Fixed Income Instruments In India

Fixed Income Instruments in India

SUMMER INTERNSHIP

Report On

“Fixed income Instruments in India” SUBMITTED TO: Executive Director Jagjit Singh

SUBMITTED BY: Deepak Singh (06-j1-121) PGDBM (2006-08)

INSTITUTE OF MARKETING AND MANAGEMENT Marketing Tower, B-11, Qutub Institutional Area, New Delhi-110016

1/90

Fixed Income Instruments in India “Fixed Income Instrument in India” is my attempt to gather maximum possible information about fixed income securities at one place. This report is based on secondary research from websites and newspapers. I have tried to cover most of the well known fixed income instruments available in Indian financial market. This report is based on the information latest by July 2007. Motive of preparing this report is collect brief information on various fixed income instruments as most of the people don’t have any information about these instruments. It is a wide topic and it is not easy to touch all the aspects of fixed income instrument in detail as well as the secondary market for government securities and corporate bonds is not fully developed in India.

Thank you, Deepak Singh [email protected] [email protected]

2/90

Fixed Income Instruments in India

TABLE OF CONTENTS 1. Executive Summary 2. Objective 3. Methodology 4. Fixed Income Instruments 4.1) Introduction 4.2) Why Invest in Fixed Income Instruments? 4.3) Risk in Fixed Income Instruments 4.4) Returns 5. Debt Market 6. Structure of Indian Debt Market 7. Regulators (RBI & SEBI) 8. Government Securities 9. Essential terms 10. Features of Government Securities 11. Auction of Securities 12. Central Government Securities 12.1) Treasury Bills 12.2) Dated Securities 12.3) Zero coupon Bonds 12.4) Partly Paid Stock 12.5) Floating Rate Bonds 12.6) Capital Indexed Bonds 12.7) Coupon Bearing Bonds 12.8) Govt. with call and put option 12.9) Strips 13. Zero Coupon Yield Curve 14. State Government Securities 14.1) State Development Loan 14.2) Coupon Bearing Bonds 15. Mandated Investments in Govt. Securities 16. Benefits of Investing in Govt. Securities 17. Public Sector Bonds 17.1) Govt. Guaranteed Bonds 17.2) PSU Bonds 17.3) Commercial Papers

3/90

Fixed Income Instruments in India 17.4) Debentures 18. Private Sector Bonds 18.1) Corporate Bonds 18.2) Corporate Debentures 18.3) Inter-Corporate Deposits 18.4) Certificate of Deposits 18.5) SPN 18.6) Commercial Papers 18.7) Floating Interest Rate 18.8) Zero Coupon Bond 19. Other Fixed Income Instruments 19.1) Company fixed Deposits 19.2) Employee’s Provident Fund 19.3) Mutual Funds 19.4) Guilt Funds 19.5) Bank Fixed Deposits 19.6) Other Prominent Govt. Schemes a) Public Provident Fund b) National Savings Schemes Account, 1992 (Discont.) c) National savings Certificates (viii) Issue d) Post Office Monthly Income Scheme e) Post Office Recurring Deposits Scheme f) Post Office Savings Account g) Post Office Time Deposit Schemes h) Kisan Vikas Patra i) RBI Relief Bonds j) Deposit Scheme for Retiring Employees of PSUs k) Deposit Scheme for Retiring Govt. Employees-89 l) Indira Vikas Patra (Discontinued) 20. Other important information 21. Liquidity Vs Return 22. Risk Vs Return 23. Suggestions for investors 24. Limitations of study 25. References/Bibliography

4/90

Fixed Income Instruments in India 1. EXECUTIVE SUMMARY Savings are essential requirements for any individual. There are lots of options available to invest in variety of securities based on individual’s profile in terms of age, income, liquidity requirement and risk tolerance level. At every age investment portfolio should comprise of both fixed and variable income instruments. This report addresses ‘Fixed Income Instruments’ which are one of the important parts of every investors saving portfolio. Fixed income instruments are basically obligations undertaken by the issuer of the instrument as regards to the repayment of interest and principal (At predetermined intervals of time), which the issuer would pay to the legal owner of the instrument. . The time of maturity and amount to be received on maturity are known in advance. Bonds, debentures, fixed deposits, and small savings schemes (National Savings Certificate and Kisan Vikas Patra among others) are some of the variants. Fixed income instruments can be arranged into 4 sections namely – 1. Government Securities 2. Public Sector Bonds 3. Private Sector Bonds 4. Others (like PPF, Kisan Vikas patra, post office etc.) The bond market in India is dominated by government bonds. Nearly 90% of total domestic bonds outstanding are government issuances (i.e. Treasury bills, notes and bonds), squeezing out corporate and other marketable debt securities PSU bonds have been consistently performing better than corporate bonds. Government bonds constitute almost 35% of GDP where as Corporate bonds constitute nearly 2% of the total GDP of India. As far as risk is concerned fixed income bonds like government Securities are considered risk free investments where as corporate bonds, debentures etc varies from a range of low to moderate risk. The very basic considerations of an investor while investing his money are how to maximize one's returns? What will he get? and what are the risks involved in investing in a particular investment?

5/90

Fixed Income Instruments in India Attribute wise summary of financial instruments: PRODUCTS RETURN LIQUIDITY RISK EQUITY Co. DEBENTURES Co. FDs BANK DEPOSITS PPF LIFE INSURANCE MUTUAL FUNDS RBI BONDS GOVT. SECURITIES GUILT FUNDS RBI REFLIEF BOND

HIGH MODERATE MODERATE LOW MODERATE LOW HIGH MODERATE MODERATE MODERATE HIGH

HIGH LOW LOW HIGH MODERATE LOW HIGH LOW MODERATE HIGH LOW

HIGH MODERATE HIGH LOW LOW LOW LOW LOW LOW MODERATE LOW

Risk Vs Return: LOW

Bank deposits, Life insurance

MODERATE

HIGH

Co. Fixed deposits

Equity, RBI relief bonds,

Co. debentures, Guilt funds

Real estate

PPF, RBI bonds, Govt. Securities

Mutual funds (fixed income part)

HIGH MODERATE

LOW

The desirability of any investment depends not only on its promising or expected return but also on the risk exposure of the investment constitutes an important element of investment decisions of the investors. For different investors this market has different investment options with variable liquidity and returns. Now investor can opt for best option according to his/her preferences.

6/90

Fixed Income Instruments in India

2. OBJECTIVE To collect information of various fixed income instruments. In India most of the people don’t have sufficient information about various fixed income instruments those are available for investment.

Objective of study is divided into two parts these are – a) To collect information about various fixed income instruments available in India. b) Study of liquidity, Risk and Return in each instrument.

7/90

Fixed Income Instruments in India

3. RESEARCH METHODOLOGY

This project report is wholly based on personal discussion and research from websites. Objective of report was fully executed with the help of secondary data available on net. The data collection and data analysis is done with the help of following methods 1. Data collection: Secondary Methods: - Journals, Corporate reports, News papers and related websites. 2. Data analysis: Data classification and analysis is being done with the help of various statistical tools such as charts, tables and graphical methods such as pie charts, bar charts, area charts etc.

8/90

Fixed Income Instruments in India

4.) 'Fixed Income' Instruments’ 4.1) Indian market Indian Capital Markets comprise of the Equities Market and the Debt Markets. Debt Markets are markets for the issuance, trading and settlement in fixed income securities of various types and features. Fixed income securities can be issued by almost any legal entity like Central and State Governments, Public Bodies, Statutory corporations, Banks and Institutions and Corporate Bodies.

Introduction to Fixed Income Instruments Fixed Income securities are one of the most innovative and dynamic instruments evolved in the financial system ever since the inception of money. Based as they are on the concept of interest and time-value of money, Fixed Income securities personify the essence of innovation and transformation, which have fueled the explosive growth of the financial markets over the past few centuries. Fixed Income securities offer one of the most attractive investment opportunities with regard to safety of investments, adequate liquidity, flexibility in structuring a portfolio, easier monitoring, long term reliability and decent returns. They are an essential component of any portfolio of financial and real assets, whether in form of pure interest bearing bonds, innovative and varied type of debt instruments or asset-backed mortgages and securitized instruments. Fixed income instruments are basically obligations undertaken by the issuer of the instrument as regards to repayment of interest and principal (At predetermined intervals of time), which the issuer would pay to the legal owner of the instrument. Fixed Income instruments are essentially of two types.  

Tradable. E.g. A debenture Non-Tradable. E.g. A bank deposit

4.2) Why Invest in Fixed Income? Fixed-income instruments in India typically include company bonds, fixed deposits and government schemes. The reasons for investing in fixed income option are mentioned below.

9/90

Fixed Income Instruments in India  Low risk tolerance One of the key benefits of fixed-income instruments is low risk i.e. the relative safety of principal and a predictable rate of return (yield). If your risk tolerance level is low, fixed-income investments might suit your investment needs better. But remember that these still have risks associated and are explained later.  Need for returns in the short-term Investment in equity shares is recommended only for that portion of your wealth for which you are unlikely to have a need in the short-term, at least five-years. Consequently, the money that you are likely to need in the short-term (for capital or other expenses), should be invested in fixed-income instruments.  Predictable versus Uncertain Returns Returns from fixed-income instruments are predictable i.e. they offer a fixed rate of return. In comparison, returns from shares are uncertain. If you need a certain predictable stream of income, fixed-income instruments are recommended. Before you decide to invest in fixed-income instruments, evaluate your needs from three key perspectives - risk, returns and liquidity. Match the investment options with your financial needs.

4.3) Risk There are two types of risks associated with investments in Fixed Income Options. a) Interest Rate Risk The price of the fixed income options are effected inversely by the interest rates. So, if the interest rates go up then the price of the existing bonds goes down and vice versa. The risk becomes important if you are interested in trading in the bonds and are not likely to hold till maturity. b) Credit Risk Credit risk refers to the possibility that the issuer fails to pay what is owed (principal and/or interest). Evaluate the credit ratings assigned by rating agencies like Moody’s, Standard & Poor, CRISIL, ICRA and CARE to find corporate bonds/ fixed deposits that match your risk tolerance level. Please note that it is not mandatory for non-finance companies to get a credit rating for their fixed deposit schemes. Hence, it is advisable to see if the company has a credit rating for any other debt instrument while evaluating fixed deposit schemes. 10/90

Fixed Income Instruments in India Also, one should understand the relation between credit rating of a company and the coupon (interest rate) which it promises. A low credit rating company would promise higher coupon than a company which has high credit rating as the risk involved in lending to low credit rated company is higher and the investor has to be compensated for the same. So, in case of fixed income option, investor should not get allured by the returns alone and should look into the underlying risks as well. Generally the government bonds are considered the safest as there is sovereign guarantee attached. But at the same time some countries are considered more reliable than others hence, in such a case the credit ratings of the country comes in to play. Hence, an emerging market government bonds would pay higher coupon than those issued by developed countries.

4.4) Returns Return calculations should consider effective yield, interest rate expectations and taxes. a) Calculate effective yield Calculate the post-tax effective yield for each instrument for comparison. Effective yield is the IRR (Internal Rate of Return) of the fixed-income instrument. For e.g. for an instrument that pays 14% monthly interest, the effective annual yield works out to 14.93%. This is definitely more attractive than an instrument that pays 14% annually. b) Consider interest rate (and inflation) expectations Once you invest in a fixed-income instrument, your investment is committed, more often than not, for the specified period of time. During this period, if interest rates increase, you will not benefit from this rise. Hence, your effective return from this investment will be lower than if you had the flexibility to invest at a higher interest rate. So, if you expect interest rates to increase, invest only in short-term instruments, and vice versa. c) Don’t forget taxes While calculating your interest yield remember to include post-tax interest receipts. For investors in high-tax brackets, tax-free government bonds/ schemes might be more attractive.

11/90

Fixed Income Instruments in India Mutual funds present an alternative avenue to invest in fixed income instruments at zero tax liability on the income received.

Tenure & Liquidity The tenure of the fixed income instrument is important as the returns get influenced by the tenure. For example, the interest rate risk we discussed above, if the interest rate rises then the existing bond with longer tenure will witness higher fall in price than one with shorter tenure. Fixed-income instruments are normally illiquid as the secondary market for these instruments is not yet developed in India. Make sure you carefully evaluate the potential liquidity, exit route and penalties of the instrument before you invest.

How to Buy? Worldwide the secondary market for fixed income instruments is more developed than in India. There are no open exchanges in India to trade debt and in case you wish to trade in bonds then your broker will have to find buyer and sellers for you. - Company bonds/ debentures Companies issue bonds and debentures through public issues that are open only for a limited period of time. Application forms for these issues are available with primary market brokers. - Company fixed deposits Fixed deposit schemes from companies are typically open round the year, unless they have exceeded their collection limits. Even in such cases, companies accept renewal from existing fixed deposit holders. - Government schemes You can invest in RBI bonds directly through the Reserve Bank of India or through a broker. Bit this option is not open for Non Resident Indians. Investments in other government schemes can normally be made through nationalized banks and post offices. - Fixed income mutual funds Fixed-income and money market mutual funds offer investors an exposure to fixed-income instruments. Open-ended mutual funds are available round the year and can be easily purchased/ sold on any business day.

12/90

Fixed Income Instruments in India 5.) DEBT MARKET: Debt market as the name suggests is where debt instruments or bonds are traded. The most distinguishing feature of these instruments is that the return is fixed i.e. they are as close to being risk free as possible, if not totally risk free. The fixed return on the bond is known as the interest rate or the coupon rate. Thus, the buyer of a bond gives the seller a loan at a fixed rate, which is equal to the coupon rate. Debt Markets are therefore, markets for fixed income securities issued by:  Central and State Governments  Municipal Corporations  Entities like Financial Institutions, Banks, Public Sector Units, and Public Ltd. companies. The money market also deals in fixed income instruments. However, difference between money and bond markets is that the instruments in the bond markets have a larger time to maturity (more than one year). The money market on the other hand deals with instruments that have a lifetime of less than one year.

6.) MARKET MICRO STRUCTURE: It is necessary to understand microstructure of any market to identify processes, products and issues governing its structure and development. In this section a schematic presentation is attempted on the micro-structure of Indian corporate debt market so that the issues are placed in a proper perspective. Figure gives a bird’s eye view of the Indian debt market structure. Figure - The Structure of the Indian Debt Market

13/90

Fixed Income Instruments in India REGULATORS SEBI, RBI, DCA MARKET SEGMENT

ISSUERS

INSTRUMENTS GOI dated securities, Treasury Bills, State Govt. securities Index bonds, zero coupon bonds

Central Govt THE SOVERIGN ISSUER

State Govt

Govt. Agencies & Stat. Bodies THE PUBLIC SECTOR

Govt. Guaranteed Bonds/ Debentures PSU Bonds, Debentures, CP

PSUs

Comm. Banks/ DFIs

CD, Debentures, Bonds Bonds, Debentures, Commercial Paper (CP) SPNs, Floating Rate Notes FCDs, PCDs, ZCBs

Corporates

THE PRIVATE SECTOR Pvt. Sect. Banks

14/90

Bonds, Debentures, CPs and CDs

INVESTORS RBI

DFIs

BANKS

PENSION FUND FIIs

CORPORATES

INDIVIDUALS

PROVIDENT FUNDS INSURANCE COS., TRUSTS, MUTUAL FUNDS

Fixed Income Instruments in India The instruments traded can be classified into the following segments based on the characteristics of the identity of the issuer of these securities: Segment

Issuer

Instruments

Government

Central Government

Treasury Bills, Dated Securities, Zero Coupon Bonds, Coupon Bearing bonds, Partly paid Stocks, Capital Index Bonds, Floating Rate Bonds, Inflation Index Bonds, STRIPS

Public Sector

Government Agencies / Statutory Bodies

Govt. Guaranteed Bonds, Debentures

Public Sector Units

PSU Bonds, Debenture, Commercial Paper

Corporate

Debentures, Bonds, Commercial Paper, Floating Rate Bonds, Zero Coupon Bonds, Inter-Corporate Deposits

Banks

Certificate of Deposits, Bonds

Financial Institutions

Certificate of Deposits, Bonds

Private

The Government Securities are referred to as Statutory Liquid Ratio (SLR) securities, as they are eligible securities for the maintenance of the SLR by the Banks.

15/90

Fixed Income Instruments in India 7.) REGULATORS RBI: The Reserve Bank of India is the main regulator for the Money Market. Reserve Bank of India also controls and regulates the G-Secs Market. Apart from its role as a regulator, it has to simultaneously fulfill several other important objectives viz. managing the borrowing program of 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. RBI controls the issuance of new banking licenses 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. Another major area under the control of the RBI is 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 RBI has moved slowly towards a regime of market determined controls.

SEBI: Regulator for the Indian Corporate Debt Market is the Securities and Exchange Board of India (SEBI). SEBI controls bond market and corporate debt market in cases where entities raise money from public through public issues. It regulates the manner in which such moneys are raised and tries 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, by way and its disclosure norms. SEBI is also a regulator for the Mutual Funds, SEBI 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 debt FIIs. Apart from the two main regulators, the RBI and SEBI, there are several other regulators specific for different classes of investors, eg the Central Provision Fund Commissioner and the Ministry of Labour regulate the Provident Funds. Religious and Charitable trusts are regulated by some of the State governments of the states, in which these trusts are located.

16/90

Fixed Income Instruments in India

8.) GOVERNMENT SECURITIES Government securities (G-secs) or gilts are sovereign securities, which are issued by the Reserve Bank of India (RBI) on behalf of the Government of India (GOI). The GOI uses these funds to meet its expenditure commitments. Definition of Government securities The Government securities are included in the definition of securities in the Securities Contracts (Regulation) Act, 1956 (SCRA) and mean a security created and issued by the Central Government or a State Government for the purpose of raising a public loan in a form specified in the Public Debt Act 1944. Permitted Exchanges: NSE, BSE and OTCEI.

9.) Essential terms one should be aware of before investing in Government Securities -An individual must be aware about the following terms associated with Government Securities:  Coupon: The 'Coupon' denotes the rate of interest payable on the security. E.g. a security with a coupon of 7.40% would draw an interest of 7.40% on the face value.  Interest Payment Dates (IP dates): The dates on which the coupon (interest) payments are made are called as the IP dates.  Last Interest Payment Date (LIP Date): LIP date refers to the date on which the interest was last paid.  Accrued Interest: Accrued interest is the interest charged at the coupon rate from the Last Interest Payment to the date of settlement. Accrued Interest for a security depends upon its coupon rate and the number of days from its LIP date to the settlement date.  Day count convention The market uses quite a few conventions for calculation of the number of days that has elapsed between two dates. The ultimate aim of any convention is to calculate (days in a month)/(days in a year). The 17/90

Fixed Income Instruments in India conventions used are as below. We take the example of a bond with Face Value 100, coupon 12.50%, last coupon paid on 15th June, 2000 and traded for value 5th October, 2000.  A/360(Actual by 360) In this method, the actual number of days elapsed between the two dates is divided by 360, i.e. the year is assumed to have 360 days.  A/365 (Actual by 365) In this method, the actual number of days elapsed between the two dates is divided by 365, i.e. the year is assumed to have 365 days.  A/A (Actual by Actual) In this method, the actual number of days elapsed between the two dates is divided by the actual days in the year.  30/360-Day Count: A 30/360-day count says that all months consist of 30 days. i.e. the month of February as well as the month of March is assumed to have thirty days.  Yield: Yield is the effective rate of interest received on a security. It takes into consideration the price of the security and hence differs as the price changes, since the coupon rate is paid on the face value and not the price of purchase. The concept can be best understood by the following example:  A security with a coupon of 7.40%:  If purchased at Rs. 100 the yield will be 7.40%  If purchased at Rs. 200 the yield becomes 3.70%.  If purchased at Rs. 50 the yield becomes 14.80%  Thus it is seen that higher the price lesser will be the yield and vicea-versa.  The yield will be equal to the coupon rate if and only if the security is purchased at the face value (Par).  Yield to Maturity (YTM): YTM implies the effective rate of interest received if one holds the security till its maturity. This is a better parameter to see the effective rate of return as YTM also takes into consideration the time factor.  Holding Period Yield (HPY): HPY comes into the picture when an investor does not hold the security till maturity. HPY denotes the effective

18/90

Fixed Income Instruments in India yield for the period from the date of purchase to the date of sale.  Clean Price: Clean Price denotes the actual price of the security as determined by the market.  Dirty Price: Dirty Price is the price that is obtained when the accrued interest is added to the Clean Price.  Shut Period: The government security pays interest twice a year. This interest is paid on the IP dates. One working day prior to the IP date, the security is not traded in the market. This period is referred to as the 'Shut Period'.  Face Value: The Face Value of the securities in a transaction is the number of Government Security multiplied by Rs.100 (face Value of each Government Security). Say, a transaction of 5000 Government Security will imply a face value of Rs. 5,00,000 (i.e. 5000 * 100)  "Cum-Interest" and "Ex-Interest" Cum-interest means the price of security is inclusive of the interest accrued for the interim period between last interest payment date and purchase date. Security with ex-interest means the accrued interest has to be paid separately  Trade Value: The Trade Value is the number of Government Security multiplied by the price of each security.  Primary Dealers & Satellite Dealers Primary Dealers can be referred to as Merchant Bankers to Government of India, comprising the first tier of the government securities market. Satellite work in tandem with the Primary Dealers forming the second tier of the market to cater to the retail requirements of the market. These were formed during the year 1994-96 to strengthen the market infrastructure and put in place an improvised and an efficient secondary government securities market trading system and encourage retailing of Government Securities on large scale.

19/90

Fixed Income Instruments in India

10.) FEATURES OF A GOVERNMENT SECURITY A Government Security has the following features:  The face value of all the securities is Rs.100.  Interest is paid on a semi-annual basis i.e. every 6 months. i.e. A security with a coupon of 7.40% will draw an interest payment of Rs 3.70 every six months.  Accrued Interest is always calculated on a 30/360-day count. Thus a Government of India (GOI) security 8.07% 2017 would imply a security carrying a coupon rate of 8.07%, payable semi-annually on the face value of Rs.100, and maturing in the year 2017.  Demat account for trading in Government Securities – Government Securities can be held in the same demat a/c used for equities.  The market lot and the tick size in the retail G-Sec market – The market lot is 10 (i.e. minimum face value of Rs.1000). The tick size is one paisa.  The settlement cycle on the exchanges The settlement in G-Sec would take place either on a T+0, T+1 or T+2 basis. Where 'T' stands for the trade date, and '0', '1', '2' implies the number of business days. i.e. On a given week having no holidays (As per the Stock exchange list) a trade taking place on Monday with T+0 cycle will be settled on Monday, a trade taking place on Saturday with T+1 cycle will be settled the next Monday and so on.  Effect of shut period on trading in stock exchanges In case of a security going into the shut period on the WDM, it would be suspended on the exchanges 1 working day prior to the IP date. For e.g. say a security's IP date is 28th Jan 2005, the security would in go the shut period on 27th Jan 2005 in the Wholesale Debt market.  Intra-day short selling permitted An individual can do intra-day short sales.  Quoting of Government Securities on the stock exchanges The prices will be quoted on a dirty price (clean price + accrued interest) basis. 20/90

Fixed Income Instruments in India  Interest Rate risk : Interest rate risk, market risk or price risk are essentially one and the same. Theses are typical of any fixed coupon security with a fixed period-to-maturity. This is on account of an inverse relation between price and interest. As interest rates rise, the price of a security will fall. However, this risk can be completely eliminated incase an investor's investment horizon identically matches the term of the security.  (Re-investment risk) : This risk is again akin to all those securities, which generate intermittent cash flows in the form of periodic coupons. The most prevalent tool deployed to measure returns over a period of time is the yield-to-maturity (YTM) method. The YTM calculation assumes that the cash flows generated during the life of a security is re-invested at the rate of the YTM. The risk here is that the rate at which the interim cash flows are re-invested may fall thereby affecting the returns.  Default risk : This kind of risk in the context of a Government security is always zero. However, these securities suffer from a small variant of default risk i.e., maturity risk. Maturity risk is the risk associated with the likelihood of the government issuing a new security in place of redeeming the existing security. In case of Corporate Securities it is referred to as Credit Risk.  What factors determine interest rates? When we talk of interest rates, there are different types of interest rates - rates that banks offer to their depositors, rates that they lend to their borrowers, the rate at which the Government borrows in the bond/G-Sec, market, rates offered to small investors in small savings schemes like NSC rates at which companies issue fixed deposits etc. The factors which govern the interest rates are mostly economy related and are commonly referred to as macroeconomic. Some of these factors are: 1) Demand for money 2) Government borrowings 3) Supply of money 4) Inflation rate 5) The Reserve Bank of India and the Government policies which determine some of the variables mentioned above.  What is a Repo trade and how is it different from a normal buy or sell transaction?

21/90

Fixed Income Instruments in India An outright Buy or sell transaction is a one where there is no intended reversal of the trade at the point of execution of the trade. The Buy or sell transaction is an independent trade and is in no way connected with any other trade at the same or a later point of time. A Ready Forward Trade (which is normally referred to as a Repo trade or a Repurchase Agreement) is a transaction where the said trade is intended to be reversed at a later point of time at a rate which will include the interest component for the period between the two opposite legs of the transactions. So in such a transaction, one participant sells securities to other with an agreement to purchase them back at a later date. The trade is called a Repo transaction from the point of view of the seller and it is called a Reverse Repo transaction from point of view of the buyer. Repos therefore facilitate creation of liquidity by permitting the seller to avail of a specific sum of money (the value of the repo trade) for a certain period in lieu of payment of interest by way of the difference between the two prices of the two trades. Repos and reverse repos are commonly used in the money markets as instruments of short-term liquidity management and can also be termed as a collateralized lending and borrowing mechanism. Banks and Financial Institutions usually enter into reverse repo transactions to manage their reserve requirements or to manage liquidity.  What are the type of transactions which take place in the market? The following two types of transactions take place in the Indian markets:  Direct transactions between banks and other wholesale market participants which account for around 25% of the Wholesale Market volumes: Here the Banks and the Institutions trade directly between themselves either through the telephone or the NDS system of the RBI.  Broker intermediated transactions, which account for around 70-75% of the trades in the market. These brokers need to be members of a Recognized Stock Exchange for RBI to allow the Banks, Primary Dealers and Institutions to undertake dealings through them.  What are the three modules in the GILT system? GILT permits trading in the Wholesale Debt Market through the three following avenues:  Order Grabbing System - which provides for active interaction between the market participants in keeping with the negotiated deal structure of the market.  Negotiated Deal Module - This permits the reporting of trades undertaken by the market participants through the members of the Exchange.  Cross Deal Module - permitting reporting of trades undertaken by two different market participants through a single member of the Exchange.

22/90

Fixed Income Instruments in India 11.) AUCTION OF SECURITIES: Auction is a process of calling of bids with an objective of arriving at the market price. It is basically a price discovery mechanism. There are several variants of auction. Auction can be price based or yield based. In securities market we come across below mentioned auction methods. (a) French Auction System: After receiving bids at various levels of yield expectations, a particular yield level is decided as the coupon rate. Auction participants who bid at yield levels lower than the yield determined as cut-off get full allotment at a premium. The premium amount is equivalent to price equated differential of the bid yield and the cut-off yield. Applications of bidders who bid at levels higher than the cut-off levels are out-right rejected. This is primarily a Yield based auction. (b) Dutch Auction Price: This is identical to the French auction system as defined above. The only difference being that the concept of premium does not exist. This means that all successful bidders get a cut-off price of Rs. 100.00 and do not need to pay any premium irrespective of the yield level bid for. (c) Private Placement: After having discovered the coupon through the auction mechanism, if on account of some circumstances the Government / Reserve Bank of India decides to further issue the same security to expand the outstanding quantum, the government usually privately places the security with Reserve Bank of India. The Reserve Bank of India in turn may sell these securities at a later date through their open market windiow albeit at a different yield. (d) On-tap issue: Under this scheme of arrangements after the initial primary placement of a security, the issue remains open to yet further subscriptions. The period for which the issue remains open may be sometimes time specific or volume specific.

23/90

Fixed Income Instruments in India THE TERM GOVERNMENT SECURITIES INCLUIDES: Central Government Securities  State Government Securities  Treasury Bills

Issuer

Instruments

Central Government Treasury Bills, Dated Securities, Zero Coupon Bonds, Coupon Bearing bonds, Partly paid Stocks, Capital Index Bonds, Floating Rate Bonds, Inflation Index Bonds, STRIPS State Governments

State Government loans, Coupon bearing bonds,

24/90

Fixed Income Instruments in India

12.) SECURITIES ISSUED BY CENTRAL GOVERNMENT -

Issuer

Instruments

Central Government

Treasury Bills, Dated Securities, Zero Coupon Bonds, Coupon Bearing bonds, Partly paid Stocks, Capital Index Bonds, Floating Rate Bonds, Inflation Index Bonds, STRIPS

12.1) TREASURY BILLS: In the short term, the lowest risk category instruments are the Treasury Bills (TBs) issued by Central government. RBI on behalf of central government issues them at a prefixed day and for a fixed amount. The TBs are issued with varying maturity usually not exceeding more than one year. They are issued for different maturities viz. 14-day, 28 days (announced in Credit policy but yet to be introduced), 91 days, 182 days and 364 days. 14 days T-Bills had been discontinued recently. 182 days T-Bills were not re-introduced.

TREASURY BILLS

91-Day T-Bill

182-Day T-Bill

25/90

364- Day T Bill

Fixed Income Instruments in India  91-Day T-Bill-- (Tenor is of 91 days) Its auction is on every Wednesday of the week and issued on following Friday. The notified amount for this auction is Rs. 500 crore.

 182-Day T- Bill-- (Tenor is of 182 days) Its auction is on every alternate Wednesday (which is not a reporting week) and issued on Friday. The notified amount for this auction is Rs. 500 crore.

 364-Day T- Bill-- (Tenor is of 364 days) Its auction is on every alternate Wednesday (which is a reporting week) and issued on Friday. The notified amount for this auction is Rs. 1000 crore. These Bills are now issued for only two tenures, namely 91 days and 364 days. A considerable part of the central government's borrowing happens through Treasury Bills of various maturities. Based on the bids received at the auctions, RBI decides the cut off yield and accepts all bids below this yield. Banks are the major investors in these instruments as they can park their short-term surpluses and also since it forms part of their SLR investments. Besides banks other investors in TBs are insurance companies, primary dealers, mutual funds, FIs and FIIs. These TBs, which are issued at a discount, can be traded in the market. Most of the time, unless the investor requests specifically, they are issued not as securities but as entries in the Subsidiary General Ledger (SGL), which is maintained by RBI. The transactions cost on TBs are non-existent and trading is considerably high in each bill, immediately after its issue and immediately before its redemption. The yield on TBs is mainly dependent on the rates prevalent in Call/Notice market. Low yield on TBs, generally a result of high liquidity in banking system as indicated by low call rates, would divert the funds from this market to other markets. This would be particularly so, if banks already hold the minimum stipulated amount (SLR) in government paper.

12.2) DATED SECURITIES Government paper with tenor beyond one year is known as dated security. At present, there are Central Government dated securities with a tenor up to 30 years in the market. These securities generally carry a fixed coupon (interest) rate and have a fixed maturity period. e.g. an 11.40% GOI 2008 G-sec. In this case 11.40%

26/90

Fixed Income Instruments in India is the coupon rate and it is maturing in the year 2008. The salient features of Dated Securities are:    

These are issued at the face value. The rate of interest and tenure of the security is fixed at the time of issuance and does not change till maturity. The interest payment is made on half yearly rest. On maturity the security is redeemed at face value.

Auction/Sale: - Dated securities are sold through auctions. Fixed coupon securities are sometimes also sold on tap that is kept open for a few days. Announcement: - A half yearly calendar is issued in case of Central Government dated securities, indicating the amounts, the period within which the auction will be held and the tenor of the security, which is made available on Reserve Bank’s website. The Government of India and the Reserve Bank also issue a press release to announce the sale, a few days (normally a week) before the auction. Amount: - Subscriptions can be for a minimum amount of Rs.10,000 and in multiples of Rs.10,000. Where are the sales held? Auctions are conducted electronically on PDO-NDS system. The bids are submitted by the members on PDO-NDS system both on their own behalf as well as on behalf of their clients. Payment: - The payment by successful bidders is made on the issue date, as specified in the auction notification, usually the working day following the auction day.

12.3) ZERO COUPON BONDS Zero Coupon Bonds (ZCBs) were introduced on January 17, 1994. ZCBs, which do not have regular interest(coupon) payments like traditional bonds, are sold at a discount and redeemed at par on final maturity. The ZCBs were beneficial, both to the Government because of the deferred payment of interest and to the investors because of the lucrative yield and absence of reinvestment risk. These securities are issued at a discount to the face value and redeemed at par. i.e. they are issued at below face value and redeemed at face value. The salient features of Zero Coupon Bonds are: 27/90

Fixed Income Instruments in India  The tenure of these securities is fixed.  No interest is paid on these securities.  The return on these securities is a function of time and the discount to face

value.

12.4) PARTLY PAID STOCK Par tly paid stock was introduced on November 14, 1994 whereby payment for the Government stock was made in four equal monthly instalments. Designed for institutions with regular flow of investible resources requiring regular investment avenues, this instrument attracted good market response and was actively traded. There was, however, only one more issue of partly paid stock on June 24, 1996 In these securities the payment of principal is made in installments over a given period of time. The salient features of Partly Paid Stock are:  These types of securities are issued at face value and the principal amount is paid in installments over a period of time.  The rate of interest and tenure of the security is fixed at the time of issuance and does not change till maturity.  The interest payment is made on half yearly rest.  These are redeemed at par on maturity.

12.5) FLOATING RATE BONDS Floating Rate Bonds (FRBs) were first issued on September 29, 1995 but were discontinued after the first issuance due to lack of market enthusiasm. They were reintroduced on November 21, 2001 on demand from market participants, with some modification in the structure. Although there was initially an overwhelming market response to these issuances, FRBs were discontinued due to the waning market interest reflected in the partial devolvement in the last two auctions on the Reserve Bank and PDs. Erosion in the market interest for FRBs at that time was, inter alia, due to strong credit pick-up and low secondary market liquidity in FRBs. These types of securities have a variable interest rate, which is calculated as a fixed percentage over a benchmark rate. The interest rate on these securities changes in sync with the benchmark rate. The salient features of Floating Rate Bonds are:  These are issued at the face value.

28/90

Fixed Income Instruments in India  The interest rate is fixed as a percentage over a predefined benchmark rate.

The benchmark rate may be a bank rate, Treasury bill rate etc.  The interest payment is made on half yearly rests.  The security is redeemed at par on maturity, which is fixed.

12.6) CAPITAL INDEXED BONDS A capital indexed bond (CIB) was issued on December 29, 1997 with a maturity of 5 years. The bond provided for inflation hedging for the principal, while the coupons of the bond were not protected against inflation. The issue of this bond met with lackluster response, both in the primary and the secondary markets due to the limited hedging against inflation. Therefore, there were no subsequent issuances. An attempt is being made to reintroduce these bonds and towards this end, a discussion paper was also widely circulated in May 2004. The proposed modified structure of the CIB would be in line with the internationally popular structure, which offers inflation linked returns on both the coupons and principal repayments at maturity. The inflation protection for the coupons and the principal repayment on the bond would be provided with respect to the Wholesale Price Index (WPI) for all commodities (1993-94=100). These securities carry an interest rate, which is calculated as a fixed percentage over the wholesale price index. The salient features of Capital Indexed Bonds are:  These securities are issued at face value.  The interest rate changes according to the change in the Wholesale price index, as the interest rate is fixed as a percentage over the wholesale price index.  The maturity of these securities is fixed and the interest is payable on half yearly rests.  The principal redemption is linked to the Wholesale price index. Inflation linked bonds: A bond is considered indexed for inflation if the payment of coupons is indexed by reference to the change in the value of a general price or wage index over the term of the instrument. The options are that either the interest payments are adjusted for inflation or the principal repayment or both. Out of the existing measures of inflation in India, viz., Consumer Price Index (CPI), GDP deflator and the Wholesale Price Index (WPI), the WPI emerges as the best index for the CIB. Thus, the WPI for All commodities (1993-94=100) released by the Office of the Economic Adviser, Ministry of Commerce and Industries, Government of India would be taken as the index for measuring the 29/90

Fixed Income Instruments in India inflation rate for the proposed bonds. However, for the purpose of inflation protection the monthly average of WPI (average of weeks) as worked out by the Reserve Bank of India, instead of WPI at the last week of the month, would be used as it smoothens the weekly variability in WPI and its effect on the market price of the bonds.

12.7) COUPON BEARING BOND “Coupon bearing bond”- A bond that pays fixed cash flow every year, until it matures at date T when it also pays the face value of the bond. Eg: B1 with face value of Rs.100, maturity T = 5 and annual cash flow of Rs.10 looks like: (10, 1), (10, 2), (10, 3), (10, 4), (110, 5)

12.8) Government securities with embedded call and put options were introduced in July 2002 for a 10-year maturity using uniform price based auction method. On these securities, the Government has the discretion to exercise the ‘call option’, after giving a notice of two months, whereby the securities may be prematurely redeemed at par on or after completion of five years tenure from the date of issuance of securities on any coupon payment date falling thereafter. The holders of the Government stock also have the discretion to exercise ‘put option’ whereby premature redemption may be made under the same conditions as the call option. There was only one issuance of this instrument.

12.9) STRIPS STRIPS is the acronym for Separate Trading of Registered Interest and Principal Securities. Stripping is the process of separating a standard coupon-bearing bond into its individual coupon and principal components. In an official STRIPS market for the Government securities, these stripped securities i.e., the newly created zero coupon bonds remain the direct obligations of the Government and are registered in the books of the agent meant for this purpose. Thus the mechanics of stripping neither impacts the direct cost of borrowing nor change the timing or quantum of the underlying cash flows; stripping only facilitates transferring the right to ownership of individual cash flows

30/90

Fixed Income Instruments in India Advantages: STRIPS would facilitate the availability of zero coupon bonds (ZCBs) to the investors and traders. They provide the most basic cash flow structure thus offering the advantage of more accurate matching of liabilities without reinvestment risk and a precise management of cash flows. Thus to some investors who set the incoming inflows against an actuarial book (eg. Insurance companies), STRIPS offer excellent investment choices. Apart from the advantages they offer to low risk investors like pension funds and insurance companies, STRIPS offer much greater leverage to hedge funds, since the zero coupon bonds are more volatile than the underlying coupon bearing bonds. Last but not the least, STRIPS offer an excellent scope to construct a zero yield curve for the sovereign bond market. Fungibility An important feature of the STRIPS market is that the coupon STRIPS of the same date from different stocks are fungible - meaning that they are just not identical but exchangeable. Thus when a few coupon bearing bonds sharing the same coupon payment dates are stripped, it may not be possible to distinguish the coupon STRIPS created out of all these bonds. All STRIPS will have a unique code number to identify. Going by the same logic, these coupon STRIPS could be used to complete the reconstitution of any of those original coupon bearing bonds whose coupon payment dates fall on the same date (provided the purchaser holds all the other coupon and principal STRIPS). Minimum Reconstitutable and Strippable amount For operational convenience the size of coupon STRIPS and principal STRIPS should be in whole paise so as to allow reconstitution. For example, for a 11.99 per cent Government stock, 2009, it will not be possible to reconstitute to, say, an amount of Rs.500, since the necessary coupon STRIPS would be Rs.29.975. Across the Stocks, it would be possible to reconstitute if the standard minimum coupon strip is Rs.1,000. Accordingly, the minimum strippable amount could be either kept at Rs.1,000 or Rs.10,000 and be increased in similar multiples. Trading and pricing There are two things that determine the prices of STRIPS viz., (i) the market mechanism of supply and demand and (ii) the prices of the underlying strippable and similar non-strippable stocks. Since STRIPS are the component parts of the underlying stock from which they are created, theoretically, the price of any strippable stock should be exactly equal to the sum of the prices of all its component parts.

31/90

Fixed Income Instruments in India 13.) ZERO COUPON YIELD CURVE The yield to maturity for coupon bonds is capable of several algebraically equivalent definitions A straight forward definition of yield to maturity is the single discount rate that equates the bond’s cash flows to the market price of the bond. But a coupon paying bonds can be viewed as a combination of separate bonds of varying maturities (of the coupons and the principal). From this point of view , it is reasonable to ask what the rate of interest on each of these loans are. In general any bond can be represented by an equation of the form: P= C1/(1+0F1) + C1/{(1+0F1)(1+1F2)} +C1/{(1+0F1)(1+1F2)(1+2F3)} + ……. Where iFr = Discount rate for cash flows at the end of r period ( i.e. the cash flow r-i periods from i th period. ). The rates represented by F’s are also known as forward rates and they are related to the zero coupon rates (i.e. the rate at which a single cash flow at any point of time in the future is discounted) by the following equation: (1+ rk )k = (1+ri)i x (1+ iFk)(k-i) where rk is the k period discount rate and r1=0F1 The point that is to be emphasized about the zero coupon rates are that they are unique for a given period . To illustrate , if we say that the 6 monthly zero coupon rate is 9.63%, then all cash flows for any bonds 6 months from now have to be discounted by 9.63% i.e. zero coupon discount rates are period specific and not bond specific. A zero coupon curve is the great invisible reality of the of the fixed income markets and it solves the bulk of the pricing problems in fixed income markets (ignoring default risk). The pricing of securities based on Yield to Maturity (YTM) suffers from the defect that although a security represents a series of cash flows occurring at different points of time, they are discounted at the same rate. Hence the YTM can be regarded as a weighted average discount rate for forward rates where the weights are the corresponding cash flows . Since the cash flows of a bond is unique, so is its YTM. In fact, if the forward curve is sharply upward sloping, the YTM of a low coupon security should be more than a high coupon security of identical tenor. This coupon effect, as it is known, is totally missed if the decisions are based on YTM. With the introduction of STRIPS, the pricing of the primary market offerings have also to be oriented towards zero coupon valuation method so as to address the problems of valuation arising out of YTM methodology. Who can strip and reconstitute Stripping/reconstitution may be allowed to be performed by only a limited number of intermediaries along with the debt manager on the specific requisition from the holders.

32/90

Fixed Income Instruments in India

Role of Government Securities Yield Curve as a Public GoodYield curve, also known as term structure of interest rates, is the representation of zero coupon yields of a series of maturities at a point of time. It is constructed by plotting the yields against the respective maturity periods of benchmark fixedincome securities. The yield curve is a measure of market’s expectations of future interest rates, given the current market conditions. Securities issued by the Government are considered risk-free, and as such, their yields are often used as the benchmarks for fixed-income securities with the same maturities. Graphic Representation of a Normal Yield Curve

The difference between short and long ends of the yield curve (spread) determines the shape of the curve which is an important indicator of the expected performance of the economy and inflation. Since the government securities yield curve represents the risk-free interest rates, it is used for pricing other instruments of various maturities. The yield The difference between short and long ends of the yield curve (spread) determines the shape of the curve which is an important indicator of the expected performance of the economy and inflation. Since the government securities yield curve represents the risk-free interest rates, it is used for pricing other instruments of various maturities. The yield curve has informational value to bond issuers for pricing as well as timing of their issue depending on the expected performance of the economy. Investors can also use the curve in choosing the right tenor of investment. For overseas investors, expected performance of different countries could be compared by looking at the respective yield curves to make investment decisions. Most other interest rates are measured on the basis of the government securities yield curve, viz., credit curve and swap curve. Similarly pricing of other financial

33/90

Fixed Income Instruments in India instrument uses the government securities yield curve in some form or the other. Thus, the yield curve acts as a kind of public good that is used constantly by participants in the financial system. The efficiency of the yield curve as a public good is enhanced under the following two conditions. First, macroeconomic volatility, especially inflation volatility, must be low so that a nominal yield curve is informative about the real cost of borrowing. Second, the government must issue a sufficient volume of debt. Yield is described as an apparatus which allows abstraction of irrelevant factors and focuses on factors relevant for interest rate risk on portfolios (Krstic and Marinkovic,1997). The fact that the yield curve acts as a public good enjoins upon all participants, in particular the regulators, the responsibility of ensuring that it is free from any undesirable and manipulative influence, as this would lead to a loss in its informational value and result in market inefficiency brought about by incorrect pricing of other financial instruments. One of the key features of development of the government securities market is the evolution of yield curve over a reasonably long period. The upward sloping yield curve, which is considered to be the usual term structure, may reflect either the presence of interest rate risk premium or the so called Hicksian liquidity premiums, or it may simply reflect the market’s anticipation about the upward trend in the general level of interest rates over the period. Theoretical analysis confirms that in an efficient market, yield curve will solely depend upon the market’s response to collective beliefs about future interest rate movements, i.e., interest rates derived from the prevailing term structure of interest rates are correct forecast of future interest rates. Thus, development of the government securities market is essential for establishing the risk-free benchmarks in financial markets and ensuring their functioning in an efficient manner.

34/90

Fixed Income Instruments in India

14.) SECURITIES ISSUED BY STATE GOVERNMENT -

Issuer

Instruments

State Governments

State Government loans/State Development loan, coupon bearing bond

14.1) State Government Securities/State Development loans These are securities issued by the state governments and are also known as State Development Loans (SDLs). The issues are also managed and serviced by the Reserve Bank of India. The tenor of state government securities is normally ten years. State government securities are available for a minimum amount of Rs.10,000 and in multiples of Rs.10,000. These are available at a fixed coupon rate. The auctions for State Government securities are held electronically on PDO-NDS module. Nine State Governments announce auctions of State Development Loans 2017 for Rs.3482.129 crore on June 19 2007 State government debt issuances are largely long-term and in the local currency, as states are not permitted to issue debt in foreign currencies directly. The typical long-term debt is a 25-year fixed-rate loan with a five-year grace period. Two of the main debt types are loans against small savings, which are subscribed by the public, and market loans, which are bought by banks.

14.2) Coupon bearing bond “Coupon bearing bond” A bond that pays fixed cash flow every year, until it matures at date T when it also pays the face value of the bond. Eg: B1 with face value of Rs.100, maturity T = 5 and annual cashflow of Rs.10 looks like: (10, 1), (10, 2), (10, 3), (10, 4), (110, 5)

35/90

Fixed Income Instruments in India

15.) MANDATED INVESTMENTS IN GOVERNMENT SECURITIES: Banks are the largest investors in government securities. In terms of the SLR provisions of the Banking Regulation Act, 1949, banks are required to maintain a minimum of 25 per cent of their net demand and time liabilities (NDTL) in liquid assets such as cash, gold and unencumbered government securities or other approved securities as Statutory Liquidity Ratio (SLR). The minimum SLR stipulation for scheduled urban co-operative banks (UCBs) is the same as for scheduled commercial banks (SCBs) from April 1, 2003. However, for nonscheduled UCBs, the minimum SLR requirement is 15 per cent for banks with NDTL of over Rs.25 crore and 10 per cent for the remaining non-scheduled UCBs. The minimum SLR stipulation for regional rural banks (RRBs) is the same as for SCBs. From April 1, 2003, the coverage under the SLR has also been made akin to SCBs. All deposits with sponsor banks, which were earlier considered as part of the SLR, were to be converted into approved securities on maturity in order to be reckoned for the SLR purpose. Recently, the Banking Regulation Amendment Act, 2007 has removed the floor limit of 25 per cent for SLR for scheduled banks. The second largest category of investors in the government securities market is the insurance companies. According to the stipulations of the Insurance Regulation and Development Authority of India (IRDA), all companies carrying out the business of life insurance should invest a minimum of 25 per cent of their controlled funds in government securities. Similarly, companies carrying on general insurance business are required to invest 30 per cent of their total assets in government securities and other guaranteed securities, of which not less than 20 per cent should be in Central Government securities. For pension and general annuity business, the IRDA stipulates that 20 per cent of their assets should be invested in government securities. The non-Government provident funds, superannuation funds and gratuity funds are required by the Central Government from January 24, 2005 to invest 40 per cent of their incremental accretions in Central and State government securities and/or units of gilt funds regulated by the Securities and Exchange Board of India (SEBI) and any other negotiable securities fully and unconditionally guaranteed by the Central/State Governments. The exposure of a trust to any inpidual gilt fund, however, should not exceed five per cent of its total portfolio at any point of time.

36/90

Fixed Income Instruments in India Non-banking financial companies (NBFCs) accepting public deposits are required to maintain 15 per cent of such outstanding deposits in liquid assets, of which not less than 10 per cent should be maintained in approved securities, including government securities and government guaranteed bonds. Investment in government securities should be in dematerialised form, which can be maintained in Constituents’ Subsidiary General Ledger (CSGL) Account of a SCB/Stock Holding Corporation of India Limited (SHCIL). In order to increase the security and liquidity of their deposits, residuary non-banking companies (RNBCs), are required to invest not less than 95 per cent of their aggregate liability to depositors (ALD) as outstanding on December 31, 2005 and entire incremental deposits over this level in directed investments, which include government securities, rated and listed securities and debt oriented mutual funds. From April 1, 2007, the entire ALD is required to be invested in directed investments only. Measures were taken to promote voluntary holding of government securities among other investor categories. For this purpose, specialised institutions were developed. The Discount and Finance House of India (DFHI), set up in April 1988, primarily for developing the money market, was also allowed to participate in the government securities market. In order to develop an efficient institutional infrastructure for an active secondary market in government securities and public sector bonds, the Securities Trading Corporation of India (STCI) commenced its operations in June 1994. With the introduction of the PD system, both DFHI and STCI later transformed themselves into PDs.

37/90

Fixed Income Instruments in India

16.) BENEFITS OF INVESTING IN A GOVERNMENT SECURITYThe Benefits of investing in a Government Security are: 1. Safety: The Zero Default Risk is the greatest attraction for investments in Government Securities. It enjoys the greatest amount of security possible, as the Government of India issues it. Hence they are also known as Gilt-Edged Securities or 'Gilts'.

2. Fixed Income: During the term of the security there is likely to be fluctuations in the Government Security prices and thus there exists a price risk associated with investment in Government Security. However, the return on the holding of investment is fixed if the security is held till maturity and the effective yield at the time of purchase is known and certain. In other words the investment becomes a fixed income investment if the buyer holds the security till maturity.

3. Convenience: Government Securities do not attract deduction of tax at source (TDS) and hence the investor having a non-taxable gross income need not file a return only to obtain a TDS refund.

4. Simplicity: To buy and sell Government Securities all an individual has to do is call his / her Equity Broker and place an order. If an individual does not trade in the Equity markets, he / she has to open a demat account and then can commence trading through any Equity broker.

5. Liquidity: Government Security when actively traded on exchanges will be highly liquid, since a national trading platform is available to the investors.

6. Diversification Government Securities are available with a tenor of a few months up to 30 years. An investor then has a wide time horizon, thus providing greater diversification opportunities.

Factors that affect the price of a Government Security – These are the factors which affect the price of the securities –  Demand and supply  Economic conditions.  General money market conditions including the position of money supply, in the economy.  Interest rates prevalent in the market and the rates of new issues.  Credit quality of the issuer. 38/90

Fixed Income Instruments in India

17.) PUBLIC SECTOR BONDS -

Segment

Issuer

Instruments

Public Sector

Government Agencies / Govt. Guaranteed Bonds, Statutory Bodies Debentures Public Sector Units

PSU Bonds, Debenture, Commercial Paper

17.1) GOVT. GUARANTEED BONDS: Introduction State Governments have been issuing a large amount of guarantees and letters of comfort on behalf of public sector undertakings (PSUs) at the State level, cooperative societies and State Cooperative Banks (StCBs) for the purpose of public investment, particularly in resource-intensive infrastructure sector and for promotion of rural development, to enable the PSUs to mobilise resources. Lenders/investors in State guaranteed papers: A. Banking Entities a) Commercial Banks b) Rural Co-operative Banks c) Urban Co-operative Banks B. Financial Institutions a) National Bank for Agriculture and Rural Development (NABARD) b) National Housing Bank (NHB) c) Small Industries Development Bank of India (SIDBI) d) Life Insurance Corporation of India (LIC) e) Housing and Urban Development Corporation (HUDCO) f) Rural Electrification Corporation (REC) g) Power Finance Corporation (PFC) h) Other Public Financial Institutions (PFIs) C. Others

39/90

Fixed Income Instruments in India a) Public and Private Sector Provident Funds (PFs); b) Charitable Trusts c) National Co-operatives Development Corporation (NCDC) d) Non-Banking Financial Corporations (NBFCs) GUARANTEE FEE

Table 2: Structure of Guarantee Fee/Commission in Some Indian States: March 2001 (per cent of guaranteed amount) Sl.No

States

Structure of Guarantee Fee

1

Andhra Pradesh

0.5% to 2%

2

Karnataka

A floor fee of 1 per cent

3

Rajasthan

0.1 to 1 per cent

4.

Orissa



5

Gujarat

1%, some state PSEs are exempt while 0.25% is charged for open market borrowing that forms part of the state annual plan.

6

West Bengal

A floor of 1 % is kept, but rises with greater default perception of the project

7

Kerala

0.75 per cent

0.02% - 0.5% for Cooperative institutions, housing, local bodies and state PSEs  1% for other guarantees and bonds;  NABARD and other agriculture related guarantees are exempted

40/90

Fixed Income Instruments in India 8

Mizoram

No Guarantee fee is charged

9

Punjab

2 % for term loans, 1/8% for procurement agencies

The Reserve Bank has also organized a workshop on 'Risk Evaluation on State Guarantees' to help State Government officials to analyse the risk of defaults on State Government guarantees.

17.2) PSU BONDS Public Sector Undertaking Bonds (PSU Bonds): These are Medium or long term debt instruments issued by Public Sector Undertakings (PSUs). The term usually denotes bonds issued by the central PSUs (i.e. PSUs funded by and under the administrative control of the Government of India). Most of the PSU Bonds are sold on Private Placement Basis to the targeted investors at Market Determined Interest Rates. Often investment bankers are roped in as arrangers to this issue. Most of the PSU Bonds are transferable and endorsement at delivery and are issued in the form of Usance Promissory Note. In case of tax free bonds, normally such bonds accompany post dated interest cheque / warrants.

17.3) COMMERCIAL PAPERS It was introduced in India in 1990 with a view to enabling highly rated corporate borrowers/ to diversify their sources of short-term borrowings and to provide an additional instrument to investors. Subsequently, primary dealers and satellite dealers were also permitted to issue CP to enable them to meet their short-term funding requirements for their operations. CPs are negotiable short-term unsecured promissory notes with fixed maturities, issued by well rated companies generally sold at a discount basis. These are basically instruments evidencing the liability of the issuer to pay the holder in due course a fixed amount (face value of the instrument) on the specified due date.

ISSUER: Corporates and primary dealers (PDs), and the all-India financial institutions (FIs) that have been permitted to raise short-term resources under the 41/90

Fixed Income Instruments in India umbrella limit fixed by Reserve Bank of India are eligible to issue CP.

Rating Requirement The minimum credit rating shall be P-2 of Credit Rating Information Services of India Ltd (CRISIL) or such equivalent rating by other agencies. Like - Investment Information and Credit Rating Agency of India Ltd. (ICRA) or - Credit Analysis and Research Ltd. (CARE) or - FITCH Ratings India Pvt. Ltd. or such other credit rating agencies as may be specified by the Reserve Bank of India from time to time, for the purpose.

Maturity CP can be issued for maturities between a minimum of 7 days and a maximum up to one year from the date of issue.

Denominations CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by a single investor should not be less than Rs.5 lakh (face value).

Limits and the Amount of Issue of CP CP can be issued as a "stand alone" product. The aggregate amount of CP from an issuer shall be within the limit as approved by its Board of Directors or the quantum indicated by the Credit Rating Agency for the specified rating, whichever is lower. Banks and FIs will, however, have the flexibility to fix working capital limits duly taking into account the resource pattern of companies' financing including CPs.

Issuing and Paying Agent (IPA) Only a

scheduled

bank

can

act

as

an

IPA

for

issuance

of

CP.

Investment in CP CP may be issued to and held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, NonResident Indians (NRIs) and Foreign Institutional Investors (FIIs)..

Mode of Issuance CP can be issued either in the form of a promissory note or in a dematerialised form through any of the depositories approved by and registered with SEBI. CP will be issued at a discount to face value as may be determined by the issuer. No issuer shall have the issue of CP underwritten or co-accepted.

17.4) Debenture (please refer to private sector)

42/90

Fixed Income Instruments in India

18.) PRIVATE SECTOR -

Segment

Issuer

Instruments

Private

Corporate

Debentures, Bonds, Commercial Paper, SPN, Floating Rate Bonds, Zero Coupon Bonds, InterCorporate Deposits Certificate of Deposits, Bonds

Banks Financial Institutions

Certificate of Deposits, Bonds

The Indian Corporate Bond Market 18.1)) CORPORATE BONDS Corporate bonds are debt securities issued by private and public corporations. Companies issue corporate bonds to raise money for a variety of purposes, such as building a new plant, purchasing equipment, or growing the business. When one buys a corporate bond, one lends money to the "issuer," the company that issued the bond. In exchange, the company promises to return the money, also known as "principal," on a specified maturity date. Until that date, the company usually pays you a stated rate of interest, generally semiannually. While a corporate bond gives an IOU from the company, it does not have an ownership interest in the issuing company, unlike when one purchases the company's equity stock.

Yields Yield is a critical concept in bond investing, because it is the tool used to measure the return of one bond against another. It enables one to make informed decisions about which bond to buy. In essence, yield is the rate of return on bond investment. However, it is not fixed, like a bond’s stated interest rate. It changes to reflect the price movements in a bond caused by fluctuating interest rates. The following example illustrates how yield works.  You buy a bond, hold it for a year while interest rates are rising and then sell it.

43/90

Fixed Income Instruments in India  



You receive a lower price for the bond than you paid for it because, no one would otherwise accept your bond’s now lower-than-market interest rate. Although the buyer will receive the same amount of interest as you did and will also have the same amount of principal returned at maturity, the buyer’s yield, or rate of return, will be higher than yours, because the buyer paid less for the bond. Yield is commonly measured in two ways, current yield and yield to maturity.

Current yield 



The current yield is the annual return on the amount paid for a bond, regardless of its maturity. If you buy a bond at par, the current yield equals its stated interest rate. Thus, the current yield on a par-value bond paying 6% is 6%. However, if the market price of the bond is more or less than par, the current yield will be different. For example, if you buy a Rs. 1,000 bond with a 6% stated interest rate at Rs. 900, your current yield would be 6.67% (Rs. 1,000 x .06/Rs.900).

Yield to maturity It tells the total return you will receive if you hold a bond until maturity. It also enables you to compare bonds with different maturities and coupons. Yield to maturity includes all your interest plus any capital gain you will realize (if you purchase the bond below par) or minus any capital loss you will suffer (if you purchase the bond above par).

Valuation of Corporate Bonds Corporate bonds tend to rise in value when interest rates fall, and they fall in value when interest rates rise. The inverse relationship between bonds and interest rates—that is, the fact that bonds are worth less when interest rates rise and vice versa can be explained as follows : When interest rates rise, new issues come to market with higher yields than older securities, making those older ones worth less. Hence, their prices go down.  When interest rates decline, new bond issues come to market with lower yields than older securities, making those older, higher-yielding ones worth more. Hence, their prices go up.  As a result, if one sells a bond before maturity, it may be worth more or less than it was paid for.

44/90

Fixed Income Instruments in India Market preference for high rated bonds: Investors in corporate debt instruments are excessively safety conscious as could be noted form the fact that there is hardly any demand for paper which is rated below AA or its equivalent by the rating companies. World over any paper rated BBB (or its equivalent) and above is considered as investment grade, except that the interest rate to be paid on BBB has to be high enough to compensate for the risk attached to it in relation to the highest rated paper. Basically it is a question of risk-reward matrix with higher risk being compensated by higher return. Globally there is considerable demand for debt paper which is rated below AA. In fact the maturity of the market is often judged by the skill of the investors to factor riskreward matrix in their investment decision so that they do not miss the high return opportunities that may exist in the case of BBB rated paper. Judged from this matrix it is clear that Indian debt market is yet to mature. This is indicated by the analysis of the outstanding bond issues with reference to their rating values assigned to them by the recognized rating agencies. Over 82percent of the debt paper is AA and above, as demand for other investment grade paper is not large enough. The majority of institutional investors by amount in the corporate debt paper are banks which are all the while in favour of highly rated paper while at the same extending loans to not so well rated corporate clients. Thus most of the banks adopt an asymmetric credit evaluation methodology when they are willing to provide loan to a client but unwilling to invest in the debt paper issued by the borrower if the debt paper is not rated very highly by the rating agencies. It is hoped that as the corporate debt market grows in size and becomes deep, liquid, and broad-based investors will start understanding the risk-reward matrix much more intelligently. Institutional investors will start to appreciate increasingly the risk-adjusted returns and the arbitrage that the market provides. Table III-4A and III-4B give the outstanding corporate debt in the market in terms of rating class, issue sizes and no. of issues.

Corporate Bonds- Outstanding Issues (Aug 25, 2005) Rating Class

No. of Issues

Market Share (%)

Issue Size (Rs.Cr)

Market Share (%)

Market Cap (Rs. Cr)

Market Share (%)

AAA/MAAA

955

61.61

92609

69.81

93872

69.68

AA+/LAA+/MAA+

320

20.65

19605

14.78

19821

14.71

AA/LAA/MAA

175

11.29

13248

9.99

13692

10.16

AA-/LA-

31

2

1272

0.96

1322

0.98

A+/LA+

16

1.03

1545

1.16

1559

1.16

45/90

Fixed Income Instruments in India A/LAMA

16

1.03

1512

1.14

1529

1.13

A-

12

0.77

1063

0.8

1065

0.79

BBB+

11

0.71

833

0.63

877

0.65

BBB/LBBB

8

0.52

722

0.54

25

0.54

B

6

0.39

257

0.19

257

0.19

1550

100

132666

100

134719

100

Grand Rating Not Available

82

9906

9916

Source: NSE WDM segment

Table-III-4B: Corporate Bonds (Structured Obligations) Outstanding Issues (Aug 25, 2005)

Rating Class

Market Share (%)

No. of Issues

Issue Size (Rs. Cr)

Market Share (%)

Market Cap (Rs. Cr)

Market Share (%)

AAA

19

8.6

3116

12.83

3144

12.75

AA+

6

2.71

175

0.72

175

0.71

AA

5

2.26

263

1.08

267

1.08

AA-

15

6.79

1700

7

1777

7.2

A+/LA+

24

10.86

3042

12.53

3197

12.96

136

61.54

12328

50.77

12671

51.37

10

4.52

1900

7.82

2017

8.18

BBB+

3

1.36

200

0.82

204

0.83

BBB

2

0.9

840

3.46

495

2.01

BB

1

0.45

718

2.96

718

2.91

221

100

24282

100

24665

100

A/LA A-

Total

46/90

Fixed Income Instruments in India 18.2) CORPORATE DEBENTURES A Debenture is a debt security issued by a company (called the Issuer), which offers to pay interest in lieu of the money borrowed for a certain period. In essence it represents a loan taken by the issuer who pays an agreed rate of interest during the lifetime of the instrument and repays the principal normally, unless otherwise agreed, on maturity. These are long-term debt instruments issued by private sector companies. These are issued in denomination as low as Rs. 1000 and have maturity ranging between one and ten years. Long maturity debentures are rarely issued, as investors are not comfortable with such maturities. Debentures enable investors to reap the dual benefits of adequate security and good returns. Unlike Fixed and Bank Deposit they can be transferred from one party to another by using transfer form. Debentures are normally issued in physical form. However, corporates/PSUs have started issuing debentures in Demat form. Generally, debentures are less liquid as compared to PSU bonds and their liquidity is inversely proportional to the residual maturity. Debentures can be secured or unsecured. Debentures are divided into different categories on the basis of: 1. Convertibility of the instrument 2. Security 1. Debentures can be classified on the basis of convertibility into: a) Non-Convertible Debentures (NCD): This type of security retains all the characteristic of a debt instruments and it cannot be converted into any other form of security (mainly equity). b) Partly Convertible Debentures (PCD): A part of this instrument can be converted into Equity share in the future at the instance of issuer. The issuer decides the ratio of the conversion at the time of subscription. c) Fully convertible Debentures (FCD): These instruments are fully convertible into Equity shares at the issuer's notice. The issuer decides the ratio of conversion. Upon conversion the investors enjoy the same status as ordinary shareholders of the company. e) Optionally Convertible Debentures (OCD): The investor has the option to either convert these debentures into shares at price decided by the issuer/agreed upon at the time of issue. 2. On basis of Security, debentures are classified into:

47/90

Fixed Income Instruments in India a) Secured Debentures: These instruments are secured by a charge on the fixed assets of the issuing company. So if the issuer fails on payment of either the principal or interest amount, his assets can be sold to repay the liability to the investors. This is usually in the form of a first mortgage or charge on the fixed assets of the company on a pari passu basis with other first charge holders like financial institutions etc. Sometimes, the charge can also be a second charge instead of a first charge. Most of the times the charge is created on behalf of the entire pool of debenture holders by a trustee specifically appointed for the purpose. b) Unsecured Debentures: These instruments are unsecured in the sense that if the issuer defaults on payment of the interest or principal amount, the investor has to be along with other unsecured creditors of the company.

(18.3) INTER-CORPORATE DEPOSITS Apart from CPs, corporates also have access to another market called the Inter Corporate Deposits (ICD) market. An ICD is an unsecured loan extended by one corporate to another. Existing mainly as a refuge for low rated corporates, this market allows funds surplus corporates to lend to other corporates. Also the betterrated corporates can borrow from the banking system and lend in this market. As the cost of funds for a corporate in much higher than a bank, the rates in this market are higher than those in the other markets. ICDs are unsecured, and hence the risk inherent in high. The ICD market is not well organised with very little information available publicly about transaction details.

(18.4) CERTIFICATE OF DEPOSITS After treasury bills, the next lowest risk category investment option is the certificate of deposit (CD) issued by banks and FIs. Allowed in 1989, CDs were one of RBI's measures to deregulate the cost of funds for banks and FIs. The rates on these deposits are determined by various factors. Low call rates would mean higher liquidity in the market. Also the interest rate on one-year bank deposits acts as a lower barrier for the rates in the market. Guidelines for Issue of Certificates of Deposit (CDs) as Amended up to June 30, 2006

48/90

Fixed Income Instruments in India Introduction Certificates of Deposit (CDs) is a negotiable money market instrument and issued in dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Eligibility CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI. Aggregate Amount  Banks have the freedom to issue CDs depending on their requirements.  An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments, viz., term money, term deposits, commercial papers and inter-corporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet. Minimum Size of Issue and Denominations Minimum amount of a CD should be Rs.1 lakh, and in the multiples of Rs. 1 lakh thereafter. Who can Subscribe CDs can be issued to individuals, corporations, companies, trusts, funds, associations, etc. Non-Resident Indians (NRIs) may also subscribe to CDs, but only on non-repatriable basis which should be clearly stated on the Certificate. Such CDs cannot be endorsed to another NRI in the secondary market. Maturity  The maturity period of CDs issued by banks should be not less than 7 days and not more than one year.  The FIs can issue CDs for a period not less than 1 year and not exceeding 3 years from the date of issue. Discount/Coupon Rate CDs may be issued at a discount on face value. Banks/FIs are also allowed to issue CDs on floating rate basis provided the methodology of compiling the floating rate is objective, transparent and market-based. The issuing bank/FI is free to determine the discount/coupon rate. Reserve Requirements

49/90

Fixed Income Instruments in India Banks have to maintain the appropriate reserve requirements, i.e., cash reserve ratio (CRR) and statutory liquidity ratio (SLR), on the issue price of the CDs. Transferability Physical CDs are freely transferable by endorsement and delivery. Dematted CDs can be transferred as per the procedure applicable to other demat securities. There is no lock-in period for the CDs. Loans/Buy-backs Banks/FIs cannot grant loans against CDs. Furthermore, they cannot buyback their own CDs before maturity. Format of CDs Banks/FIs should issue CDs only in the dematerialized form. However, according to the Depositories Act, 1996, investors have the option to seek certificate in physical form. Accordingly, if investor insists on physical certificate, the bank/FI may inform Financial Markets Department, Reserve Bank of India, Central Office, Fort, Mumbai - 400001 about such instances separately.

(18.5) SPN Secured Premium Notes (SPN) with Detachable Warrants: SPN which is issued along with a detachable warrant, is redeemable after a notice period, say four to seven years. The warrants attached to it ensure the holder the right to apply and get allotted equity shares; provided the SPN is fully paid. There is a lock-in period for SPN during which no interest will be paid for an invested amount. The SPN holder has an option to sell back the SPN to the company at par value after the lock in period. If the holder exercises this option, no interest/ premium will be paid on redemption. In case the SPN holder holds its further, the holder will be repaid the principal amount along with the additional amount of interest/ premium on redemption in installments as decided by the company. The conversion of detachable warrants into equity shares will have to be done within the time limit notified by the company.

(18.6) Commercial Papers (Please refer to Public Sector Bond) (18.7) Floating Interest rate (Please refer to Government securities part) (18.8) Zero Coupon Bond (Please refer to Government securities part)

50/90

Fixed Income Instruments in India

19.) OTHER FIXED INCOME INSTRUMENTS: 1. Company Fixed Deposits 2. Employee’s Provident Fund 3. Mutual Funds 4. Guilt Funds 5. Bank Fixed Deposits 6. Other prominent government schemes

19.1) COMPANY FIXED DEPOSITS Fixed Deposits in companies that earn a fixed rate of return over a period of time are called Company Fixed Deposits. Financial institutions and Non-Banking Finance Companies (NBFCs) also accept such deposits. Deposits thus mobilised are governed by the Companies Act under Section 58A. These deposits are unsecured, i.e., if the company defaults, the investor cannot sell the documents to recover his capital, thus making them a risky investment option. Benefits of investing in Company Fixed Deposits     

High interest. Short-term deposits. Lock-in period is only 6 months. No Income Tax is deducted at source if the interest income is up to Rs 5,000 in one financial year Investment can be spread in more than one company, so that interest from one company does not exceed Rs. 5,000

Company Fixed Deposits have always offered interest which is 2-3% higher than Bank Deposit rate, becaue they have to pay higher interest to banks for borrowing money.  interest payments Interest is paid on monthly/quarterly/half yearly/yearly basis or on maturity, and is sent either through cheque or through Electronic Clearing System basis.  TDS is deducted if the interest on fixed deposit exceeds Rs.5000/- in a financial year.

51/90

Fixed Income Instruments in India Which companies can accept a deposits ? Companies registered under the Companies Act 1956, such as:     

Manufacturing Companies. Non-Banking Finance Companies. Housing Finance Companies. Financial Institutions. Government Companies.

Upto what limits can a company accept deposit? A Non-Banking Non-Finance Company(Manufacturing Company) can accept deposits subject to following limits.  Upto 10% of the aggregate of paid-up share capital and free reserves if the deposits are from shareholders or guaranteed by the directors.  Otherwise upto 25% of the aggregate of paid-up share capital and free reserves. A Non-Banking Finance Company can accept deposits upto following limits:  An Equipment Leasing Company can accept four times of its net owned fund.  A Loan or Investment Company can accept deposit upto one and half time of its net owned funds. Period of the deposit Company Fixed Deposits can be accepted by a Manufacturing Company having duration from 6 months to 3 years. Non-Banking Finance Companies can accept deposit from 1 year to 5 years period. A Housing Finance Company can accept deposit from 1 year to 7 years.

19.2) EMPLOYEE’S PROVIDENT FUNDS (EPF) Employee’s Provident funds Act, 1952 The Employees Provident Funds and Miscellaneous Provisions Act, provides for compulsory contributory fund for the future of an employee after his retirement or for his dependents in case of his early death. It extends to the whole of India except the State of Jammu and Kashmir and is applicable to: a. every factory engaged in any industry specified in Schedule 1 in which 20 or more persons are employed; b. every other establishment employing 20 or more persons or class of such establishments which the Central Govt. may notify;

52/90

Fixed Income Instruments in India c. any other establishment so notified by the Central Government even if employing less than 20 persons. EMPLOYEES ENTITLED Every employee, including the one employed through a contractor (but excluding an apprentice engaged under the Apprentices Act or under the standing orders of the establishment and casual laborers), who is in receipt of wages upto Rs. 6,500 p.m., shall be eligible for becoming a member of the funds. The condition of three months? continuous service or 60 days of actual work, for membership of the scheme, has been done away with, w.e.f. 1.11.1990. Workers are now eligible for joining the scheme from the date of joining the service. TERM OF SCHEME Every member of the Employees? Pension Fund Scheme shall continue to remain the member till the earliest happening of any of the following events: i. he attains the age of 58 years; or ii. he avails the withdrawal benefit to which he is entitled vide para 14 of the scheme; or iii. he dies; or iv. the pension is vested in him. Every employer shall send to the Commissioner, within three months of the commencement of the scheme, a consolidated return of the employees entitled to become members of the new scheme. EMPLOYER/S CONTRIBUTION The employer is required to contribute the following amounts towards Employees? Provident Fund and Pension Fund a. In case of establishments? employing less than 20 persons or a sick industrial (BIFR) company or ?sick establishments? or any establishment in the jute, beedi, brick, coir or gaur gum industry. ?10% of the basic wages, dearness allowance and retaining allowance, if any. b. In case of all other establishments? employing 20 or more person-12% of the wages, D.A., etc. A part of the contribution is remitted to the Pension Fund and the remaining balance continues to remain in Provident Fund account. Where, the pay of an employee exceeds RS. 6500 p.m., the contribution payable to Pension Fund shall be limited to the amount payable on his pay of RS. 6500 only, however, the employees may voluntarily opt for the employer?s share of contributions on wages beyond the limit of RS. 6500 to be credited to the Pension Fund. INTEREST

53/90

Fixed Income Instruments in India The employer shall be liable to pay simple interest @ 12% p.a. on any amount due from him under the Act, from the date on which it becomes due till the date of its actual payment.

19.3) MUTUAL FUND A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. The money thus collected is then invested in capital market instruments such as shares, debentures and other securities. The income earned through these investments and the capital appreciation realised are shared by its unit holders in proportion to the number of units owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost. The flow chart below describes broadly the working of a mutual fund:

Mutual Fund Operation Flow Chart

Concept of Mutual Fund

Many investors with common financial objectives pool their money

Investors, on a proportionate basis, get mutual fund units for the sum contributed to the pool

The money collected from investors is invested into shares, debentures and other securities by the fund manger

54/90

Fixed Income Instruments in India The fund manager realizes gains or losses, and collects dividend or interest income

Any capital gains or losses from such investments are passed on to the investors in promotion of the number of units held by them

TYPES OF MUTUAL FUND SCHEMES  By Structure o Open - Ended Schemes o Close - Ended Schemes o Interval Schemes  By Investment Objective o Growth Schemes o Income Schemes (√) o Balanced Schemes o Money Market Schemes (√)  Other Schemes o Tax Saving Schemes o Special Schemes  Index Schemes  Sector Specfic Schemes

Association of Mutual Funds in India (AMFI) With the increase in mutual fund players in India, a need for mutual fund association in India was generated to function as a non-profit organisation. Association of Mutual Funds in India (AMFI) was incorporated on 22nd August, 1995. AMFI is an apex body of all Asset Management Companies (AMC) which has been registered with SEBI. Till date all the AMCs are that have launched mutual fund schemes are its members. It functions under the supervision and guidelines of its Board of Directors. Association of Mutual Funds India has brought down the Indian Mutual Fund

55/90

Fixed Income Instruments in India Industry to a professional and healthy market with ethical lines enhancing and maintaining standards. It follows the principle of both protecting and promoting the interests of mutual funds as well as their unit holders.

 Income/Debt-oriented schemes (√) These schemes are for investors who are in need of regular and a steady flow of income stream. Investors get a fixed sum of money on a monthly, bi-annually or on an annual basis depending on the options chosen by them while filling the application form. A good chunk of such scheme is invested in fixed income securities like corporate debentures (debt instruments issued by companies like say Bajaj Auto that have a high safety rating (lower risk of default) and are very much like fixed deposit schemes of banks) and bonds issued by the Indian government as well as corporate bonds (again like fixed deposits; a bond has a fixed tenure and a fixed rate of interest known as coupon rate). Though risks in these schemes is much lower than growth schemes the chances of capital appreciation are also lesser. It is a moderate-risk, moderate-returns kind of scheme. Investors whose risk appetite is not very high can avail of these schemes. Though not affected by wild fluctuations in the equity market the NAVs of income schemes are sensitive to interest rates. If interest rates go up the value of NAVs of income schemes go down. Their NAVs and interest rates share an inverse relation. The current situation is the case in point as interest rates are on an upward journey. Again good for long-term investors as interest rate changes even out over a period of 3-5 years. Franklin Templeton Mutual Fund's FT India Monthly Income Plan and Canbank Mutual fund's CANINCOME are examples of two such schemes.

 Money market schemes (√) This scheme is for those investors who want to earn steady but assured income on their surplus funds in the short-term. This scheme basically aims to provide easy liquidity (investors can sell the units of these schemes and get cash in lieu). Apart from that investors can rest assured that the money they put in will not reduce in value, that is, it offers capital protection. The assured income generated from such schemes is the icing on the cake. Mutual funds offering this scheme invest their corpus in treasury bills (short-term debt instrument offered by the government; say a 30-day fixed deposit offered by a bank), certificates of deposit (same as fixed deposit schemes offered by companies like say ACC), apart from a host of other short-term debt schemes of the government.

56/90

Fixed Income Instruments in India This scheme offers highest security and least volatility. However, the returns are lower along with high safety of your principal amount. Fidelity Mutual Fund's Fidelity Short Term Income Fund and Franklin Templeton Mutual Fund's Templeton India Liquid Plus are the examples of such money market schemes.

19.4) GILT FUNDS Gilt funds, as they are conveniently called, are mutual fund schemes floated by asset management companies with exclusive investments in government securities. The schemes are also referred to as mutual funds dedicated exclusively to investments in government securities. Government securities mean and include central government dated securities, state government securities and treasury bills. The gilt funds provide to the investors the safety of investments made in government securities and better returns than direct investments in these securities through investing in a variety of government securities yielding varying rate of returns gilt funds, however, do run the risk.. The first gilt fund in India was set up in December 1998. Liquidity Support Eligibility All gilt funds - public and private sector, open-ended or close- ended - are eligible to avail liquidity support and other facilities from the Reserve Bank of India. The gilt funds schemes should, however, have the approval of the Securities and Exchange Board of India. It would be prudent for the gilt funds to submit an advance copy of the draft offer document to the Reserve Bank of India for preliminary scrutiny at the time of submitting the draft offer document to the Securities and Exchange Board of India. This is to enable the Reserve Bank to satisfy itself that the scheme proposed to be floated by the gilt funds is in conformity with the Reserve Bank's guidelines for availing liquidity support from the Reserve Bank of India. Conditions The Reserve Bank of India provides liquidity support by way of reverse repos subject to the following terms and conditions: i. Re-purchase agreements (reverse repos) with the Reserve Bank are in eligible central government dated securities and treasury bills of all maturities.

57/90

Fixed Income Instruments in India ii. iii. iv. v. vi. vii. viii. ix.

The prices of the securities for reverse repo transactions are determined by the Reserve Bank of India, at its discretion. The securities tendered by the gilt funds for reverse repos by the Reserve Bank are in multiples of Rs. 10 lakh (face value). Gilt funds can avail the reverse repo facility for a maximum period of 14 days at a time. The repo rate is the Bank Rate. Liquidity support is made available at Mumbai only. The gilt funds, however, are free to transmit the funds to other centers of the Reserve Bank under its Remittance Facility Scheme. The gilt funds cannot use the funds raised through the reverse repos facility for on-lending in the call/notice money market. The Reserve Bank reserves the right to partially accept or reject any application for liquidity support without assigning any reason. The Reserve Bank can call for all relevant information from gilt funds in regard to their operations and the gilt funds are required to provide it.

19.5) BANK FIXED DEPOSIT A fixed deposit is meant for those investors who want to deposit a lump sum of money for a fixed period; say for a minimum period of 15 days to five years and above, thereby earning a higher rate of interest in return. Investor gets a lump sum (principal + interest) at the maturity of the deposit. Bank fixed deposits are one of the most common savings scheme open to an average investor. Fixed deposits also give a higher rate of interest than a savings bank account. The facilities vary from bank to bank. Some of the facilities offered by banks are overdraft (loan) facility on the amount deposited, premature withdrawal before maturity period (which involves a loss of interest) etc. Bank deposits are fairly safer because banks are subject to control of the Reserve Bank of India.

Returns The rate of interest for Bank Fixed Deposits varies between 4 and 11 per cent, depending on the maturity period (duration) of the FD and the amount invested. Interest rate also varies between each bank. A Bank FD does not provide regular interest income, but a lump-sum amount on its maturity. Some banks have facility to pay interest every quarter or every month, but the interest paid may be at a discounted rate in case of monthly interest. The Interest payable on Fixed Deposit

58/90

Fixed Income Instruments in India can also be transferred to Savings Bank or Current Account of the customer. The deposit period can vary from 15, 30 or 45 days to 3, 6 months, 1 year, 1.5 years to 10 years.

Duration

Interest rate (%) per annum

15-30 days

4 -5 %

30-45 days

4.25-5 %

46-90 days

4.75--5.5 %

91-180 days

5.5-6.5 %

181-365 days

5.75-6.5 %

1-2 years

6-8 %

2-3 years

6.25-8 %

3-5 years

6.75-8

Advantages Bank deposits are the safest investment after Post office savings because all bank deposits are insured under the Deposit Insurance & Credit Guarantee Scheme of India. It is possible to get a loans up to75- 90% of the deposit amount from banks against fixed deposit receipts. The interest charged will be 2% more than the rate of interest earned by the deposit. With effect from A.Y. 1998-99, investment on bank deposits, along with other specified incomes, is exempt from income tax up to a limit of Rs.12, 000/- under Section 80L. Also, from A.Y. 1993-94, bank deposits are totally exempt from wealth tax. The 1995 Finance Bill Proposals introduced tax deduction at source (TDS) on fixed deposits on interest incomes of Rs.5000/- and above per annum.

How to apply? One can get a bank FD at any bank, be it nationalised, private, or foreign. You have to open a FD account with the bank, and make the deposit. However, some banks insist that you maintain a savings account with them to operate a FD. When a depositor opens an FD account with a bank, a deposit receipt or an account statement is issued to him, which can be updated from time to time, depending on the duration of the FD and the frequency of the interest calculation. Check deposit receipts carefully to see that all particulars have been properly and accurately filled in. Fixed Deposits: Documentation (UTI Bank)

59/90

Fixed Income Instruments in India The following documents are required when applying for a Fixed Deposit An Individual, Hindu Undivided Family, Sole Proprietorship Concern

 



Trusts

    

Associations / Clubs

 



Partnership Firm

 



A valid passport or a valid driving license An introduction by any other bank or an introduction by an UTI Bank Savings Account holder for the last six months A photograph

Copy of the Trust Deed Copy of the registration certificate Copy of the Resolution of The Trustees Authorising the members concerned to open and operate the account Photographs of the members operating the account

Bye-laws of the Association Copy of the Resolution by the board authorising the members concerned to open and operate the account Photographs of the members operating the account

Partnership Deed Letter from partners approving the persons concerned to open and operate the account Photographs of the persons operating the account

60/90

Fixed Income Instruments in India 19.6) OTHER PROMINENET GOVERNMENT SCHEMES The list of prominent government schemes available for investors is given below.  Public Provident Fund  National savings Certificates (viii) Issue  Post Office Monthly Income Scheme  Post Office Recurring Deposits Scheme  Post Office Savings Account  Post Office Time Deposit Schemes  Kisan Vikas Patra  RBI Relief Bonds  Depost Scheme for Retiring Employees of PSUs  Deposit Scheme for Retiring Govt. Employees-89  National Savings Schemes Account, 1992 (Discontinued)  Indira Vikas Patra (Discontinued)

61/90

Fixed Income Instruments in India a) PUBLIC PROVIDENT FUND

Terms of Investment Tax-free interest, highest post-tax fixed-income yield for individuals in high tax bracket.

Annual rate of Interest

9.50%

Periodicity of interest payment

Compounded annually

Effective annual yield

9.50% tax-free

Maturity period

15 years

Minimum Investment Amount

Rs100 per annum

Maximum Investment Amount

Rs60,000 per annum

Investment in multiples of

Rs100

62/90

Fixed Income Instruments in India

Availability Eligibility

Individuals or on behalf of minors, HUF, AOP, NRIs

Available at

Selected post offices and banks

Tax Benefits I.T. section applicable

Sec. 88 for tax rebate

On sum invested

20% tax rebate, subject to a maximum investment of Rs60,000

On interest received

Interest receipts totally tax-free

Liquidity Premature Withdrawal

Available every year from 7th financial year

Loan against investment

Available from 3rd financial year

Transferability

Not transferable to other persons. Transferable from Bank to post office account

63/90

Fixed Income Instruments in India b) NATIONAL SAVING CERTIFICATES (VIII) ISSUE Terms of Investment Investment amount as well as interest-accrued and reinvested qualify for tax rebates Annual rate of Interest

9.50%

Periodicity of interest payment

Compounded semi-annually

Effective annual yield

9.73%

Maturity period

6 years

Minimum Investment Amount

Maximum Investment Amount

Investment in multiples of

Rs100

No limit

Rs100/ Rs500/ Rs1,000/ Rs5,000/ Rs10,000

64/90

Fixed Income Instruments in India Availability Eligibility

Individuals or on behalf of minors, trusts

Available at

All head post offices and selected sub-post offices

Tax Benefits I.T. section applicable

Sec. 88 for investment amount, eligible under Sec. 80L for interest earned

On sum invested

Eligible for rebate upto a maximum of Rs60,000 under Sec. 88

On interest received

Upto Rs12,000 under Sec. 80L. Interest accrued qualifies for rebate under Sec.88

Liquidity Premature Withdrawal

After end of 4 years

Loan against investment

Can be pledged with banks for loan

Transferability

Not allowed

65/90

Fixed Income Instruments in India c) POST OFFICE MONTHLY INVESTMENT SCHEMES Terms of Investments Interest payable monthly, 10% bonus on maturity

Annual rate of Interest

9.50%

Periodicity of interest payment

Monthly

Effective annual yield

9.92%

Maturity period

6 years

Minimum Investment Amount

Rs6,000

Maximum Investment Amount

Rs3,00,000 (single account), Rs6,00,000 (joint account)

Investment in multiples of

Rs6,000

66/90

Fixed Income Instruments in India

Availability Eligibility

Individuals

Available at

All head post offices and selected sub-post offices

Tax Benefits I.T. section applicable

Eligible under Sec. 80L for interest earned

On sum invested

No benefits

On interest received

Upto Rs12,000 under Sec. 80L

Liquidity Premature Withdrawal

After 1 year at 5% discount, after 3 years no discount for withdrawal

Loan against investment

Not available

Transferability

Not allowed

67/90

Fixed Income Instruments in India d) POST OFFICE RECURRING DEPOSITS SCHEME Terms of Investment Recurring Deposit Scheme

Annual rate of Interest

11.50%

Periodicity of interest payment

Compounded quarterly

Effective annual yield

12.01%

Maturity period

5 years

Minimum Investment Amount

Rs10 per month

Maximum Investment Amount

No limit

Investment in multiples of

Rs5

68/90

Fixed Income Instruments in India

Availability Eligibility

Individuals, trusts, welfare and regiment funds

Available at

All head post offices and selected sub-post offices

Tax Benefits I.T. section applicable

Eligible under Sec. 80L for interest earned

On sum invested

No benefits

On interest received

Upto Rs12,000 under Sec. 80L.

Liquidity Premature Withdrawal

50% of the outstanding amount can be withdrawn after 1 year.

Loan against investment

Not available

Transferability

Not allowed, extension of scheme for another 5 years on a year-to-year basis

69/90

Fixed Income Instruments in India e) POST OFFICE SAVINGS SCHEME Terms of Investment Similar to a Bank Account, cheque facility available

Annual rate of Interest

4.5%

Periodicity of interest payment

Compounded annually

Effective annual yield

4.5% tax-free

Maturity period

Not applicable

Minimum Investment Amount

Rs20

Maximum Investment Amount

Rs50,000 for individuals, no limit for other investors

Investment in multiples of

Not applicable

70/90

Fixed Income Instruments in India

Availability Eligibility

All categories of investors

Available at

All head post offices and selected sub-post offices

Tax Benefits I.T. section applicable

None

On sum invested

No benefits

On interest received

Interest is totally tax-free

Liquidity Premature Withdrawal

Cheque facility available, cheques are accepted by scheduled banks

Loan against investment

Not available

Transferability

Not allowed

71/90

Fixed Income Instruments in India f) POST OFFICE TIME DEPOSITS SCHEME Terms of Investment Similar to a Fixed Deposit Scheme

Annual rate of Interest

9%, 10%, 11% 11.5% for maturity periods of 1,2,3 and 5 years respectively

Periodicity of interest Compounded quarterly payment

Effective annual yield

9.3%, 10.4%, 11.5% 12% for maturity periods of 1,2,3 and 5 years respectively

Maturity period

Depends on option (see annual rate of interest).Can vary between 1,2,3 and 5 years

Minimum Investment Amount

Rs50

Maximum Investment No limit Amount

Investment in multiples of

Rs50

72/90

Fixed Income Instruments in India

Availability Eligibility

Individuals, trusts, welfare and regiment funds

Available at

All head post offices and selected sub-post offices

Tax Benefits I.T. section applicable

Eligible under Sec. 80L for interest earned

On sum invested

No benefits

On interest received

Upto Rs12,000 under Sec.80L

Liquidity Premature Withdrawal

After 6 months, not eligible for interest for accounts closed within 1 year

Loan against investment

After 1 year

Transferability

Not allowed

73/90

Fixed Income Instruments in India

g) KISAN VIKAS PATRA Terms of Investment Money doubles in 6 & 1/2 years.

Annual rate of Interest

9.50%

Periodicity of interest payment

Compounded annually

Effective annual yield

9.50%

Maturity period

6 & 1/2 years

Minimum Investment Amount Rs100

Maximum Investment Amount

Investment in multiples of

No limit

Rs100/ Rs500/ Rs1,000/ Rs5,000/ Rs50,000

74/90

Fixed Income Instruments in India

Availability Eligibility

Individuals, and on behalf of minors, trusts

Available at

Post offices

Tax Benefits I.T. section applicable

None

On sum invested

None

On interest received

None

Liquidity Premature Withdrawal

Not Available

Loan against investment

Not available

Transferability

Not available

75/90

Fixed Income Instruments in India h) RBI RELIEF BOND Terms of Investment Tax-free interest. Issued as promissory notes.Regular and cumulative schemes

Annual rate of Interest

8.50%

Periodicity of interest Compounded semi-annually for cumulative payment schemes, otherwise interest paid annually

Effective annual yield 8.50% for cumulative schemes

Maturity period

5 years

Minimum Investment Amount

Rs10,000

Maximum Investment No limit Amount

Investment in multiples of

Rs1,000

76/90

Fixed Income Instruments in India Availability Eligibility

Individuals, and on behalf of minors, HUF, NRIs

Available at

Agents/ brokers affiliated to government/ RBI

Tax Benefits I.T. section applicable

None

On sum invested

None

On interest received

Totally exempt from tax

Liquidity Premature Withdrawal

After 2 1/2 years, lower interest on premature withdrawal

Loan against investment

Not available

Transferability

For promissory notes - by endorsement and transfer; for stock certificate - by transfer instrument with registration

77/90

Fixed Income Instruments in India i) DEPOSIT SCHEME FOR RETIRING EMPLOYEES OF PSUs Terms of Investment Interest on amounts invested within three months of retirement is totally exempt from tax. Similar in nature to fixed deposit schemes

Annual rate of Interest

9.00%

Periodicity of interest payment

Compounded semi-annually

Effective annual yield

9.20%

Maturity period

3 years

Minimum Investment Amount

Rs1,000

Maximum Investment Amount

Total retirement benefit

Investment in multiples of

Rs1,000

78/90

Fixed Income Instruments in India Availability Eligibility

Individuals retiring from service with PSUs

Available at

SBI branches & subsidiaries, selected nationalised branches, selected sub-post offices

Tax Benefits I.T. section applicable

None

On sum invested

None

On interest received

Totally exempt from tax

Liquidity Premature Withdrawal

After 1 year but before 3 years with only one withdrawal per year. Interest rate will be lower at 4% p.a. against 9% from date of deposit to withdrawal.

Loan against investment

Not available

Transferability

Not allowed

79/90

Fixed Income Instruments in India j) DEPOSIT SCHEME FOR RETIRING GOVERNMENT EMPLOYEES -89 Terms of Investment Interest on amounts invested within three months of retirement is totally exempt from tax.

Annual rate of Interest

9.0%

Periodicity of interest payment

Compounded semi-annually

Effective annual yield

9.2%

Maturity period

3 years

Minimum Investment Amount

Rs1,000

Maximum Investment Amount

Total retirement benefit

Investment in multiples of

Rs1,000

80/90

Fixed Income Instruments in India Availability Eligibility

Individuals retiring from service with central/ state government offices

Available at

SBI branches & subsidiaries, selected nationalised branches, selected sub-post offices

Tax Benefits I.T. section applicable

None

On sum invested

None

On interest received

Totally exempt from tax

Liquidity Premature Withdrawal

After 1 year but before 3 years with only one withdrawal per year. Interest rate will be lower at 4% p.a. against 9% from date of deposit to withdrawal.

Loan against investment

Not available

Transferability

Not allowed

81/90

Fixed Income Instruments in India

20) OTHER IMPORTANT INFORMATION:  The bond market is dominated by government bonds. Government bond issuances, resulting from persistently high fiscal deficits, as well as specific regulatory requirements, have underpinned the supply and demand conditions in India’s debt capital markets. Nearly 90% of total domestic bonds outstanding are government issuances (i.e. Treasury bills, notes and bonds), squeezing out corporate and other marketable debt securities (see chart).

Government issuance leads the local bond market Domestic bonds outstanding, % of total

68%

Government bonds Treasury bills State loans PSU bonds Corporate bonds 4%

3%

6%

4% 15%

Others

As of March 2006. PSU = Public Sector Undertaking Source: National Stock Exchange

 PSU bonds by far outweigh the size of private corporate bonds (see chart below), reflecting a number of factors, foremost of which are the lists of regulatory requirements for private issues. Regulatory oversight of the segment falls under the purview of the Securities and Exchange Board of India (SEBI).

82/90

Fixed Income Instruments in India

Private corporate bonds outweighed by PSU bonds Distribution of issuance, % 120 100 80

Private corporate bonds

60

PSU bonds

40 20 0 2004

2005

2006

As of end- March of the year. Source: National Stock Exchange

 Government bond issuances rule the roost The government bond segment is the oldest and largest component of the debt market. Its size has taken off exponentially over the past decades, with the total stock of debt outstanding at roughly USD 280 bn as of June 2006 4, increasing three and a half times since 1995. This translates to roughly 35% of GDP, in line with several large Asian economies and is not significantly lower than that of the United States (see chart below).

83/90

Fixed Income Instruments in India A siz eable governm ent bond m arket % of GD P 50 45 40 35 30 25 20 15 10 5 0

2001 2005

T h ailan d

C h in a

So u th Ko r e a

In d ia

M alays ia

USA

Source: BIS

 Corporate bond market: A huge potential awaits In contrast to the government bond market, the size of the corporate bond market (i.e. corporate issuers plus financial institutions) remains very shallow (see chart below), amounting to just USD 16.8 bn10, or less than 2% of GDP at the end of June 2006. A well-developed corporate bond market would give companies greater flexibility to define their optimum capital structure. By the same token, investors would benefit from having a wider range of asset classes to diversify their fixed income investments. C o r p o r a te b o n d m a r k e t h a s y e t to d e v e lo p % of G DP 50 45 40 35 30 25 20 15 10 5 0

2001 2005

In d ia

C h in a

T h a ila n d

US A

Source: BIS

84/90

So u th Ko r e a

M a la y s ia

Fixed Income Instruments in India 21.) REVIEW OF INVESTMENT OPTIONS: PRODUCTS

RETURN

LIQUIDITY

RISK

EQUITY

HIGH

HIGH

HIGH

Co. DEBENTURES

MODERATE

LOW

MODERATE

Co. FDs

MODERATE

LOW

HIGH

BANK DEPOSITS

LOW

HIGH

LOW

PPF

MODERATE

MODERATE

LOW

LIFE INSURANCE

LOW

LOW

LOW

MUTUAL FUNDS

HIGH

HIGH

LOW

RBI BONDS

MODERATE

LOW

LOW

GOVT. SECURITIES

MODERATE

MODERATE

LOW

GUILT FUNDS

MODERATE

HIGH

MODERATE

RBI REFLIEF BOND

HIGH

LOW

LOW

22.) LIQUIDITY Vs RETURNS: LOW Bank deposits

MODERATE Guilt funds

HIGH Equity, mutual fund

PPF, Govt. Securities

Life Insurance

RBI bond, Co. FDs, Co. debentures

85/90

HIGH

MODERATE SSI, RBI relief bond

LOW

Fixed Income Instruments in India LIQUIDITY AND RETURNS: (suggestions)  Low liquidity, Low returns This investment option is suitable for those who do not want to take risk and are satisfied with low returns and bank deposits are the good example of such type of funds.  Low liquidity, Moderate returns An investor with this objective can invest in RBI Bonds, Co. FDs or Co. debentures where he could expect moderate returns and low liquidity. Here RBI bonds are low risky as compared to Company fixed deposits and Co. debentures.  Moderate liquidity, Moderate returns Those investors who want moderate liquidity and moderate returns PPF and Government securities are the good options. These investments are with minimum locking period with impressive returns.  High liquidity, High returns – (equity, mutual fund) Growth equity and mutual funds schemes are the best options for the investors with a high liquidity appetite along with a high return. These investment options are highly attractive and fast money making machines.

23.) RISK AND RETURNS: Risk and return are two inseparable parts of an investment strategy. They have a direct relation with each other. Higher the risks higher are the returns and vice versa. The very basic considerations of an investor while investing his money are how to maximize one's returns? What will he get? and what are the risks involved in investing in a particular investment.

RISK VS RETURNS: -

86/90

Fixed Income Instruments in India LOW MODERATE HIGH

Bank deposits, Life insurance

Co. Fixed deposits

Equity, RBI relief bonds

HIGH

Co. debentures, Guilt funds

Real estate

MODERATE

PPF, RBI bonds, Govt. Securities

Mutual funds

LOW

Graphical representation of risk and return of different investment options:

Source: wealth creation guide 87/90

Fixed Income Instruments in India

RISK AND RETURNS (suggestions):  Low risk, Low returns (Short investment horizon) With this investment objective the investor has the option of short-term Bank deposits for 1-6 months where he could expect returns of 6%-8% p.a. depending on the tenure.  Low risk, Moderate returns (Investment horizon of at least 1 year) An investor with this objective can invest in Company/NBFC deposits, which are `AAA' rated. This will fetch him returns of around 9% p.a. with moderate liquidity e.g. HDFC Ltd. Kotak Mahindra Ltd. and ICICI Home Finance. However, after factoring in tax implications, the actual return on these deposits comes down to less than 8% p.a. The other option is government securities i.e. guilts returns of over 8-9% p.a. along with high safety and liquidity. However these have limited tax benefits, as the interest is taxable subject to Rs 3,000 tax benefit u/s 80L. The other option is Relief Bonds which gives 8.5% p.a. tax-free returns with maximum safety (it is backed by the Government of India). However the liquidity is very low as the investment is locked for 5 years.  Moderate risk, Moderate Returns (Investment horizon of 1 year) An investor with this objective can opt for Company deposits with moderate safety i.e. `AA' rated that will fetch him over 10% p.a. returns e.g. Dewan Housing and Berger Paints. However these investments are not liquid. The other option is the Income and gilt funds, which can give returns of over 10% p.a. and also offer tax benefits, as the dividends from mutual funds are tax free in the hands of the investor. Both income and gilt funds have very high liquidity. However these funds can be very volatile in short term.  High risk, High returns (Long term investment) Growth (equity) Before you actually make a call on where to put your money, it is imperative that you define your objectives in terms of risk appetite, tenure and expected returns. A good investment plan would tend to be diversified in all these aspects.

88/90

Fixed Income Instruments in India

LIMITAIONS OF STUDY  ‘Fixed income instruments’ is a very wide topic in itself and time period was not sufficient to understand terms and conditions of such a wide verity of instruments available in India. This report is based on the limited information gathered on fixed income instruments.  Risk factor is crucial part of any investment decision of the investor but this report doesn’t speak in terms of value of risk in different instruments that are available.  Charts of risk, returns and liquidity are made on the basis of the outcomes of the information gathered.  Lack of availability of resources (Books, journals, etc.) about present Indian market scenario in library.

89/90

Fixed Income Instruments in India

References: The data was collected from the following sources: 1. College library (IMM) 2. Ankit Jain finance manager (G-Cube solutions) 3. Economic Times 4. Business Standards 5. Business World 6. Financial Economics (journal) 7. Wealth creation guide 8. Websites & Links a) www.nse-india.com b) www.bseindia.com c) www.moneycotrol.com d) www.valueresearchonline.com e) www.rbi.org.in f) www.helplinelaw.com g) www.amfiindia.com h) www.webindia123.com/finance i) www.personalfn.com j) www.thehindubusinessline.com k) www.economictimes.com l) www.crisil.com

90/90