NISM-Series XXII Fixed Income Securities Certification Examination Workbook (May 2021) PDF

XXII Fixed Income Securities  Workbook for NISM-Series-XXII: Fixed Income Securities Certification Examination National Institute of Securities Markets www.nism.ac.in This workbook has been devel...

XXII Fixed Income Securities  Workbook for NISM-Series-XXII: Fixed Income Securities Certification Examination National Institute of Securities Markets www.nism.ac.in This workbook has been developed to assist candidates in preparing for the National Institute of Securities Markets (NISM) Certification Examination for Fixed Income Securities (NISM-Series-XXII: Fixed Income Securities Certification Examination). Workbook Version: May 2021 Published by: National Institute of Securities Markets © National Institute of Securities Markets, 2021 NISM Bhavan, Plot 82, Sector 17, Vashi Navi Mumbai – 400 703, India National Institute of Securities Markets Patalganga Campus Plot IS-1 & IS-2, Patalganga Industrial Area Village Mohopada (Wasambe) Taluka-Khalapur District Raigad-410222 Website: www.nism.ac.in All rights reserved. Reproduction of this publication in any form without prior permission of the publishers is strictly prohibited. 1 Foreword National Institute of Securities Markets (NISM) is a leading provider of high end professional education, certifications, training and research in financial markets. NISM engages in capacity building among stakeholders in the securities markets through professional education, financial literacy, enhancing governance standards and fostering policy research. NISM works closely with all financial sector regulators in the area of financial education. NISM Certification programs aim to enhance the quality and standards of professionals employed in various segments of the financial services sector. NISM’s School for Certification of Intermediaries (SCI) develops and conducts certification examinations and Continuing Professional Education (CPE) programs that aim to ensure that professionals meet the defined minimum common knowledge benchmark for various critical market functions. NISM certification examinations and educational programs cater to different segments of intermediaries focusing on varied product lines and functional areas. NISM Certifications have established knowledge benchmarks for various market products and functions such as Equities, Mutual Funds, Derivatives, Compliance, Operations, Advisory and Research. NISM certification examinations and training programs provide a structured learning plan and career path to students and job aspirants who wish to make a professional career in the securities markets. Till March 2021, NISM has issued more than 13 lakh certificates through its Certification Examinations and CPE Programs. NISM supports candidates by providing lucid and focused workbooks that assist them in understanding the subject and preparing for NISM Examinations. NISM has designed this examination workbook to assist candidates appearing for the NISM-Series-XXII: Fixed Income Securities Certification Examination. This book covers all important topics related to Fixed Income Securities markets in India. These include the basics of Indian debt markets, classification of fixed income securities based on various criteria, pricing of bonds, yield measures, term structure of interest rates, risks associated with investing in Fixed Income Securities and measuring of interest rate risk. This book also covers the Money market, Government debt market and Corporate debt market in India. It will be immensely useful to all those who want to have a better understanding of Fixed Income Securities markets. S.K. Mohanty Director 2 Disclaimer The contents of this publication do not necessarily constitute or imply its endorsement, recommendation, or favoring by the National Institute of Securities Markets (NISM) or the Securities and Exchange Board of India (SEBI). This publication is meant for general reading and educational purpose only. It is not meant to serve as guide for investment. The views and opinions and statements of authors or publishers expressed herein do not constitute a personal recommendation or suggestion for any specific need of an Individual. It shall not be used for advertising or product endorsement purposes. The statements/explanations/concepts are of general nature and may not have taken into account the particular objective/ move/ aim/ need/ circumstances of individual user/ reader/ organization/ institute. Thus NISM and SEBI do not assume any responsibility for any wrong move or action taken based on the information available in this publication. Therefore, before acting on or following the steps suggested on any theme or before following any recommendation given in this publication user/reader should consider/seek professional advice. The publication contains information, statements, opinions, statistics and materials that have been obtained from sources believed to be reliable and the publishers of this title have made best efforts to avoid any errors. However, publishers of this material offer no guarantees and warranties of any kind to the readers/users of the information contained in this publication. Since the work and research is still going on in all these knowledge streams, NISM and SEBI do not warrant the totality and absolute accuracy, adequacy or completeness of this information and material and expressly disclaim any liability for errors or omissions in this information and material herein. NISM and SEBI do not accept any legal liability what so ever based on any information contained herein. While the NISM Certification examination will be largely based on material in this workbook, NISM does not guarantee that all questions in the examination will be from material covered herein. 3 About NISM Certifications The School for Certification of Intermediaries (SCI) at NISM is engaged in developing and administering Certification Examinations and CPE Programs for professionals employed in various segments of the Indian securities markets. These Certifications and CPE Programs are being developed and administered by NISM as mandated under Securities and Exchange Board of India (Certification of Associated Persons in the Securities Markets) Regulations, 2007. The skills, expertise and ethics of professionals in the securities markets are crucial in providing effective intermediation to investors and in increasing the investor confidence in market systems and processes. The School for Certification of Intermediaries (SCI) seeks to ensure that market intermediaries meet defined minimum common benchmark of required functional knowledge through Certification Examinations and Continuing Professional Education Programmes on Mutual Funds, Equities, Derivatives, Securities Operations, Compliance, Research Analysis, Investment Advice, Portfolio Management and many more. Certification creates quality market professionals and catalyzes greater investor participation in the markets. Certification also provides structured career paths to students and job aspirants in the securities markets. About the Workbook This workbook has been developed to assist candidates in preparing for the National Institute of Securities Markets (NISM) Certification Examination for Fixed Income Securities. NISM-Series- XXII: Fixed Income Securities Certification Examination seeks to enhance the knowledge and proficiency in the Fixed Income Securities markets in India. This book covers many important aspects of Fixed Income Securities Markets in India including the basics of Indian debt markets, types of fixed income securities, pricing of bonds, yield measures, term structure of interest rates and the risks associated with investing in Fixed Income Securities. This book also covers the Money Market, Government Debt Market and Corporate Debt Market in India. Acknowledgement This workbook has been developed jointly by the Certification Team of NISM and Dr. Golaka C Nath and reviewed by Dr. Kishore Rathi, NISM’s Resource Persons. NISM gratefully acknowledges the contribution of the Examination Committee for NISM-Series- XXII: Fixed Income Securities Certification Examination consisting of industry experts. 4 About the Certification Examination for Fixed Income Securities The examination seeks to create a common minimum knowledge benchmark for all associated persons employed or engaged in the Fixed Income Securities markets in India. NISM-Series-XXII: Fixed Income Securities Certification Examination is a voluntary examination and is open to all. It seeks to enhance the knowledge and proficiency in the Fixed Income Securities markets in India and aims to enhance the quality of services provided by the professional in this market. Examination Objectives This book covers all important topics related to Fixed Income Securities markets in India. These include the basics of Indian debt markets, types of fixed income securities, pricing of bonds, yield measures, term structure of interest rates, risks associated with investing in Fixed Income Securities as well as the Money market, Government debt market and Corporate debt market in India. On successful completion of the examination, the candidate should:  Know the basics of Indian debt markets and different terminologies used in debt markets.  Understand the classification of fixed income securities based on various criteria such as issuer, maturity, coupon, currencies, embedded options, etc.  Be aware of the risks associated with investing in fixed income securities.  Know the pricing of bonds (including floating rate bond), price-yield relationship and price time path of a bond.  Understand the sources of returns and the traditional yield measures  Understand the term structure of interest rates and the relationship between spot and forward rates.  Understand the concepts of measuring the interest rate risk (including the concepts of Duration, Modified Duration, Price value of basis point, Convexity measures, etc.)  Know the Indian Money Market and understand various instruments available in the money market.  Understand the Government Debt Market in India including the issuance mechanism, secondary market, clearing and settlement, valuation and key regulatory guidelines.  Understand the Corporate Debt Market in India including the issuance mechanism, secondary market and key regulatory guidelines. Assessment Structure The examination consists of 85 multiple choice questions (70 questions of 1-mark each and 15 questions of 2-marks each), adding to a total of 100 marks. The assessment structure is as follows: Multiple Choice Questions [70 questions of 1-mark each] 70 * 1 = 70 marks Multiple Choice Questions [15 questions of 2-marks each] 15 * 2 = 30 marks 5 The examination should be completed in 2 hours. The passing score for the examination is 60 marks (i.e., 60%). There shall be negative marking of 25% of the marks assigned to the question for each wrong answer (i.e., the penalty due to negative marking will be -0.25 marks in case of a 1-mark question and -0.50 marks in case of a 2-marks question). How to register and take the examination To find out more and register for the examination please visit www.nism.ac.in 6 Contents CHAPTER 1: OVERVIEW OF THE INDIAN DEBT MARKET....................................................................... 9 1.1 Role of the Debt Market................................................................................................................ 10 1.2 Importance of Debt Markets......................................................................................................... 12 1.3 The Bond Market Ecosystem......................................................................................................... 13 1.4 Role of Regulators.......................................................................................................................... 14 1.5 Role of Credit Rating Agencies....................................................................................................... 15 1.6 Role of Monetary Policy in Debt Markets..................................................................................... 19 1.7 Evolution of Debt Markets............................................................................................................. 22 1.8 Market Dynamics........................................................................................................................... 23 CHAPTER 2: TYPES OF FIXED INCOME SECURITIES.............................................................................. 28 2.1 Classification of fixed income securities based on the Type of Issuer......................................... 29 2.2 Classification of fixed income securities based on Maturity........................................................ 30 2.3 Classification of fixed income securities based on Coupon.......................................................... 31 2.4 Classification of fixed income securities based on Currencies..................................................... 33 2.5 Classification of fixed income securities based on Embedded Options....................................... 34 2.6 Classification of fixed income securities based on Security......................................................... 36 2.7 Other fixed income securities in India........................................................................................... 37 CHAPTER 3: RISKS ASSOCIATED WITH INVESTING IN FIXED INCOME SECURITIES............................. 42 3.1 Risks associated with fixed income securities............................................................................... 42 3.2 Risk Mitigation Tools...................................................................................................................... 49 CHAPTER 4: PRICING OF BONDS.......................................................................................................... 52 4.1 Concept of “Par Value”.................................................................................................................. 52 4.2 Time Value of Money..................................................................................................................... 52 4.3 Determining Cash Flow, Yield and Price of Bonds........................................................................ 58 4.4 Pricing of Different Bonds.............................................................................................................. 60 4.5 Price-Yield Relationship................................................................................................................. 69 4.6 Price Time Path of a Bond.............................................................................................................. 71 4.7 Pricing of a Floating Rate Bond...................................................................................................... 72 CHAPTER 5: YIELD MEASURES AND TOTAL RETURN........................................................................... 74 5.1 Understand the Sources of Return................................................................................................ 75 5.2 Traditional Yield Measures............................................................................................................ 77 CHAPTER 6: TERM STRUCTURE OF INTEREST RATES........................................................................... 89 6.1 Yield Curve and Term Structure..................................................................................................... 89 7 6.2 Relationship between Spot and Forward Rates.......................................................................... 109 6.3 Determinants of the Shape of the Term Structure..................................................................... 111 CHAPTER 7: MEASURING INTEREST RATE RISK................................................................................. 113 7.1 Price Volatility Characteristics of Option Free Bonds and Bonds with Embedded Options...... 113 7.2 Understand the Concept of Duration.......................................................................................... 116 7.3 Difference between Modified Duration and Effective Duration................................................ 125 7.4 Price Value of Basis Point (PV01)................................................................................................. 127 7.5 Convexity Measure....................................................................................................................... 127 7.6 Modified Convexity and Effective Convexity.............................................................................. 131 7.7 Taylor’s Expansion and Its Application in Approximating Bond Price Changes......................... 132 CHAPTER 8: INDIAN MONEY MARKET............................................................................................... 135 8.1 Introduction to Money Market.................................................................................................... 135 8.2 Types of Instruments in Money Market...................................................................................... 135 8.3 Trends in the Indian Money Market............................................................................................ 140 8.4 Importance of the Call Money Market........................................................................................ 141 8.5 Important Rates in the Indian Inter-Bank Call Market............................................................... 142 CHAPTER 9: GOVERNMENT DEBT MARKET....................................................................................... 146 9.1 Introduction to Government Debt Market................................................................................. 146 9.2 Types of Instruments in Government Debt Market.................................................................... 149 9.3 Trends in the Indian G-Sec Market.............................................................................................. 153 9.4 The Issuance Mechanism............................................................................................................. 155 9.5 Secondary Market Infrastructure for G-Secs in India.................................................................. 159 9.6 Clearing and Settlement of Secondary Market Trades............................................................... 161 9.7 G-sec Valuation in India............................................................................................................... 162 9.8 Key Regulatory Guidelines for the Indian G-Sec Market............................................................ 163 CHAPTER 10: CORPORATE DEBT MARKET......................................................................................... 165 10.1 The Indian Corporate Debt Market........................................................................................... 165 10.2 Types of Instruments in Corporate Debt Market...................................................................... 167 10.3 Trends in Indian Corporate Debt Market.................................................................................. 171 10.4 Issuance Mechanism.................................................................................................................. 173 10.5 Secondary Market Mechanism.................................................................................................. 176 10.6 Key Regulatory Guidelines for Corporate Debt Market............................................................ 177 10.7 Corporate Bond Valuation......................................................................................................... 178 8 CHAPTER 1: OVERVIEW OF THE INDIAN DEBT MARKET LEARNING OBJECTIVES: After studying this chapter, you should know about:  Role of the Debt Markets  Importance of Debt Markets  Bond Market Ecosystem  Role of Regulators  Role of Credit Rating Agencies  Role of Monetary Policy in Debt Markets  Evolution of Debt Markets  Market Dynamics Debt is a concept of “I owe You” in which the receiver of the favour is willing to return the favour with agreed rate of return for using the favour for the time period. In simple terms, Mr. A is borrowing some money “X” from Mr. B for 3 months with a promise to pay back “X+Δ”. This “Δ” is calculated as a percentage or rate of return on the Principal X. For example, Δ = X * R% *3/12 where “R% is the annual rate of interest agreed to be paid for the use of Principal amount “X” by Mr. A. In this example, Mr. A is the “Borrower”, Mr. B is the “Lender” and “R” is the agreed rate of interest expressed as percentage per annum and time period is “3/12” years (i.e., 3 months). To make the process formal and enforceable, Mr. A can give in writing a “Note” that he would return the borrowed Principal money “X” to Mr. B after 3 months with agreed rate of interest at R% per annum. Simply put, we can state that the “Note” given by Mr. A is treated as a “Debt instrument” or a tradable security (Mr. B can assign the same to someone against appropriate payment before 3 months, if he requires liquidity and wants to exit the transaction): Mr. A here is the Issuer, Mr. B is the Investor, R is the Yield or Rate of interest on the date of transaction for the borrowed time (here 3 months). The tradable instrument is called “Negotiable Instrument”, as necessary stamp duty is also being paid to the concerned authorities at the time of issuance for ensuring the enforceability of the contract in the appropriate court of law. The tradability of the instrument increases liquidity in the market and provides an exit route to Mr. B. Here Mr. B, as investor, takes a default risk or credit risk on the promise made by the Issuer, Mr. A, in the Note. If the Note is tradable, it becomes a security with a maturity (the date by which Mr. A has promised to pay back the borrowed funds with promised rate of interest). Debt refers to obligation of repayment of borrowing by a legal entity such as an individual, a corporate firm or a Government. Debt is raised by selling bonds, bills, and/or notes (also known as instruments) to creditors with a promise of repaying the principal amount and periodic returns or interest on the principal. Debt instruments generally have a fixed time 9 line. From accounting perspective, debt is an asset for the investor and is a liability for the borrower. Borrowing funds through the issue of debt instruments helps entities with large financing requirements, as a single creditor may not be able to provide such as large amount of money. Creditors may also prefer tradable debt instruments that can be sold to meet their own liquidity requirements as well as to manage the risk on their credit exposures. These instruments also provide an opportunity to investors with surplus liquidity to earn returns, leading to the evolution of the debt market. The debt market refers to the market where buyers and sellers trade in various debt instruments. The development of a vibrant debt market is essential for a country’s economic progress as the debt market helps to reallocate resources from savers to investors. 1.1 Role of the Debt Market Firms need finance for their day to day operations. Business owners raise finance mostly using debt and equity. "Debt" involves borrowed money to be repaid with interest, while "Equity" involves raising money by selling interest in the company. Debt is a charge on income for the firm, while the return on equity is an allocation / appropriation of profit made by the company. Similarly, governments also borrow so that they can finance spending for development of the society and country. Borrowing at both firm and government levels can be either to fund temporary liquidity shortfall or for funding long- term asset creation. Depending upon the duration and purpose of borrowing, a variety of debt instruments can be used for raising the funds. The debt market facilitates borrowing of funds using such instruments to investors having varied risk appetite. Inherently, all debt instruments are essentially loans or IOUs, with an undertaking to pay or service regular promised coupon or interest and repay the principal amount borrowed after a specified period as promised at the time of borrowing. As the periodic interest or cash flows are typically fixed and known in advance, these instruments are more popularly referred to as “Fixed Income Securities”. Chart 1.1: 10 Borrowing money to finance the operations and growth of a business is a kind of leverage the company takes against its equity capital. This way, the owner does not have to give up (or dilute) control of the business, but too much debt can inhibit the growth of the company and many companies have gone bankrupt under the pressure of debt. Hence, a balanced decision on the level of leverage is imperative based on the careful assessment of pros and cons of the available financing avenues. Advantages of Debt Compared to Equity  Debt is a long term source of capital for borrowers.  Borrowing through a debt paper by the owner would not reduce the control of the company for the borrower. Lender of funds will have priority over equity holders, only in case of bankruptcy of the company.  The lender would get the promised interest rate as per the indenture of the issue as well as the principal at the time of maturity. The lenders are indifferent to the profit made by the company that is shared as dividend to the equity holders.  In case of debt, the future obligations are mostly known to the company for making the cash flow planning and repayment planning. Hence, a proper and efficient cash flow management is key to the success of debt management.  Interest or the coupon to be paid on debt is tax-deductible to the company as it is an expense for the company. This tax deductibility reduces weighted average cost of capital for the company. Higher the marginal tax rate of the company, larger is the benefit of such tax savings.  Raising large amount of debt capital through private placement is generally less complicated as it is sold to qualified institutional buyers and unlike public issuances of equity, complex regulations may be avoided.  For its debt obligations, the company is not required to send periodic mailings to large numbers of investors, hold periodic meetings of shareholders, or seek the vote of shareholders before taking certain actions.  Debt is long term and lenders tend to be more committed than the equity holders.  In the long-run, debt is cheaper than equity. The return on investment for equity holders is eventually higher than the interest paid on debt financing. Disadvantages of Debt Compared to Equity  Certain debt instruments may put restrictions on the company's core activities, and at times, exclusivity clauses can harm the company in general.  Unlike equity, debt must be repaid at some point in time resulting in liquidity outflow.  Debt repayment causes cash flow risk for the company and at times the company may not be able to refinance debt or raise money from the market to repay the existing debt, if the market condition turns bad. 11   Debt is a leverage action and high leverage can jeopardize the growth plans of the companies. High leverage may also increase the risk of default. Historically, many good companies have gone into bankruptcy due to the burden of huge debt.  Debt obligations are fixed at the beginning of the issuance with future dates known to both issuers and lenders. These obligations have to be repaid irrespective of the market conditions.  If repayment of debt is not properly planned, the company’s usual operations may get jeopardized because of such debt repayment obligations. At times, unplanned cash flow causes upheave in working capital finance, jeopardizing production plan and operations of the company.  The larger a company's debt-equity ratio, the more risky is the company considered by lenders and investors. Accordingly, there is a limit to the level of debt a business can take in its balance sheet.  Some form of debt like secured debentures require the company to create a lien on the assets of the company or create sinking fund out of operational cash flows which may be burdensome at times, specifically at the time of market stress. 1.2 Importance of Debt Markets In any economy, the Government generally issues the largest amount of debt to fund its expenditure. A well-developed debt market helps the Government to raise debt at a reasonable cost. A liquid debt market lowers the borrowing cost for all and it provides greater pricing efficiency. Debt is funded either by bank loans or by bond issuances. A corporate bond market dealing with issuance of pure corporate paper helps an economic entity to raise funds at cheaper cost. The debt market brings together large number of buyers and sellers to price the debt instruments efficiently. A well-developed debt market reduces degree of banking support for the economy, as risk is distributed among many investors. A well-developed debt market helps the banking system with better Asset- Liability Management. The development of a well-functioning debt market helps to channelize the collective investment schemes to invest in the market and also facilitate in bringing retail investors to invest directly in debt. The well developed and liquid debt market also helps various long term investors like pension funds, insurance companies which have different investment objectives, as they invest for very long term, to match and immunize their liabilities. The primary debt market helps Governments and corporates to directly sell their securities to investors. Typically, Governments issue debt through “Auctions” while corporates issue debt papers through “Private Placement”. The secondary debt market provides an exit route to the investors and it also provides important information on price discovery process through credit risk appetite, spread, default probability, etc. The tradability of bonds issued by a borrower helps the market in getting required information on the firm. 12 However, in practice, issuance of debt is a multi-level process adhering to various regulations. It involves underwriting, credit rating, listing with stock exchanges, coordinating with issue managers to distribute to the right investors, liquidity in the market, banking support, etc. A well-functioning debt market would require developed and sustainable legal framework with clear bankruptcy codes. The regulatory cost of the debt can be at times prohibitive for smaller borrowers. Hence, small and medium firms usually prefer bank borrowing vis-a-vis debt issuances. 1.3 The Bond Market Ecosystem The debt market deals in both Government as well non-Government debt instruments. The market has three important functionaries: (a) issuers like Government and Corporate firms; (b) intermediaries like merchant bankers and brokers selling debt; and (c) investors like commercial banks, collective investment schemes like mutual funds, pension funds, insurance companies, retail investors, etc. Typically, a firm wishing to float/issue debt instruments, for raising funds for its business requirements, contacts an intermediary like an investment banker or a merchant banker who helps the firm in selling the debt papers to qualified institutional buyers or High Net-worth Individuals (HNI). Before issuing a debt instrument, the issuer approaches a Credit Rating Agency (CRA) that vets the relative riskiness of the payments promised by the issuer. A debt instrument with a higher rating attracts lower interest rates, as it indicates relatively lower risk. All investors who failed to get the instruments in the primary market can purchase those securities from the secondary market. Thus, the three critical participants in the debt market are: 1. Issuers are Governments, commercial banks, public sector companies, private corporate firms, etc. 2. Intermediaries are investment banks and merchant banks who help issuers to sell bonds to the investors. 3. Investors are the private corporate treasuries, collective investment vehicles like mutual funds, insurance companies, commercial banks, pension funds, high net-worth Individuals, etc. Investors can further be classified as domestic and international investors. In India, public issuance of a debt instrument has to go through elaborate vetting process as laid down by the Securities and Exchange Board of India (SEBI). Listing of a debt instrument in a recognized Stock Exchange and dematerialization of the instrument are important functions to be carried out by the issuing company or by the issue manager appointed by the issuing company. Rating agencies play a key role in summarizing information about the company issuing debt and this rating information is a key element for the investors, helping them in both the primary and secondary market transactions. The regulators ensure orderly development of the market with fair and transparent practices to protect investors. The 13 Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) are the main regulators in the Indian debt market. Chart 1.2: Indian Debt market typically has three distinct segments – (a) Government debt, known as “G-sec” market with Government of India issuing dated papers, Treasury Bills and State governments issuing State Development Loans of various maturities; (b) Public sector units (PSU) and Banks issuing instruments to raise resources from the market; and (c) private sector raising resources through issuance of debt papers. Government of India also issues Floating Rate Bonds, Inflation Indexed Bonds, Special Securities, and Cash Management Bills while State Governments raise funds using UDAY Bonds. PSU Bonds are popular among investors because of their perceived low risk and Commercial Banks issue short term papers like Certificate of Deposits (CDs) as well as long term bonds to fund their various business needs. The private corporates issue instruments like Bonds, Debentures, Commercial Papers (CPs), Floating Rate Notes (FRNs), Zero Coupon Bonds (ZCBs), etc. 1.4 Role of Regulators Reserve Bank India (RBI) manages the borrowing of the Central and State Governments including the Union Territories. The RBI also acts as the regulator for the Money market and the G-Sec market. The RBI also governs instruments issued by Commercial Banks and other Institutions regulated by it. The RBI Act, 1934, Government Securities Act, 2006, Payment & Settlement Systems Act, 2007, Foreign Exchange Management Act, 1999, Banking 14 Regulation Act, 2017, etc. are the major regulations used by RBI to ensure an efficient debt market for Government securities. The Securities and Exchange Board of India (SEBI) is the regulator for the corporate bond market including instruments issued by Commercial Banks and PSUs, provided such issuances by the above regulated entities are of more than one year of maturity. The role of SEBI is paramount when the funds are raised through public issuance. As per the guidelines issued by SEBI, the issuers are required to fully disclose the risks to the investors. For this, the regulator has implemented elaborate risk disclosure standards. Institutional investors like Foreign Portfolio Investors and Mutual Funds also adhere to SEBI guidelines while investing in the market. SEBI also frames guidelines for Debenture Trustees, Credit Rating agencies, Merchant Bankers, etc. to enable a smooth and well-functioning debt market. 1.5 Role of Credit Rating Agencies Credit risk is the risk of default on a debt that arises from the borrower failing to make required payments. Sovereign domestic currency based debt instruments are regarded as safe sovereign investment and perceived to be “credit risk free”. Pricing and returns for non- government debt instruments are dictated by their issuers’ creditworthiness i.e., the continuing ability of the issuer / borrower to service the debt payments. Any deterioration in financial capability of the borrowing firm may result in delinquency, either in part or in full. Debt investments are generally long term investments and are illiquid. Hence, investors must have full information about the issuer as well as the issue, through regulatory and voluntary disclosures. The voluminous information about the issuer as well as the issue are required to be standardized and summarized through a well-qualified and unbiased agency that can provide the independent view about the possible future performance of the debt. This particular role of providing risk information about the possible future performance of the issue is typically performed by a Credit Rating Agency in the debt market. As per the extant SEBI regulations in force in the capital markets, it is necessary for an issuer to obtain a rating from any of the major credit rating agencies. In India, the Rating Agencies are regulated by SEBI under SEBI (Credit Rating Agencies) Regulations, 1999. A Credit Rating Agency (CRA) is a company that provides information about the riskiness of a debt instrument or a company in terms of its promised performance of a debt instrument. They are regulated by SEBI and have to follow governance standards while giving the Rating on a debt instrument. They issue letter grades to instruments: “AAA” for highest safety, “D” for a Default and many other grades in between. The CRAs may rate government and corporate bonds, CDs, CPs, municipal bonds, preferred stock, mortgage-backed securities and collateralized debt obligations, etc. Investors typically see the rating before they invest in a debt instrument. 15 Credit rating started in 1909 in the USA with Moody’s rating of corporate and railroad bonds as these bonds promised future performance. In the current times, credit rating has become an integral part of debt market around the globe. Credit Rating and Investor Services of India Ltd (CRISIL) started functioning in India in 1988 to rate corporate papers. SEBI mandates disclosure of at least one Credit Rating while issuing debt instrument. The credit rating represents a CRA’s evaluation of the qualitative and quantitative information pertaining to the prospective debtor, including information provided by the prospective debtor and other non-public information obtained by the credit rating agency’s analysts. Ratings are the probability of default on repayment of principal or interest on relative scale i.e., an issuer’s likelihood to default and its likelihood to default compared to another similar issuer. Ratings assigned by the rating agencies are taken as a key indicator of the relative riskiness of the bonds and to determine the credit spread to be charged for these instruments. It must be noted that the CRAs always qualify the rating provided for an entity or instrument and encourage investors to look for other possible publicly available information on the companies along with the Rating information. Often bonds are rated by more than one rating agency but the issuer is not bound to publish all the ratings. For ease of understanding by investors, CRAs generally assign letter grades for their view of the instruments. The highest quality (safest, lower yielding) bonds are commonly referred to as “AAA”, while the least creditworthy are termed as "junk". Common Scale of Ratings:  AAA to BBB-: Investment Grade  BB+ to CCC-: Non-investment or Junk Grade  D: Default Rating  Short term Scale: A1+ to D Ratings may also be issued for an issuer or a country’s sovereign. Issuer rating is called Issuer Default Rating (IDR) which refers to the probability of issuer defaulting. Advantages of Credit Rating:  The CRAs are provided with the bulk of information by the issuer and they take into account the private as well as pubic information about the Company and its management along with its financial position to give a simplified riskiness rating. CRAs take complex data and general information and transform the same into an easily understandable form for the investor. The rating information is available to the investors freely on the website of the rating agency, if the rating is accepted by the issuer. For the investor, seeking such information from the websites of Rating Agencies is costless. 16   Credit Rating provides relative riskiness of the instrument in clear form and also guides the market about any rating downgrade or upgrade at regular intervals. A consolidated history of rating migration of corporate entities may be used for understanding the possible probability of default level in the country vis-a-vis other countries.  Rated instruments can be compared across global markets and the global investors can easily understand and interpret the risk of investment in a debt instrument.  Credit rating agencies are independent institutions and their opinion on riskiness of an instrument is important for investors. However, as the issuers pay for the ratings, an inherent conflict of interest is built into the system.  Credit rating also helps companies to improve their own image. A company with many high rated instruments would be regarded as a preferred investment destination by many investors, including the collective investment schemes like Mutual Funds.  Credit rating aids investors in decision making choices between comparative investments with regards to: risk identification, issuer credibility, independent opinion and view about the potential risk, wider choice, saving in time and resources for understanding riskiness of the instrument and benefits of intensive surveillance by the rating agency.  Credit rating is also beneficial to the issuing company, as rated instruments make it: easy to sell debt, lowers cost of borrowing, opens up a wider market, facilitates image building for the company and are particularly beneficial to new and unknown corporate firms. For corporate bonds, default risk gauges the possible capacity of the bond issuers to make payment of the contractual interest and principal on agreed dates. Default Risk is the qualitative representation by the credit rating of the issue and the possibility of default increases, if the rating is downgraded by the rating agency during the life of the instrument. It is quantified as Probability of Default (PD) associated with the bond rating category. PD is measured using historical, annual default rates of bonds in different rating categories. Rating Migration is the possible change of rating (both upgrade and downgrade) of an instrument before its maturity. From the Table below, we can interpret that 87.19% of companies retained their “AAA” rating while 8.69% of Companies that were rated “AAA” were downgraded to “AA” and 3.37% of the said AAA rated companies did not seek Rating continuation after one year. The diagonal of the Migration matrix is very important to understand the relative riskiness of a market vis-à-vis other global markets. More percentage of companies retaining their original rating or showing improvement of rating (leftward move) is an indication of stability of the market. 17 Chart 1.3: A credit rating downgrade of the bond issuer impacts the spread over the risk-free yield curve at which the corporate bond is valued and thus translates into potential mark-to- market losses on a long bond position. A credit rating upgrade can similarly lead to potential mark-to-market losses on a short bond position. Rating Migration Risk is quantified by Rating Transition Probabilities released by CRAs. Each CRA has its own methodology for these matrices which are used for valuation of the instruments. Accurate and reliable default and transition/migration rates are important for all debt-market participants as they are critical inputs for valuation and pricing of debt instruments and loan exposures. They allow investors and lenders to quantify credit risk in their debt exposures and decide on the pricing. These are also critical inputs for credit risk assessment models. The top global CRAs are Moody’s, Standard and Poor’s (S&P) and Fitch Ratings. Some of the prominent CRAs in India are: a) The Credit Rating Information Services of India Ltd. (CRISIL) b) ICRA Ltd. c) Credit Analysis & Research Ltd. (CARE) d) Fitch Ratings India Pvt. Ltd. e) Brickwork Ratings India Pvt. Ltd. f) Acuite Ratings & Research Ltd. g) Infomerics Valuation and Rating Pvt. Ltd. (IVRPL) 18 1.6 Role of Monetary Policy in Debt Markets The effect of monetary policy can be best understood using the policy transmission chart: Chart 1.4: Bond yields are significantly affected by the central bank’s monetary policy. Monetary policy at its core is about determining interest rates. Any change in policy rate affects the banks immediately as they have to borrow from and lend funds to RBI at the policy rates on a daily basis through Repo and Reverse Repo rates. The new rates are passed on to the customers using a spread mechanism. The process is commonly known as “Monetary Policy Transmission”. In turn, sovereign interest rates define the risk-free rate of return. The risk- free rate of return has a large impact on the price of (thereby the demand for) all types of financial securities, including bonds. Central banks can influence the direction of asset prices through monetary policy. The central bank may use various monetary policy instruments (both direct and indirect ones) to engineer directional swings in the economy, if the central bank thinks that the changed direction may be beneficial for the society at large. During recessionary period, the central bank tends to lower interest rates to pump prime the economy by inducing higher demand which ultimately may lead to increases in asset prices. By lowering interest rates, the central bank ensures lower cost of borrowing to the corporate sector to foster growth. When the asset prices reach bubble stage, central banks may raise interest rate to downsize the effective demand to moderate the asset prices. Economic Boom and bust cycles are well managed by monetary policy effectiveness. 19 The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy in India. This responsibility is explicitly mandated under the Reserve Bank of India Act, 1934. The Monetary Policy Committee (MPC) constituted by the Central Government under Section 45ZB determines the policy interest rate required to achieve the inflation target. The MPC has 6 members and is chaired by the Governor of RBI. RBI’s Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy. RBI has also set up internal Financial Market Committee (FMC) to monitor the liquidity situation in the financial system, specifically in the Banking system. The FMC of the RBI meets regularly to review the liquidity conditions in the market so as to ensure that the operating target of monetary policy is kept close to the policy repo rate. Monetary policy target rate is the inter-bank call rate because the stable call market rate ensures availability of adequate liquidity to banks at a reasonable rate reflective of the market condition for most secured borrowers like Banks. Any substantial change in the call market rate (either very high rate or very low rate compared to the RBI policy Repo rate) for a longer period brings the monetary policy into focus. The primary objective of monetary policy is to maintain price stability while maintaining required level of growth to support employment and income of the population at large. In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework. The Central Government has notified in the Official Gazette that 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent. This would be the target for the RBI to foster its policy framework. The Central Government notified the following as factors that constitute failure to achieve the inflation target: (a) the average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters; or (b) the average inflation is less than the lower tolerance level for any three consecutive quarters. Prior to the amendment in the RBI Act in May 2016, the flexible inflation targeting framework was governed by an Agreement on Monetary Policy Framework between the Government and RBI. The RBI Act has an explicit provision for the RBI to operate the monetary policy framework of the country to sustain growth and maintain price stability. The policy framework generally aims at fixing policy Repo rate based on the current and evolving macroeconomic situation in the country as well as global position, liquidity condition in the economy, asset price levels, foreign exchange positions, etc. The RBI also fixes Reverse repo rate as well as Marginal Standing Facility (MSF) rates linking the said rates to an interest rate corridor. Repo rate changes are transmitted through supply of funds or absorption of funds through commercial banks and RBI linkage window called Liquidity Adjustment Facility (LAF). Once the Repo rate is fixed by RBI, the operating framework designed by the Reserve Bank 20 envisages liquidity management on a day-to-day basis through lending and borrowing actions of the RBI using commercial banking channel that will have an influence on the operating target – the weighted average call rate (WACR) which is supposed to move around the Repo rate depending on the excess or shortage of liquidity in the market. The operating framework is fine-tuned and revised on regular basis for consistency with the monetary policy stance. The liquidity management framework was last revised significantly in February 2020. There are several direct and indirect ways that are used for implementing monetary policy:  Repo Rate: This is the policy rate. It is a fixed interest rate using which RBI lends funds to banks against approved securities under the liquidity adjustment facility (LAF).  Reverse Repo Rate: It is a fixed interest rate using which RBI borrows funds from banks against approved securities under the liquidity adjustment facility (LAF).  Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo auctions. Progressively, RBI has increased the proportion of liquidity injected under variable Repo and reduced the availability of support through fixed rate channel. The aim of term repo is to help develop the inter-bank term money market, which in turn can set market based benchmarks for pricing of loans and deposits, and thereby improve transmission of monetary policy. RBI also conducts variable interest rate reverse repo auctions, as necessitated by the market conditions.  Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow additional amount of overnight money from RBI by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system.  Corridor: The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate (WACR).  Bank Rate: It is the rate at which RBI is ready to buy or rediscount bills of exchange or other commercial papers. This rate has been aligned to the MSF rate and, therefore, it changes automatically as and when the MSF rate changes alongside policy repo rate changes.  Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with RBI as a share of such per cent of its net demand and time liabilities (NDTL).  Statutory Liquidity Ratio (SLR): This is the share of NDTL that a bank is required to maintain in safe and liquid assets, such as, unencumbered government securities, cash and gold. Changes in SLR often influence the availability of resources in the banking system for lending to the private sector.  Open Market Operations (OMOs): These include both, outright purchase and sale of government securities, for injection and absorption of durable liquidity, respectively. 21   Market Stabilization Scheme (MSS): This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated G-Secs and T-Bills. The cash so mobilized is held in a separate government account with RBI.  Long Term Repo Operations (LTROs): From the fortnight beginning on February 15, 2020, RBI conducts term repos of one-year and three-year tenors of appropriate sizes with a view to assuring banks about the availability of durable liquidity at reasonable cost relative to prevailing market conditions. LTRO is going to be the guiding principle for near permanent liquidity management. The objective of the monetary policy is to ensure a stable sovereign bond market that would help in establishing a reliable sovereign yield curve for the market to price risky debt of non- sovereign borrowers and issuers by charging a spread for relative risk involved in the transaction. The liquidity of the sovereign bond market or G-Sec market is extremely important as artificial pricing can jeopardize the bond market development. The monetary policy over the years has helped in establishing a well-functioning G-sec market in India and also helped corporate bond market to grow in terms of issuance. 1.7 Evolution of Debt Markets India has a large bank-dominated financial system with banking sector providing large credit to corporates. The regulators – both RBI and SEBI – have been putting in place many structural changes to improve the debt market access so that the dependence on banks reduces. Corporate Bond Market: Global Scenario At over 322% of GDP, global debt at the end of 2019 was 40 percentage points ($87 trillion) higher than at the onset of the 2008 financial crisis. As at end of 2019, in mature markets total debt topped $180 trillion or 383% of these countries’ combined GDP, while in emerging markets, at $72 trillion, it was double the level it was in 2010, driven mainly by a $20 trillion surge in corporate debt. China’s debt was nearly 310% of its GDP - one of the highest in emerging markets (2019). Domestic bonds had the highest share in total debt securities with the share of general government debt at nearly 49% of total debt outstanding. Globally corporate debt markets are Over the Counter (OTC) markets. The transactions are concluded among large institutions or dealers using a telephonic link rather than accessing exchange platforms like equity markets. As these markets are wholesale in nature with very large institution taking part, retail investors are generally absent and they typically invest through collective investment scheme like Mutual funds. 22 Corporate Bond Market in India In India, corporate debt transactions are executed bilaterally between the counterparties and reported to the exchanges for settlement purposes. Recent years have seen increased collective investment vehicles such as mutual funds and alternative investment funds (AIFs) taking part in debt market investment. Mutual funds have played a very crucial role in channelizing the savings to the debt oriented schemes. In order to stimulate flow of foreign investment into debt market, regulators have gradually increased the limits for investment by Foreign Portfolio investors. FPI investment in corporate bonds is also subject to aggregate ceilings, which are nominally lower than the aggregate ceiling on government bonds but represent a higher percentage of outstanding corporate debt securities. The authorities also relaxed the maturity limits on FPI debt holdings, lowering the minimum maturity to one year, from the previous three-year limit. Consistent investment interest by domestic institutions like mutual funds, pension funds and insurance funds as well as foreign portfolio investors (FPIs) has helped in developing the corporate bond market. 1.8 Market Dynamics The debt market in India has grown significantly over the past two decades. However, it is still dominated by the government debt segment although the share of the Central Government has been gradually coming down and that of the States rising. The extent of outstanding corporate bonds as a percentage of a country’s GDP is often referred to as Penetration. The penetration data is an indicator of the level of development of the bond market in a country. Penetration of bond markets in India, however, remains low in comparison to developed countries. Table 1.1: Indian Debt Market Key Ratios (IMF) Total Non- Household private financial Nominal debt, General Central debt, corporations gross loans and government government loans and debt, loans domestic Year debt debt debt debt and debt product securities (percent of (percent of securities securities (INR (percent GDP) GDP) (percent (percent of billions) of GDP) of GDP) GDP) 2000 31.19 2.55 28.64 73.65 55.60 21774.13 2001 31.83 3.03 28.80 78.73 57.01 23558.45 2002 35.08 3.50 31.58 82.85 59.82 25363.27 2003 34.83 4.49 30.34 84.24 57.22 28415.03 23  2004 38.37 6.30 32.07 83.29 55.13 32422.10 2005 42.97 7.90 35.07 80.89 52.18 36933.69 2006 47.52 9.56 37.96 77.11 49.09 42947.06 2007 50.04 10.08 38.37 74.03 47.44 49870.90 2008 54.93 10.10 43.40 72.74 47.50 56300.60 2009 52.54 8.74 43.63 71.09 49.36 64778.30 2010 55.81 8.68 46.58 66.04 44.74 77841.20 2011 58.06 8.68 48.53 68.29 45.77 87363.30 2012 58.94 8.68 50.49 67.66 47.09 99440.10 2013 59.52 8.89 51.53 67.38 46.98 112335.20 2014 58.53 9.19 50.30 66.83 46.03 124679.60 2015 58.55 9.65 49.95 68.78 45.77 137718.70 2016 54.65 9.82 44.82 67.67 45.62 153623.90 2017 53.30 10.50 45.29 67.83 44.26 170950.10 2018 54.81 11.05 45.48 68.05 43.87 190101.60 Chart 1.5: 100 93 Outstanding Stock of Debt in Indian Capital Market Outstanding Face Value ₹ Lakh Crore 90 83 80 76 69 70 60 60 53 50 47 41 40 34 29 29 31 30 26 23 16 19 20 12 14 9 10 10 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Dated G-Secs (Centre + States) Corporate Bonds Source: CCIL & SEBI The Indian corporate bond market has grown over the years. The issuances are predominantly through private placement and dominated by high credit issuers. In 2019-20, 71% of the issuances were by entities rated ‘A’ or higher, of which ‘AAA’ had a share of nearly 44% of total primary issuances. 24 Table 1.2: Rating Analysis of Primary Issuances Amount (₹ Crore) Ratings Year AAA AA A A1 BBB BB B C NA FY18 2,57,033 1,05,780 19,643 - 5,527 2,341 773 28 1,41,931 FY19 2,47,660 92,257 10,190 800 6,586 2,049 200 150 82,138 FY20 1,02,100 51,454 12,026 0 4,048 831 477 0 63,657 Source: CCIL Table 1.3: Trading Activity in Indian Debt Market Outright G-Sec Market Corporate Bond Market Total Average Total Average Value Value Value (₹ Value (₹ Period Trades (₹ Crore) Trades Crore) Trades (₹ Crore) Trades Crore) FY09 2,45,873 21,62,135 1,042 9,162 - 86,327 - 367 FY10 3,16,505 29,12,293 1,324 12,185 - 209,163 - 879 FY11 3,32,346 28,64,444 1,340 11,550 12,219 190,001 49 769 FY12 4,12,403 34,92,733 1,726 14,614 18,313 240,106 77 1,009 FY13 6,57,073 65,88,036 2,715 27,223 29,583 292,918 123 1,215 FY14 8,18,509 89,39,292 3,368 36,787 69,518 972,156 287 4,017 FY15 9,78,654 1,01,66,302 4,129 42,896 72,364 10,13,504 305 4,276 FY16 8,83,363 97,38,000 3,650 40,240 63,701 9,05,333 264 3,757 FY17 13,40,376 1,68,55,738 5,562 69,941 72,416 11,24,988 300 4,668 FY18 9,18,130 1,13,85,918 3,810 47,244 50,631 13,50,033 210 5,602 FY19 8,04,146 93,41,044 3,323 38,599 37,813 10,90,407 156 4,506 FY20 9,63,385 1,33,45,845 3,981 55,148 43,619 15,55,518 180 6,401 Source: CCIL The private placement of debt as well as transactions in debt securities generally results in fragmentation, low liquidity and inefficient price discovery. For example, 24,010 corporate bonds were outstanding at end-December 2019 with an average outstanding size of only ₹131 crore as compared to only 116 outstanding Central Government dated securities with an average outstanding size of ₹54,138 crore. This has been a major cause of the illiquidity in the secondary market despite regulatory measures to give a boost to the segment. As part of its efforts to boost corporate bond market liquidity, SEBI has facilitated reissuance of corporate bonds to reduce fragmentation. 25 Chart 1.6: Secondary market trading in corporate bonds has picked up gradually in the recent past, with trading volumes rising nearly 8 times from ₹2 lakh crore in 2009-10 to nearly ₹16 lakh crore in 2019-20. However, this is only 12 per cent in terms of the volumes in the outright G- sec market. Trading is entirely OTC with trades settled bilaterally and reported to stock exchanges. The most significant classes of investors are the insurance companies and mutual funds followed by banks, national pension savings schemes and employee provident funds. FPIs and other categories of investors account for the remaining share. Sector-wise breakup of issuances in the primary market for corporate debt shows the dominance of finance and infrastructure companies which account for nearly 90 per cent of total issuances. Chart 1.7: Sectorwise Primary Market Issuances of Corporate Bonds (Rs. Crores) 300000 252217 250000 234753 207711 200000 153080 150000 110633 96004 100000 51131 50000 39245 38514 21996 14951 5585 0 FY18 FY19 FY20 Finance Infrastructure Manufacturing Others The primary market witnessed a dip in issuance in recent years after the debacle of ILFS and DFHL where investor lost appetite for corporate papers due to large value defaults. 26 Sample Questions: 1. Debt securities are often called fixed income securities because ________. (a) The government fixes the maximum rate that can be paid on bonds (b) They are held predominantly by older people who are living on fixed incomes (c) They pay a fixed amount at maturity (d) They promise either a fixed stream of income or a stream of income determined by a specific formula Ans: (d) 2. A Corporate debt instrument's rating movement from AAA to AA indicates: _________. (a) Deterioration in Country's Economic parameters (b) Deterioration in issuer's financial capability (c) Change in Government regime in domestic market (d) Changes in Central bank policies Ans: (b) 3. Ratings of a bond determine its spreads over ________. (a) Sovereign bonds (b) Currencies (c) Issuers (d) Derivatives Ans: (a) 4. Monetary policy at its core is about determining ____________. (a) Credit flow (b) Interest rate (c) Inflation (d) Growth Ans: (b) 5. What is the average daily balance that a bank is required to maintain with RBI as a notified percentage of its NDTL? (a) CRR (b) SLR (c) WACR (d) LAF Ans: (a) 27 CHAPTER 2: TYPES OF FIXED INCOME SECURITIES LEARNING OBJECTIVES: After studying this chapter, you should know about:  Classification of Fixed Income Securities based on Type of Issuer  Classification of Fixed Income Securities based on Maturity  Classification of Fixed Income Securities based on Coupon  Classification of Fixed Income Securities based on Currencies  Classification of Fixed Income Securities based on Embedded Options  Classification of Fixed Income Securities based on Securities  Other Fixed Income Securities in India A bond is a financial security issued by a legal entity to raise funds from the financial market and agrees to refund/return the borrowed amount (principal) at the end of the contract period or at various time intervals as given in the indenture along with the promised interest or coupon. Agreed annual interest promised by the issuer on the bond is generally referred to as Coupon. A bond is akin to a loan with a maturity and coupon rate paid at various intervals viz. quarterly or half-yearly or annually. However, it differs from a loan mainly with respect to its tradability. A bond is usually tradable and can change many hands before it matures; whereas a loan usually is not traded or transferred freely. A loan brings permanent risk to the lender till the loan is repaid but the bond holder can transfer his risk to other risk takers through efficient pricing mechanism. The value of the loan does not change but the value of the bond changes on continuous basis depending on future interest rate regime in the economy as well as the credit worthiness of the borrower. While bonds can be classified in many ways, for ease of understanding, the basic classification of bonds can be considered based on the following criteria:  Based on issuers;  Based on maturity;  Based on coupon;  Based on currencies;  Based on embedded options;  Based on priority of claims;  Based on purpose of issue;  Based on underlying;  Based on taxation. In this unit we shall discuss the various classifications of bonds based on their inherent features. 28 2.1 Classification of fixed income securities based on the Type of Issuer The borrowers of funds who borrowed by the way of issuing of bonds are called Issuers. Bonds are usually gauged for their riskiness based on the issuer’s profile. The value of the bond mainly depends on the ability of the borrower to service the debt obligations as per the bond indenture. 2.1.1 Government Bonds / Sovereign Bonds / Gilt edged Bonds A sovereign bond is issued by the government and is typically denominated in the domestic currency to support planned and unplanned expenditures. Government bonds are also known as “sovereign debt” and are generally issued via auctions and traded in the secondary market. Government bonds issued in local currency are considered risk free as the Government, being a sovereign entity, can print the currency to repay its obligation to bond holders. However, as demonstrated during the European debt crisis (2008-2012), Governments may also default in debt payments in case of an emergency situation. Because of their relative low risk, government bonds typically pay lower interest rates than the bonds issued by other issuers in the country. In India, government bonds constitute the largest segment of the fixed income market. This also includes the securities issued by the various State Governments and Union Territories, which are known as State Development Loans (SDLs). Indian Government Securities market (G-sec) also includes the special securities issued by the central and state governments in India. Special securities are issued by the Government for providing various subsidies like oil, fertilizer, bank recapitalization, etc. 2.1.2 Municipal Bonds Local authorities may also issue bonds to fund projects such as infrastructure, libraries, or parks. These are known as “municipal bonds”, and often carry certain tax advantages for investors. Municipal bonds are also known as "muni bonds" or "muni". A municipal bond is categorized based on the source of its interest payments and principal repayments. For example, a general obligation bond (GO) is issued by governmental entities and is not backed by revenue from a specific project but rather by the credit and taxing power of the issuing jurisdiction. GO bonds are primarily used to subsidize the development of public projects. On the other hand, a revenue bond is a category of municipal bonds supported by the revenue from a specific project, such as a toll bridge, a highway or a local stadium. Revenue bonds that finance income-producing projects are thus secured by a specified revenue source. In India, while very few local authorities or municipal authorities have issued such bonds, the market is gradually picking up. The Ahmedabad Municipal Corporation was the first municipal corporation in Southeast Asia to raise money through public issuance, when it had raised ₹100 crore through this route in 1998. 29 2.1.3 Corporate Bonds A corporate bond is issued by a corporate to raise capital. The performance of the bond during its life depends on future revenues and profitability of the corporate. Debt is typically cheaper source of financing for corporates and, unlike issuance of more equity, their ownership structure is not diluted. In some cases, the corporate’s physical assets may be used as collateral. Corporate bonds carry higher risk vis-a-vis government bonds and hence the bond holders expect higher interest rates to compensate for the additional risk they take while investing in the bond. Corporates issue short term papers like Commercial papers (CPs) to fund their short-term requirement or for their working capital funding. The corporate papers are issued either through public issuance or private placements. The creditworthiness of the issuer (i.e., issuer’s ability to discharge its financial obligations) is to be assessed periodically by one or more of credit rating agencies. The bond’s credit rating, and ultimately the company's credit rating, impacts the market price of the bond in both primary and secondary markets. The Credit Rating Agencies (CRAs) assign ratings through letter grades for their common and global understanding. The highest quality (and safest) bonds are given “AAA”, while the high risk bonds are known as "junk" or “high-yield bonds”. The difference between the yields on corporate bonds and government bonds is called the credit spread. 2.1.4 Securitized Debt Securitization is the process of monetizing illiquid loan assets of a lender such as a bank, into a liquid pool of tradable assets. Securitization is achieved by creation of a Special Purpose Vehicle (SPV) and structuring the pool of loans into tradable bonds. Securitized (or asset- backed) securities transfer ownership of assets (i.e., loans and receivables) to the SPV. 2.2 Classification of fixed income securities based on Maturity Bonds are issued for various maturities depending on the requirement of funds as well as the demand from the investors. Long term bonds are generally costlier than short term loans as the funds are locked in for a longer period of time while investors may suffer from illiquidity. Bonds may be classified in terms of maturities like ultra-short term, short term, medium term and long term. Short term borrowings are typically made for working capital requirement where as long term funds are used for project, capital and infrastructure funding. Collective investment schemes also create debt oriented funds using such maturities. The returns on bonds by similar rating class of issuers also vary according to the maturity, which forms the basis of yield curve theories. 2.2.1 Overnight Debt / Borrowings Typically, banks borrow overnight funds from the money market as well as from the RBI. These borrowings can be collateralized or clean. Collateralized borrowings cost less vis-à-vis 30 clean borrowings. The RBI plays a very important role in this market through absorption or supplying liquidity through banks and Primary Dealers. 2.2.2 Ultra Short Term Debt (Money Market) Short term borrowings up to one year are covered under this category. Mostly, money market instruments like Commercial Papers (CP), Certificate of Deposits (CD), Treasury Bills (TB), Cash Management Bills (CMB), etc. belong to this category. 2.2.3 Short Term Debt Bonds with maturity spanning from 1 to 5 years are referred to short term bonds. Bonds maturing within a year are classified under money market instruments as discussed above. 2.2.4 Medium Term Debt These are bonds maturing in 5 to 12 years. These are also referred to as intermediate bonds. Generally, the bulk of debt issuances take place in this segment. 2.2.5 Long Term Debt These are bonds with maturity beyond 12 years. Mostly Government of India bonds are of long term maturity. 2.3 Classification of fixed income securities based on Coupon The promised interest as per the indenture of the bond is referred to as the coupon. The coupon payments on bonds have a pre-determined payment frequency and may be paid annually, semi-annually, quarterly or monthly. Bonds are classified on basis of coupons as these are returns on the investment made by the holders. 2.3.1 Plain Vanilla Bonds A plain vanilla bond is the simplest form of a bond with a fixed coupon and defined maturity and is usually issued and redeemed at the face value. It is also known as a straight bond or a bullet bond. These bonds have intermittent cash flows in the form of coupons received as well as the final cash flow of the face value of the bond on maturity. 2.3.2 Zero-Coupon Bonds A zero coupon bond (ZCB) is a discounted instrument which does not pay any interest and are redeemed at the Face Value of the Bond at the time of maturity. These bonds are issued at a discount and redeemed at the face value with the difference amounting to the return earned by the investor. ZCBs have a single cash flow at maturity which is equal to the face value of the bond. Common examples of ZCBs in India include Treasury Bills and Cash Management Bills and STRIPS created by separating and trading independently (in other words “stripping off”) the coupons from the final principal payment of normal bonds. ZCBs are highly sensitive to changes in the interest rate as they do not have intervening cash 31 flows and are generally used by long term fixed income investors such as pension funds and insurance companies to gauge and offset the interest rate risk of these firms’ long-term liabilities. 2.3.3 Floating Rate Bonds Floating rate bonds (FRBs) do not pay any pre-fixed coupons but are linked to a benchmark interest rate (generally a short-term rate like the 182-day Treasury bill rate in India). The coupon rate is reset on each coupon payment date. When the general interest rate rises in the market, the benchmark interest rises and hence does the coupon on the FRBs. The same situation reverses when the interest rate falls. FRBs typically trade very close to their face value as interest resets happen at regular intervals. These instruments are generally immune to interest rate risk and are considered conservative investments. 2.3.4 Caps and Floor Most FRB issuers may issue bonds which will cap their interest payment obligation if the interest rate rises. These instruments may also provide for a floor beyond which the interest rate will not fall in order to protect the interest of the investors. If an FRB has both a cap to protect the issuer and a floor to protect the investor, it is called a “Collar”. 2.3.5 Inverse Floater These types of bonds are similar to FRBs in that the coupon is related to the benchmark linked to the bond (but it is inversely related in case of Inverse Floaters). If the benchmark increases, the Coupon falls and vice versa. For example, in India generally the interest rate on such bonds is linked to a negative spread over the fixed coupon rate. The spread is usually few percentage points over the benchmark MIBOR rate. If the interest rates go up, corporates end up paying less as the coupon will be a few percentage point lower than the original coupon rate. This has mostly been used by NBFCs to raise funds while mutual funds are the primary investors. 2.3.6 Inflation Indexed Bonds These are a type of FRBs which protect investors from the adverse effects of rising prices by being indexed to an inflation measure like the WPI or CPI in India. Only the face/par value or both par value and coupons may be indexed against the inflation measure. 2.3.7 Step Up/Down Bonds These bonds are designed to pay lower coupon in the initial years of the bond and higher coupon towards maturity. These bonds are preferred by issuers like start-ups who expect their cash flows to balloon after some time and hence would like to service the bonds with lower cash flows at the beginning. The investors of these bonds also take higher risk as higher cash flows are expected after some time and hence expect higher interest rate to make the investment attractive. These bonds are generally risky. 32 Step down bonds are the exact opposite of step up bonds. These bonds pay high interest at the beginning of the bond and as the time moves towards maturity, the coupon drops. Such bonds are usually issued by companies where revenues/profits are expected to decline in a phased manner; this may be due to wear and tear of the assets or machinery as in the case of leasing. The step up and step down bonds are used for better cash flow planning of both issuers and investors. 2.3.8 Deferred Coupon Bonds This is a mixture of coupon paying bond and a ZCB. In the initial years, these bonds do not pay any interest but these bonds pay very high interest after a few years and typically few years before the maturity. The corporates having high gestation period typically prefer this kind of arrangement. 2.3.9 Deep Discount Bonds When a zero coupon bond is issued at a high discount to the Face Value, it is generally referred to as a Deep Discount bond. Normally, a discount of 20% or more with relatively longer maturity is the main characteristics of the Deep Discount Bond. Typically, infrastructure companies issue such kind of bonds as their gestation period is very long. These bonds carry high risk. Junk bonds are examples of deep-discount bonds. 2.4 Classification of fixed income securities based on Currencies With increased globalization of financial markets, often investments are spread across continents yielding cash flows in different currencies. Hence, bonds can also be classified on the basis of currencies. 2.4.1 Foreign currency Denominated Bonds Many Governments as well as corporates issue bonds in overseas market in foreign currency denominations. For example, Indian companies typically issue US Dollar denominated bonds to raise cheaper funds from international markets. However, these bonds carry foreign currency risk as any devaluation of the domestic currency would increase the cost for the issuers as its repayment would be done by acquiring foreign currency from the market at higher exchange rate. Generally, bonds are named after the country of the currency in which the bond is issued, e.g. Yankee bonds, Samurai bonds, etc. A Yankee bond is a U.S. dollar denominated bond that is issued in the USA by a non-US issuer. A Samurai bond is a yen denominated bond that is issued in Japan by a non-Japanese issuer. A dual currency bond is issued with coupon being payable in one currency while principal would be paid in another currency. 33 2.4.2 Masala Bonds Masala bonds are the debt securities issued by Indian corporates to raise money outside India but the debt is denominated in Indian Rupees. Masala as a word is recognized the world-over for Indian spices and was thus used by the World Bank- backed International Finance Corporation (IFC) for global bonds of Indian corporates. Unlike dollar bonds, where the borrower takes the currency risk, in case of the masala bonds, the investors bear the currency risk. The first masala bond was issued by the IFC in November 2014 when it raised a ₹1,000 crore to fund infrastructure projects in India. Later in August 2015, IFC for the first time issued green masala bonds and raised ₹3,150 crore to be used for private sector investments that address climate change in India. In July 2016, HDFC became the first Indian company to issue Masala bonds to raise funds. 2.5 Classification of fixed income securities based on Embedded Options An embedded option bond is an instrument with a provision of callability by the issuer and puttability by the investor. The optionality influences the price of the bond as the risk is higher for these bonds. The “Call” feature incorporates the right of the issuer to call back / repay the bond on a specific date. The same way, the “Put” provision of the bond gives the right to seek redemption of the bond by the investor on a particular date. A bond having call provision is likely to be called when the cost of refinancing the bond is low due to fall in interest rates. A bond having “Put” option may encourage the investors to submit the bond for redemption when interest rate rises. The bonds with embedded options are valued using option premia. 2.5.1 Straight Bonds A straight bond is a bond that pays interest at regular pre-determined intervals and at maturity pays back the principal that was originally invested. A straight bond is also called a plain vanilla bond or a bullet bond. These bonds pay regular coupon which is typically fixed at the beginning or at the issuance time. It is the most basic form of debt investments. 2.5.2 Bond with a Call Option A bond with a Call provision gives the right to the bond issuer to call back the bond and pay the borrowed funds to investors before the original maturity date but at the pre-fixed call date. The issuer invokes this right only when the market interest rate is lower than the interest in the callable bond. However, the callable bonds generally require premium to be paid at the time of redemption when called. 2.5.3 Bond with a Put Option A bond with a Put provision gives the right to the bond investor to seek redemption of the bond from the issuer before maturity date but at the pre-fixed Put date. The investor invokes this right only when the market interest rate is higher than the interest in the 34 puttable bond. However, these bonds generally require discount at the time of redemption when the investor chooses to redeem the same before maturity. 2.5.4 Convertible Bonds (including FCCB) Convertible bonds are the bonds issued by corporates and such bonds get converted to equity shares at a specified time at a pre-fixed conversion price. The bondholder has the right to convert the said bonds to equity shares and issuing company cannot refuse the conversion as it is agreed at the time of the issuance. These bonds are preferred by foreign investors who would like to test the company for some time before talking an exposure to the equity shares of that company. This is a hybrid security as the price of the bond depends on market interest rate, equity share prices and the rating of the issue. The agreed conversion ratio determines the number of shares the bond holder would get if he/she exercises the option of conversion on the agreed date. The conversion price is set at the time of issuance of the security. The conversion price and ratio can be found in the bond indenture or in the security prospectus. The convertible bond is ideal for investors seeking gain from rising equity prices as the conversion price is decided at the time of issuance. An investor has to always calculate the value of the bond on conversion date taking the face value and the future promised interest. If the stock acquired through conversion is priced higher than the value of the bond, then the investor would convert the said bond. There are mandatory convertible bonds that are required to be converted by the investor at a particular conversion ratio and price. Exchangeable bonds are like the convertible bonds but these bonds can be exchanged for equity shares of some other issuer and then issuer would take the risk of buying the equity stock from the market to exchange against the bonds. Typically, these bonds are exchanged for equity stocks of some group companies of the issuer. A foreign currency convertible bond (FCCB) is a special type of bond issued in the currency other than the domestic currency. In other words, companies issue foreign currency convertible bonds to raise money in foreign currency. These bonds are preferred by foreign investors as these are bonds but can be exchanged for equity shares if the same is beneficial to the investor. 2.5.5 Warrants A warrant is a bond with option rights. For a limited time, it confers the right to buy equity securities, such as shares, of the bond issuer at a predetermined price (exercise price). Warrants are derivative instruments like options that give the right but not the obligation to the investor to buy an equity stock at a certain price before expiration. As these are option contracts, it will have strike or exercise price. Warrants can be American or European - an American warrant can be exercised at any time before or on the expiration date but a European warrant can be exercised on the expiration date only. Warrants have Call and Put types and these are traded in the Over the Counter (OTC) market. 35 Warrants are issued as a sweetener to bond holders that allow the issuer to offer a lower coupon rate. Warrants can be separated from the bonds and can be traded in the secondary market. Covered warrants are issued by financial institutions who might have acquired these stocks and holding them in their portfolio. 2.6 Classification of fixed income securities based on Security All bonds are in essence fungible loans for which returns ultimately depend on the servicing ability of the issuer. Bonds can be secured or unsecured. These can be senior or junior types depending on their claim in the company’s asset at the time of liquidation. Bonds lower in priority of claims offer higher yields to compensate for the risk inherent in them. Bonds may also be secured against specific assets of the user. Hence, it is critical for investors to be aware of the priority in claims of the security they intend to invest in depending on their risk appetite. 2.6.1 Secured debt The debt payout at the time of liquidation is made according to the seniority of bonds. Junior bonds are typically subordinate to senior bonds. The senior bonds are put at the top of the hierarchy in the structure as the “secured” debt. Otherwise, the age of the debt determines which has seniority if bonds are not secured. Secured bonds have collateral ranking and they would be paid first out of the assigned assets which have been collateralized against such debt. This makes it more secure with higher recovery rate vis-à- vis lower level unsecured junior bonds in the event the company defaults. Secured debt holders are paid out first in case of liquidation. 2.6.2 Unsecured debt Unsecured debt instruments are issued by companies without any specific collaterals allocated against these issuances. Companies issue such unsecured debt using their name and reputation in the market. These bonds are paid out last, if any bankruptcy happens. But senior unsecured debt is paid out first and then the junior unsecured debt is paid out. 2.6.3 Subordinated debt Subordinated bonds are issued by companies that pay higher coupon but are more risky as these bonds are paid out just before the equity holders at the time of liquidation. In India, banks issue subordinate bonds to shore up their Tier II capital as per the capital adequacy requirement. 2.6.4 Credit enhanced bonds Credit enhancement is a strategy to show the investors that the company would be able to pay back the borrowings as there is some kind of guarantee system in place to support the borrowings. It is a method whereby a borrower or a bond issuer attempts to improve the credit worthiness of its debt offering. Through credit enhancement, the lender or bond 36 holder is provided with reassurance that the borrower will meet its repayment through an additional collateral, insurance, or a third party guarantee. A company lowers its cost of borrowing using credit enhancement. The credit enhancement also leads to better rating grade for the bond and reduces the risk for investors. 2.7 Other fixed income securities in India Apart from the basic categories of bonds described above, there are several other types of fixed income securities which attract investors with specific investment requirements. Some of these instruments are discussed below. 2.7.1 Sovereign Gold Bonds Sovereign Gold Bonds (SGB) are government securities denominated in grams of gold. These are considered as substitute for physical gold. SGBs are issued by RBI on behalf of Government of India in order to reduce the import of gold into the country. These are paid out in domestic currency but the value is determined using the price of gold at the time of issue and redemption. These are held in demat form and remove the risk of physical gold holding and are free from issues like making charges and purity in the case of gold held in jewelry form. Minimum investment is one gram with a maximum limit of subscription of 4 kg for individuals, 4 kg for Hindu Undivided Family (HUF) and 20 kg for trusts and similar entities notified by the government from time to time per fiscal year (April-March). SGBs bear interest at the rate of 2.50 per cent (fixed rate) per annum on the amount of initial investment. 2.7.2 Perpetual Bonds Perpetual bonds do not have specified maturity but the bond issuer pays interest on the bond to the investor till the issuing entity exists. The yield offered by these bonds is significantly higher due to the associated high risks such as: a. Perpetual bonds are lower in order of liquidation and they are considered as subordinate to senior level bonds. b. The perpetual bonds are non-cumulative in nature and the interest is not guaranteed in case of loss made in a year. c. Perpetual bonds have “Call” provision which can be used by the issuer to call back the bond. d. Perpetual bonds have very low liquidity and it is extremely difficult to sell such bonds in the market. In India, banks and non-banking finance companies (NBFCs) have been major issuers of perpetual bonds to meet the Basel III norms (also known as AT-1 instruments). 2.7.3 AT1 Bonds As per Basel III norms, Indian banks have to maintain capital at a minimum ratio of 11.50 per cent of their risk-weighted assets. Out of these, 9.50 per cent needs to be in Tier-1 capital 37 and only 2 per cent in Tier-2 capital. Tier-1 capital can include perpetual bonds without any expiry date. These instruments are often treated as quasi-equity. RBI is the regulator for these bonds in India. AT1 bonds carry a face value of ₹10 lakh