A Bond is simply a loan given to the issuer (borrower) by the bondholder (lender) whereby terms of interest payment and the redemption date/s are pre-determined. When you purchase a bond, you are lending money to any entity known as issuer. The legal document registering this loan is called a bond and the issuer pays interest to you on the amount of money you lend and on expiry of the tenure shall pay back the Principal amount.
While Bonds are securities that are mostly issued by the government, bonds issued by companies are often called Debentures.
There are various types of bonds available in the market:
There is a wide variety of individual bonds to choose from in creating a portfolio that matches your investment needs and expectations. Individual can purchase bonds in two ways:
Bond Category | Credit Quality | Liquidity | Examples |
---|---|---|---|
Government | Highest | Highest | Govt bonds, T-bills |
Public Sector Enterprise | High Grade | Medium | IRFC, REC, PFC, NTPC, NHAI etc |
Private Sector Companies | High to Low | Varies | HDFC Ltd, Tata Capital ltd, Shriram Transport Finance Co. Ltd etc |
Maturity | Yield | Price Volatility |
---|---|---|
Short | Lower | Lower |
Long | Higher | Higher |
There are number of key variables that comprise the risk profile of bond. Few variables we have already understood earlier are price, interest rate, yield, maturity. Other important parameters are redemption features, embedded options, assessing risk and credit ratings and tax status. Let’s understand each one of these parameters or variables:
While the maturity date indicates how long a bond will be outstanding for, many bonds are structured in such a way so that an issuer or investor can opt for early maturity date. The same are discussed below:
All investments offer a balance between risk and potential returns. The risk is the chance that you will lose some or all money that you have invested. Bonds as an investment avenue can be a great tool to generate income and are widely considered to be a safe investment, when compared to stocks. However, you as an investor should identify some potential risks for holding corporate and government bonds. Following are the list of risks involved with investment in bonds.
Duration: The term duration has a special meaning in the context of bonds. It is a measurement of how long, in years, it takes for the price of the bond to be repaid by its internal cash flows. It is an important measure for you as an investor to consider, as bonds with higher duration carry more risk and have higher price volatility than bond with lower durations. There are two basic types of bonds duration:
Convexity: Convexity of a Bond is a measure that shows the relationship between bond price and Bond yield, i.e., the change in the duration of the bond due to a change in the rate of interest, which helps a risk management tool to measure and manage the portfolio’s exposure to interest rate risk and risk of loss of expectation
If we were to graph the relationship between price and yield for a bond, the result would not be a straight line, but a curve or convex line, as shown in below diagram. The degree to which the line is curved shows how much a bond’s price changes as the result of change in yield.
Convexity is used as a risk management tool and helps to measure and manage the amount of market risk to which a portfolio of bonds is exposed. The main thing for you to remember about convexity is that it shows how much a bond's yield changes in response to changes in price. A bond with greater convexity is less affected by interest rates than a bond with less convexity. Also, bonds with greater convexity will have a higher price than bonds with a lower convexity, regardless of whether interest rates rise or fall.
You as an investor need to understand tax implications for any asset class you choose to invest as any income through various asset classes can attract various kinds of taxes. In bonds too, there are certain tax considerations you need to check before investing. In bonds, there are two types of income that you earn:
The Surcharge and Health and Education Cess on the above-mentioned tax will be applicable based on the respective income slab of the investor.
The Reserve Bank of India (RBI) was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934.The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. Though originally privately owned, since nationalisation in 1949, the Reserve Bank is fully owned by the Government of India.
The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as:
"to regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage; to have a modern monetary policy framework to meet the challenge of an increasingly complex economy, to maintain price stability while keeping in mind the objective of growth."
The Main Functions of Reserve Bank of India are stated here-in below
Monetary Authority:
The Securities and Exchange Board of India (SEBI) was established on April 12, 1992 in accordance with the provisions of the Securities and Exchange Board of India Act,1992.
The Preamble of the Securities and Exchange Board of India describes the basic functions of the Securities and Exchange Board of India as "...to protect the interests of investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto"
The main Functions of SEBI are stated here-in below:
The Fixed Income Money Market and Derivatives Association (FIMMDA) is an association of Scheduled Commercial Banks, Public Financial Institutions, Primary Dealers and Insurance Companies. Voluntary market body for the bond, money and derivatives markets with members representing all major institutional segments of the market.
SEBI has laid down the framework of trading / reporting trades in Corporate Bonds on exchanges and the same must be settled through the Clearing Corporation of the Stock Exchanges (ICCL [BSE] & NCL [NSE]). Thus, helping in mitigating the counter party risk and improving the transparency in trading of Corporate Bonds.
NSE Clearing Limited (NSE Clearing) (formerly known as National Securities Clearing Corporation Limited, NSCCL), a wholly owned subsidiary of NSE is responsible for clearing and settlement of all trades executed / reported on NSE, collateral management and risk management functions for various segments of NSE.
Indian Clearing Corporation Limited ("ICCL") was incorporated in 2007 as a wholly owned subsidiary of BSE Ltd. ("BSE"). ICCL carries out the functions of clearing, settlement, collateral management and risk management for various segments of BSE.
Rating agencies assess the credit risk of specific debt securities and the borrowing entities. In the bond market, a rating agency provides an independent evaluation of the creditworthiness of debt securities issued by governments and corporates.
Credit ratings of borrowers are based on the due diligence conducted by the rating agencies. The objective of a rating agencies is to evaluate the financial situation of the borrower and their capacity to service/repay their financial obligations.
Credit rating acts as a catalyst for channelizing investments in debt instruments by enabling individual and institutional investors in making informed investment decisions.
Following are the list of ratings for long term securities.
Rating | Description |
---|---|
AAA | Instruments with this rating are considered to have the highest degree of safety regarding timely servicing of financial obligations. Such instruments carry lowest credit risk. |
AA | Instruments with this rating are considered to have high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk. |
A | Instruments with this rating are considered to have adequate degree of safety regarding timely servicing of financial obligations. Such instruments carry low credit risk. |
BBB | Instruments with this rating are considered to have moderate degree of safety regarding timely servicing of financial obligations. Such instruments carry moderate credit risk. |
BB | Instruments with this rating are considered to have moderate risk of default regarding timely servicing of financial obligations. |
B | Instruments with this rating are considered to have high risk of default regarding timely servicing of financial obligations. |
C | Instruments with this rating are considered to have very high risk of default regarding timely servicing of financial obligations. |
D | Instruments with this rating are in default or are expected to be in default soon. |
Rating Agency may apply '+' (plus) or '-' (minus) signs for ratings from ‘AA' to 'C' to reflect comparative standing within the category.
A rating outlook indicates the direction in which a rating may move over a medium-term horizon of one to two years. A rating outlook can be 'Positive', 'Stable', or 'Negative'. A 'Positive' or 'Negative' rating outlook is not necessarily a precursor of a rating change.
A debenture trustee is an entity that holds the property of Bond/Debenture Issuer Company for the benefit of the debenture holders. They are SEBI regulated entities designed for better investor protection and reducing the events of defaults by financial institutions issuing Bond/Debentures.
A debenture trustee is a single point of contact who can act as a link between the issuer company and debenture holder for the smooth functioning of the process and protecting the interest of the debenture holders.
A debenture trustee keeps a track of issuer company actions to ensure that all the conditions mentioned in the offer are adhered to and debenture holder obligations are met. In case of default by the issuer company, the debenture trustee takes possession of the collateral/mortgaged assets in favour of debenture trustee for benefit of the debenture holders and paying their dues.
The KYC (Know Your Client)/ Registration process is your first step towards investing in financial instruments. If you want to invest in the Bond Market through us, you shall have to submit the undermentioned documents through your registered email-id.
Once you submit all the documents, our operations team will shall verify the aforesaid documents and in case of any discrepancy they shall get in touch with you and shall request you to remediate the same. Once your registration documents are in order, we shall intimate the same to you and you shall then be able to invest / sell Bonds through us.
As any transaction in the Bond Market has to be reported and settled to the Clearing Corporation, we shall be registering your KYC with the Clearing Corporations.
Registration/ Account opening process is a one-day process if all the requisite documents are submitted by you correctly.
Investors can use their existing bank and demat account/s for investing in bonds. If any investor doesn’t have a demat account, then based on their request IndiaBonds team will help them in opening a demat account.
Note: You can register maximum upto 5 Bank account/s and Demat account/s register with Clearing Corporation. The Investor will have to select and inform 1 Bank and 1 Demat account as their Default Bank / Demat accounts. Investor, at the time of doing transaction with the Counter Party (Registered Participants) they will have to inform from which Bank / Demat account they want to fulfill their Pay-in obligations (as the case may be) and in which Bank / Demat account they want to receive their Pay-out obligations (as the case may be).
The Steps to be followed are stated below:
Note: Incase any of the counter party fails to fulfill his / their Pay-in Obligations (Funds / Securities) in that scenario Clearing Corporation shall be returning back the funds / securities so received and the said reported transaction shall be treated as cancelled.
Minimum investment amount ranges between Rs. 10,000 to Rs. 10,00,000 depending on product type and underlying bonds.
Fixed Deposits and Bonds are both fixed income instruments, which offer interest income to investors.
What are Fixed Deposits? A fixed deposit (FD) is a financial instrument provided by banks, NBFCs and companies which provides investors with a higher rate of interest than a regular savings account, until the given maturity date.
What are Fixed Deposits? A fixed deposit (FD) is a financial instrument provided by banks, NBFCs and companies which provides investors with a higher rate of interest than a regular savings account, until the given maturity date.
It is always advisable to check the features of both these instruments in order to fetch good returns.
Features | Bonds/ Non-Convertible Debentures | Fixed Deposits |
---|---|---|
Safety | Most bonds are secured in nature as its backed by assets | For Bank FDs are insured up to Rs 5 lakh (capital & interest) per depositor, other than Bank FDs are unsecured in nature |
Liquidity | Can be liquidated anytime as bonds are tradable on exchanges | Can be withdrawn pre-maturely, however, liquidity at reduced interest rates or penalty charges |
Returns | Offers fixed returns and chance of taking advantage of interest rate cycle to maximize returns | Returns are fixed. Cannot be traded hence you cannot take advantage of interest rate changes in the economy |
Credit Rating | It is mandatory for issuers to get the instrument rated by at least one credit rating agency | Mandatory for NBFCs but not for others. Bank FDs are not rated |
Taxation | As per the tax slab of the individual other than tax free bonds | As per the tax slab of the individual |
TDS (Tax Deducted at Source) | Listed bonds and NCDs held in demat mode do not attract TDS and incase of taxable security held in physical mode TDS is subject to prescribed limit | TDS is applicable if interest exceeds above the prescribed limit |
Interest Payout Frequency | Monthly/Quarterly/Annually/Cumulative | Monthly/Quarterly/Annually/Cumulative |
What are Bond or Debt Funds? Bond funds are mutual funds that invest in bonds. Put another way, one bond fund can be considered a basket of dozens or hundreds of underlying bonds (holdings) within one bond portfolio. Most bond funds are comprised of a certain type of bond, such as corporate or government, and further defined by time period to maturity, such as short-term (less than 3 years), intermediate-term (3 to 10 years) and long-term (10 years or more).
Features | Bonds/ Non-Convertible Debentures | Debt/Bond Funds |
---|---|---|
Price | The price of the bond may fluctuate while investor holds the bond. | Bond funds are not valued by a price but a net asset value (NAV) of the underlying holdings in the bond portfolio. |
Principal Amount Risk | Bond holder receives principal amount invested at a time of bond maturity. Hence, there is no loss of principal amount | As bond funds consider NAV and not the price, investor can lose some of their principal amount if NAV falls. |
Returns/ Interest Rates | Returns are fixed and hence can be useful for investor to determine exact returns at maturity of the bond. | Returns vary depending on market conditions and interest rate scenario in the economy. |
Credit Risk | Invest in higher credit quality securities with better returns. | Depends on credit quality of underlying securities in which the fund invests. |
Liquidity | Most listed bonds are liquid and tradable on exchange. | Investors can generally redeem fund units at any time, at the current market value (or NAV) of the fund. Some funds may carry a redemption fee/exit load. |
Stocks and bonds are the two main classes of assets investors use in their portfolios. Stocks offer an ownership stake in a company, while bonds are akin to loans made to a company (a corporate bond) or any other organization. In general, stocks are considered riskier and more volatile than bonds. However, there are many different kinds of stocks and bonds, with varying levels of volatility, risk and return.
Features | Bonds | Equity |
---|---|---|
Safety | Investment in bonds are generally safer as you don’t hold a risk of losing principal amount | Equity investment is riskier investment as there can be chances of losing principal amount |
Predictable Returns | It has fixed and predictable returns in form of interest payments at periodic intervals unless the issuer defaults | Returns are subject to market price of the shares |
Market Risk | In bond investment interest income is fixed at the time of purchase and remains same till term of maturity. Hence, market risk is negligible. | Stocks are more volatile and market prices affect the returns drastically. Market risk is much higher. |
Bankruptcy | Bond holders are the first in line to get their amount invested as they are lenders and generally bonds are backed by assets. | Shareholders are last in line during bankruptcy and you may lose the entire investment. |
Interest Rate Risk | Bonds are subject to interest rate risk and changes in interest rate can lead to lower investment return | Interest rate risk does not impact equity investment to larger extent |
Investment Objectives - “It’s very difficult to get somewhere if you have no idea where you are going!”
As in most endeavors, setting goals is an important part of creating an investment portfolio. You need to have investment objectives, while you create a portfolio. Also, investment objective should not only be identified, but prioritized as some goals may conflict with each other. Following are some of the investment objectives that you may consider:
Current Income: It stands to reason that anyone considering the creation of a bond portfolio would have current income high on their list of objectives, if not the primary goal. The maximization of current income becomes a risk/reward decision as higher yielding bonds present greater risk.
Capital Appreciation: Capital appreciation is when an investment or portfolio increases in value. Many people do not think about bonds when it comes to capital appreciation, but the reality is that bonds do fluctuate in value, and can be used to meet this investment objective, though they should probably not be the only asset class in the portfolio. Longer maturity and discount bonds provide the most price movement when interest rates change, but this also increases the portfolio’s price risk.
Capital Preservation: Capital preservation is when a portfolio’s principal maintains its value. Investors that are seeking the preservation of capital are looking to minimize price risk. Investors looking for capital preservation would usually want to purchase bonds with shorter maturity with high credit ratings.
Tax Minimization: This is usually considered a secondary objective, but investors seeking to minimize taxes may want to consider tax-free bonds.
Broadly, we can categorize Investment goals in two categories:
a) Cash Flow Goals – Want to earn Rs 50,000/- per month through investments
b) Capital Appreciation Goals – Want to have Rs 2 crore portfolio in next 10 years.
Investment objectives of current income and tax minimization will fall in the category of cash flow goals, while capital appreciation and preservation will be in capital appreciation goals. To conclude, you need to know what you want to achieve, so that you know which category (cash flow goals & capital appreciation goals) is suitable, and what is the reasonable returns to expect.
Once you have finalized goals and objectives, you should consider knowing different strategies that you can start investing in bonds as per your goals and needs. There are various techniques you and your investment advisor can use to help you match your investment goals with your risk tolerance.
Passive Portfolio Management
Passive portfolio management is essentially a buy-and-hold approach. Passive portfolio management provides the least amount of risk, but also the lowest potential returns. Passive portfolio management is also known as indexing, because it involves choosing an index that you wish to match the return of, and recreating it in the portfolio. Matching an index by replicating every security in it is not practical, as many indexes contain hundreds or thousands of securities. Professional portfolio managers will index by creating a portfolio of securities that match various characteristics of the index such as coupon, maturity, duration, and credit rating. The duration component is probably the most important determinant of portfolio performance, followed closely by the credit rating.
Enhanced Indexing
Enhanced indexing is a hybrid of passive and active portfolio management. The objective is to outperform the targeted index, but it also presents the risk of underperforming the index. One strategy involves deviating from the characteristics of the portfolio. For example, a manager may create a portfolio with a slightly longer average duration or lower average credit rating. Another strategy involves creating an indexed portfolio with most of the assets, and actively managing a smaller portion of the assets.
Asset-Liability Management
Asset-liability management (ALM) is a portfolio management strategy that involves matching the cash flows of the portfolio assets with liabilities. In other words, the portfolio is constructed so the interest payments and maturities of the bonds in the portfolio are matched against the future payment obligations. While this is popular with large institutional investors, such as insurance companies, it is less common with retail investors. However, it can be an effective strategy for investors who are retired or are approaching retirement. The advantage is that it lowers the price risk because the investor is less likely to have to sell an investment at a loss.
Active Portfolio Management
Active portfolio managers are attempting to outperform the benchmark. This is often very difficult to achieve, especially considering the higher transaction fees that result from increased trade activity. It is the strategy that presents the highest potential return, but the risk is also higher. Active managers do not believe in the efficient market hypothesis, or they believe that markets are not significantly efficient. Most retail investors do not prefer managing bond portfolio actively as it involves transaction fees and has higher risk.
Investment Strategies
Once you have finalized goals and objectives, you should consider knowing different strategies that you can start investing in bonds as per your goals and needs. There are various techniques you and your investment advisor can use to help you match your investment goals with your risk tolerance.
Diversification is the allocation of assets to several categories in order to spread, and therefore possibly mitigate, risk. Regardless of your investment objectives, diversification is an important consideration in building any portfolio. Diversification can be achieved in any number of ways, including by:
Market timing involves attempts to correctly anticipate changes in interest rates. Bond traders and investors can use several methods to try to forecast interest rates and structure trades to profit from their forecasts. Forecasting just about anything, be it weather, corporate earnings, or financial markets, forecasting changes in interest rates is as much an art as a science. It is impossible to forecast with extreme accuracy, but professional bond traders employ various techniques to try to stack the odds in their favor. Because the Reserve Bank of India changes interest rates to implement monetary policy in order to pursue its stated goal of “price stability and sustainable economic growth,” predicting what the RBI is going to do can help forecast interest rates. “RBI watching” is something that virtually all bond investors do to help them determine the future course of interest rates.
Relative value (RV) strategies attempt to take advantage of temporary price anomalies between different bonds. In other words, the spread between the two bonds is exceedingly large, and the manager expects the spread to return to normal. The anomaly may be in a credit spread, a yield spread, or a maturity spread.
Aggressive managers will usually go long the cheap security and short the expensive bond. These trades are usually made market neutral by weighting the long and short position by the price sensitivity of each bond. An investor can also take advantage of relative value anomalies by swapping out of an expensive security in their portfolio into a cheap.
A government security is a tradable instrument issued by the Central Government or by the State Governments and is acknowledged as Government’s debt obligation. Government securities carry practically no risk of default and are called risk-free gilt-edged instruments. These securities are short-term (treasury bills with original maturity of less than one-year) or long-term securities (Government bonds or other dated securities issued by State Governments with original maturity of one-year or more).
Government of India also issues other instruments such as Savings Bonds, National Saving Certificates, oil bonds, Food Corporation of Indiabonds, fertilizer bonds, power bonds, etc. These bonds and securities are, usually not fully tradable and are, therefore, not eligible to be SLR securities.
Treasury Bills (T-bills): Treasury bills are money market and short-term debt instruments issued by the Government of India and are presently issued in three tenors, namely, 91 day, 182 day and 364 day. Treasury bills are zero coupon securities and pay no interest. They are issued at a discount and redeemed at the face value at maturity.
The Reserve Bank of India conducts auctions usually every Wednesday to issue T-bills. Payments for the T-bills purchased are made on the following Friday.
Dated Government Securities: These are long term securities and carry a fixed or floating coupon rate which is paid on the face value, payable at fixed time periods (usually half-yearly). The tenor of dated securities can be up to 30 years. Government security contains the following features - coupon, name of the issuer, maturity and face value. For example, 5.79% GS 2030 would mean:
Coupon: 5.79% paid on face value
Name of Issuer: Government of India
Date of Issue : May 11, 2020
Maturity : May 11, 2030
Coupon Payment Dates : Half-yearly ( 11th May and 11th November) every year
The coupon payment date if falls on Sunday or a holiday, then the coupon is paid on the next working date for dated Government Securities, however, if the redemption or maturity date falls on Sunday or a holiday, then the redemption proceeds are paid on the previous working day. The types of government securities issued are fixed rate bonds, floating rate bonds, zero-coupon bonds, special securities (food bonds, oil bonds, fertilizer bonds, etc).
State Development Loan (SDLs): State Government also raises loans from the market known as SDL. These dated securities are issued through an auction similar to Central Government Securities and pay interest at half-yearly intervals, while principal is repaid on the maturity date. Securities issued by Central Government and SDL qualify for SLR and also eligible as a collateral for borrowing through market repo and borrowing by eligible entities from RBI’s daily Liquidity Adjustment Facility (LAF).
Primary issuance of government securities is conducted through auction method on electronic platform called NDS platform. The members of this electronic platform consist of commercial banks, scheduled urban co-operative banks, primary dealers, insurance companies and provident funds. These members maintain funds account (current account) and securities account (SGL) with RBI and can place their bids in the auction through NDS electronic platform.
The RBI, in consultation with Government of India issues an indicative half-yearly auction calendar that contains information about the borrowing amount, security tenor and likely period during which auctions will be held. RBI also issues a notification and press release a week prior to the auction with exact security details on its website www.rbi.org.in.
There are two types of auction method used by the RBI to issue government securities:
Yield Based Auction: A yield based auction is generally conducted when a new Government security is issued. Investors bid in yield terms up to two decimal places (for example, 8.19%, 8.20%, etc.). Bids are arranged in ascending order and the cut-off yield is arrived at the yield corresponding to the notified amount of the auction. The cut-off yield is taken as the coupon rate for the security. Successful bidders are those who have bid at or below the cut-off yield. Bids which are higher than the cut-off yield are rejected.
Price Based Auction: A price based auction is conducted when Government of India re-issues securities issued earlier. Bidders quote in terms of price per Rs.100 of face value of the security (e.g., Rs.102.00, Rs.101.00, Rs.100.00, Rs.99.00, etc., per Rs.100/-). Bids are arranged in descending order and the successful bidders are those who have bid at or above the cut-off price. Bids which are below the cut-off price are rejected.
Economics is a social science that studies how individuals, governments and companies make choices on allocating scarce resources to satisfy their unlimited wants. The concept of choice is the core to economics and how economic agents such as companies and individuals make choices in the face of the constraints that drive economic theory. Economists assume that every economic agent always acts in self-interest to seek maximization of their own well being. Let’s consider few economic laws and principles that affect bond markets.
The law of supply and demand is interaction between supply of a resource (in our case bonds) and demand for that resource. The law defines the effect that the availability of a product and the desire (demand) for that product has on price. Generally, if there is a low supply and a high demand, the price will be high. In contrast, the greater the supply and the lower the demand, the lower the price will be. Equilibrium is achieved when price of supply meets the price point of demand for a product. In bond market, the law of supply and demand can contribute to explain a bond’s price and its interest rate at any given time. It becomes the base to any economic understanding.
Bond’s supply and demand determine the interest rate in the bond market, and a bond becomes a tradable commodity. Investors such as you, buy bonds while companies and government supply bonds. Consequently, the interaction of supply and demand functions in the bond market determines the price and quantity.
While an understanding of economics is important to understanding any financial market, it is particularly important when it comes to the bond market. One of the prime determinants of bond prices is the general level of interest rates and the level of interest rates is driven by macroeconomics.
Experienced bond investors and traders keep a close eye on economic indicators and indexes, such as gross domestic product (GDP), which is the sum of all of a country’s goods and services produced in a year; and the consumer price index (CPI) which measures the overall rate of change in the prices of consumer goods and services.
A faltering economy is not the only concern for bond investors- an economy that is growing too rapidly will lead to excessive demand for goods and services, which will eventually lead to rapidly increasing prices, or price inflation (the law of supply and demand). A declining economy, as evidenced by a declining GDP, and an “overheated” economy, as evidenced by a rapidly increasing GDP, which will eventually lead to significant increases in the CPI, will both have a significant impact on bond prices.
Flight to quality refers to the herd-like behavior of investors to shift out of risky assets during financial downturns or bear markets. For example, an economic decline will have an impact on the financial fortune of the issuers of most bonds, be they corporations or state and local governments, thereby affecting the price of the bonds. Issues of lower credit quality are typically more affected, as they are less able to withstand an environment of lower revenues and earnings. In significant downturns, investors usually sell out of equities and lower quality bonds and purchase much safer instruments; most often are high rated (AAA) Government and PSU bonds of shorter duration. This phenomenon is known as a ‘flight to quality/safety’ and can lead to an increase in the price of certain government bond issues for a period of time.
Inflation is often described as the general rise of prices in the economy. However, the increase in prices is merely the effect, called price inflation. Monetary inflation, which is the expansion of credit in the financial markets, is what often drives price inflation. As credit expands, and more money becomes available in the marketplace, the price of goods and services generally rise in response. This is because the inflation increases supply of money in circulation while simultaneously decrease in the value of money as a result.
There are two types of inflation index most widely tracked: Wholesale Price Index (WPI) and Consumer Price Index (CPI). In recent years, RBI has started targeting CPI for setting monetary policy. The CPI is the average change over time of the prices paid by consumers for basket of goods and services. Both CPI and WPI are normally quoted as percentage change over a specified period of time.
Interest rates, bond yields (prices) and inflation expectations have a correlation to one another. Movement in short-term interest rates, as dictated by country’s central bank (RBI), will affect different bonds with different terms to maturity differently, depending on the market’s expectations of future levels of inflation.
Inflation is a bond’s worst enemy. Inflation erodes the purchasing power of a bond’s future cash flows. The timing of a bond’s cash flows is important. This includes the bond’s term to maturity. If market participants believe that there is higher inflation on the horizon, interest rates and bond yields will rise and the price will decrease to compensate for the loss of the purchasing power of future cash flows. Those bonds with the longest cash flows will see their yields rise and prices fall the most.
A concept that is critical to an understanding of financial markets is the business cycle (also known as the economic cycle). The business cycle refers to fluctuations in economic activity, most often as measured by changes in gross domestic product (GDP). These recurring fluctuations are somewhat random and do not follow a predictable pattern.
There are five stages in a business cycle:
a) Expansion b) Peak c) Contraction d) Trough e) Recovery
Expansion stage of the cycle is characterized by rising employment wages and profits that fuels the expansion of supply and demand for goods and services and consumer confidence that encourages spending. Expansion is most often accompanied by the accommodative monetary policies of low interest rates and expanding money supply. Eventually, the expansion leads to inflation as there are too many rupees chasing too few goods. The central bank then adopts more restrictive monetary policy and raises interest rates. As the supply of money contracts and high interest rates discourage consumer and business spending, unemployment increases and economic activity peaks and eventually begin to decline. The central bank (RBI) begins to loosen monetary policy until economic activity reaches a trough and begins to recover.
Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation's economy. The government uses fiscal policy to influence aggregate demand. Aggregate demand is the total consumption, government spending and investment that occur within an economy. The government policy attempts to influence the direction of the economy through changes in government spending or taxes. The government uses their spending or tax rates to influence aggregate demand – increasing it during economic slowdown and increasing it when there is excess growth. Simply put, the government has two levers when setting fiscal policy
(a) Government can change the levels of taxation
(b) Government can change the levels of spending
Fiscal policy can be used to influence both expansion and contraction of GDP as a measure of economic growth. Let’s check the impact of fiscal policy on economy and bond market mentioned below:
Monetary policy is the use of the supply of money and short-term interest rates to influence economic growth and inflation. Monetary policy consists of the actions of a central bank that determine the size and rate of growth of the money supply, which in turn affects interest rates.
Money is necessary in order to carry out transactions. However inherent to the holding of money is the trade-off between liquidity advantage of holding money and the interest advantage of holding other assets. When the demand of money is stable, monetary policy can help to stabilize an economy. However, when the demand for money is not stable, real and nominal interest rates will change and there will be economic fluctuations. Monetary policy is maintained through actions such as modifying the interest rate, buying or selling of government bonds, and changing the amount of money banks are required to keep in the reserves. Let’s look at various tools of monetary policy:
Cash Reserve Ratio (CRR): CRR is a set percentage of customer net deposits that a bank is required to hold in reserves, or funds that are not allowed be loaned. The required reserve ratio is a tool in monetary policy, given that change in cash reserve ratio directly impact the amount of loanable funds available. The Reserve Bank of India (RBI) uses the CRR to drain out excessive money from the system.
Key Interest rate: RBI uses Reverse Repo Rate and Repo Rate to control interest rate in India. Reverse Repo Rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money is in safe hands with a good interest. An increase in Reverse Repo Rate can prompt to park more fund with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out the banking system.
Repo Rate is the rate at which the RBI lends money to commercial banks is called Repo Rate. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the RBI. A reduction in the Repo Rate helps banks get money at a cheaper rate and vice versa. The Repo Rate in India is similar to the discount rate in the US.
Open Market Operations: An open market operation (OMO) is an instrument of monetary policy which involves buying or selling of government securities from or to the public and banks. The mechanism influences the reserve position of banks, yield on government securities to control the flow of credit and buys government securities to increase credit flow. Open market operation makes bank rate policy effective and maintains stability in government securities market.
Statutory Liquidity Ratio: Every banks has to maintain a certain quantity of liquid assets with themselves at any point of time of their total net time and demand liabilities. These assets have to be kept in non-cash form such as G-secs, gold, approved securities like bonds, etc. The ratio of the liquid assets to time and demand assets is termed as the Statutory Liquidity Ratio.
Monetary Policy has direct impact on bond market and bond markets takes cues from prevailing interest rates in the economy to determine yields and price of government bonds and corporate bonds.
A Bond is simply a loan given to the issuer (borrower) by the bondholder (lender) whereby terms of interest payment and the redemption date/s are pre-determined. When you purchase a bond, you are lending money to any entity known as issuer. The legal document registering this loan is called a bond and the issuer pays interest to you on the amount of money you lend and on expiry of the tenure shall pay back the Principal amount.
While Bonds are securities that are mostly issued by the government, bonds issued by companies are often called Debentures.
There are various types of bonds available in the market:
There is a wide variety of individual bonds to choose from in creating a portfolio that matches your investment needs and expectations. Individual can purchase bonds in two ways:
Bond Category | Credit Quality | Liquidity | Examples |
---|---|---|---|
Government | Highest | Highest | Govt bonds, T-bills |
Public Sector Enterprise | High Grade | Medium | IRFC, REC, PFC, NTPC, NHAI etc |
Private Sector Companies | High to Low | Varies | HDFC Ltd, Tata Capital ltd, Shriram Transport Finance Co. Ltd etc |
Maturity | Yield | Price Volatility |
---|---|---|
Short | Lower | Lower |
Long | Higher | Higher |
There are number of key variables that comprise the risk profile of bond. Few variables we have already understood earlier are price, interest rate, yield, maturity. Other important parameters are redemption features, embedded options, assessing risk and credit ratings and tax status. Let’s understand each one of these parameters or variables:
While the maturity date indicates how long a bond will be outstanding for, many bonds are structured in such a way so that an issuer or investor can opt for early maturity date. The same are discussed below:
All investments offer a balance between risk and potential returns. The risk is the chance that you will lose some or all money that you have invested. Bonds as an investment avenue can be a great tool to generate income and are widely considered to be a safe investment, when compared to stocks. However, you as an investor should identify some potential risks for holding corporate and government bonds. Following are the list of risks involved with investment in bonds.
Duration: The term duration has a special meaning in the context of bonds. It is a measurement of how long, in years, it takes for the price of the bond to be repaid by its internal cash flows. It is an important measure for you as an investor to consider, as bonds with higher duration carry more risk and have higher price volatility than bond with lower durations. There are two basic types of bonds duration:
Convexity: Convexity of a Bond is a measure that shows the relationship between bond price and Bond yield, i.e., the change in the duration of the bond due to a change in the rate of interest, which helps a risk management tool to measure and manage the portfolio’s exposure to interest rate risk and risk of loss of expectation
If we were to graph the relationship between price and yield for a bond, the result would not be a straight line, but a curve or convex line, as shown in below diagram. The degree to which the line is curved shows how much a bond’s price changes as the result of change in yield.
Convexity is used as a risk management tool and helps to measure and manage the amount of market risk to which a portfolio of bonds is exposed. The main thing for you to remember about convexity is that it shows how much a bond's yield changes in response to changes in price. A bond with greater convexity is less affected by interest rates than a bond with less convexity. Also, bonds with greater convexity will have a higher price than bonds with a lower convexity, regardless of whether interest rates rise or fall.
You as an investor need to understand tax implications for any asset class you choose to invest as any income through various asset classes can attract various kinds of taxes. In bonds too, there are certain tax considerations you need to check before investing. In bonds, there are two types of income that you earn:
The Surcharge and Health and Education Cess on the above-mentioned tax will be applicable based on the respective income slab of the investor.
The Reserve Bank of India (RBI) was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934.The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. Though originally privately owned, since nationalisation in 1949, the Reserve Bank is fully owned by the Government of India.
The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as:
"to regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage; to have a modern monetary policy framework to meet the challenge of an increasingly complex economy, to maintain price stability while keeping in mind the objective of growth."
The Main Functions of Reserve Bank of India are stated here-in below
Monetary Authority:
The Securities and Exchange Board of India (SEBI) was established on April 12, 1992 in accordance with the provisions of the Securities and Exchange Board of India Act,1992.
The Preamble of the Securities and Exchange Board of India describes the basic functions of the Securities and Exchange Board of India as "...to protect the interests of investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto"
The main Functions of SEBI are stated here-in below:
The Fixed Income Money Market and Derivatives Association (FIMMDA) is an association of Scheduled Commercial Banks, Public Financial Institutions, Primary Dealers and Insurance Companies. Voluntary market body for the bond, money and derivatives markets with members representing all major institutional segments of the market.
SEBI has laid down the framework of trading / reporting trades in Corporate Bonds on exchanges and the same must be settled through the Clearing Corporation of the Stock Exchanges (ICCL [BSE] & NCL [NSE]). Thus, helping in mitigating the counter party risk and improving the transparency in trading of Corporate Bonds.
NSE Clearing Limited (NSE Clearing) (formerly known as National Securities Clearing Corporation Limited, NSCCL), a wholly owned subsidiary of NSE is responsible for clearing and settlement of all trades executed / reported on NSE, collateral management and risk management functions for various segments of NSE.
Indian Clearing Corporation Limited ("ICCL") was incorporated in 2007 as a wholly owned subsidiary of BSE Ltd. ("BSE"). ICCL carries out the functions of clearing, settlement, collateral management and risk management for various segments of BSE.
Rating agencies assess the credit risk of specific debt securities and the borrowing entities. In the bond market, a rating agency provides an independent evaluation of the creditworthiness of debt securities issued by governments and corporates.
Credit ratings of borrowers are based on the due diligence conducted by the rating agencies. The objective of a rating agencies is to evaluate the financial situation of the borrower and their capacity to service/repay their financial obligations.
Credit rating acts as a catalyst for channelizing investments in debt instruments by enabling individual and institutional investors in making informed investment decisions.
Following are the list of ratings for long term securities.
Rating | Description |
---|---|
AAA | Instruments with this rating are considered to have the highest degree of safety regarding timely servicing of financial obligations. Such instruments carry lowest credit risk. |
AA | Instruments with this rating are considered to have high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk. |
A | Instruments with this rating are considered to have adequate degree of safety regarding timely servicing of financial obligations. Such instruments carry low credit risk. |
BBB | Instruments with this rating are considered to have moderate degree of safety regarding timely servicing of financial obligations. Such instruments carry moderate credit risk. |
BB | Instruments with this rating are considered to have moderate risk of default regarding timely servicing of financial obligations. |
B | Instruments with this rating are considered to have high risk of default regarding timely servicing of financial obligations. |
C | Instruments with this rating are considered to have very high risk of default regarding timely servicing of financial obligations. |
D | Instruments with this rating are in default or are expected to be in default soon. |
Rating Agency may apply '+' (plus) or '-' (minus) signs for ratings from ‘AA' to 'C' to reflect comparative standing within the category.
A rating outlook indicates the direction in which a rating may move over a medium-term horizon of one to two years. A rating outlook can be 'Positive', 'Stable', or 'Negative'. A 'Positive' or 'Negative' rating outlook is not necessarily a precursor of a rating change.
A debenture trustee is an entity that holds the property of Bond/Debenture Issuer Company for the benefit of the debenture holders. They are SEBI regulated entities designed for better investor protection and reducing the events of defaults by financial institutions issuing Bond/Debentures.
A debenture trustee is a single point of contact who can act as a link between the issuer company and debenture holder for the smooth functioning of the process and protecting the interest of the debenture holders.
A debenture trustee keeps a track of issuer company actions to ensure that all the conditions mentioned in the offer are adhered to and debenture holder obligations are met. In case of default by the issuer company, the debenture trustee takes possession of the collateral/mortgaged assets in favour of debenture trustee for benefit of the debenture holders and paying their dues.
The KYC (Know Your Client)/ Registration process is your first step towards investing in financial instruments. If you want to invest in the Bond Market through us, you shall have to submit the undermentioned documents through your registered email-id.
Once you submit all the documents, our operations team will shall verify the aforesaid documents and in case of any discrepancy they shall get in touch with you and shall request you to remediate the same. Once your registration documents are in order, we shall intimate the same to you and you shall then be able to invest / sell Bonds through us.
As any transaction in the Bond Market has to be reported and settled to the Clearing Corporation, we shall be registering your KYC with the Clearing Corporations.
Registration/ Account opening process is a one-day process if all the requisite documents are submitted by you correctly.
Investors can use their existing bank and demat account/s for investing in bonds. If any investor doesn’t have a demat account, then based on their request IndiaBonds team will help them in opening a demat account.
Note: You can register maximum upto 5 Bank account/s and Demat account/s register with Clearing Corporation. The Investor will have to select and inform 1 Bank and 1 Demat account as their Default Bank / Demat accounts. Investor, at the time of doing transaction with the Counter Party (Registered Participants) they will have to inform from which Bank / Demat account they want to fulfill their Pay-in obligations (as the case may be) and in which Bank / Demat account they want to receive their Pay-out obligations (as the case may be).
The Steps to be followed are stated below:
Note: Incase any of the counter party fails to fulfill his / their Pay-in Obligations (Funds / Securities) in that scenario Clearing Corporation shall be returning back the funds / securities so received and the said reported transaction shall be treated as cancelled.
Minimum investment amount ranges between Rs. 10,000 to Rs. 10,00,000 depending on product type and underlying bonds.
Fixed Deposits and Bonds are both fixed income instruments, which offer interest income to investors.
What are Fixed Deposits? A fixed deposit (FD) is a financial instrument provided by banks, NBFCs and companies which provides investors with a higher rate of interest than a regular savings account, until the given maturity date.
What are Fixed Deposits? A fixed deposit (FD) is a financial instrument provided by banks, NBFCs and companies which provides investors with a higher rate of interest than a regular savings account, until the given maturity date.
It is always advisable to check the features of both these instruments in order to fetch good returns.
Features | Bonds/ Non-Convertible Debentures | Fixed Deposits |
---|---|---|
Safety | Most bonds are secured in nature as its backed by assets | For Bank FDs are insured up to Rs 5 lakh (capital & interest) per depositor, other than Bank FDs are unsecured in nature |
Liquidity | Can be liquidated anytime as bonds are tradable on exchanges | Can be withdrawn pre-maturely, however, liquidity at reduced interest rates or penalty charges |
Returns | Offers fixed returns and chance of taking advantage of interest rate cycle to maximize returns | Returns are fixed. Cannot be traded hence you cannot take advantage of interest rate changes in the economy |
Credit Rating | It is mandatory for issuers to get the instrument rated by at least one credit rating agency | Mandatory for NBFCs but not for others. Bank FDs are not rated |
Taxation | As per the tax slab of the individual other than tax free bonds | As per the tax slab of the individual |
TDS (Tax Deducted at Source) | Listed bonds and NCDs held in demat mode do not attract TDS and incase of taxable security held in physical mode TDS is subject to prescribed limit | TDS is applicable if interest exceeds above the prescribed limit |
Interest Payout Frequency | Monthly/Quarterly/Annually/Cumulative | Monthly/Quarterly/Annually/Cumulative |
What are Bond or Debt Funds? Bond funds are mutual funds that invest in bonds. Put another way, one bond fund can be considered a basket of dozens or hundreds of underlying bonds (holdings) within one bond portfolio. Most bond funds are comprised of a certain type of bond, such as corporate or government, and further defined by time period to maturity, such as short-term (less than 3 years), intermediate-term (3 to 10 years) and long-term (10 years or more).
Features | Bonds/ Non-Convertible Debentures | Debt/Bond Funds |
---|---|---|
Price | The price of the bond may fluctuate while investor holds the bond. | Bond funds are not valued by a price but a net asset value (NAV) of the underlying holdings in the bond portfolio. |
Principal Amount Risk | Bond holder receives principal amount invested at a time of bond maturity. Hence, there is no loss of principal amount | As bond funds consider NAV and not the price, investor can lose some of their principal amount if NAV falls. |
Returns/ Interest Rates | Returns are fixed and hence can be useful for investor to determine exact returns at maturity of the bond. | Returns vary depending on market conditions and interest rate scenario in the economy. |
Credit Risk | Invest in higher credit quality securities with better returns. | Depends on credit quality of underlying securities in which the fund invests. |
Liquidity | Most listed bonds are liquid and tradable on exchange. | Investors can generally redeem fund units at any time, at the current market value (or NAV) of the fund. Some funds may carry a redemption fee/exit load. |
Stocks and bonds are the two main classes of assets investors use in their portfolios. Stocks offer an ownership stake in a company, while bonds are akin to loans made to a company (a corporate bond) or any other organization. In general, stocks are considered riskier and more volatile than bonds. However, there are many different kinds of stocks and bonds, with varying levels of volatility, risk and return.
Features | Bonds | Equity |
---|---|---|
Safety | Investment in bonds are generally safer as you don’t hold a risk of losing principal amount | Equity investment is riskier investment as there can be chances of losing principal amount |
Predictable Returns | It has fixed and predictable returns in form of interest payments at periodic intervals unless the issuer defaults | Returns are subject to market price of the shares |
Market Risk | In bond investment interest income is fixed at the time of purchase and remains same till term of maturity. Hence, market risk is negligible. | Stocks are more volatile and market prices affect the returns drastically. Market risk is much higher. |
Bankruptcy | Bond holders are the first in line to get their amount invested as they are lenders and generally bonds are backed by assets. | Shareholders are last in line during bankruptcy and you may lose the entire investment. |
Interest Rate Risk | Bonds are subject to interest rate risk and changes in interest rate can lead to lower investment return | Interest rate risk does not impact equity investment to larger extent |
Investment Objectives - “It’s very difficult to get somewhere if you have no idea where you are going!”
As in most endeavors, setting goals is an important part of creating an investment portfolio. You need to have investment objectives, while you create a portfolio. Also, investment objective should not only be identified, but prioritized as some goals may conflict with each other. Following are some of the investment objectives that you may consider:
Current Income: It stands to reason that anyone considering the creation of a bond portfolio would have current income high on their list of objectives, if not the primary goal. The maximization of current income becomes a risk/reward decision as higher yielding bonds present greater risk.
Capital Appreciation: Capital appreciation is when an investment or portfolio increases in value. Many people do not think about bonds when it comes to capital appreciation, but the reality is that bonds do fluctuate in value, and can be used to meet this investment objective, though they should probably not be the only asset class in the portfolio. Longer maturity and discount bonds provide the most price movement when interest rates change, but this also increases the portfolio’s price risk.
Capital Preservation: Capital preservation is when a portfolio’s principal maintains its value. Investors that are seeking the preservation of capital are looking to minimize price risk. Investors looking for capital preservation would usually want to purchase bonds with shorter maturity with high credit ratings.
Tax Minimization: This is usually considered a secondary objective, but investors seeking to minimize taxes may want to consider tax-free bonds.
Broadly, we can categorize Investment goals in two categories:
a) Cash Flow Goals – Want to earn Rs 50,000/- per month through investments
b) Capital Appreciation Goals – Want to have Rs 2 crore portfolio in next 10 years.
Investment objectives of current income and tax minimization will fall in the category of cash flow goals, while capital appreciation and preservation will be in capital appreciation goals. To conclude, you need to know what you want to achieve, so that you know which category (cash flow goals & capital appreciation goals) is suitable, and what is the reasonable returns to expect.
Once you have finalized goals and objectives, you should consider knowing different strategies that you can start investing in bonds as per your goals and needs. There are various techniques you and your investment advisor can use to help you match your investment goals with your risk tolerance.
Passive Portfolio Management
Passive portfolio management is essentially a buy-and-hold approach. Passive portfolio management provides the least amount of risk, but also the lowest potential returns. Passive portfolio management is also known as indexing, because it involves choosing an index that you wish to match the return of, and recreating it in the portfolio. Matching an index by replicating every security in it is not practical, as many indexes contain hundreds or thousands of securities. Professional portfolio managers will index by creating a portfolio of securities that match various characteristics of the index such as coupon, maturity, duration, and credit rating. The duration component is probably the most important determinant of portfolio performance, followed closely by the credit rating.
Enhanced Indexing
Enhanced indexing is a hybrid of passive and active portfolio management. The objective is to outperform the targeted index, but it also presents the risk of underperforming the index. One strategy involves deviating from the characteristics of the portfolio. For example, a manager may create a portfolio with a slightly longer average duration or lower average credit rating. Another strategy involves creating an indexed portfolio with most of the assets, and actively managing a smaller portion of the assets.
Asset-Liability Management
Asset-liability management (ALM) is a portfolio management strategy that involves matching the cash flows of the portfolio assets with liabilities. In other words, the portfolio is constructed so the interest payments and maturities of the bonds in the portfolio are matched against the future payment obligations. While this is popular with large institutional investors, such as insurance companies, it is less common with retail investors. However, it can be an effective strategy for investors who are retired or are approaching retirement. The advantage is that it lowers the price risk because the investor is less likely to have to sell an investment at a loss.
Active Portfolio Management
Active portfolio managers are attempting to outperform the benchmark. This is often very difficult to achieve, especially considering the higher transaction fees that result from increased trade activity. It is the strategy that presents the highest potential return, but the risk is also higher. Active managers do not believe in the efficient market hypothesis, or they believe that markets are not significantly efficient. Most retail investors do not prefer managing bond portfolio actively as it involves transaction fees and has higher risk.
Investment Strategies
Once you have finalized goals and objectives, you should consider knowing different strategies that you can start investing in bonds as per your goals and needs. There are various techniques you and your investment advisor can use to help you match your investment goals with your risk tolerance.
Diversification is the allocation of assets to several categories in order to spread, and therefore possibly mitigate, risk. Regardless of your investment objectives, diversification is an important consideration in building any portfolio. Diversification can be achieved in any number of ways, including by:
Market timing involves attempts to correctly anticipate changes in interest rates. Bond traders and investors can use several methods to try to forecast interest rates and structure trades to profit from their forecasts. Forecasting just about anything, be it weather, corporate earnings, or financial markets, forecasting changes in interest rates is as much an art as a science. It is impossible to forecast with extreme accuracy, but professional bond traders employ various techniques to try to stack the odds in their favor. Because the Reserve Bank of India changes interest rates to implement monetary policy in order to pursue its stated goal of “price stability and sustainable economic growth,” predicting what the RBI is going to do can help forecast interest rates. “RBI watching” is something that virtually all bond investors do to help them determine the future course of interest rates.
Relative value (RV) strategies attempt to take advantage of temporary price anomalies between different bonds. In other words, the spread between the two bonds is exceedingly large, and the manager expects the spread to return to normal. The anomaly may be in a credit spread, a yield spread, or a maturity spread.
Aggressive managers will usually go long the cheap security and short the expensive bond. These trades are usually made market neutral by weighting the long and short position by the price sensitivity of each bond. An investor can also take advantage of relative value anomalies by swapping out of an expensive security in their portfolio into a cheap.
A government security is a tradable instrument issued by the Central Government or by the State Governments and is acknowledged as Government’s debt obligation. Government securities carry practically no risk of default and are called risk-free gilt-edged instruments. These securities are short-term (treasury bills with original maturity of less than one-year) or long-term securities (Government bonds or other dated securities issued by State Governments with original maturity of one-year or more).
Government of India also issues other instruments such as Savings Bonds, National Saving Certificates, oil bonds, Food Corporation of Indiabonds, fertilizer bonds, power bonds, etc. These bonds and securities are, usually not fully tradable and are, therefore, not eligible to be SLR securities.
Treasury Bills (T-bills): Treasury bills are money market and short-term debt instruments issued by the Government of India and are presently issued in three tenors, namely, 91 day, 182 day and 364 day. Treasury bills are zero coupon securities and pay no interest. They are issued at a discount and redeemed at the face value at maturity.
The Reserve Bank of India conducts auctions usually every Wednesday to issue T-bills. Payments for the T-bills purchased are made on the following Friday.
Dated Government Securities: These are long term securities and carry a fixed or floating coupon rate which is paid on the face value, payable at fixed time periods (usually half-yearly). The tenor of dated securities can be up to 30 years. Government security contains the following features - coupon, name of the issuer, maturity and face value. For example, 5.79% GS 2030 would mean:
Coupon: 5.79% paid on face value
Name of Issuer: Government of India
Date of Issue : May 11, 2020
Maturity : May 11, 2030
Coupon Payment Dates : Half-yearly ( 11th May and 11th November) every year
The coupon payment date if falls on Sunday or a holiday, then the coupon is paid on the next working date for dated Government Securities, however, if the redemption or maturity date falls on Sunday or a holiday, then the redemption proceeds are paid on the previous working day. The types of government securities issued are fixed rate bonds, floating rate bonds, zero-coupon bonds, special securities (food bonds, oil bonds, fertilizer bonds, etc).
State Development Loan (SDLs): State Government also raises loans from the market known as SDL. These dated securities are issued through an auction similar to Central Government Securities and pay interest at half-yearly intervals, while principal is repaid on the maturity date. Securities issued by Central Government and SDL qualify for SLR and also eligible as a collateral for borrowing through market repo and borrowing by eligible entities from RBI’s daily Liquidity Adjustment Facility (LAF).
Primary issuance of government securities is conducted through auction method on electronic platform called NDS platform. The members of this electronic platform consist of commercial banks, scheduled urban co-operative banks, primary dealers, insurance companies and provident funds. These members maintain funds account (current account) and securities account (SGL) with RBI and can place their bids in the auction through NDS electronic platform.
The RBI, in consultation with Government of India issues an indicative half-yearly auction calendar that contains information about the borrowing amount, security tenor and likely period during which auctions will be held. RBI also issues a notification and press release a week prior to the auction with exact security details on its website www.rbi.org.in.
There are two types of auction method used by the RBI to issue government securities:
Yield Based Auction: A yield based auction is generally conducted when a new Government security is issued. Investors bid in yield terms up to two decimal places (for example, 8.19%, 8.20%, etc.). Bids are arranged in ascending order and the cut-off yield is arrived at the yield corresponding to the notified amount of the auction. The cut-off yield is taken as the coupon rate for the security. Successful bidders are those who have bid at or below the cut-off yield. Bids which are higher than the cut-off yield are rejected.
Price Based Auction: A price based auction is conducted when Government of India re-issues securities issued earlier. Bidders quote in terms of price per Rs.100 of face value of the security (e.g., Rs.102.00, Rs.101.00, Rs.100.00, Rs.99.00, etc., per Rs.100/-). Bids are arranged in descending order and the successful bidders are those who have bid at or above the cut-off price. Bids which are below the cut-off price are rejected.
Economics is a social science that studies how individuals, governments and companies make choices on allocating scarce resources to satisfy their unlimited wants. The concept of choice is the core to economics and how economic agents such as companies and individuals make choices in the face of the constraints that drive economic theory. Economists assume that every economic agent always acts in self-interest to seek maximization of their own well being. Let’s consider few economic laws and principles that affect bond markets.
The law of supply and demand is interaction between supply of a resource (in our case bonds) and demand for that resource. The law defines the effect that the availability of a product and the desire (demand) for that product has on price. Generally, if there is a low supply and a high demand, the price will be high. In contrast, the greater the supply and the lower the demand, the lower the price will be. Equilibrium is achieved when price of supply meets the price point of demand for a product. In bond market, the law of supply and demand can contribute to explain a bond’s price and its interest rate at any given time. It becomes the base to any economic understanding.
Bond’s supply and demand determine the interest rate in the bond market, and a bond becomes a tradable commodity. Investors such as you, buy bonds while companies and government supply bonds. Consequently, the interaction of supply and demand functions in the bond market determines the price and quantity.
While an understanding of economics is important to understanding any financial market, it is particularly important when it comes to the bond market. One of the prime determinants of bond prices is the general level of interest rates and the level of interest rates is driven by macroeconomics.
Experienced bond investors and traders keep a close eye on economic indicators and indexes, such as gross domestic product (GDP), which is the sum of all of a country’s goods and services produced in a year; and the consumer price index (CPI) which measures the overall rate of change in the prices of consumer goods and services.
A faltering economy is not the only concern for bond investors- an economy that is growing too rapidly will lead to excessive demand for goods and services, which will eventually lead to rapidly increasing prices, or price inflation (the law of supply and demand). A declining economy, as evidenced by a declining GDP, and an “overheated” economy, as evidenced by a rapidly increasing GDP, which will eventually lead to significant increases in the CPI, will both have a significant impact on bond prices.
Flight to quality refers to the herd-like behavior of investors to shift out of risky assets during financial downturns or bear markets. For example, an economic decline will have an impact on the financial fortune of the issuers of most bonds, be they corporations or state and local governments, thereby affecting the price of the bonds. Issues of lower credit quality are typically more affected, as they are less able to withstand an environment of lower revenues and earnings. In significant downturns, investors usually sell out of equities and lower quality bonds and purchase much safer instruments; most often are high rated (AAA) Government and PSU bonds of shorter duration. This phenomenon is known as a ‘flight to quality/safety’ and can lead to an increase in the price of certain government bond issues for a period of time.
Inflation is often described as the general rise of prices in the economy. However, the increase in prices is merely the effect, called price inflation. Monetary inflation, which is the expansion of credit in the financial markets, is what often drives price inflation. As credit expands, and more money becomes available in the marketplace, the price of goods and services generally rise in response. This is because the inflation increases supply of money in circulation while simultaneously decrease in the value of money as a result.
There are two types of inflation index most widely tracked: Wholesale Price Index (WPI) and Consumer Price Index (CPI). In recent years, RBI has started targeting CPI for setting monetary policy. The CPI is the average change over time of the prices paid by consumers for basket of goods and services. Both CPI and WPI are normally quoted as percentage change over a specified period of time.
Interest rates, bond yields (prices) and inflation expectations have a correlation to one another. Movement in short-term interest rates, as dictated by country’s central bank (RBI), will affect different bonds with different terms to maturity differently, depending on the market’s expectations of future levels of inflation.
Inflation is a bond’s worst enemy. Inflation erodes the purchasing power of a bond’s future cash flows. The timing of a bond’s cash flows is important. This includes the bond’s term to maturity. If market participants believe that there is higher inflation on the horizon, interest rates and bond yields will rise and the price will decrease to compensate for the loss of the purchasing power of future cash flows. Those bonds with the longest cash flows will see their yields rise and prices fall the most.
A concept that is critical to an understanding of financial markets is the business cycle (also known as the economic cycle). The business cycle refers to fluctuations in economic activity, most often as measured by changes in gross domestic product (GDP). These recurring fluctuations are somewhat random and do not follow a predictable pattern.
There are five stages in a business cycle:
a) Expansion b) Peak c) Contraction d) Trough e) Recovery
Expansion stage of the cycle is characterized by rising employment wages and profits that fuels the expansion of supply and demand for goods and services and consumer confidence that encourages spending. Expansion is most often accompanied by the accommodative monetary policies of low interest rates and expanding money supply. Eventually, the expansion leads to inflation as there are too many rupees chasing too few goods. The central bank then adopts more restrictive monetary policy and raises interest rates. As the supply of money contracts and high interest rates discourage consumer and business spending, unemployment increases and economic activity peaks and eventually begin to decline. The central bank (RBI) begins to loosen monetary policy until economic activity reaches a trough and begins to recover.
Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation's economy. The government uses fiscal policy to influence aggregate demand. Aggregate demand is the total consumption, government spending and investment that occur within an economy. The government policy attempts to influence the direction of the economy through changes in government spending or taxes. The government uses their spending or tax rates to influence aggregate demand – increasing it during economic slowdown and increasing it when there is excess growth. Simply put, the government has two levers when setting fiscal policy
(a) Government can change the levels of taxation
(b) Government can change the levels of spending
Fiscal policy can be used to influence both expansion and contraction of GDP as a measure of economic growth. Let’s check the impact of fiscal policy on economy and bond market mentioned below:
Monetary policy is the use of the supply of money and short-term interest rates to influence economic growth and inflation. Monetary policy consists of the actions of a central bank that determine the size and rate of growth of the money supply, which in turn affects interest rates.
Money is necessary in order to carry out transactions. However inherent to the holding of money is the trade-off between liquidity advantage of holding money and the interest advantage of holding other assets. When the demand of money is stable, monetary policy can help to stabilize an economy. However, when the demand for money is not stable, real and nominal interest rates will change and there will be economic fluctuations. Monetary policy is maintained through actions such as modifying the interest rate, buying or selling of government bonds, and changing the amount of money banks are required to keep in the reserves. Let’s look at various tools of monetary policy:
Cash Reserve Ratio (CRR): CRR is a set percentage of customer net deposits that a bank is required to hold in reserves, or funds that are not allowed be loaned. The required reserve ratio is a tool in monetary policy, given that change in cash reserve ratio directly impact the amount of loanable funds available. The Reserve Bank of India (RBI) uses the CRR to drain out excessive money from the system.
Key Interest rate: RBI uses Reverse Repo Rate and Repo Rate to control interest rate in India. Reverse Repo Rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money is in safe hands with a good interest. An increase in Reverse Repo Rate can prompt to park more fund with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out the banking system.
Repo Rate is the rate at which the RBI lends money to commercial banks is called Repo Rate. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the RBI. A reduction in the Repo Rate helps banks get money at a cheaper rate and vice versa. The Repo Rate in India is similar to the discount rate in the US.
Open Market Operations: An open market operation (OMO) is an instrument of monetary policy which involves buying or selling of government securities from or to the public and banks. The mechanism influences the reserve position of banks, yield on government securities to control the flow of credit and buys government securities to increase credit flow. Open market operation makes bank rate policy effective and maintains stability in government securities market.
Statutory Liquidity Ratio: Every banks has to maintain a certain quantity of liquid assets with themselves at any point of time of their total net time and demand liabilities. These assets have to be kept in non-cash form such as G-secs, gold, approved securities like bonds, etc. The ratio of the liquid assets to time and demand assets is termed as the Statutory Liquidity Ratio.
Monetary Policy has direct impact on bond market and bond markets takes cues from prevailing interest rates in the economy to determine yields and price of government bonds and corporate bonds.