refers to the date on which the bond matures, or the date on which the borrower has agreed to repay (redeem) the principal amount to the lender. The borrowing is extinguished with redemption, and the bond ceases to exist after that date. Term to maturity, on the other hand, refers to the number of years remaining for the bond to mature. Term to maturity of a bond changes everyday, from the date of issueof the bond until its maturity. Coupon Rate refers to the periodic interest payments that are made by the borrower (who is also the issuer of the bond) to the lender (the subscriber of the bond) and the coupons are stated upfront either directly specifying the number (e.g.8%) or indirectly tying with a benchmark rate (e.g. MIBOR+0.5%). Coupon rate is the rate at which interest is paid, and is usually represented as a percentage of the par value of a bond. Principal is the amount that has been borrowed, and is also called the par value or face value of the bond. The coupon is the product of the principal and the coupon rate. Typical face
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values in the bond market are Rs. 100.All Government bonds have the face value of Rs.100. In many cases, the name of the bond itself conveys the key features of a bond. For example a GS CG2008 11.40% bond refers to a Central Government bond maturing in the year 2008, and paying a coupon of 11.40%.
3. MODIFYING THE COUPON OF A BOND
In a plain vanilla bond, coupon is paid at a pre-determined rate, as a percentage of the par value of the bond. Several modifications to the manner in which coupons / interest on a bond are paid are possible. Zero Coupon Bond: In such a bond, no coupons are paid. The bond is instead issued at a discount to its face value, at which it will be redeemed. There are no intermittent payments of interest. When such a bond is issued for a very long tenor, the issue price is at a steep discount to the redemption value. Such a zero coupon bond is also called a deep discount bond. The effective interest earned by the buyer is the difference between the face value and the discounted price at which the bond is bought. There are also instances of zero coupon bonds being issued at par, and redeemed with interest at a premium. The essential feature of this type of bonds is the absence of intermittent cash flows. Treasury Strips : In the United States, government dealer firms buy coupon paying treasury bonds, and create out of each cash flow of such a bond, a separate zero coupon bond. For example, a 7 -year coupon-paying bond comprises of 14 cash flows, representing half-yearly coupons and the repayment of principal on maturity. Dealer firms split this bond into 14 zero coupon bonds, each one with a differing maturity and sell them separately, to buyers with varying tenor preferences. Such bonds are known as treasury strips. (Strips is an acronym for Separate Trading of Registered Interest and Principal Securities). We do not have treasury strips yet in the Indian markets. RBI and Government are making efforts to develop market for strips in government securities. Floating Rate Bonds: Instead of a pre-determined rate at which coupons are paid, it is possible to structure bonds, where the rate of interest is re-set periodically, based on a benchmark rate. Such bonds whose coupon rate is not fixed, but reset with reference to a
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benchmark rate, are called floating rate bonds. For example, IDBI issued a 5 year floating rate bond, in July 1997, with the rates being re-set semi-annually with reference to the 10 year yield on Central Government securities and a 50 basis point mark-up. In this bond, every six months, the 10-year benchmark rate on government securities is ascertained. The coupon rate IDBI would pay for the next six months is this benchmark rate, plus 50 basis points. The coupon on a floating rate bond thus varies along with the benchmark rate, and is reset periodically. The Central Government has also started issuing floating rate bonds tying the coupon to the average cut-off yields of last six 364-day T-bills yields. Some floating rate bonds also have caps and floors, which represent the upper and lower limits within which the floating rates can vary. For example, the IDBI bond described above had a floor of 13.5%. This means, the lender would receive a minimum of 13.5% as coupon rate, should the benchmark rate fall below this threshold. A ceiling or a cap represents the maximum interest that the borrower will pay, should the benchmark rate move above such a level. Most corporate bonds linked to the call rates, have such a ceiling to cap the interest obligation of the borrower, in the event of the benchmark call rates rising very steeply. Floating rate bonds, whose coupon rates are bound by both a cap and floor, are called as range notes, because the coupon rates vary within a certain range. The other names, by which floating rate bonds are known, are variable rate bonds and adjustable rate bonds. Other Variations: In the mid-eighties, the US markets witnessed a variety of coupon structures in the high yield bond market (junk bonds) for leveraged buy-outs. In many of these cases, structures that enabled the borrowers to defer the payment of coupons were created. Some of the more popular structures were: (a) Deferred interest bonds, where the borrower could defer the payment of coupons in the initial 3 to 7 year period; (b) Step-up bonds, where the coupon was stepped up by a few basis points periodically, so that the interest burden in the initial years is lower, and increases over time; (c) Extendible reset bond, in which investment bankers reset the rates, not on the basis of a benchmark, but after re-negotiating a new rate, which in the opinion of the lender and borrower, represented the rate for the bond after taking into account the new circumstances at the time of reset.
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4. MODIFYING THE TERM TO MATURITY OF A BOND
Callable Bonds: Bonds that allow the issuer to alter the tenor of a bond, by redeeming it prior to the original maturity date, are called callable bonds. The inclusion of this feature in the bond’s structure provides the issuer the right to fully or partially retire the bond, and is therefore in the nature of call option on the bond. Since these options are not separated from the original bond issue, they are also called embedded options. A call option can be an European option, where the issuer specifies the date on which the option could be exercised. Alternatively, the issuer can embed an American option in the bond, providing him the right to call the bond on or anytime before a pre-specified date. The call option provides the issuer the option to redeem a bond, if interest rates decline, and re-issue the bonds at a lower rate. The investor, however, loses the opportunity to stay invested in a high coupon bond, when interest rates have dropped. The call option, therefore, can effectively alter the term of a bond, and carries an added set of risks to the investor, in the form of call risk, and re-investment risk. As we shall see later, the prices at which these bonds would trade in the market are also different, and depend on the probability of the call option being exercised by the issuer. In the home loan markets, pre-payment of housing loans represent a special case of call options exercised by borrowers. Puttable Bonds: Bonds that provide the investor with the right to seek redemption from the issuer, prior to the maturity date, are called puttable bonds. The put options embedded in the bond provides the investor the rights to partially or fully sell the bonds back to the issuer, either on or before pre-specified dates. The actual terms of the put option are stipulated in the original bond indenture. A put option provides the investor the right to sell a low coupon-paying bond to the issuer, and invest in higher coupon paying bonds, if interest rates move up. The issuer will have to re-issue the put bonds at higher coupons. Puttable bonds represent a re-pricing risk to the issuer. When interest rates increase, the value of bonds would decline. Therefore put options, which seek redemptions at par, represent an additional loss to the issuer.
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Convertible Bonds: A convertible bond provides the investor the option to convert the value of the outstanding bond into equity of the borrowing firm, on pre-specified terms. Exercising this option leads to redemption of the bond prior to maturity, and its replacement with equity. At the time of the bond’s issue, the indenture clearly specifies the conversion ratio and the conversion price. The conversion ratio refers to the number of equity shares, which will be issued in exchange for the bond that is being converted. The conversion price is the resulting price when the conversion ratio is applied to the value of the bond, at the time of conversion. Bonds can be fully converted, such that they are fully redeemed on the date of conversion. Bonds can also be issued as partially convertible, when a part of the bond is redeemed and equity shares are issued in the pre-specified conversion ratio, and the non-convertible portion continues to remain as a bond.
5. MODIFYING THE PRINCIPAL REPAYMENT OF A BOND
Amortising Bonds: The structure of some bonds may be such that the principal is not repaid at the end but over the life of the bond. A bond, in which payment made by the borrower over the life of the bond, includes both interest and principal is called an amortising bond. Auto loans, consumer loans and home loans are examples of amortising bonds. The maturity of the amortising bond refers only to the last payment in the amortising schedule, because the principal is repaid over time. Bonds with Sinking Fund Provisions: In certain bond indentures, there is a provision that calls upon the issuer to retire some amount of the outstanding bonds every year. This is done either by buying some of the outstanding bonds in the market, or as is more common, by creating a separate fund, which calls the bonds on behalf of the issuer. Such provisions that enable retiring bonds over their lives are called sinking fund provisions. In many cases, the sinking fund is managed by trustees, who regularly retire part of the outstanding bonds, usually at par. Sinking funds also enable paying off bonds over their life, rather than at maturity. One usual variant is applicability of the sinking fund provision after few years of the issue of the bond, so that the funds are available to the borrower for a minimum period, before redemption can commence.
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DEBT MARKET IN INDIA
6.1 Historical development
The debt market is much more popular than the equity markets in most parts of the world. In India the reverse has been true. Indian debt markets, in the early nineties, were characterised by controls on pricing of assets, segmentation of markets and barriers to entry, low levels of liquidity, limited number of players, near lack of transparency, and high transactions cost. Lacunae in institutional infrastructure and inefficient market practices characterized the government securities market. In fact the sole objective pursued was to keep the cost of government borrowing as low as possible. The GOI bond market did not use trading on an exchange. It featured bilateral negotiation between dealers. The market thus lacked price-time priority and the bilateral transactions imposed counterparty credit risk on participants. This narrowed down the market into a “club” with homogeneous credit risk. Financial reforms in early 1990s have significantly changed the Indian debt markets for the better and have added greater transparency and have brought the issuances closer to the market levels. Most debt instruments are now priced freely on the markets; trading mechanisms have been altered to provide for higher levels of transparency, higher liquidity, and lower transactions costs; new participants have entered the markets, broad basing the types of players in the markets; methods of security issuance, and innovation in the structure of instruments have taken place; there has been a significant improvement in the dissemination of market information.
6.2 Market Segments:
The debt market in India comprises broadly two segments, viz., Government Securities Market and Corporate Debt Market. The latter is further classified as Market for PSU Bonds and Private Sector Bonds.
We now see a fairly well-segmented debt market in India comprising of the following segments:
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6.3 Government Securities (g-sec) market:
The market for government securities is the oldest and most dominant in terms of market capitalisation, outstanding securities, trading volume and number of participants. It not only provides resources to the government for meeting its short term and long term needs, but also sets benchmark for pricing corporate paper of varying maturities and is used by RBI as an instrument of monetary policy. The instruments in this segment are fixed coupon bonds, commonly referred to as dated securities, treasury bills, floating rate bonds, zero coupon bonds and inflation index bonds. The government securities market has witnessed significant transformation in the 1990s in terms of market design. The most significant developments include introduction of auctionbased price determination for government securities, development of new instruments and mechanisms for government borrowing as well as participation by new market participants, increase in information dissemination on market borrowings and secondary market transactions, screen based negotiations for trading, and the development of the yield curve for government securities for marking-to-market portfolios of banks.
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As a result of the gradual reform process undertaken over the years, the Indian G-Sec market has now become increasingly broad-based, characterised by an efficient auction process, an active secondary market and a fairly liquid yield curve up to 30 years. An active Primary Dealer (PD) system and electronic trading and settlement technology that ensure safe settlement with Straight through Processing (STP) and central counterparty guarantee support the market now. Secondary Markets for Government Bonds Government bonds are deemed to be listed as soon as they are issued. Markets for government securities are pre-dominantly wholesale markets, with trades done on telephonic negotiation. NSE WDM provides a trading platform for Government bonds, and reports over 65% of all secondary market trades in government securities. Currently, transactions in government securities are required to be settled on the trade date or next working day unless the transaction is through a broker of a permitted stock exchange in which case settlement can be on T+2 basis. State Government Bonds The State government bond issuance is presently managed by the RBI along with the central borrowings. States have the option to raise their money through auction system or on tap basis.
Corporate bond market
Until 1992, interest rate on corporate bond issuance was regulated and was uniform across credit categories. In the initial years, corporate bonds were issued with “sweeteners” in the form of convertibility clause or equity warrants. Most corporate bonds were plain coupon paying bonds, though a few variations in the form of zero coupon securities, deep discount bonds and secured promissory notes were issued. After the de-regulation of interest rates on corporate bonds in 1992, we have seen a variety of structures and instruments in the corporate bond markets, including securitized products, corporate bond strips, and a variety of floating rate instruments with floors and caps. In the recent years, there has been an increase in issuance of corporate bonds with embedded put and call options. The major part of the corporate debt is privately placed with tenors of 1-12 years. However, in terms of raising debt through public issuance in capital market, is only an
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insignificant part of the Indian Debt Market. The lack of market infrastructure and comprehensive regulatory framework coupled with low issuance leading to low liquidity in the secondary market, narrow investor base, inadequate credit assessment skills, high cost of issuance, lack of transparency in trades and underdevelopment of securitization of products are some of the major factors that hindered the growth of the private corporate debt market. Over the years greater innovation has been witnessed in the corporate bond issuances, like floating rate instruments, zero coupon bonds, convertible bonds, callable (put-able) bonds and step-redemption bonds. The listed corporate bonds also trade on the Wholesale Debt Segment of NSE. But the percentage of the bonds trading on the exchange is small. The secondary market for corporate bonds till now has been over the counter market. 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
PSU Bonds (taxable and non-taxable) The issues by government sponsored institutions like, Development Financial Institutions, as well as the infrastructure-related bodies and the PSUs, who make regular forays into the market to raise medium-term funds, constitute the second segment of debt markets. The gradual withdrawal of budgetary support to PSUs by the government since 1991 has compelled them to look at the bond market for mobilising resources. The preferred mode of issue has been private placement, barring an occasional public issue. Banks, financial institutions and other corporates have been the major subscribers to these issues. The tax-free bonds, which constitute over 50% of the outstanding PSU bonds, are quite popular with institutional players. FI/Bank bonds (recent development) For example, step bonds issued by ICICI in 1998, paid progressively higher rates of interest as the maturity approached while the IDBI’s step bond was issued with a feature to pay out the redemption amount in instalments after an initial holding period. The deep discount bond issued by IDBI in the same year had two put and call options before maturity.
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In addition, we are also beginning to see the arrival of securitised bonds, backed by assets like auto-finance receivables, energy sale receivables, etc.
6.5 Participants in Indian bond market
SBI and its associates are the single largest owners of state government securities. The banking system as a whole is a large investor in government securities. One of the reasons for banks to invest in state government bonds is the relatively lower risk-weighting on these bonds, compared to the risk weighting in case of corporate lending. The prudential investment norms of LIC and provident funds have also enabled a sizeable holding of state government securities by these entities.
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6.6 Secondary Market for Debt Instruments
The NSE- WDM segment provides the formal trading platform for trading of a wide range of debt securities. Initially, government securities, treasury bills and bonds issued by public sector undertakings (PSUs) were made available for trading. This range has been widened to include non-traditional instruments like, floating rate bonds, zero coupon bonds, index bonds, 18 commercial papers, certificates of deposit, corporate debentures, state government loans, SLR and non-SLR bonds issued by financial institutions, units of mutual funds and securitized debt. The WDM trading system, known as NEAT (National Exchange for
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Automated Trading), is a fully automated screen based trading system that enables members across the country to trade simultaneously with enormous ease and efficiency. The instrument-wise turnover for securities listed on the NSE-WDM is shown in Table
Retail Debt Market :With a view to encouraging wider participation of all classes of investors across the country (including retail investors) i n government securities, the Government, RBI and SEBI have introduced trading in government securities 20 for retail investors. Trading in this retail debt market segment (RDM) on NSE has been introduced w.e.f. January 16, 2003. RDM Trading: Trading takes place in the existing Capital Market segment of the Exchange and in the same manner in which the trading takes place in the equities (Capital Market) segment. The RETDEBT Market facility on the NEAT system of Capital Market Segment is used for entering transactions in RDM session. The trading holidays and market timings of the RDM segment are the same as the Equities segment. Negotiated Dealing System: The first step towards electronic bond trading in India was the introduction ofthe RBIs Negotiated Dealing System in February 2002. NDS, interalia, facilitates screen based negotiated dealing for secondary market transactions in government securities and money market instruments, online reporting of transactions in the instruments available on the NDS and dissemination of trade information to the market. Government Securities (including T-bills), call money, notice/term money, repos in eligible securities are available for negotiated dealing through NDS among the members. NDS members concluding deals, in the telephone market in instruments available on NDS, are required to report the deal on NDS system within 15 minutes of concluding the deal. With the objective of creating a broad-based and transparent market in government securities and thereby enhancing liquidity in the system, the NDS was designed to provide: • Electronic bidding in primary market auctions (T-Bills, dated securities, state government securities) by members,
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• • •
Electronic bidding for OMO of RBI including repo auctions under LAF, Screen based negotiated dealing system for secondary market operations, Reporting of deals in government securities done among NDS members outside the system (over telephone or using brokers of exchanges) for settlement,
• •
•
Dissemination of trade information to NDS members, Countrywide access of NDS through INFINET, Electronic connectivity for settlement of trades in secondary market both for outright and repos either through CCIL or directly through RBI, and Creation and maintenance of basic data of instruments and members.
NDS-OM: It is an electronic, screen based, anonymous order driven trading system introduced by RBI as part of the existing NDS system to facilitate electronic dealing in government securities. It is accessible to members through RBIs INFINET Network. The system facilitates price discovery, liquidity, increased operational efficiency and transparency. The NDS-OM System supports trading in all Central Government Dated Securities and State Government securities in T+1 settlement type. Since August 1, 2006 the system was enhanced to facilitate trading in Treasury Bills and When Issued transaction in a security authorized for issuance but not as yet actually issued. All ‘WI’ transactions are on an ‘if’ basis, to be settled if and when the actual security is issued. Further, RBI has permitted the execution of intra-day short sale transaction and the covering of the short position in government securities can be done both on and outside the NDS-OM platform i.e. through telephone market.
7. EUROBOND MARKETS
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7.1 Historical development of the Eurobond Market
The growth of the Eurobond market was extraordinary. Shortly after the introduction of the Interest Equalization Tax, in June 1963, the first offshore bond issue denominated in U.S. dollars was launched. In the same year a total of USD 145 million in new Eurobond issues was raised, and by 1968 the volume had risen to USD 3 billion. On the strength of its early success, the Eurobond market quickly established itself:
• •
It had a marketplace in London. The U.K. authorities allowed the market to develop without regulations or restrictions. London became, and remains today, the principal centre for new issues and the trading of USD denominated Eurobonds.
•
The speed and simplicity of issuing in the Eurobond market compared favourably with the principal foreign bond market, the U.S. Yankee market.
•
The establishment in 1969 of the Association of International Bond Dealers (AIBD) provided a forum for improving the design of the market.
•
The early establishment of a clearing system, Euroclear and Cedel in 1969 and 1970, respectively, resolved the problem of delivery and custody.
7.2 Characteristics of Eurobonds
A Eurobond is an international debt security and its structure is similar to the standard debt security used in domestic bond markets. The basic characteristics are listed below:
•
A Eurobond is a debt contract between a borrower and an investor, which records the borrower's obligation to pay interest and the principal amount of the bond on specified dates.
• • •
A Eurobond is transferable. A Eurobond is intended to be tradable. A Eurobond is a medium- to long-term debt security.
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•
A Eurobond is generally launched through a public offering and listed on a stock exchange.
The full terms and conditions of an issue are printed on the actual bond, which has three components:
• The face: Sets out the name of the borrower, short detail on maturity, the interest-rate
coupon (or in the case of FRN, the interest base and margin), and the formal promise to pay interest and principal.
• The reverse: Sets out (1) the terms and conditions of the issue and (2) the details of
the banks responsible for payments of interest and principal.
• The coupons: They are a series of detachable coupons, which are presented on interest
payment dates as evidence of entitlement to payment. These are identical in all respects except the date of payment.
7.3 Organization of a Traditional Eurobond Syndicate
Eurobonds are issued and sold through underwriting syndicates. Participants in these syndicates are investment banks, merchant banks, and the merchant banking subsidiaries of commercial banks.
A potential borrower -a company, a bank, an international organization, or a governmentreceives unsolicited proposals. These proposals keep the potential borrower in touch with market opportunities and pricing and, when the borrower, or issuer, asks for new issue proposals, help to ensure competitive bidding. Each house offers some niche of expertise in placement or in derivative products, which together bring the issuer a broad understanding of the marketplace. Borrowers look to issuing houses which demonstrate commitment and competence in the analysis of their borrowing requirement in the submission of timely, cost attractive, and marketable proposals.
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Based on the proposals, the borrower selects an investment bank and invites it to become the lead manager of a Eurobond issue on the borrower's behalf. The major contribution of the lead manager, or issuing house, lies in its expertise with respect to the presentation of a firsttime issuer, the selection of a syndicate, the decision of a timely launch, the support of the issue in the aftermarket, and the maintenance of an effective secondary market.
After being selected by the issuer, the lead manager invites a small additional group of banks to assist it in negotiating terms with the borrower, in assessing the market, and in organizing and managing the new issue. These additional banks are called the co-managers. The comanagers and the lead manager become the managing group. The lead-manager in selecting banks to make up a management group has two priorities: (1) sharing the risk of the issue and (2) helping to place it. In practice, the lead-manager consults with the potential co-managers on pricing prior to submission of a proposal, and, in doing so, will measure their interest in the issue. The co-managers, however, give no commitment and in the event of bad market conditions -i.e., adverse changes in interest rates- may decline the invitation. In addition, two other categories of banks -underwriters and the selling group- will be invited to participate in bringing the bonds to market. In general, proposals include recommendations for a syndicate of underwriters who enhance the placement.
The borrower sells the bonds to the managing group. In turn, the managing group sells the bonds either directly to both the underwriters and the selling group or else sells the bonds to the underwriters, who in turn sell the bonds to the selling group. Members of the selling group sell to final investors. Underwriters differ from pure sellers in that underwriters commit themselves ahead of time to buy the bonds at a set minimum price from the managers even if the bonds cannot be resold to sellers or end investors for a price greater than this pre-agreed minimum. Roles in a Eurobond syndicate are nested: Managers are also underwriters and sellers, and underwriters are usually also sellers.
The principal paying agent in a Eurobond issue is the bank that has the responsibility for receiving interest and principal payments from the borrower and disbursing them to end investors. When a fiscal agent is used in a new issue, the fiscal agent and the principal agent are the same. A fiscal agent is a bank appointed to act on behalf of the borrower, one that
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takes care of the mechanics of bond authentication and distribution to investors as well as acting as principal agent. An alternative to a fiscal agent is a trustee. A trustee acts as the representative of all bondholders in any legal action stemming from bond covenant defaults. If a trustee is used for a new Eurobond issue, then a separate paying agent will be appointed to act on behalf of the bond issuer.
7.4 Eurobond secondary market
Public Eurobond issues are listed on one or more stock exchanges. The principal exchanges for issues in USD, CAD, ECUs, and AUD are the Luxembourg Stock Exchange and the London Stock Exchange. Issues denominated in European currencies tend to be listed on the home exchange; for example, issues in Dutch guilder are listed on the Amsterdam exchange. Although Eurobond issues are listed, there is no legal obligation on dealers to deal on the exchanges. From early on, dealers in Eurobonds dealt over-the-counter, adopting the practice of money and foreign exchange markets.
In 1969, Eurobond dealers created an around the clock market among financial institutions across the world that formed the AIBD (Association of International Bond Dealers). The AIBD's original purpose was to create a framework of rules under which the fledging overthe-counter Eurobond market could function and to provide direction and stability to this rapidly changing market. In 1991, the AIBD was reorganized into the International Securities
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Market Association (ISMA) to recognize the fact that many AIBD members expanded into other securities. The ISMA, based in Zurich, is the self-regulatory industry body and trade association for the international securities market. The ISMA has some similarities to the U.S. National Association of Securities Dealers (NASD). All market-makers and dealers in Eurobonds are part of the ISMA. The ISMA requires its members to report the terms of their deals through a trade-matching and confirmation electronic system named TRAX. This is done to ensure price transparency in the market. TRAX handles 40,000 to 50,000 transactions per day, providing reliable traded prices on over 3,500 securities daily. Therefore, the ISMA in effect serves as an alternative stock exchange. It has no trading floor, nor does it specify formal listing requirements or issuer reporting requirements.
Swiss banks are the largest investors, but because of a local stamp tax on al l Swiss transactions, they often consummate their deals elsewhere. London is the main center for Eurobond trading.
A market-maker quotes a net price to a financial institution in the form of a bid and ask price. No commissions are charged. Market makers always take on a number of costs in providing liquidity services. These costs include (i) acquiring a non-optimal portfolio from a liquidity point of view, and (ii) the cost of running the dealing room and settlements system. Eurobonds market makers have an additional cost: being forced to trade with some investors who may have superior information (insider trading is quite possible in a Eurobond market that enjoys no direct protection from any regulatory body, like the Securities Exchange Commission). Bid-ask spreads on Eurobonds vary according to the liquidity of the traded Eurobond. Spreads vary between .125 percent on very liquid issues (and less on FRNs) to as much as .50 percent and more on small-size issues with little secondary trading.
Traders are constantly checking computer terminals to evaluate market conditions. The Reuters service is used universally and provides a very extensive range of information on markets in debt and equity securities, foreign exchange and money markets. Eurobonds are assigned individual codes and details of an issue can be accessed by entering the dedicated code. Eurobond prices are published on Reuters screens by market makers and serve as a
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guide to dealing prices at any moment. Other sources of information for traders are Telerate (Reuters main competitor, based in the U.S.), Datastream, and Bloomberg.
When a trade is made, settlement by exchange of bonds and cash takes place on the value date, in general, three business days later. The standard-size transaction is 100 bonds (with USD 1000 of face value). Quoted prices apply to standard-size transactions. Smaller transactions are negotiated at higher spread costs.
Two international securities clearing systems were developed in 1969 and 1970, respectively. Euroclear was the first, set up in Brussels by Morgan Guaranty Trust Company. One year later, Cedel was established in Luxembourg. Physical delivery of the bonds has become rare. The Eurobonds are held with positories, in different countries, to the order of the clearing house. The accounting of the transaction is carried out in Brussels or Luxembourg. Both clearing houses provide financing as well as settlement functions.
8. FOREIGN BOND MARKET
Foreign bonds are issued on a local market by a foreign borrower and are usually denominated in the local currency. Foreign bond issues and trading are under the supervision of localvmarket authorities. Foreign bonds issued on national markets have a long history. They often have colorful names: Yankee Bonds (in the U.S.), samurai bonds (in Japan), Rembrandt bonds (in the Netherlands) and bulldog bonds (U.K.).
8.1 Yankee Bonds
Yankee bonds must be registered under the Securities Act of 1933, which involves meeting the disclosure requirements of the U.S. S.E.C. If the bonds are listed (usually NYSE), they must also be registered under the Securities Exchange Act of 1934. The ordinarily long fourweek registration period can be speeded up by shelf registration. In shelf registration, the
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borrower files a prospectus that covers all anticipated borrowing within the coming year. Then at the time of a new issue, the borrower only has to add a prospectus supplement, which takes only a week to clear. Yankee issues are usually rated by a bond rating agency such as Standard and Poor's Corporation or Moody's Investors Services, Inc. A rating is necessary if the bonds are to be sold to certain U.S. institutional investors. Use of the Yankee bond market has tended to be restricted to borrowers with AAA credit ratings.There is no withholding tax on coupon payments to foreigners who purchase Yankee bonds. Coupons are usually paid semiannually.
8.2 DEM Foreign Bonds
If a banking syndicate selling international DEM bonds is composed of only German banks, the bonds are classified as DEM "foreign" bonds. International DEM bonds are issued in cities outside Germany but are listed on German stock exchanges and are cleared through the Effektengiro system, a special clearing system in Frankfurt. The bonds are held with depositaries known as Kassenvereine which are located throughout Germany.
8.3 Samurai Bonds
A yen-denominated bond issued in Tokyo by a non-Japanese company and subject to Japanese regulations. Other types of yen-denominated bonds are Euroyens issued in countries other than Japan. Samurai bonds give issuers the ability to access investment capital available in Japan. The proceeds from the issuance of samurai bonds can be used by non-Japanese companies to break into the Japanese market, or it can be converted into the issuing company's local currency to be used on existing operations. Samurai bonds can also be used to hedge foreign exchange rate risk.
8.4 Swiss Franc International Bonds
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There is no CHF Eurobond market and international borrowers have access to what is for all intents and purposes a domestic market only. The Swiss government does not allow issues in CHF outside Switzerland and international banks may not lead-manage, co-manage or underwrite issues by foreign borrowers except through subsidiaries incorporated in Switzerland. This regulation has created in Switzerland the largest foreign bond market in the world. The CHF is chosen as a unit of account with relatively stable purchasing power, while Swiss banks act as politically neutral institutions. CHF foreign bonds are bearer bonds, have annual coupons, and have a minimum denomination of CHF 5000. They are usually listed and traded on one of the Swiss stock exchanges. CHF bonds are usually lead managed by one of the "big three": Swiss Bank Corporation, Union Bank of Switzerland, or Credit Suisse. A certain percentage of the Swiss francs received by the borrower have to be converted to other currencies.
8.5 Bulldog Bond
A bulldog bond is a sterling bond whose issuer is not British. A bulldog bond would usually be issued because the issuer has (or intends to acquire) a revenue stream or assets in sterling. Matching these to sterling debt reduces exchange rate risk. These sterling bonds are referred to as bulldog bonds as the bulldog is a national symbol of England.
8.6 Why Do Investors Care About International Bonds?
For Portfolio Diversification: While investing in foreign bonds can increase your returns, adding foreign bonds can significantly reduce the overall risk of your bond portfolio. Diversification also works in the world bond market. The lower the correlation, the greater is the diversification benefits. Because of the lack of co-movements across national markets, the risk reduction attained from investing in a given number of global securities is likely to be much greater.
8.7 Differences among Bond Markets
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1. Issuing Techniques Domestic bonds are usually underwritten by a syndicate of national banks. Dutch, British, Canadian and Swiss government bonds are sold under a tender system, where banks place bids. In the U.K. once an issue has been listed, the Bank of England often sells part of a gilts issue directly on the market through its broker. Eurobonds are issued through an international syndicate of financial institutions. Institutional investors may buy new bonds directly a few days before they are officially issued. This is the so-called gray market. In the Eurobond market bonds are sold under a variety of procedures: the traditional issuing system, the bought deal, the FPRO, and the tender system.
2. Dealing Trading of U.S. domestic bonds is transacted between market makers, which are specialized in financial institutions. On European bond markets, orders are generally sent to the exchange floors through brokers. In the U.S. trading usually takes place over the counter, although some bonds, especially foreign dollar bonds, are listed on the NYSE. Over the counter trading also takes place in Switzerland, U.K., Germany, the Netherlands for non-government issues. In Japan, bonds are both traded over the counter and on the securities exchanges. In brokers' markets bond buyers and sellers pay the same price, but must pay a commission to the broker. In the U.S. prices are net of commissions, but there is a bid-ask spread on all quotations. Although the Eurobond market has no physical location, most of the bonds are listed on the Luxembourg or London stock exchanges to satisfy the requirement of obtaining a public quotation at least once a year or quarter. However, very few transactions go through the exchange.
3. Quotations Bonds are usually quoted on a price-plus-accrued-interest basis. This means the price is quoted separately (as a percentage of the bond's nominal value) from the percentage coupon accrued from the last coupon date to the trade date. That is, Cash price = Quoted price + Accrued Interest = P + A.
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This means that the market price, P, is clean of coupon effect -i.e., accrued interest, A- and allows meaningful comparison between various bonds. Other bonds, like convertible bonds, index linked bonds or FRNs where the coupon is determined expost (at the end of the coupon period) are quoted with coupons attached. Some straight bonds follow this method, as in the U.K. gilt market, the market for UK government bonds. In the U.K., bonds with more than five years to maturity are traded without any separate allowance for accrued interest (i.e., with the coupon attached). That is, in the U.K. gilt market the price quoted falls on the ex-dividend, or ex date, the date when the bond trades without the next coupon payment.
4. Yields Most financial institutions around the world calculate and publish yields-to-maturity on bonds. Unfortunately, the methods differ across countries. Therefore, yields are not comparable. Most European institutions calculate an annual, and accurate, actuarial yield-tomaturity using the AIBD recommended formula. U.S. (and often U.K.) institutions publish a semiannual actuarial yield
5. Legal Aspects Bonds are issued in either bearer or registered forms. In most of the issues on Eurobond markets, the bearer of a bond is assumed to its legal owner. Bearer bonds provide confidentiality, which is very important to some investors. On the other hand, in the U.S. owners must be registered in the books of the issuer. Share registration allows for easier transfer of interest payments and amortization. Coupons are usually paid annually on markets where bonds are issued in bearer form (this reduces the cost associated with coupon payments). Straight Eurobond coupons in all currencies are paid this way. In many countries, retail purchases of foreign bonds are restricted. The motivation for these restrictions stems from exchange controls or attempts by government to ensure domestic investor protection.
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9. BOND MARKET INDICES AND BENCHMARKS
Market benchmarks serve a purpose of providing information to the participants about the prices prevailing in the markets. In the bond markets, the most important market indicator, which every participant wants to track, is the movement in interest rates. Market indicators enable pricing, valuation and performance evaluation. We shall discuss 2 widely tracked benchmarks: the NSE-MIBOR which provides the money market benchmark, and the I -Sec bond indices, which track returns on government securities.
9.1 Features of a Bond Index
The index must be: 1. Representative: An index should span and weight the appropriate markets, instruments and individual securities to reflect the opportunities available to the domestic and international institutional investor. • Markets: The index should cover securities of a wide range of maturities, say one to ten years. • Instruments: The Instruments should have fixed coupons; they must be tradable and redeemable for cash. Thus, the index excludes most of the long dated securities and low coupon securities (which are not traded). • Issues: Each issue of a qualifying instrument must meet certain liquidity criteria to be included in the index. It should generally be traded and at acceptable bid-offer spreads. (Which have now defined as 10 paise)
•
Current Yield: The principal appreciation of a low coupon bond is more than that of a high coupon bond to compensate for the lower interest accrual. To avoid a distortion of the principal returns index on this count, securities where the current yield and YTM differ by more than 100bps are excluded from the index.
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2. Investible and Replicable: An index should include only securities in which an investor can deal at short notice and for which firm prices exist. Firm prices should ideally exist for all constituent securities. The benchmark issues included in the index ought to be · · · widely recognised market indicators issues with high trading volume recent issues with current coupon
A security is excluded from the index if it does not have a market lot (Rs. 5 crore or Rs. 10 crore) trade for three continuous trading days. 3. Accurate and Reliable: Index return calculations should accurately reflect the actual changes in the value of a portfolio consisting of the same securities. 4. Transparent: Investment managers should know which securities are included in an index and how it is constructed. The fund manager must be able to create his own benchmark index and track it.
9.2 Principal Return Index and Total Return Index
The PRI tracks the price movements of bonds and is a mirror image of the movement of market yields. The TRI tracks the returns available in the bond market. In a falling interest rate scenario, the index gains on account of interest accrual and capital gains, losing on reinvestment income, whereas during rising interest rate periods, the interest accrual and reinvestment income is offset by capital losses. Therefore the TRI typically has a positive slope except during periods when the drop in market prices is higher than the interest accrual.
While there exists an array of indices for the equity market, a well-constructed and widely accepted bond index is conspicuous by its absence. There are a few additional difficulties in construction and maintenance of debt indices. First, on account of the fixed maturity of bonds vis-à-vis the perpetuity of equity, the universe of bonds changes frequently (new issues come in while existing issues are redeemed). Secondly, while market prices for the constituents of an equity index are normally available on all trading days over a long period of time, market
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prices of constituent bonds in a bond index, irrespective of the selection criteria used, may not be available daily.
9.3 THE FIMMDA NSE MIBID-MIBOR
One of the methodologies used to obtain market information in distributed dealer markets is the conduct of a poll amongst dealers, and create an order book that comprises the prices at which these dealers are willing to trade as principals. The design of the poll can be tuned to achieve the objective of estimating the market rates at the instant of sampling. There are two variations to the objective of such polling: one kind of poll occurs either at the beginning of the market or during market hours, when participants in the poll provide their estimate of the market rates at the time of the poll; an alternate methodology is the polling of the last traded prices from dealers soon after the close of the market. The polling technique, which uses a sample of dealers, can have two variations: dealers can be asked to quote rates at which they would trade as principals; alternatively dealers could provide their estimate of the market rate, at the time of polling. The results of the poll are impacted by the choice of these alternate polling objectives. From the results of the poll, by putting together the rates of the sample of dealers, estimates of liquidity in the market as a whole is estimated. The estimation techniques have to account for biases created by extending the results obtained from the sample, for the market as a whole. The manner in which the mean of the sample is estimated has important implications for the reliability of the estimate, because the range of poll results could carry elements of noise, manipulation and idiosyncratic variation, which would impact the sample mean. The NSE MIBOR is a polled benchmark, whose polling and sample mean estimation techniques explicitly account for the above issues in creating a market benchmark for debt markets.
10. OTHER DEBT INSTRUMENTS
10.1 Central Government Securities: T-Bills
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Treasury bills are short-term debt instruments issued by the Central government. There are 3 types of T-bills which are issued: 91-day, 182-day and 364-day, representing the 4 types of tenors for which these instruments are issued. Until 1988, the only kind of Treasury bill that was available was the 91-day bill, issued on tap; at a fixed rate of 4.5% (the rates on these bills remained unchanged at 4.5% since 1974!). 182-day T-bills were introduced in 1987, and the auction process for T-bills was started. 364 day T-bill was introduced in April 1992, and in July 1997, the 14-day T-bill was also introduced. RBI did away with 14-day and 182-day Treasury Bills from May 2001. It was decided in consultation with the Central Government to re-introduce, 182 day TBs from April 2005. All T-bills are now sold through an auction process according to a fixed auction calendar, announced by the RBI. Ad hoc treasury bills, which enabled the automatic monetisation of central government budget deficits, have been eliminated in 1997. All T-bill issuances now represent market borrowings of the central government. T-bills are available for a minimum amount of Rs. 25,000 and in multiples of Rs. 25,000. Banks and PDs are major bidders in the T-bill market. Both discriminatory and uniform price auction methods are used in issuance of T-bills. Currently, the auctions of all T-bills are multiple/discriminatory price auctions, where the successful bidders have to pay the prices they have actually bid for. Non-competitive bids, where bidders need not quote the rate of yield at which they desire to buy these T-bills, are also allowed from provident funds and other investors.
Investors in T-Bills: Generally, RBI, Banks, and State Governments invest in T Bills apart from other private players like the insurance cos. Secondary Market Activity in T-Bills:
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Treasury bills are mostly held to maturity by a majority of the buyers. Secondary market activity is quite sparse. The 364-day T-bill is comparatively more actively traded.
10.2 Commercial Paper & Certificate of Deposits
Commercial paper (CP) is a short-term instrument, introduced in 1990, to enable non-banking companies to borrow short-term funds through liquid money market instruments. CPs were intended to be part of the working capital finance for corporates, and were therefore part of the working capital limits as set by the maximum permissible bank finance (MPBF). CP issues are regulated by RBI Guidelines issued from time to time stipulating term, eligibility, limits and amount and method of issuance. It is mandatory for CPs to be credit rated.
Salient Features of CPs:
•
Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note.
•
Corporates and primary dealers (PDs), and the all-India financial institutions (FIs) that have been permitted to raise short-term resources under the umbrella limit fixed by Reserve Bank of India are eligible to issue CP.
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CP can be issued for maturities between a minimum of 7 days and a maximum up to one year from the date of issue. The maturity date of the CP should not go beyond the date up to which the credit rating of the issuer is valid.
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CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by a single investor should not be less than Rs.5 lakh (face value).
•
CP may be issued to and held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by
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FIIs would be within the limits set for their investments by Securities and Exchange Board of India (SEBI).
10.3 Certificate of Deposits (CDs)
With a view to further widening the range of money market instruments and giving investors greater flexibility in deployment of their short term surplus funds, Certificate of Deposits (CDs) were introduced in India in 1989. They are essentially securitized short term time deposits issued by banks and all- India Financial Institutions during the period of tight liquidity at relatively higher discount rates as compared to term deposits. Certificates of Deposits (CDs) are short-term borrowings by banks. CDs differ from term deposit because they involve the creation of paper, and hence have the facility for transfer and multiple ownerships before maturity. CD rates are usually higher than the term deposit rates, due to the low transactions costs. Banks use the CDs for borrowing during a credit pick-up, to the extent of shortage in incremental deposits. Most CDs are held until maturity, and there is limited secondary market activity. Salient Features of CDs:
•
CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI.
•
Certificates of Deposit (CDs) is a negotiable money market instrument and issued in dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period.
•
Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India.
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•
•
Banks have the freedom to issue CDs depending on their requirements. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments, viz., term money, term deposits, commercial papers and inter-corporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet.
•
Minimum amount of a CD should be Rs.1 lakh, i.e., the minimum deposit that could be accepted from a single subscriber should not be less than Rs. 1 lakh and in the multiples of Rs. 1 lakh thereafter.
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CDs can be issued to individuals, corporations, companies, trusts, funds, associations, etc. Non-Resident Indians (NRIs) may also subscribe to CDs, but only on nonrepatriable basis which should be clearly stated on the Certificate. Such CDs cannot be endorsed to another NRI in the secondary market.
•
The maturity period of CDs issued by banks should be not less than 7 days and not more than one year. The FIs can issue CDs for a period not less than 1 year and not exceeding 3 years from the date of issue.
11. REFERENCES
11.1 Websites • • •
www.rbi.org www.investopedia.com www.wikipedia.com
11.2 Books/Manuals • Multinational Finance – Adrian Buckley
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doc_820989730.doc
The documentation explains on Debt Markets and also Bond markets in India.
AN INTRODUCTION TO DEBT MARKETS (Bond Markets in India)
TABLE OF CONTENT
1. DEBT INSTRUMENTS: FUNDAMENTAL FEATURES..............................................3 2. INSTRUMENT FEATURES..............................................................................................3 3. MODIFYING THE COUPON OF A BOND.....................................................................4 4. MODIFYING THE TERM TO MATURITY OF A BOND............................................6 5. MODIFYING THE PRINCIPAL REPAYMENT OF A BOND.....................................7 DEBT MARKET IN INDIA....................................................................................................8
6.1 Historical development ........................................................................................8 6.2 Market Segments:.................................................................................................8 Corporate bond market.............................................................................................10 6.5 Participants in Indian bond market.....................................................................12 6.6 Secondary Market for Debt Instruments.............................................................13
7. EUROBOND MARKETS .................................................................................................15
7.1 7.2 7.3 7.4 Historical development of the Eurobond Market ................................................16 Characteristics of Eurobonds .............................................................................16 Organization of a Traditional Eurobond Syndicate..............................................17 Eurobond secondary market...............................................................................19
8. FOREIGN BOND MARKET............................................................................................21
8.1 8.2 8.3 8.4 8.5 8.6 8.7 Yankee Bonds.....................................................................................................21 DEM Foreign Bonds.............................................................................................22 Samurai Bonds....................................................................................................22 Swiss Franc International Bonds.........................................................................22 Bulldog Bond.......................................................................................................23 Why Do Investors Care About International Bonds?............................................23 Differences among Bond Markets.......................................................................23
9. BOND MARKET INDICES AND BENCHMARKS......................................................26
9.3 THE FIMMDA NSE MIBID-MIBOR...........................................................................28
10. OTHER DEBT INSTRUMENTS...................................................................................28
10.1 Central Government Securities: T-Bills..............................................................28 10.2 Commercial Paper & Certificate of Deposits.....................................................30 10.3 Certificate of Deposits (CDs).............................................................................31
11. REFERENCES................................................................................................................32
11.1 Websites...........................................................................................................32 11.2 Books/Manuals..................................................................................................32
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1. DEBT INSTRUMENTS: FUNDAMENTAL FEATURES
Debt instruments are contracts in which 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 such interest payment, and the repayment of the principal amount borrowed (either in instalments or in bullet). In the Indian securities markets, we generally use the term ‘bond’ for debt instruments issued by the Central and State governments and public sector organisations, and the term ‘debentures’ for instruments issued by private corporate sector.
2. INSTRUMENT FEATURES
The principal features of a bond are: a) Maturity b) Coupon c) Principal In the bond markets, the terms maturity and term-to-maturity, are used quite frequently. Maturity of a bond refers to the date on which the bond matures, or the date on which the borrower has agreed to repay (redeem) the principal amount to the lender. The borrowing is extinguished with redemption, and the bond ceases to exist after that date. Term to maturity, on the other hand, refers to the number of years remaining for the bond to mature. Term to maturity of a bond changes everyday, from the date of issueof the bond until its maturity. Coupon Rate refers to the periodic interest payments that are made by the borrower (who is also the issuer of the bond) to the lender (the subscriber of the bond) and the coupons are stated upfront either directly specifying the number (e.g.8%) or indirectly tying with a benchmark rate (e.g. MIBOR+0.5%). Coupon rate is the rate at which interest is paid, and is usually represented as a percentage of the par value of a bond. Principal is the amount that has been borrowed, and is also called the par value or face value of the bond. The coupon is the product of the principal and the coupon rate. Typical face
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values in the bond market are Rs. 100.All Government bonds have the face value of Rs.100. In many cases, the name of the bond itself conveys the key features of a bond. For example a GS CG2008 11.40% bond refers to a Central Government bond maturing in the year 2008, and paying a coupon of 11.40%.
3. MODIFYING THE COUPON OF A BOND
In a plain vanilla bond, coupon is paid at a pre-determined rate, as a percentage of the par value of the bond. Several modifications to the manner in which coupons / interest on a bond are paid are possible. Zero Coupon Bond: In such a bond, no coupons are paid. The bond is instead issued at a discount to its face value, at which it will be redeemed. There are no intermittent payments of interest. When such a bond is issued for a very long tenor, the issue price is at a steep discount to the redemption value. Such a zero coupon bond is also called a deep discount bond. The effective interest earned by the buyer is the difference between the face value and the discounted price at which the bond is bought. There are also instances of zero coupon bonds being issued at par, and redeemed with interest at a premium. The essential feature of this type of bonds is the absence of intermittent cash flows. Treasury Strips : In the United States, government dealer firms buy coupon paying treasury bonds, and create out of each cash flow of such a bond, a separate zero coupon bond. For example, a 7 -year coupon-paying bond comprises of 14 cash flows, representing half-yearly coupons and the repayment of principal on maturity. Dealer firms split this bond into 14 zero coupon bonds, each one with a differing maturity and sell them separately, to buyers with varying tenor preferences. Such bonds are known as treasury strips. (Strips is an acronym for Separate Trading of Registered Interest and Principal Securities). We do not have treasury strips yet in the Indian markets. RBI and Government are making efforts to develop market for strips in government securities. Floating Rate Bonds: Instead of a pre-determined rate at which coupons are paid, it is possible to structure bonds, where the rate of interest is re-set periodically, based on a benchmark rate. Such bonds whose coupon rate is not fixed, but reset with reference to a
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benchmark rate, are called floating rate bonds. For example, IDBI issued a 5 year floating rate bond, in July 1997, with the rates being re-set semi-annually with reference to the 10 year yield on Central Government securities and a 50 basis point mark-up. In this bond, every six months, the 10-year benchmark rate on government securities is ascertained. The coupon rate IDBI would pay for the next six months is this benchmark rate, plus 50 basis points. The coupon on a floating rate bond thus varies along with the benchmark rate, and is reset periodically. The Central Government has also started issuing floating rate bonds tying the coupon to the average cut-off yields of last six 364-day T-bills yields. Some floating rate bonds also have caps and floors, which represent the upper and lower limits within which the floating rates can vary. For example, the IDBI bond described above had a floor of 13.5%. This means, the lender would receive a minimum of 13.5% as coupon rate, should the benchmark rate fall below this threshold. A ceiling or a cap represents the maximum interest that the borrower will pay, should the benchmark rate move above such a level. Most corporate bonds linked to the call rates, have such a ceiling to cap the interest obligation of the borrower, in the event of the benchmark call rates rising very steeply. Floating rate bonds, whose coupon rates are bound by both a cap and floor, are called as range notes, because the coupon rates vary within a certain range. The other names, by which floating rate bonds are known, are variable rate bonds and adjustable rate bonds. Other Variations: In the mid-eighties, the US markets witnessed a variety of coupon structures in the high yield bond market (junk bonds) for leveraged buy-outs. In many of these cases, structures that enabled the borrowers to defer the payment of coupons were created. Some of the more popular structures were: (a) Deferred interest bonds, where the borrower could defer the payment of coupons in the initial 3 to 7 year period; (b) Step-up bonds, where the coupon was stepped up by a few basis points periodically, so that the interest burden in the initial years is lower, and increases over time; (c) Extendible reset bond, in which investment bankers reset the rates, not on the basis of a benchmark, but after re-negotiating a new rate, which in the opinion of the lender and borrower, represented the rate for the bond after taking into account the new circumstances at the time of reset.
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4. MODIFYING THE TERM TO MATURITY OF A BOND
Callable Bonds: Bonds that allow the issuer to alter the tenor of a bond, by redeeming it prior to the original maturity date, are called callable bonds. The inclusion of this feature in the bond’s structure provides the issuer the right to fully or partially retire the bond, and is therefore in the nature of call option on the bond. Since these options are not separated from the original bond issue, they are also called embedded options. A call option can be an European option, where the issuer specifies the date on which the option could be exercised. Alternatively, the issuer can embed an American option in the bond, providing him the right to call the bond on or anytime before a pre-specified date. The call option provides the issuer the option to redeem a bond, if interest rates decline, and re-issue the bonds at a lower rate. The investor, however, loses the opportunity to stay invested in a high coupon bond, when interest rates have dropped. The call option, therefore, can effectively alter the term of a bond, and carries an added set of risks to the investor, in the form of call risk, and re-investment risk. As we shall see later, the prices at which these bonds would trade in the market are also different, and depend on the probability of the call option being exercised by the issuer. In the home loan markets, pre-payment of housing loans represent a special case of call options exercised by borrowers. Puttable Bonds: Bonds that provide the investor with the right to seek redemption from the issuer, prior to the maturity date, are called puttable bonds. The put options embedded in the bond provides the investor the rights to partially or fully sell the bonds back to the issuer, either on or before pre-specified dates. The actual terms of the put option are stipulated in the original bond indenture. A put option provides the investor the right to sell a low coupon-paying bond to the issuer, and invest in higher coupon paying bonds, if interest rates move up. The issuer will have to re-issue the put bonds at higher coupons. Puttable bonds represent a re-pricing risk to the issuer. When interest rates increase, the value of bonds would decline. Therefore put options, which seek redemptions at par, represent an additional loss to the issuer.
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Convertible Bonds: A convertible bond provides the investor the option to convert the value of the outstanding bond into equity of the borrowing firm, on pre-specified terms. Exercising this option leads to redemption of the bond prior to maturity, and its replacement with equity. At the time of the bond’s issue, the indenture clearly specifies the conversion ratio and the conversion price. The conversion ratio refers to the number of equity shares, which will be issued in exchange for the bond that is being converted. The conversion price is the resulting price when the conversion ratio is applied to the value of the bond, at the time of conversion. Bonds can be fully converted, such that they are fully redeemed on the date of conversion. Bonds can also be issued as partially convertible, when a part of the bond is redeemed and equity shares are issued in the pre-specified conversion ratio, and the non-convertible portion continues to remain as a bond.
5. MODIFYING THE PRINCIPAL REPAYMENT OF A BOND
Amortising Bonds: The structure of some bonds may be such that the principal is not repaid at the end but over the life of the bond. A bond, in which payment made by the borrower over the life of the bond, includes both interest and principal is called an amortising bond. Auto loans, consumer loans and home loans are examples of amortising bonds. The maturity of the amortising bond refers only to the last payment in the amortising schedule, because the principal is repaid over time. Bonds with Sinking Fund Provisions: In certain bond indentures, there is a provision that calls upon the issuer to retire some amount of the outstanding bonds every year. This is done either by buying some of the outstanding bonds in the market, or as is more common, by creating a separate fund, which calls the bonds on behalf of the issuer. Such provisions that enable retiring bonds over their lives are called sinking fund provisions. In many cases, the sinking fund is managed by trustees, who regularly retire part of the outstanding bonds, usually at par. Sinking funds also enable paying off bonds over their life, rather than at maturity. One usual variant is applicability of the sinking fund provision after few years of the issue of the bond, so that the funds are available to the borrower for a minimum period, before redemption can commence.
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DEBT MARKET IN INDIA
6.1 Historical development
The debt market is much more popular than the equity markets in most parts of the world. In India the reverse has been true. Indian debt markets, in the early nineties, were characterised by controls on pricing of assets, segmentation of markets and barriers to entry, low levels of liquidity, limited number of players, near lack of transparency, and high transactions cost. Lacunae in institutional infrastructure and inefficient market practices characterized the government securities market. In fact the sole objective pursued was to keep the cost of government borrowing as low as possible. The GOI bond market did not use trading on an exchange. It featured bilateral negotiation between dealers. The market thus lacked price-time priority and the bilateral transactions imposed counterparty credit risk on participants. This narrowed down the market into a “club” with homogeneous credit risk. Financial reforms in early 1990s have significantly changed the Indian debt markets for the better and have added greater transparency and have brought the issuances closer to the market levels. Most debt instruments are now priced freely on the markets; trading mechanisms have been altered to provide for higher levels of transparency, higher liquidity, and lower transactions costs; new participants have entered the markets, broad basing the types of players in the markets; methods of security issuance, and innovation in the structure of instruments have taken place; there has been a significant improvement in the dissemination of market information.
6.2 Market Segments:
The debt market in India comprises broadly two segments, viz., Government Securities Market and Corporate Debt Market. The latter is further classified as Market for PSU Bonds and Private Sector Bonds.
We now see a fairly well-segmented debt market in India comprising of the following segments:
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6.3 Government Securities (g-sec) market:
The market for government securities is the oldest and most dominant in terms of market capitalisation, outstanding securities, trading volume and number of participants. It not only provides resources to the government for meeting its short term and long term needs, but also sets benchmark for pricing corporate paper of varying maturities and is used by RBI as an instrument of monetary policy. The instruments in this segment are fixed coupon bonds, commonly referred to as dated securities, treasury bills, floating rate bonds, zero coupon bonds and inflation index bonds. The government securities market has witnessed significant transformation in the 1990s in terms of market design. The most significant developments include introduction of auctionbased price determination for government securities, development of new instruments and mechanisms for government borrowing as well as participation by new market participants, increase in information dissemination on market borrowings and secondary market transactions, screen based negotiations for trading, and the development of the yield curve for government securities for marking-to-market portfolios of banks.
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As a result of the gradual reform process undertaken over the years, the Indian G-Sec market has now become increasingly broad-based, characterised by an efficient auction process, an active secondary market and a fairly liquid yield curve up to 30 years. An active Primary Dealer (PD) system and electronic trading and settlement technology that ensure safe settlement with Straight through Processing (STP) and central counterparty guarantee support the market now. Secondary Markets for Government Bonds Government bonds are deemed to be listed as soon as they are issued. Markets for government securities are pre-dominantly wholesale markets, with trades done on telephonic negotiation. NSE WDM provides a trading platform for Government bonds, and reports over 65% of all secondary market trades in government securities. Currently, transactions in government securities are required to be settled on the trade date or next working day unless the transaction is through a broker of a permitted stock exchange in which case settlement can be on T+2 basis. State Government Bonds The State government bond issuance is presently managed by the RBI along with the central borrowings. States have the option to raise their money through auction system or on tap basis.
Corporate bond market
Until 1992, interest rate on corporate bond issuance was regulated and was uniform across credit categories. In the initial years, corporate bonds were issued with “sweeteners” in the form of convertibility clause or equity warrants. Most corporate bonds were plain coupon paying bonds, though a few variations in the form of zero coupon securities, deep discount bonds and secured promissory notes were issued. After the de-regulation of interest rates on corporate bonds in 1992, we have seen a variety of structures and instruments in the corporate bond markets, including securitized products, corporate bond strips, and a variety of floating rate instruments with floors and caps. In the recent years, there has been an increase in issuance of corporate bonds with embedded put and call options. The major part of the corporate debt is privately placed with tenors of 1-12 years. However, in terms of raising debt through public issuance in capital market, is only an
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insignificant part of the Indian Debt Market. The lack of market infrastructure and comprehensive regulatory framework coupled with low issuance leading to low liquidity in the secondary market, narrow investor base, inadequate credit assessment skills, high cost of issuance, lack of transparency in trades and underdevelopment of securitization of products are some of the major factors that hindered the growth of the private corporate debt market. Over the years greater innovation has been witnessed in the corporate bond issuances, like floating rate instruments, zero coupon bonds, convertible bonds, callable (put-able) bonds and step-redemption bonds. The listed corporate bonds also trade on the Wholesale Debt Segment of NSE. But the percentage of the bonds trading on the exchange is small. The secondary market for corporate bonds till now has been over the counter market. 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
PSU Bonds (taxable and non-taxable) The issues by government sponsored institutions like, Development Financial Institutions, as well as the infrastructure-related bodies and the PSUs, who make regular forays into the market to raise medium-term funds, constitute the second segment of debt markets. The gradual withdrawal of budgetary support to PSUs by the government since 1991 has compelled them to look at the bond market for mobilising resources. The preferred mode of issue has been private placement, barring an occasional public issue. Banks, financial institutions and other corporates have been the major subscribers to these issues. The tax-free bonds, which constitute over 50% of the outstanding PSU bonds, are quite popular with institutional players. FI/Bank bonds (recent development) For example, step bonds issued by ICICI in 1998, paid progressively higher rates of interest as the maturity approached while the IDBI’s step bond was issued with a feature to pay out the redemption amount in instalments after an initial holding period. The deep discount bond issued by IDBI in the same year had two put and call options before maturity.
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In addition, we are also beginning to see the arrival of securitised bonds, backed by assets like auto-finance receivables, energy sale receivables, etc.
6.5 Participants in Indian bond market
SBI and its associates are the single largest owners of state government securities. The banking system as a whole is a large investor in government securities. One of the reasons for banks to invest in state government bonds is the relatively lower risk-weighting on these bonds, compared to the risk weighting in case of corporate lending. The prudential investment norms of LIC and provident funds have also enabled a sizeable holding of state government securities by these entities.
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6.6 Secondary Market for Debt Instruments
The NSE- WDM segment provides the formal trading platform for trading of a wide range of debt securities. Initially, government securities, treasury bills and bonds issued by public sector undertakings (PSUs) were made available for trading. This range has been widened to include non-traditional instruments like, floating rate bonds, zero coupon bonds, index bonds, 18 commercial papers, certificates of deposit, corporate debentures, state government loans, SLR and non-SLR bonds issued by financial institutions, units of mutual funds and securitized debt. The WDM trading system, known as NEAT (National Exchange for
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Automated Trading), is a fully automated screen based trading system that enables members across the country to trade simultaneously with enormous ease and efficiency. The instrument-wise turnover for securities listed on the NSE-WDM is shown in Table
Retail Debt Market :With a view to encouraging wider participation of all classes of investors across the country (including retail investors) i n government securities, the Government, RBI and SEBI have introduced trading in government securities 20 for retail investors. Trading in this retail debt market segment (RDM) on NSE has been introduced w.e.f. January 16, 2003. RDM Trading: Trading takes place in the existing Capital Market segment of the Exchange and in the same manner in which the trading takes place in the equities (Capital Market) segment. The RETDEBT Market facility on the NEAT system of Capital Market Segment is used for entering transactions in RDM session. The trading holidays and market timings of the RDM segment are the same as the Equities segment. Negotiated Dealing System: The first step towards electronic bond trading in India was the introduction ofthe RBIs Negotiated Dealing System in February 2002. NDS, interalia, facilitates screen based negotiated dealing for secondary market transactions in government securities and money market instruments, online reporting of transactions in the instruments available on the NDS and dissemination of trade information to the market. Government Securities (including T-bills), call money, notice/term money, repos in eligible securities are available for negotiated dealing through NDS among the members. NDS members concluding deals, in the telephone market in instruments available on NDS, are required to report the deal on NDS system within 15 minutes of concluding the deal. With the objective of creating a broad-based and transparent market in government securities and thereby enhancing liquidity in the system, the NDS was designed to provide: • Electronic bidding in primary market auctions (T-Bills, dated securities, state government securities) by members,
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• • •
Electronic bidding for OMO of RBI including repo auctions under LAF, Screen based negotiated dealing system for secondary market operations, Reporting of deals in government securities done among NDS members outside the system (over telephone or using brokers of exchanges) for settlement,
• •
•
Dissemination of trade information to NDS members, Countrywide access of NDS through INFINET, Electronic connectivity for settlement of trades in secondary market both for outright and repos either through CCIL or directly through RBI, and Creation and maintenance of basic data of instruments and members.
NDS-OM: It is an electronic, screen based, anonymous order driven trading system introduced by RBI as part of the existing NDS system to facilitate electronic dealing in government securities. It is accessible to members through RBIs INFINET Network. The system facilitates price discovery, liquidity, increased operational efficiency and transparency. The NDS-OM System supports trading in all Central Government Dated Securities and State Government securities in T+1 settlement type. Since August 1, 2006 the system was enhanced to facilitate trading in Treasury Bills and When Issued transaction in a security authorized for issuance but not as yet actually issued. All ‘WI’ transactions are on an ‘if’ basis, to be settled if and when the actual security is issued. Further, RBI has permitted the execution of intra-day short sale transaction and the covering of the short position in government securities can be done both on and outside the NDS-OM platform i.e. through telephone market.
7. EUROBOND MARKETS
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7.1 Historical development of the Eurobond Market
The growth of the Eurobond market was extraordinary. Shortly after the introduction of the Interest Equalization Tax, in June 1963, the first offshore bond issue denominated in U.S. dollars was launched. In the same year a total of USD 145 million in new Eurobond issues was raised, and by 1968 the volume had risen to USD 3 billion. On the strength of its early success, the Eurobond market quickly established itself:
• •
It had a marketplace in London. The U.K. authorities allowed the market to develop without regulations or restrictions. London became, and remains today, the principal centre for new issues and the trading of USD denominated Eurobonds.
•
The speed and simplicity of issuing in the Eurobond market compared favourably with the principal foreign bond market, the U.S. Yankee market.
•
The establishment in 1969 of the Association of International Bond Dealers (AIBD) provided a forum for improving the design of the market.
•
The early establishment of a clearing system, Euroclear and Cedel in 1969 and 1970, respectively, resolved the problem of delivery and custody.
7.2 Characteristics of Eurobonds
A Eurobond is an international debt security and its structure is similar to the standard debt security used in domestic bond markets. The basic characteristics are listed below:
•
A Eurobond is a debt contract between a borrower and an investor, which records the borrower's obligation to pay interest and the principal amount of the bond on specified dates.
• • •
A Eurobond is transferable. A Eurobond is intended to be tradable. A Eurobond is a medium- to long-term debt security.
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•
A Eurobond is generally launched through a public offering and listed on a stock exchange.
The full terms and conditions of an issue are printed on the actual bond, which has three components:
• The face: Sets out the name of the borrower, short detail on maturity, the interest-rate
coupon (or in the case of FRN, the interest base and margin), and the formal promise to pay interest and principal.
• The reverse: Sets out (1) the terms and conditions of the issue and (2) the details of
the banks responsible for payments of interest and principal.
• The coupons: They are a series of detachable coupons, which are presented on interest
payment dates as evidence of entitlement to payment. These are identical in all respects except the date of payment.
7.3 Organization of a Traditional Eurobond Syndicate
Eurobonds are issued and sold through underwriting syndicates. Participants in these syndicates are investment banks, merchant banks, and the merchant banking subsidiaries of commercial banks.
A potential borrower -a company, a bank, an international organization, or a governmentreceives unsolicited proposals. These proposals keep the potential borrower in touch with market opportunities and pricing and, when the borrower, or issuer, asks for new issue proposals, help to ensure competitive bidding. Each house offers some niche of expertise in placement or in derivative products, which together bring the issuer a broad understanding of the marketplace. Borrowers look to issuing houses which demonstrate commitment and competence in the analysis of their borrowing requirement in the submission of timely, cost attractive, and marketable proposals.
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Based on the proposals, the borrower selects an investment bank and invites it to become the lead manager of a Eurobond issue on the borrower's behalf. The major contribution of the lead manager, or issuing house, lies in its expertise with respect to the presentation of a firsttime issuer, the selection of a syndicate, the decision of a timely launch, the support of the issue in the aftermarket, and the maintenance of an effective secondary market.
After being selected by the issuer, the lead manager invites a small additional group of banks to assist it in negotiating terms with the borrower, in assessing the market, and in organizing and managing the new issue. These additional banks are called the co-managers. The comanagers and the lead manager become the managing group. The lead-manager in selecting banks to make up a management group has two priorities: (1) sharing the risk of the issue and (2) helping to place it. In practice, the lead-manager consults with the potential co-managers on pricing prior to submission of a proposal, and, in doing so, will measure their interest in the issue. The co-managers, however, give no commitment and in the event of bad market conditions -i.e., adverse changes in interest rates- may decline the invitation. In addition, two other categories of banks -underwriters and the selling group- will be invited to participate in bringing the bonds to market. In general, proposals include recommendations for a syndicate of underwriters who enhance the placement.
The borrower sells the bonds to the managing group. In turn, the managing group sells the bonds either directly to both the underwriters and the selling group or else sells the bonds to the underwriters, who in turn sell the bonds to the selling group. Members of the selling group sell to final investors. Underwriters differ from pure sellers in that underwriters commit themselves ahead of time to buy the bonds at a set minimum price from the managers even if the bonds cannot be resold to sellers or end investors for a price greater than this pre-agreed minimum. Roles in a Eurobond syndicate are nested: Managers are also underwriters and sellers, and underwriters are usually also sellers.
The principal paying agent in a Eurobond issue is the bank that has the responsibility for receiving interest and principal payments from the borrower and disbursing them to end investors. When a fiscal agent is used in a new issue, the fiscal agent and the principal agent are the same. A fiscal agent is a bank appointed to act on behalf of the borrower, one that
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takes care of the mechanics of bond authentication and distribution to investors as well as acting as principal agent. An alternative to a fiscal agent is a trustee. A trustee acts as the representative of all bondholders in any legal action stemming from bond covenant defaults. If a trustee is used for a new Eurobond issue, then a separate paying agent will be appointed to act on behalf of the bond issuer.
7.4 Eurobond secondary market
Public Eurobond issues are listed on one or more stock exchanges. The principal exchanges for issues in USD, CAD, ECUs, and AUD are the Luxembourg Stock Exchange and the London Stock Exchange. Issues denominated in European currencies tend to be listed on the home exchange; for example, issues in Dutch guilder are listed on the Amsterdam exchange. Although Eurobond issues are listed, there is no legal obligation on dealers to deal on the exchanges. From early on, dealers in Eurobonds dealt over-the-counter, adopting the practice of money and foreign exchange markets.
In 1969, Eurobond dealers created an around the clock market among financial institutions across the world that formed the AIBD (Association of International Bond Dealers). The AIBD's original purpose was to create a framework of rules under which the fledging overthe-counter Eurobond market could function and to provide direction and stability to this rapidly changing market. In 1991, the AIBD was reorganized into the International Securities
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Market Association (ISMA) to recognize the fact that many AIBD members expanded into other securities. The ISMA, based in Zurich, is the self-regulatory industry body and trade association for the international securities market. The ISMA has some similarities to the U.S. National Association of Securities Dealers (NASD). All market-makers and dealers in Eurobonds are part of the ISMA. The ISMA requires its members to report the terms of their deals through a trade-matching and confirmation electronic system named TRAX. This is done to ensure price transparency in the market. TRAX handles 40,000 to 50,000 transactions per day, providing reliable traded prices on over 3,500 securities daily. Therefore, the ISMA in effect serves as an alternative stock exchange. It has no trading floor, nor does it specify formal listing requirements or issuer reporting requirements.
Swiss banks are the largest investors, but because of a local stamp tax on al l Swiss transactions, they often consummate their deals elsewhere. London is the main center for Eurobond trading.
A market-maker quotes a net price to a financial institution in the form of a bid and ask price. No commissions are charged. Market makers always take on a number of costs in providing liquidity services. These costs include (i) acquiring a non-optimal portfolio from a liquidity point of view, and (ii) the cost of running the dealing room and settlements system. Eurobonds market makers have an additional cost: being forced to trade with some investors who may have superior information (insider trading is quite possible in a Eurobond market that enjoys no direct protection from any regulatory body, like the Securities Exchange Commission). Bid-ask spreads on Eurobonds vary according to the liquidity of the traded Eurobond. Spreads vary between .125 percent on very liquid issues (and less on FRNs) to as much as .50 percent and more on small-size issues with little secondary trading.
Traders are constantly checking computer terminals to evaluate market conditions. The Reuters service is used universally and provides a very extensive range of information on markets in debt and equity securities, foreign exchange and money markets. Eurobonds are assigned individual codes and details of an issue can be accessed by entering the dedicated code. Eurobond prices are published on Reuters screens by market makers and serve as a
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guide to dealing prices at any moment. Other sources of information for traders are Telerate (Reuters main competitor, based in the U.S.), Datastream, and Bloomberg.
When a trade is made, settlement by exchange of bonds and cash takes place on the value date, in general, three business days later. The standard-size transaction is 100 bonds (with USD 1000 of face value). Quoted prices apply to standard-size transactions. Smaller transactions are negotiated at higher spread costs.
Two international securities clearing systems were developed in 1969 and 1970, respectively. Euroclear was the first, set up in Brussels by Morgan Guaranty Trust Company. One year later, Cedel was established in Luxembourg. Physical delivery of the bonds has become rare. The Eurobonds are held with positories, in different countries, to the order of the clearing house. The accounting of the transaction is carried out in Brussels or Luxembourg. Both clearing houses provide financing as well as settlement functions.
8. FOREIGN BOND MARKET
Foreign bonds are issued on a local market by a foreign borrower and are usually denominated in the local currency. Foreign bond issues and trading are under the supervision of localvmarket authorities. Foreign bonds issued on national markets have a long history. They often have colorful names: Yankee Bonds (in the U.S.), samurai bonds (in Japan), Rembrandt bonds (in the Netherlands) and bulldog bonds (U.K.).
8.1 Yankee Bonds
Yankee bonds must be registered under the Securities Act of 1933, which involves meeting the disclosure requirements of the U.S. S.E.C. If the bonds are listed (usually NYSE), they must also be registered under the Securities Exchange Act of 1934. The ordinarily long fourweek registration period can be speeded up by shelf registration. In shelf registration, the
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borrower files a prospectus that covers all anticipated borrowing within the coming year. Then at the time of a new issue, the borrower only has to add a prospectus supplement, which takes only a week to clear. Yankee issues are usually rated by a bond rating agency such as Standard and Poor's Corporation or Moody's Investors Services, Inc. A rating is necessary if the bonds are to be sold to certain U.S. institutional investors. Use of the Yankee bond market has tended to be restricted to borrowers with AAA credit ratings.There is no withholding tax on coupon payments to foreigners who purchase Yankee bonds. Coupons are usually paid semiannually.
8.2 DEM Foreign Bonds
If a banking syndicate selling international DEM bonds is composed of only German banks, the bonds are classified as DEM "foreign" bonds. International DEM bonds are issued in cities outside Germany but are listed on German stock exchanges and are cleared through the Effektengiro system, a special clearing system in Frankfurt. The bonds are held with depositaries known as Kassenvereine which are located throughout Germany.
8.3 Samurai Bonds
A yen-denominated bond issued in Tokyo by a non-Japanese company and subject to Japanese regulations. Other types of yen-denominated bonds are Euroyens issued in countries other than Japan. Samurai bonds give issuers the ability to access investment capital available in Japan. The proceeds from the issuance of samurai bonds can be used by non-Japanese companies to break into the Japanese market, or it can be converted into the issuing company's local currency to be used on existing operations. Samurai bonds can also be used to hedge foreign exchange rate risk.
8.4 Swiss Franc International Bonds
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There is no CHF Eurobond market and international borrowers have access to what is for all intents and purposes a domestic market only. The Swiss government does not allow issues in CHF outside Switzerland and international banks may not lead-manage, co-manage or underwrite issues by foreign borrowers except through subsidiaries incorporated in Switzerland. This regulation has created in Switzerland the largest foreign bond market in the world. The CHF is chosen as a unit of account with relatively stable purchasing power, while Swiss banks act as politically neutral institutions. CHF foreign bonds are bearer bonds, have annual coupons, and have a minimum denomination of CHF 5000. They are usually listed and traded on one of the Swiss stock exchanges. CHF bonds are usually lead managed by one of the "big three": Swiss Bank Corporation, Union Bank of Switzerland, or Credit Suisse. A certain percentage of the Swiss francs received by the borrower have to be converted to other currencies.
8.5 Bulldog Bond
A bulldog bond is a sterling bond whose issuer is not British. A bulldog bond would usually be issued because the issuer has (or intends to acquire) a revenue stream or assets in sterling. Matching these to sterling debt reduces exchange rate risk. These sterling bonds are referred to as bulldog bonds as the bulldog is a national symbol of England.
8.6 Why Do Investors Care About International Bonds?
For Portfolio Diversification: While investing in foreign bonds can increase your returns, adding foreign bonds can significantly reduce the overall risk of your bond portfolio. Diversification also works in the world bond market. The lower the correlation, the greater is the diversification benefits. Because of the lack of co-movements across national markets, the risk reduction attained from investing in a given number of global securities is likely to be much greater.
8.7 Differences among Bond Markets
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1. Issuing Techniques Domestic bonds are usually underwritten by a syndicate of national banks. Dutch, British, Canadian and Swiss government bonds are sold under a tender system, where banks place bids. In the U.K. once an issue has been listed, the Bank of England often sells part of a gilts issue directly on the market through its broker. Eurobonds are issued through an international syndicate of financial institutions. Institutional investors may buy new bonds directly a few days before they are officially issued. This is the so-called gray market. In the Eurobond market bonds are sold under a variety of procedures: the traditional issuing system, the bought deal, the FPRO, and the tender system.
2. Dealing Trading of U.S. domestic bonds is transacted between market makers, which are specialized in financial institutions. On European bond markets, orders are generally sent to the exchange floors through brokers. In the U.S. trading usually takes place over the counter, although some bonds, especially foreign dollar bonds, are listed on the NYSE. Over the counter trading also takes place in Switzerland, U.K., Germany, the Netherlands for non-government issues. In Japan, bonds are both traded over the counter and on the securities exchanges. In brokers' markets bond buyers and sellers pay the same price, but must pay a commission to the broker. In the U.S. prices are net of commissions, but there is a bid-ask spread on all quotations. Although the Eurobond market has no physical location, most of the bonds are listed on the Luxembourg or London stock exchanges to satisfy the requirement of obtaining a public quotation at least once a year or quarter. However, very few transactions go through the exchange.
3. Quotations Bonds are usually quoted on a price-plus-accrued-interest basis. This means the price is quoted separately (as a percentage of the bond's nominal value) from the percentage coupon accrued from the last coupon date to the trade date. That is, Cash price = Quoted price + Accrued Interest = P + A.
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This means that the market price, P, is clean of coupon effect -i.e., accrued interest, A- and allows meaningful comparison between various bonds. Other bonds, like convertible bonds, index linked bonds or FRNs where the coupon is determined expost (at the end of the coupon period) are quoted with coupons attached. Some straight bonds follow this method, as in the U.K. gilt market, the market for UK government bonds. In the U.K., bonds with more than five years to maturity are traded without any separate allowance for accrued interest (i.e., with the coupon attached). That is, in the U.K. gilt market the price quoted falls on the ex-dividend, or ex date, the date when the bond trades without the next coupon payment.
4. Yields Most financial institutions around the world calculate and publish yields-to-maturity on bonds. Unfortunately, the methods differ across countries. Therefore, yields are not comparable. Most European institutions calculate an annual, and accurate, actuarial yield-tomaturity using the AIBD recommended formula. U.S. (and often U.K.) institutions publish a semiannual actuarial yield
5. Legal Aspects Bonds are issued in either bearer or registered forms. In most of the issues on Eurobond markets, the bearer of a bond is assumed to its legal owner. Bearer bonds provide confidentiality, which is very important to some investors. On the other hand, in the U.S. owners must be registered in the books of the issuer. Share registration allows for easier transfer of interest payments and amortization. Coupons are usually paid annually on markets where bonds are issued in bearer form (this reduces the cost associated with coupon payments). Straight Eurobond coupons in all currencies are paid this way. In many countries, retail purchases of foreign bonds are restricted. The motivation for these restrictions stems from exchange controls or attempts by government to ensure domestic investor protection.
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9. BOND MARKET INDICES AND BENCHMARKS
Market benchmarks serve a purpose of providing information to the participants about the prices prevailing in the markets. In the bond markets, the most important market indicator, which every participant wants to track, is the movement in interest rates. Market indicators enable pricing, valuation and performance evaluation. We shall discuss 2 widely tracked benchmarks: the NSE-MIBOR which provides the money market benchmark, and the I -Sec bond indices, which track returns on government securities.
9.1 Features of a Bond Index
The index must be: 1. Representative: An index should span and weight the appropriate markets, instruments and individual securities to reflect the opportunities available to the domestic and international institutional investor. • Markets: The index should cover securities of a wide range of maturities, say one to ten years. • Instruments: The Instruments should have fixed coupons; they must be tradable and redeemable for cash. Thus, the index excludes most of the long dated securities and low coupon securities (which are not traded). • Issues: Each issue of a qualifying instrument must meet certain liquidity criteria to be included in the index. It should generally be traded and at acceptable bid-offer spreads. (Which have now defined as 10 paise)
•
Current Yield: The principal appreciation of a low coupon bond is more than that of a high coupon bond to compensate for the lower interest accrual. To avoid a distortion of the principal returns index on this count, securities where the current yield and YTM differ by more than 100bps are excluded from the index.
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2. Investible and Replicable: An index should include only securities in which an investor can deal at short notice and for which firm prices exist. Firm prices should ideally exist for all constituent securities. The benchmark issues included in the index ought to be · · · widely recognised market indicators issues with high trading volume recent issues with current coupon
A security is excluded from the index if it does not have a market lot (Rs. 5 crore or Rs. 10 crore) trade for three continuous trading days. 3. Accurate and Reliable: Index return calculations should accurately reflect the actual changes in the value of a portfolio consisting of the same securities. 4. Transparent: Investment managers should know which securities are included in an index and how it is constructed. The fund manager must be able to create his own benchmark index and track it.
9.2 Principal Return Index and Total Return Index
The PRI tracks the price movements of bonds and is a mirror image of the movement of market yields. The TRI tracks the returns available in the bond market. In a falling interest rate scenario, the index gains on account of interest accrual and capital gains, losing on reinvestment income, whereas during rising interest rate periods, the interest accrual and reinvestment income is offset by capital losses. Therefore the TRI typically has a positive slope except during periods when the drop in market prices is higher than the interest accrual.
While there exists an array of indices for the equity market, a well-constructed and widely accepted bond index is conspicuous by its absence. There are a few additional difficulties in construction and maintenance of debt indices. First, on account of the fixed maturity of bonds vis-à-vis the perpetuity of equity, the universe of bonds changes frequently (new issues come in while existing issues are redeemed). Secondly, while market prices for the constituents of an equity index are normally available on all trading days over a long period of time, market
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prices of constituent bonds in a bond index, irrespective of the selection criteria used, may not be available daily.
9.3 THE FIMMDA NSE MIBID-MIBOR
One of the methodologies used to obtain market information in distributed dealer markets is the conduct of a poll amongst dealers, and create an order book that comprises the prices at which these dealers are willing to trade as principals. The design of the poll can be tuned to achieve the objective of estimating the market rates at the instant of sampling. There are two variations to the objective of such polling: one kind of poll occurs either at the beginning of the market or during market hours, when participants in the poll provide their estimate of the market rates at the time of the poll; an alternate methodology is the polling of the last traded prices from dealers soon after the close of the market. The polling technique, which uses a sample of dealers, can have two variations: dealers can be asked to quote rates at which they would trade as principals; alternatively dealers could provide their estimate of the market rate, at the time of polling. The results of the poll are impacted by the choice of these alternate polling objectives. From the results of the poll, by putting together the rates of the sample of dealers, estimates of liquidity in the market as a whole is estimated. The estimation techniques have to account for biases created by extending the results obtained from the sample, for the market as a whole. The manner in which the mean of the sample is estimated has important implications for the reliability of the estimate, because the range of poll results could carry elements of noise, manipulation and idiosyncratic variation, which would impact the sample mean. The NSE MIBOR is a polled benchmark, whose polling and sample mean estimation techniques explicitly account for the above issues in creating a market benchmark for debt markets.
10. OTHER DEBT INSTRUMENTS
10.1 Central Government Securities: T-Bills
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Treasury bills are short-term debt instruments issued by the Central government. There are 3 types of T-bills which are issued: 91-day, 182-day and 364-day, representing the 4 types of tenors for which these instruments are issued. Until 1988, the only kind of Treasury bill that was available was the 91-day bill, issued on tap; at a fixed rate of 4.5% (the rates on these bills remained unchanged at 4.5% since 1974!). 182-day T-bills were introduced in 1987, and the auction process for T-bills was started. 364 day T-bill was introduced in April 1992, and in July 1997, the 14-day T-bill was also introduced. RBI did away with 14-day and 182-day Treasury Bills from May 2001. It was decided in consultation with the Central Government to re-introduce, 182 day TBs from April 2005. All T-bills are now sold through an auction process according to a fixed auction calendar, announced by the RBI. Ad hoc treasury bills, which enabled the automatic monetisation of central government budget deficits, have been eliminated in 1997. All T-bill issuances now represent market borrowings of the central government. T-bills are available for a minimum amount of Rs. 25,000 and in multiples of Rs. 25,000. Banks and PDs are major bidders in the T-bill market. Both discriminatory and uniform price auction methods are used in issuance of T-bills. Currently, the auctions of all T-bills are multiple/discriminatory price auctions, where the successful bidders have to pay the prices they have actually bid for. Non-competitive bids, where bidders need not quote the rate of yield at which they desire to buy these T-bills, are also allowed from provident funds and other investors.
Investors in T-Bills: Generally, RBI, Banks, and State Governments invest in T Bills apart from other private players like the insurance cos. Secondary Market Activity in T-Bills:
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Treasury bills are mostly held to maturity by a majority of the buyers. Secondary market activity is quite sparse. The 364-day T-bill is comparatively more actively traded.
10.2 Commercial Paper & Certificate of Deposits
Commercial paper (CP) is a short-term instrument, introduced in 1990, to enable non-banking companies to borrow short-term funds through liquid money market instruments. CPs were intended to be part of the working capital finance for corporates, and were therefore part of the working capital limits as set by the maximum permissible bank finance (MPBF). CP issues are regulated by RBI Guidelines issued from time to time stipulating term, eligibility, limits and amount and method of issuance. It is mandatory for CPs to be credit rated.
Salient Features of CPs:
•
Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note.
•
Corporates and primary dealers (PDs), and the all-India financial institutions (FIs) that have been permitted to raise short-term resources under the umbrella limit fixed by Reserve Bank of India are eligible to issue CP.
•
CP can be issued for maturities between a minimum of 7 days and a maximum up to one year from the date of issue. The maturity date of the CP should not go beyond the date up to which the credit rating of the issuer is valid.
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CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by a single investor should not be less than Rs.5 lakh (face value).
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CP may be issued to and held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by
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FIIs would be within the limits set for their investments by Securities and Exchange Board of India (SEBI).
10.3 Certificate of Deposits (CDs)
With a view to further widening the range of money market instruments and giving investors greater flexibility in deployment of their short term surplus funds, Certificate of Deposits (CDs) were introduced in India in 1989. They are essentially securitized short term time deposits issued by banks and all- India Financial Institutions during the period of tight liquidity at relatively higher discount rates as compared to term deposits. Certificates of Deposits (CDs) are short-term borrowings by banks. CDs differ from term deposit because they involve the creation of paper, and hence have the facility for transfer and multiple ownerships before maturity. CD rates are usually higher than the term deposit rates, due to the low transactions costs. Banks use the CDs for borrowing during a credit pick-up, to the extent of shortage in incremental deposits. Most CDs are held until maturity, and there is limited secondary market activity. Salient Features of CDs:
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CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI.
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Certificates of Deposit (CDs) is a negotiable money market instrument and issued in dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period.
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Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India.
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•
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Banks have the freedom to issue CDs depending on their requirements. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments, viz., term money, term deposits, commercial papers and inter-corporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet.
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Minimum amount of a CD should be Rs.1 lakh, i.e., the minimum deposit that could be accepted from a single subscriber should not be less than Rs. 1 lakh and in the multiples of Rs. 1 lakh thereafter.
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CDs can be issued to individuals, corporations, companies, trusts, funds, associations, etc. Non-Resident Indians (NRIs) may also subscribe to CDs, but only on nonrepatriable basis which should be clearly stated on the Certificate. Such CDs cannot be endorsed to another NRI in the secondary market.
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The maturity period of CDs issued by banks should be not less than 7 days and not more than one year. The FIs can issue CDs for a period not less than 1 year and not exceeding 3 years from the date of issue.
11. REFERENCES
11.1 Websites • • •
www.rbi.org www.investopedia.com www.wikipedia.com
11.2 Books/Manuals • Multinational Finance – Adrian Buckley
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