UNDERSTANDING

DEBT MARKETS

Basic of Debt Market

What is the Debt Market?

What is the Money Market?

The Debt Market is the market

Where fixed income securities of
various types and features are issued
and traded

Money market instruments are fixed

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

Securities Issued by:

The Money

Central and State Governments,

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

Market is basically concerned with the

issue and trading of securities with
short term maturities or quasi-money
instruments

Basic of Debt Market

Why should one invest in Fixed Income Securities?
Fixed Income securities offer a predictable stream of payments by way of interest and repayment of
principal at the maturity of the instrument. The debt securities are issued by the eligible entities
against the moneys borrowed by them from the investors in these instruments. Therefore, most debt
securities carry a fixed charge on the assets of the entity and generally enjoy a reasonable degree of
safety by way of the security of the fixed and/or movable assets of the company.
The investors benefit by investing in fixed income securities as they preserve and increase
their invested capital and also ensure the receipt of regular interest income.
The investors can even neutralize the default risk on their investments by investing in Govt.
securities, which are normally referred to as risk-free investments due to the sovereign
guarantee on these instruments.
The prices of Debt securities display a lower average volatility as compared to the prices of
other financial securities and ensure the greater safety of accompanying investments.
Debt securities enable wide-based and efficient portfolio diversification and thus assist in
portfolio risk-mitigation.

Importance of Debt markets to the economy

The key role of the debt markets in the Indian

Economy stems from the following reasons:
Efficient mobilization and allocation of resources in the economy
Financing the development activities of the Government
Transmitting signals for implementation of the monetary policy
Facilitating liquidity management in tune with overall short term and long term objectives.
Since the Government Securities are issued to meet the short term and long term financial needs
of the government, they are not only used as instruments for raising debt, but have emerged as
key instruments for internal debt management, monetary management and short term liquidity
management.
The returns earned on the government securities are normally taken as the benchmark rates of
return sand are referred to as the risk free return in financial theory. The Risk Free rate obtained
from the G-sec rates are often used to price the other non-govt. securities in the financial markets.

What are debt Instruments?

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

Key Features of a Debt instrument

Coupon

Zero Coupon Bonds

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

Maturity

Callable Bonds
Putable Bonds
Convertible Bonds

Principal

Amortising Bonds
Bonds with Sinking Funds

Segments in the Debt Market

Government Securities
Corporate Bonds
Money Market

Participants and Products in the Debt Markets

FINANCIAL MARKET
MONEY
MARKET

DEBT
MARKET

FOREX
MARKET

G-SECS

CENTRAL
Govt.

CALL / NOTICE

T-BILLS

BONDS

STATE
Govt.

TERMS
MONEY

CAPITAL
MARKET

FI
BONDS

CD

ICD

PSU
BONDS

CP

REPO

Corporate
Securities

COMMERCIAL
BILL

Participants and Products in the Debt Markets

Market Segment

Issuer

Instruments

Government Securities

Central Government

Zero Coupon Bonds, Coupon Bearing

Bonds, Treasure Bills, STRIPS

Public Sector Bonds

State Government
Government Agencies /
Statutory Bodies

Coupon Bearing Bonds.

Public Sector Units

PSU Bonds, Debentures, Commercial

Paper

Corporates

Debentures , Bonds, Commercial Paper,

Floating Rate Bonds. Zero Coupon
Bonds, Inter-Corporate Deposits

Banks

Certificates of
Deposits, Debentures, Bonds

Financial Institutions

Certificates of Deposits, Bonds

Public Sector Bonds

Private Sector Bonds

Private Sector Bonds

Govt. Guaranteed Bonds, Debentures

Government Securities (GSec)

Long Term (> 1 year) Debt Products Used by Long Term Debt/Income Funds
Borrowing by Government of India
Categorised as Sovereign Debt thus ZERO Credit Risk
Normally available with maturities of 1 yrs to 30 yrs
RBI announces the auction of government securities through a press notification, and invites bids.
Choices of Treasury Auctions
Discriminatory Price Auctions (French)
Uniform Price Auction (Dutch)
Price Based Auction
Yield Based Auction
SGL Accounts*
Constituent SGL Accounts
**SGL stands for 'Subsidiary General Ledger' account. It is a facility provided by RBI to large banks and financial institutions to hold their investments in Government
securities and Treasury bills in the electronic book-entry form.
As all investors in Government securities do not have an access to the SGL accounting system, RBI has permitted such investors to hold their securities in physical stock
certificate form. They may also open a Constituent SGL account with any entity authorised by RBI for this purpose and thus avail of the DVP settlement. Such client accounts
are referred to as Constituent SGL accounts.

Corporate Debt 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

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

Credit Ratings

Credit rating is primarily intended to systematically measure credit risk arising from transactions
between lender and borrower.
Credit risk is the risk of a financial loss arising from the inability (known in credit parlance as default) of
the borrower to meet the financial obligations towards its creditor

Credit Ratings
Independent Opinion on credit worthiness of an issuer,
awarded by a registered credit rating agency.
Both Quantitative and qualitative research
Only credit opinions, no guarantees
Can be different grades by different agencies
Credit Rating agency appointed by the issuer
Advantages of Credit rating

Issuer: Widen investor base

Lower cost of funds
Higher financial flexibility

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

Credit Rating
In India, it is mandatory for credit rating agencies to register themselves with SEBI
and abide by the SEBI (Credit Rating) Regulations, 1999.
There are 4 SEBI registered credit rating agencies in India, namely:
CRISIL
Long Term: AAA to D
Short term: P1+ to P5
ICRA
Long term: LAAA to LD
Short term: A1+ to A5
Fitch
Long term: AAA to D
Short term: F1+ to F5
CARE
Long term: CARE AAA to CARE D
Short term: PR1+ to PR5

Credit rating from CRISIL (An example)

High Investment Grades

AAA (Triple A) Highest Safety
AA (Double A) High Safety
Investment Grades
A Adequate Safety Changes in circumstances can adversely impact
such issue more than higher rated issues
BBB (Triple B) Moderate Safety changing circumstances are likely to
lead to weakened capacity
Speculative Grades
BB (Double B) Inadequate Safety
B -High Risk
C Substantial Risk
D Default

CPs and CDs

What is Commercial Paper (CPs)?

Short-term instrument (less than 12 months), introduced in 1990, to enable non
banking companies to borrow short-term funds through liquid money market instruments.
Intended to be part of the working capital finance for a corporate
Mandatory for CPsto be credit rated

What are Certificates of Deposit (CDs)?

Short-term borrowings by banks (Less than 12 months)
Rates are higher than the term deposit rates on account of low costs for bulk mobilization
as compared to retail deposits

What are REPOs?

REPOS are better known as Repurchase Agreements, a sale & a Repurchase Agreement
has a borrower sell securities for cash to a lender and agree to repurchase to repurchase
those securities at a later date for more cash. A reporters the difference between borrowed
and paid back cash expressed as a percentage
In Indian Financial System, RBI accepts approved securities from member banks in
exchange for cash at a predefined rate called the repo rate. REPO rate thus is the rate at
which RBI lends to banks in exchange for securities
Repos are popular because they can virtually eliminate credit problems
Reverse-Repoby the central banks acts as a floor to call money market
Repo and reverse-repo together become corridor for call money market
Worldwide Central Bankers use Repost manage Money Supply in the economy

Repo Transaction

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

What are CBLOs?

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

approved by RBI
Developed by CCIL (Clearing Corporation of India Ltd.) for the benefit of the entities who
have either been phased out from inter bank call money market or have been given
restricted participation
CBLO is a discounted instrument available in electronic book entry form for the maturity
period ranging from 1 day to 90 Days (as per RBI guidelines can be uptoa year).
Dealing System through:
Indian Financial Network (INFINET), a closed user group to the Members of the

Dealing System (NDS) who maintain Current account with RBI.

Negotiated

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

CBLOContinued

Mutual Funds are major lenders

Primary Dealers are major borrowers
Transaction Denomination INR 5 M
Auction basis Discount rate & Maturity
Unlike REPO, lenders here can call their funds and borrowers can repay before
maturity by unwinding their position
Participants Banks, MFs, Co-operative Banks, FIs, Insurance Companies, NBFCs,
Corporate, Provident/Pension Funds

What are T-Bills?

Short-term debt instruments issued by the Central government.

Currently 3 types of T-bills are issued, 91-day, 182 -day and 364-day.
Sold through an auction at a discount to face value

BOND VALUATION

Fundamentals of Valuation

The valuation model

Bond Valuation An Example

Principal Amount = Rs.100000

Coupon = 12% p.a.
Installment = Annual
Maturity (n) = 5 yrs
Present Interest rate in the market / Discount Rate(r)= 8% p.a.
Present Value of Cash flow over 5 Years of this Bond = 12000/((1+8%)^1 +
12000/(1+8%)^2.(12000+100000)/(1+8%)^5
Present Value of all Cash flow of this bond = 1,15,970.80

Frequently used
terms in debt
Markets

Yield
Yield to Maturity (YTM)
Yield Curve
Spread
Duration
Modified duration

Yield

Yield refers to the percentage rate of return paid on a stock in the form of dividends, or the effective
rate of interest paid on a bond or note
There are many different kinds of yields depending on the investment scenario and the characteristics
of the investment
Current Yield is the coupon divided by the Market Price and gives a fair approximation of the present
yield
Current Yield = Coupon of the Security(in%) x Face Value of the Security
(viz. 100 in case of G- Secs.)/Market Price of the Security
Eg: Suppose the market price for a 10.18% G-Sec 2012 is Rs.120. The current yield on the
security will be (0.1018 x 100)/120 = 8.48%
The yield on the government securities is influenced by various factors such as level of money supply in
the economy, inflation, future interest rate expectations, borrowing program of the government & the
monetary policy followed by the government

Yield To Maturity

Yield To Maturity (YTM) is the most popular measure of yield in the Debt Markets and is the
percentage rate of return paid on a bond, note or other fixed income security if you buy and hold
the security till its maturity date
Yield to maturity on a bond is also called the Internal Rate of Return (IRR)
The calculation for YTM is based on the coupon rate, length of time to maturity and market price.
It is the Internal Rate of Return on the bond and can be determined by equating the sum of the
cash-flows throughout the life of the bond to zero. A critical assumption underlying the YTM is
that the coupon interest paid over the life of the bond is assumed to be reinvested at the same
rate
The YTM is basically obtained through a trial and error method by determining the
value of the entire range of cash-flows for the possible range of YTMsso as to find
the one rate at which the cash-flows sum up to zero.

Yield to Maturity Sample Calculation

A G-Sec -8.00% GOI Loan 2010 with only 2 cash flows remaining to maturity as under:
Maturity Date: 30th January 2010
Interest Payment Dates: 30th January, 30th July
and trading currently at Rs. 115 for 1 Unit, will have a YTM as follows:
Settlement Date: 17th March 2009 (Date at which ownership is transferred to the
Buyer)
Frequency of Interest Payments: 2
Day Count Convention: 30/360 (which in MS-EXCEL is taken as Basis 4)
Yield To Maturity: 4.8626%
The same can be computed from MS-EXCEL through the YIELD Formula by input of the parameters given above. It can
be checked by discounting the said cash-flows, i.e., the two coupons of Rs. 8.00 each and the principal repayment of
Rs.100/-from the interest payment dates and maturity dates to the date of settlement

Yield Curve

The graphical depiction of the relationship between the interest rates (or yields) on bonds of the
same credit quality and different maturities is known as the yield curve
In other words, the yield curve is a depiction of debt market interest rates across
maturities, with time being plotted on the X-axis and yields on the Y-axis. The curve graphically
demonstrates the rate at which market participants are willing to transact debt capital for shortterm, medium-term and long-term periods
The yield curve is generally upward sloping indicating that investors demand a premium for
holding securities for a longer period of time.

Types of yield curveNormal

CurveFlat CurveInverted Curve

Yield Curve

Credit Spread

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

Movement in Credit Spreads of 10 Y AAA Corp Bond

V/s 10 Y Govt. Bond10Y

Duration

Duration is the weighted average term to maturity

Duration of a bond is less than its maturity
except for zero coupon bond
Duration is longer the longer the maturity
except for deep discount bonds
As YTM increases, duration decreases

Modified Duration

The modified duration of a bond measures the percentage change in its price for a
given change in interest rates or yields
Modified Duration = Duration/ (1+ytm)
Modified duration measures the risk of the bond with respect to changes in the
yield, in other words it is the price risk of the bond with a unit change in yield, in
general longer duration bonds carry more price risk for a given change in yield and vice
versa

Price-Yield relationship in Bonds A few pointers

The basic bond valuation equation shows that the yield and price are inversely related
This relationship is however, not uniform for all bonds, nor is it symmetrical for
increases and decreases in yield, by the same quantum
Price-yield relationship between bonds is not a straight line, but is convex.
The sensitivity of price to changes in yield in not uniform across bonds.
Higher the term to maturity of the bond, greater the price sensitivity.
Lower the coupon, higher the price sensitivity. Other things remaining the same, bonds
with higher coupon exhibit lower price sensitivity than bonds with lower coupons.

Price-Yield relationship in Bonds Graphical

Representation Price / Yield Graph (10Y Govt Security)

Calculation of return from debt instruments

Overall Return = Interest return + Capital return due to change in interest rates
In a falling interest rate scenario, the overall returns would be high and vice versa in a
rising interest rate scenario.
In a falling interest rate scenario, the overall returns would depend on the duration of
the bond and the current yield of the bond

Volatility due to change in Interest rate Change in Bond

Price vs Duration for 1% Yield Change-

About Pass Through

Certificates (PTCs)

Background
When certain financial asset classes (retail or corporate) are pooled together and undivided interest in the
pool is sold, pass-through securities are created
The term 'undivided interest' means that each holder of the security has a proportionate
interest in each cash flow generated by the pool
The pass-through securities assure that cash flow from the underlying asset classes
would
be passed through to the holders of the securities in the form of regular payments
of interest and
principal
The entity selling the receivables (also usually the originating entity) to the Trust is called
the Originator' and the entity which has borrowed the funds and is responsible for
repayment is the obligor
Nature of a Typical PTC transaction:
First, a special purpose vehicle (SPV) is created, to de-link the pool assets (cash flows) from the
company that wants to securitise(the `originator'). The SPV is usually a trust and has no borrowings of its
own
The SPV then issues tradable debt instruments called `pass through certificates' and sells
them to potential investors. Proceeds from the sale of PTCsare then utilized by the SPV to
purchase/ buy-out the asset pools from the Originator
In a typical securitization deal, assets in the pool include auto loans, Commercial vehicle (CV) and
construction equipment (CE) loans, personal loans OR single corporate loans
Since the SPV is a set up as a bankruptcy remote entity, it is not impacted by bankruptcy of the originator

Schematic Representation of a PTC Transaction

Different Types of PTC transactions

The PTC market in India can be broadly segregated into two categories viz
Single corporate loans. Herein, a loan given by an originator (Bank/ NBFC/ FI etc.)
to a single entity (obligor) is converted into pass through certificates and sold to end
investors
Retail asset pools comprising multiple borrowers and asset classes such as Personal
loans, Credit Card receivables, Construction Equipments, Commercial Vehicles,
passenger cars and two wheelers
Difference between Retail pool PTC transactions different from Single Loan PTCs
Unlike single loan sell-downs, the retail asset pools comprise several different
borrowers within multiple asset classes. A transaction may involve either a single
asset class (such as CVs or CEs) or a composite pool comprising multiple asset
classes
In retail pool transactions, the exposure is towards several small ticket borrowers
and hence the methodology of analysis (explained later) is different from that
followed for single loan PTCs, wherein the exposure is on the corporate borrower
Retail pool PTCs in majority of the cases are rated the highest (i.e. AAA) owing to
the stipulation of a cash collateral, unlike single loan PTCs, wherein the rating is
mostly the same as the stand-alone rating (in the absence of any credit
enhancement) enjoyed by the issuer on other instruments such as debentures and
bonds

Ratings for PTCs

All PTCs are rated by one of the four accredited rating agencies in the country
The rating is based on the financial strength of the obligor, as the end-investors have no recourse to
the originator of the loans
Effectively the rating on the PTCs represents the stand-alone credit risk of the obligor
The rating takes into account the relative repayment ability of the obligor

Nature of risks in PTCs

There is no difference in the credit risk on the exposure taken through a single loan PTC vis--vis a
plain vanilla debenture
Credit risk assessment in a PTC investment is based on the analysis of the obligor and not
originator of the loan
The methodology adopted to evaluate the credit risk in the case of a single loan PTC is identical to
that followed in the case of investment in debentures / CPsor other financial instruments issued by
the obligor

Debt Fund
Investing - Risk

Risks associated with Debt Securities

Default Risk: This can be defined as the risk that an issuer of a bond may be unable to make
timely payment of interest or principal on a debt security or to otherwise comply with the
provisions of a bond indenture and is also referred to as credit risk
Interest Rate Risk: can be defined as the risk emerging from an adverse change in the interest
rate prevalent in the market so as to affect the yield on the existing instruments. A good case
would be an upswing in the prevailing interest rate scenario leading to a situation where the
investors' money is locked at lower rates whereas if he had waited and invested in the changed
interest rate scenario, he would have earned more
Reinvestment Rate Risk: can be defined as the probability of a fall in the interest rate resulting in
a lack of options to invest the interest received at regular intervals at higher rates at comparable
rates in the market

Risks associated with trading in Debt Securities

Counter Party Risk: is the normal risk associated with any transaction and refers to the failure or
inability of the opposite party to the contract to deliver either the promised security or the salevalue at the time of settlement
Price Risk: refers to the possibility of not being able to receive the expected price on any order
due to a adverse movement in the prices

Credit Risk

Probability of default by the borrower

Change in credit rating
downgrade increases the yield & decreases the price
upgrade decreases the yield & increases the price
SpreadThe payoff for assuming credit risk

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