Debt

An Overview

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

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

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

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

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

Other risks associated with trading in debt securities are more generic in nature, such as:

• Counter Party Risk refers to the failure or inability of the opposite party in the contract to deliver either the promised security or the sale value at the time of settlement.
• Price Risk refers to the possibility of not being able to receive the expected price on any order due to an adverse movement in the prices.

Indian Debt Market
The Indian debt market is composed of government bonds and corporate bonds. However, the Central government bonds are predominant and they form most liquid component of the bond market. In 2003, the National Stock Exchange (NSE) introduced Interest Rate Derivatives. MCX Stock Exchange (MCX-SX) is also planning to launch the same in 2009.

The trading platforms for government securities are the ‘Negotiated Dealing System’ and the Wholesale Debt Market (WDM) segment of NSE and BSE. In the negotiated market, the trades are normally decided by the seller and the buyer, and reported to the exchange through the broker, whereas the WDM trading system, known as NEAT (National Exchange for Automated Trading), is a fully automated screen-based trading system, which enables members across the country to trade simultaneously with enormous ease and efficiency.

The instruments traded can be classified into the following segments based on the characteristics of the identity of the issuer of these securities: 

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

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

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

Debt Instruments are categorized as:

• Government of India dated Securities (G Secs) are 100-rupee face-value units/ debt paper issued by the Government of India in lieu of their borrowing from the market. They are referred to as SLR securities in the Indian markets as they are eligible securities for the maintenance of the SLR ratio by the banks.
• Corporate debt market: The corporate debt market basically contains PSU bonds and private sector bonds. The Indian primary Corporate Debt market is basically a private placement market with most of the corporate bonds being privately placed among the wholesale investors, which include banks, financial Institutions, mutual funds, large corporates & other large investors.

The following debt instruments are available in the corporate debt market:

• Non-Convertible Debentures
• Partly-Convertible Debentures/Fully-Convertible Debentures (convertible into Equity Shares)
• Secured Premium Notes
• Debentures with Warrants
• Deep Discount Bonds
• PSU Bonds/Tax-Free Bonds

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

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

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

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

Regulatory Authority
The regulators of the Indian debt market are:

RBI: The Reserve Bank of India is the main regulator for the money market. It controls and regulates the G-Secs market. Apart from its role as a regulator, it has to simultaneously fulfill several other important objectives, such as managing the borrowing programme for the Government of India, controlling inflation, ensuring adequate credit at reasonable costs to various sectors of the economy, managing the foreign exchange reserves of the country and ensuring a stable currency environment.

The RBI controls the issuance of new banking licences to banks. It controls the manner in which various scheduled banks raise money from depositors. Further, it controls the deployment of money through its policies on CRR, SLR, priority sector lending, export refinancing, guidelines on investment assets, etc.

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

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

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

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