Basics of Debt Market

Basics of Debt Market

What is the Debt Market?

It is a market meant for trading (i.e. buying or selling) fixed income instruments. Fixed income instruments could be securities issued by Central and State Governments, Municipal Corporations, Govt. Bodies or by private entities like financial institutions, banks, corporates, etc.

What is bonds/debt?

Simply put, a bond/debt can be defined as a loan for which an investor is the lender. The issuer of the bond pays the investor interest (at a predetermined rate and schedule) in return for the funding.

The maturity date refers to the date on which the issuer has to repay the principal to the investor.

What is the difference between debt and equity?

When an investor invests money via equity, he becomes an owner in the corporation issuing the equity shares. With ownership he also gets voting right in the company and a share in future profits.

In case of debt, the investor becomes a creditor to the issuing entity. As a creditor, he has higher claim to the assets of the entity as compared to a shareholder in the event of the company filing for bankruptcy. However, a debt investor does not get voting rights or a share in future profits. He is only repaid in the form of a predetermined interest rate.

What are the advantages of fixed income/debt?

The common trend among retail investors is investing in equity, since equities are perceived to offer a higher scope of better returns. However, to build a diversified and stable portfolio, investing in debt securities is a must since it assures fixed income.

What is Face Value/Par Value?

Face value (or par value or principal) is the amount the investor will get back from the issuer once the debt instrument matures.

Bonds may be issued at face value or at a discount to the face value.

Investors should also keep in mind that the price at which the instrument trades in the market is not the face value. The price of an instrument can keep fluctuating throughout its life based on market forces.

If a bond trades for a price higher than its face value, then it is said to be traded at a premium. If it is trading below the face value, it is said to be traded at a discount.

What is Coupon or Interest Rate?

The coupon is the amount the investor will receive via interest payments for the debt instrument. It is called coupon, since earlier there used to be physical coupons on the instrument which the holder had to tear off to redeem the interest.

While most bonds pay interest on a semi-annual basis, some may even pay interest on a monthly, quarterly or annual basis.

The interest is calculated and paid on the face value of the instrument, irrespective of its price in the market.

Based on the instrument, the coupon may either be fixed or floating. In the case of a fixed coupon the rate of interest remain constant till the maturity of the instrument. In case of a floating-rate coupon, the interest rate may be adjusted by the issuer if required.

What is Maturity in debt markets?

Maturity is the date on which the investor is repaid the principal by the issuer. The tenure for the maturity of an instrument can range from one day to 30 years.

Generally, for a longer the time period towards maturity the issuer pays a higher interest rate on the instrument.

Instruments with a maturity under 364 days are termed as short-term instruments.

Who is an Issuer?

Any corporate or government entity that issues a fixed income security is termed as an issuer.

While selecting a debt instrument, the investor should primarily consider the stability of the issuer, since this assures repayment of the principal.

In the Indian context, instruments issued by the Central or State governments are far more stable than those issued by any corporate.

What is the Money Market?

It is a market to issue and trade securities with short term maturity or quasi-money instruments. Instruments like treasury bills, certificates of deposits, commercial papers, bills of exchange etc are traded in the money market.

Why should one invest in fixed income securities?

The primary advantage of a fixed income security is a steady and predictable source of payments by way of interest and repayment of principal at the time of maturity of the instrument. Debt instruments are generally issued by eligible entities (public or private) against money borrowed by them from investors. Hence, debt securities enjoy relatively higher safety towards repayment.

What are the advantages of investing in Government Securities?

Government securities (also called G-Secs) offer the investor virtually zero default risk, making these one of the most stable forms of fixed income instruments. Another advantage is that there will not be any TDS deduction on the interest income in G-Secs.

Who can issue fixed income securities?

Fixed income securities can be issued by any entity (public or private) provided they meet the statutory norms on issue of such securities.

What is the importance of the Debt Market to the economy?

Debt markets are vital to the sustained growth of any economy since they offer efficient mobilisation and allocation of financial resources. Debt instruments are used to finance developmental activities undertaken by the Government. They also aid in managing the liquidity in the economy.

What are the benefits of an efficient Debt Market to the financial system and the economy?

Borrowings from the debt market allow the Government to reduce its dependence on external sources of funding. It also reduces the pressure on institutional financing to fund public sector or private sector projects.

What are the different types of risks with regard to debt securities?

The default risk associated with debt securities is inability of the issuer to make timely payments towards interest or principal of the security.

Some instruments may also be likely to a risk emerging from an adverse change in interest rate, which would affect the returns/yield from existing instruments.

Another risk is reinvestment rate risk i.e. the possibility of a reduction in interest rates resulting in a lack of options to invest the interest received.

Who regulates the fixed income markets?

The issue & trade of securities in India are regulated by either RBI or SEBI.

Government securities and bonds, instruments issued by banks and financial institutions are regulated by RBI while issues of non-government securities (i.e. issue by corporates) are regulated by SEBI.

What are the segments in the secondary debt market?
The secondary debt market in India can be broadly categorised into –

• Wholesale Debt Market – comprising of investors like Banks, financial institutions, RBI, insurance companies, Mutual funds, corporates and FIIs.
• Retail Debt Market – comprising of investors like individuals, pension funds, private trusts, NBFCs and other legal entities.

Who are the most prominent investors in the Wholesale Debt Market in India?

The Commercial Banks and the Financial Institutions are the most prominent participants in the Wholesale Debt Market in India.

What are the types of trades in the Wholesale Debt Market?

There are normally two types of transactions either an outright sale/purchase OR a Repo trade.

What is Yield?

The return (in terms of percentage) paid on an instrument in the form of dividend or interest is called Yield. Based on the kind of investment, there are many different kinds of yields.

In the debt markets, yield to maturity (YTM) is the most popular measure to quantify the rate of return paid on a fixed income instrument.

How is the price of instruments determined in the debt markets?

The price of instruments in debt markets is based on the forces of demand and supply. The price of the instrument is also governed by changes in economic conditions, money market conditions, changes in prevalent interest rates, rates of new issues and credit quality of the issuer.

How is Yield related to the price?

Yields and Bond Prices are inversely related. Hence, an increase in price will reduce the yield and vice versa.

How are the Face Value, Trade Value and Settlement value different from each other?

• Face value is the cumulative face value of securities traded in a transaction.

• Trade value is the cumulative price of the traded securities or instruments.

• Settlement value is the sum of trade value plus the Accrued Interest on the instrument.

What are the types of transactions which take place in the market?

There are two types of transactions in the market -
• Direct transactions between wholesale market participants. These account for approximately 25% of the wholesale market volumes.

• Broker intermediated transactions i.e. where brokers undertake dealings for banks, institutions or other entities.

What is the structure of the Corporate Debt Market in India?

The corporate debt market can be classified into Primary market and Secondary market.

In the primary market, corporate debt is via private placements like corporate bonds placed with wholesale investors like banks, financial institutions, mutual funds, etc.

The Secondary market for corporate debt is available on platforms offered by various exchanges in the country.

What are the various kinds of debt instruments available in the Corporate Debt Market?

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

What are the securities/instruments traded in the Retail Debt Segment (REDS) at the Exchange?

Retail trading on Central government securities is currently done through the BOLT system provided by exchanges. The exchange may also introduce the following debt securities for retail trade –
• State Government Securities
• Treasury Bills
• STRIPS
• Interest Rate Derivative products

Who are the participants in the Retail Debt Market?

The participants in the Retail Debt Market can be divided into -
• Mutual Funds
• Provident Funds
• Pension Funds
• Private Trusts
• Religious Trusts and charitable organizations having large investible corpus
• State Level and District Level Co-operative Banks
• Housing Finance Companies
• NBFCs and RNBCs
• Corporate Treasuries
• Hindu-Undivided Families (HUFs)
• Individual Investors

What is the future scenario for the Retail Debt Market in India?

The retail market has shown signs of steady growth over the last few years, and is expected to grow significantly over the next few years. The availability of a wide range of debt securities for retail trading and increased market participation are the key factors that will contribute to the growth.

What is the trading structure in the Wholesale Debt Market?

Globally debt markets are dominated by Government securities, which dominate close to 50-75% of the trading volumes in all markets. Instruments issued by Central government in India account for close to 90% of the trading volumes while those issues by State governments account for 3-4% of the trading volumes.

Who are the main investors of Government Securities in India?

Banks and Financial institutions are the largest investors in G-Secs. In fact, banks account for more than 60% of the transactions in the Wholesale debt market.

What are the main features of G-Secs and T-Bills in India?

All Government securities in India have a face value of Rs. 10 and are issued by RBI on behalf of the Central government. G-Secs are normally interest bearing, and have semi-annual interest payments for a period of 5-30 years.

Treasury bills or T-bills are short term securities issued by RBI (for Government of India) meant to fund temporary requirements. The maturity on T-bills ranges from 91 days to 364 days. T-bills have a face value of Rs. 100 but do not have any interest payment. They are generally issued at a discount and redeemed at face-value at the end of the maturity period.

What is the issuance process of G-Secs?

Government securities are generally issued by RBI on either a yield based or price-based auction. Recently, RBI has announced a non-competitive bidding facility for retail investors in G-Secs.

How can investors in India hold G-Secs?

• Physical Security (which is mostly outdated & not used much)
• SGL (Subsidiary General Ledger) A/c with the Public Debt Office of the RBI Constituent SGL A/c with Banks or PDs who hold the G-secs on behalf of the investors in their SGL-II A/cs of RBI, meant only for client holdings.
• Same Demat A/c as is used for equities at the Depositories. NSDL & CDSL will hold them in their SGL-II A/cs of RBI, meant only for client holdings.

What are the common redemption features/provisions on debt instruments?

Call Provision
Some bonds are issued with a provision via which the investor can redeem the bonds at a specific date and price before maturity. Since, such a provision is meant to safeguard the issuer; callable bonds have a higher interest return as compared to non-callable bonds.

Put Provision
A Put provision gives an investor the option to sell the bond to the issuer prior to maturity at a specific date and time. Since, this is meant to protect the investor, the interest rates on such bonds is comparatively lower.

Conversion
Some corporate bonds allow investor to convert the bond in common stock (equity shares) instead of redeeming the bond for cash payment. These bonds are also called convertible bonds.

Principal Payments and Average Life
Some bonds are linked to the average life of the instrument. These instruments are traded and prices as per their average life rather than the maturity date.

What is Default in relation to bond markets?

Failure of a bond issuer to pay principal or interest as per the predetermined schedule is termed as default. A default can also occur if the issuer fails to meet/comply with the obligations related to reporting requirements, etc.

In case of a bankruptcy, bond holders, being creditors, have the first right to the assets of the issuer when receiving a payout by way of liquidation. The kind of bond held also determines an investor’s status during bankruptcy.

Secured bonds are instruments which are backed by a specific collateral (or asset) of the issuer, If the issuer defaults, a secured bond investor has the first claim to the said collateral.

Unsecured bonds do not have a claim to any specific collateral from the issuer. Unsecured bonds normally offer a higher coupon rate due to a higher risk of investment.

What are the risks of investing in bonds?

Interest rate risk: The bond trading prices are inversely related to the interest rates. When interest rates rise, bond prices decline. If you need to sell you bond in a high interest rate environment, you may get less than you paid for it. The risk from fluctuations in interest rate declines the closer the instrument is to maturity.

Credit risk: If the issuer faces a financial crunch or bankruptcy, it may default on payments towards the instrument.

Liquidity risk: If the coupon rate is lower than prevailing interest rates in the market, then an investor may find it difficult to sell the instrument before maturity. Debt instruments are generally more liquid during the initial period after they are issued.

Call risk or reinvestment risk: For a bond with a call option, the issuer may redeem the instrument prior to maturity as per the predetermined dates and prices for such a trade. Issuers normally redeem such bonds when the interest rates are falling, and as a result investors have to reinvest their funds at a lowerrate.