Money Market And Its Instruments

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ASSIGNMENT INDIAN FINANCIAL SYSTEM  Money Market And Its Instruments 

Fixed Income Securities – “In Fixed Income Securities Income varies inversely with purchase price… Why???”

Submitted to:-

Submitted by:-

Dr. KP Ramakrishnan

Vidhu Jain Section F12 Roll No 83

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Money Market and its Instruments Money Market: Money market means market where money or its equivalent can be traded. Money is synonym of liquidity. Money market consists of financial institutions and dealers in money or credit who wish to generate liquidity. It is better known as a place where large institutions and government manage their short term cash needs. For generation of liquidity, short term borrowing and lending is done by these financial institutions and dealers. Money Market is part of financial market where instruments with high liquidity and very short term maturities are traded. Due to highly liquid nature of securities and their short term maturities, money market is treated as a safe place. Hence, money market is a market where short term obligations such as treasury bills, commercial papers and bankers acceptances are bought and sold. Benefits and functions of Money Market: Money markets exist to facilitate efficient transfer of short-term funds between holders and borrowers of cash assets. o For the lender/investor, it provides a good return on their funds. o For the borrower, it enables rapid and relatively inexpensive acquisition of cash to cover short-term liabilities. One of the primary functions of money market is to provide focal point for RBI’s intervention for influencing liquidity and general levels of interest rates in the economy. RBI being the main constituent in the money market aims at ensuring that liquidity and short term interest rates are consistent with the monetary policy objectives.

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Money Market & Capital Market: Money Market is a place for short term lending and borrowing, typically within a year. It deals in short term debt financing and investments. On the other hand, Capital Market refers to stock market, which refers to trading in shares and bonds of companies on recognized stock exchanges. Individual players cannot invest in money market as the value of investments is large, on the other hand, in capital market, anybody can make investments through a broker. Stock Market is associated with high risk and high return as against money market which is more secure. Further, in case of money market, deals are transacted on phone or through electronic systems as against capital market where trading is through recognized stock exchanges. Money Market Futures and Options: Active trading in money market futures and options occurs on number of commodity exchanges. They function in the similar manner like any other futures and options. Money Market Instruments: Money market instruments are generally characterized by a high degree of safety of principal and are most commonly issued in units of $1 million or more. Maturities range from one day to one year; the most common are three months or less. Active secondary markets for most of the instruments allow them to be sold prior to maturity. Unlike organized securities or commodities exchanges, the money market has no specific location. Available from financial institutions, money markets give the smaller investor the opportunity to get in on treasury securities. The institution buys a variety of treasury securities with the money you invest. The rate of return changes daily, and services such as check writing may be offered. The major

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participants in the money market are commercial banks, governments, corporations, government-sponsored enterprises, money market mutual funds; futures market exchanges, brokers and dealers. Investment in money market

is

done

through

money

market

instruments.

Money

market

instrument meets short term requirements of the borrowers and provides liquidity to the lenders. Common Money Market Instruments are as follows: 1. Treasury Bills 2. Repurchase Agreements (Repo/Reverse Repo) 3. Commercial paper 4. Certificate of Deposits 5. Bankers Acceptance

6. Eurodollar

•

Treasury Bills (T--Bills): Treasury Bills, one of the safest money market instruments, are short term borrowing instruments of the Central Government of the Country issued through the Central Bank (RBI in India). These are issued by the Reserve Bank usually a period of 91 days. The Reserve Bank uses these bills to take money out of the market. This will reduce a banks ability to lend to its clients leading to a contraction of the money supply. The bill consists of an obligation to pay the bearer the face value of the bill upon a given date. A bank buying such a bill will not pay face value for it but would instead buy it at a discount. The bill is tradable so the purchaser does not have to hold it until the due date. If interest rates decrease during the term of the bill, the holder can sell the bill at a profit before the due date. They are zero risk instruments, and hence the returns are not so attractive. It is available both in primary market as well as secondary market. It is a promise to pay a said sum after a specified period. T-bills are

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short-term securities that mature in one year or less from their issue date. They are issued with three-month, six-month and one-year maturity periods. The Central Government issues T- Bills at a price less than their face value (par value). They are issued with a promise to pay full face value on maturity. So, when the T-Bills mature, the government pays the holder its face value. The difference between the purchase price and the maturity value is the interest income earned by the purchaser of the instrument. T-Bills are issued through a bidding process at auctions. The bid can be prepared either competitively or non-competitively. In the second type of bidding, return required is not specified and the one determined at the auction is received on maturity. Whereas, in case of competitive bidding, the return required on maturity is specified in the bid. In case the return specified is too high then the T-Bill might not be issued to the bidder. At present, the Government of India issues three types of treasury bills through auctions, namely, 91-day, 182-day and 364-day. There are no treasury bills issued by State Governments. Treasury bills are available for a minimum amount of Rs.25K and in its multiples. While 91-day T-bills are auctioned every week on Wednesdays, 182-day and 364-day Tbills are auctioned every alternate week on Wednesdays. The Reserve Bank of India issues a quarterly calendar of T-bill auctions which is available at the Banks’ website. It also announces the exact dates of auction, the amount to be auctioned and payment dates by issuing press releases prior to every auction. Payment by allottees at the auction is required to be made by debit to their/ custodian’s current account. T-bills auctions are held on the Negotiated Dealing System (NDS) and the members electronically submit their bids on the system. NDS is an electronic platform for facilitating dealing in Government Securities

and

Money

Market

Instruments.

RBI

issues

these

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instruments to absorb liquidity from the market by contracting the money supply. In banking terms, this is called Reverse Repurchase (Reverse Repo). On the other hand, when RBI purchases back these instruments at a specified date mentioned at the time of transaction, liquidity is infused in the market. This is called Repo (Repurchase) transaction.

•

Repurchase Agreements : Repurchase transactions, called Repo or Reverse Repo are transactions or short term loans in which two parties agree to sell and repurchase the same security. They are usually used for overnight borrowing. Repo/Reverse Repo transactions can be done only between the parties approved by RBI and in RBI approved securities viz. GOI and State Govt. Securities, T-Bills, PSU Bonds, FI Bonds, Corporate Bonds etc. Under repurchase agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and price. A repo agreement is the sale of a security with commitment to repurchase the same security as a specified price and on specified date while a reverse repo is purchase of security with a commitment to sell at predetermined price and date. A repo transaction for party would mean reverse repo for the second party. In lieu of the loan, the borrower pays a contracted rate to the lender, which is called the repo rate. As against the call money market where the lending is totally unsecured, the lending in the repo is backed by a simultaneous transfer of securities. The main players in this market are all institutional players like banks, primary dealers like PNB Gilts Limited, financial institutions, mutual funds, insurance companies etc. allowed to operate a SGL with the Reserve Bank of India. Further RBI also operates daily repo/ reverse repo auctions to provide a benchmark rates in the markets as well as managing in the

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liquidity in the system. RBI sucks or injects liquidity in the banking system by daily repo/ reverse operations. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date at a predetermined price. Such a transaction is called a Repo when viewed from the perspective of the seller of the securities and Reverse Repo when viewed from the perspective of the buyer of the securities. Thus, whether a given agreement is termed as a Repo or Reverse Repo depends on which party initiated the transaction. The lender or buyer in a Repo is entitled to receive compensation for use of funds provided to the counterparty. Effectively the seller of the security borrows money for a period of time (Repo period) at a particular rate of interest mutually agreed with the buyer of the security who has lent the funds to the seller. The rate of interest agreed upon is called the Repo rate. The Repo rate is negotiated by the counterparties independently of the coupon rate or rates of the underlying securities and is influenced by overall money market conditions. •

Commercial Papers: Commercial paper is a low-cost alternative to bank loans. It is a short term unsecured promissory note issued by corporate and financial institutions at a discounted value on face value. They are usually issued with fixed maturity between one to 270 days and for financing of accounts receivables, inventories and meeting short term liabilities. Say, for example, a company has receivables of Rs 1 lacs with credit period 6 months. It will not be able to liquidate its receivables before 6 months. The company is in need of funds. It can issue commercial papers in form of unsecured promissory notes at discount of 10% on face value of Rs 1 lacs to be matured after 6 months. The company has strong credit rating and finds buyers easily. The company is able to liquidate its receivables immediately and the INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 2007-

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buyer is able to earn interest of Rs 10K over a period of 6 months. They yield higher returns as compared to T-Bills as they are less secure in comparison to these bills; however chances of default are almost negligible but are not zero risk instruments. Commercial paper being an instrument not backed by any collateral, only firms with high quality credit ratings will find buyers easily without offering any substantial discounts. They are issued by corporate to impart flexibility in raising working capital resources at market determined rates. Commercial Papers are actively traded in the secondary market since they are issued in the form of promissory notes and are freely transferable in demat form. CHARACTERISTICS OF COMMERCIAL PAPER: Securities offered to the public must be registered with the Securities and Exchange Commission according to the Securities Act of 1933. Registration requires extensive public disclosure, including issuing a prospectus on the offering. It is a time-consuming and expensive process. Most commercial paper is issued under Section 3(a)(3) of the 1933 Act which exempts from registration requirements short-term securities as long as they have certain characteristics. The exemption requirements have been a factor shaping the characteristics of the commercial paper market.

The following are requirements for

exemption: - The maturity of commercial paper must be less than 270 days. In practice, most commercial paper has a maturity of between 5 and 45 days, with 3035 days being the average maturity. Many issuers continuously roll over their commercial paper, financing a more-or-less constant amount of their assets using commercial paper. The nine-month maturity limit is not violated by INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 200709

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the continuous rollover of notes, as long as the rollover is not automatic but is at the discretion of the issuer and the dealer. Notes must be of a type not ordinarily purchased by the general public. In practice,

the

denomination

of

commercial

paper

is

large:

minimum

denominations are usually $100,000, although face amounts as low as $10,000 are available from some issuers.

Typical face amounts are in

multiples of $1 million, because most investors are institutions. Issuers will usually sell an investor the specific amount of commercial paper needed. That proceeds from commercial paper issues be used to finance "current transactions," which include the funding of operating expenses and the funding of current assets such as receivables and inventories. Proceeds cannot be used to finance fixed assets, such as plant and equipment, on a permanent basis. Firms are allowed to finance construction as long as the commercial paper financing is temporary and to be paid off shortly after completion of construction with long-term funding through a bond issue, bank loan, or internally generated cash flow. Commercial paper is typically a discount security (like Treasury bills): the investor purchases notes at less than face value and receives the face value at maturity. The difference between the purchase price and the face value, called the discount, is the interest received on the investment. Commercial paper is, occasionally, issued as an interest-bearing note (by request of investors). The investor pays the face value and, at maturity, receives the face value and accrued interest. All commercial paper interest rates are quoted on a discount basis. Until the 1980s, most commercial paper was issued in physical form in which the obligation of the issuer to pay the face amount at maturity is recorded by printed certificates that are issued to the investor in exchange for funds. INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 200709

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A safekeeping agent hired by the investor held the certificates, until presented for payment at maturity. On the day of maturity, the investor presents the notes and receives payment. Commercial banks, in their role as issuing, paying, and clearing agents, facilitate the settling of commercial paper by carrying out the exchanges between issuer, investor, and dealer required to transfer commercial paper for funds. An increasing amount of commercial paper is being issued in book-entry form whereby entries in computerized accounts are replacing the physical commercial paper certificates. Book-entry systems will eventually completely replace the physical printing and delivery of notes. The Depository Trust Company (DTC), a clearing cooperative operated by member banks, began plans in September 1990 to convert most commercial paper transactions to book-entry form. By May 1992, more than 40 percent of commercial paper was issued through the DTC in book-entry form. The advantages of a paperless system are significant. In the long run the fees and costs associated with the book-entry system will, be significantly less than under the physical delivery system. The expense of delivering and verifying certificates and the risks of messengers failing to deliver certificates on time will be eliminated. As all transactions between an issuing agent and a paying agent will be settled with a single end-of-day wire transaction, the problem of daylight overdrafts, which arise from non-synchronous issuing and redeeming of commercial paper will be reduced. •

Certificate of Deposit: It is a short term borrowing more like a bank term deposit account. It is a promissory note issued by a bank in form of a certificate entitling the bearer to receive interest. The certificate bears the maturity date, the fixed rate of interest and the value. It can be issued in any denomination. They are stamped and transferred by

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endorsement. Its term generally ranges from three months to five years and restricts the holders to withdraw funds on demand. However, on payment of certain penalty the money can be withdrawn on demand also. Money in a CD is tied up from a few months to six years or more depending on the terms of the specific CD you buy. A notice of withdrawal is required and a penalty imposed if you withdraw money before the CD matures. Interest earned is higher than paid on insured savings accounts. The longer you tie up money in a CD, the higher the interest rate earned. Interest is paid either at time of purchase or at maturity, depending on the policy of the financial institution. In most cases, the more money you invest, the higher the rate of interest earned. All earnings are subject to income tax. CD’s are available from banks, savings and loans and credit unions. No purchase fees are charged. The returns on certificate of deposits are higher than T-Bills because it assumes higher level of risk. While buying Certificate of Deposit, return method should be seen. Returns can be based on Annual Percentage Yield (APY) or Annual Percentage Rate (APR). In APY, interest earned is based on compounded interest calculation. However, in APR method, simple interest calculation is done to generate the return. Accordingly, if the interest is paid annually, equal return is generated by both APY and APR methods. However, if interest is paid more than once in a year, it is beneficial to opt APY over APR.

•

Banker’s Acceptance: It is a short term credit investment created by a non financial firm and guaranteed by a bank to make payment. It is simply a bill of exchange drawn by a person and accepted by a bank. It is a buyer’s promise to pay to the seller a certain specified amount at certain date. A banker’s acceptance is used for international trade

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as means of verifying payment. For instance, if an importer wants to import a product from a foreign country, he will often get a letter of credit from his bank and send it to the exporter. The letter of credit is a document issued by a bank that guarantees the payment of the importer’s draft for a specified amount and time. Thus, the exporter can rely on the bank’s credit rather than the importer’s. The exporter presents the shipping documents and the letter of credit to his domestic bank, which pays for the letter of credit at a discount, because the exporter’s bank won’t receive the money from the importer’s bank until later. The domestic bank then sends a time draft to the importer’s bank, which then stamps it “accepted” and, thus, converting the time draft into a banker’s acceptance. This negotiable instrument is backed by the importer’s promise to pay, the imported goods, and the bank’s guarantee of payment. The same is guaranteed by the banker of the buyer in exchange for a claim on the goods as collateral. The person drawing the bill must have a good credit rating otherwise the Banker’s Acceptance will not be tradable. The most common term for these instruments is 90 days. However, they can very from 30 days to180 days. For corporations, it acts as a negotiable time draft for financing imports, exports and other transactions in goods and is highly useful when the credit worthiness of the foreign trade party is unknown. The seller need not hold it until maturity and can sell off the same in secondary market at discount from the face value to liquidate its receivables.

•

Euro Dollars: The Eurodollars are basically dollar- denominated deposits that are held in banks outside the United States. Since the Eurodollar market is free from any stringent regulations, the banks can

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operate at narrower margins as compared to the banks in U.S. The Eurodollars are traded at very high denominations and mature before six months. The Eurodollar market is within the reach of large institutions only and individual investors can access it only through money market funds. Eurocurrency is a more general term that can refer to any currency that is deposited in banks whose domestic currency is different from the deposited currency, and it can involve any country, including the Far East and the Cayman Islands. Eurodollars or Eurocurrency does not necessarily involve either Europe or the Euro. Multi-national corporations deposit their domestic currency in foreign banks because they can often get better terms trading their currency with the locals than by exchanging domestic currency for foreign currency at a bank. The interest paid on these deposits is usually equal to the London Interbank Offer Rate (LIBOR), which is slightly higher than the yield for 3-month Treasuries.

•

Broker’s Loans and Call Loans: Broker’s loans are loans from commercial banks to brokers so that the broker’s customers can finance stock purchases. The broker uses the stocks, held in street name, for collateral for the loans.

Time notes are loans that must be paid by a specific date for a specified interest rate, with terms of 6 months or less. A demand note (aka call loan) is a loan that is payable on demand the next day at 1 day’s interest. If the note is not demanded, then the term is extended by another day, and so on, up to 90 days. The interest rate for each day varies with the prevailing interest rate. An individual player cannot invest in majority of the Money Market Instruments, hence for retail market, money market instruments are repackaged into Money Market Funds. A INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 200709

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money market fund is an investment fund that invests in low risk and low return bucket of securities viz money market instruments. It is like a mutual fund, except the fact mutual funds cater to capital market and money market funds cater to money market. Money Market funds can be categorized as taxable funds or non taxable funds. Having understood, two modes of investment in money market viz Direct Investment in Money Market Instruments & Investment in Money Market Funds, lets move forward to understand functioning of money market account. Money Market Account: It can be opened at any bank in the similar fashion as a savings account. However, it is less liquid as compared to regular savings account. It is a low risk account where the money parked by the investor is used by the bank for investing in money market instruments and interest is earned by the account holder for allowing bank to make such investment. Interest is usually compounded daily and paid monthly. There are two types of money market accounts: •

Money Market Transactional Account: By opening such type of account, the account holder can enter into transactions also besides investments, although the numbers of transactions are limited.

•

Money Market Investor Account: By opening such type of account, the account holder can only do the investments with no transactions.

Money Market Index: To decide how much and where to invest in money market an investor will refer to the Money Market Index. It provides

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information about the prevailing market rates. There are various methods of identifying Money Market Index like:

•

Smart Money Market Index- It is a composite index based on intraday price pattern of the money market instruments.

•

Salomon Smith Barney’s World Money Market Index- Money market instruments are evaluated in various world currencies and a weighted average is calculated. This helps in determining the index.

•

Banker’s Acceptance Rate- As discussed above, Banker’s Acceptance is a money market instrument. The prevailing market rate of this instrument i.e. the rate at which the banker’s acceptance is traded in secondary market, is also used as a money market index.

•

LIBOR/MIBOR- London Inter Bank Offered Rate/ Mumbai Inter Bank Offered Rate also serves as good money market index. This is the interest rate at which banks borrow funds from other banks.

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FIXED INCOME SECURITIES Fixed income security originally referred to instruments that pay a fixed rate of interest, usually fixed coupon rate. Fixed-income

securities

can

be

contrasted

with

variable

return

securities such as stocks. To understand the difference between stocks and bonds, you have to understand a company's motivation. A company wants to raise money, and it doesn't want to wait until it has earned enough through ongoing operations (selling products or providing services). In order for a company to grow as a business, it often must raise money; to finance an acquisition, buy equipment or land or invest in new product development. Investors will only give money to the company if they believe that they will be given something in return commensurate with the risk profile of the company. The company can either pledge a part of itself, by giving equity in the company (stock), or the company can give a promise to pay regular interest and repay principal on the loan (bond or bank loan) or (preferred stock). These days the definition of fixed income securities includes many debts instruments whose promised cash flows are far from fixed. People who invest in fixed-income securities are typically looking for a constant and secure return on their investment. For example, a retired person might like to receive a regular dependable payment to live on, but not consume principal. This person can buy a bond with their money, and use the coupon payment (the interest) as that regular dependable payment.

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When the bond matures or is refinanced, the person will have their money returned to them. Interest rates change over time, based on a variety of factors, particularly rates set by the Federal Reserve. For example, if a company wants to raise $1 million and not a lot of people in the market have free cash to lend, the company will have to offer a high rate of interest (coupon) to get people to buy their bond. If there are a lot of people in the market trying to get a return on their money, the company can offer a lower coupon.

Types of Fixed Income Securities •

A money market account is simply a bank account which offers the prevailing\ (and constantly changing) interest rate.

•

Zero coupon bonds do not pay any coupon, but only the principal at maturity. These are a form of short term debt. E.g. Treasury bills, commercial paper, Negotiable Certificates of Deposit (NCD’s)...

•

Consuls are fixed coupon bonds which mature at 1, i.e. they pay a fixed percentage of the principal at regular intervals for all time, but the principal is never repaid.

•

Annuities pay a constant amount at regular intervals. These constant payments thus include both the interest and part of the principal. The gradual payment of the principal is called amortization.

•

Floating rate notes (FRN’s) are bonds that pay a variable coupon at regular intervals. This variable coupon is generally linked to some market-observable reference rate

•

Structured notes are a class of debts instruments with more complex pay-off patterns, possibly tailored to an investor’s requirements. For example inverse floaters have coupon payments that vary inversely

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with a reference date: The coupon might be (15%¡LIBOR)+. Inverse floaters can be used to hedge against falling interest rates. •

Callable bonds can be called back by the issuer at fixed price on fixed dates. AB Corp. floats a 10-year 15%-fixed coupon bond. After 5 years, its cost of capital is in the region of 6%, but AB Corp. is still paying 15%. If the bond has a call feature built in, AB Corp. can call back the bond, and float a new issue with a 6% coupon instead.

•

Puttable bonds can be put back to the issuer at fixed prices on fixed dates. Investor X buys a 20-year 10%-fixed coupon bond from AArated AB Corp. After 10 years, this credit rating has migrated to B-. The bond has devalued substantially, but if it has a put feature built in, then investor X can sell the bond back to AB Corp. at a reasonable price.

•

Convertible bonds can be converted to equity at a predetermined conversion ratio on predetermined dates. A bond with a conversion ratio of 3 allows the bond to be converted to shares.

FIXED INCOME SECURITIES INCOME VARIES INVERSELY WITH PURCHASE PRICE AND VICEVERSA. WHY ?? Since the fixed income market is driven by interest rates (prices are inversely related to yields), those things which impact on rates directly influence prices.

The biggest driver of these rates, from a macro

perspective, is monetary policy, the decisions central banks make in regards to the level of domestic interest rates.

Since the central banks directly

control interest rates (at least short-term rates), they have a heavy influence over their level and direction. Other, less direct, influencers include: •

Government fiscal policy

•

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I n d i a n Fi n a n c i a l S y s t e m •

Employment

•

Inflation

•

Currency exchange rates and trade

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Obviously, when considering the likes of corporate debt, considerations related to that particular issuer come in to play. This includes things like earnings, total debt outstanding, interest cover ratios, and others. All of this, though, is also account for in the credit rating. Fixed income securities offer a predictable stream of payments by way of interest and repayment of principal at the maturity of the instrument. The debt securities are issued by the eligible entities against the moneys borrowed by them from the investors in these instruments. Therefore, most debt securities carry a fixed charge on the assets of the entity and generally enjoy a reasonable degree of safety by way of the security of the fixed and/or movable assets of the company. The investors benefit by investing in fixed income securities as they preserve and increase their invested capital and also ensure the receipt of regular interest income. The investors can even neutralise the default risk on their investments by investing in govt. securities, which are normally referred to as

risk-free

investments

due

to

the

sovereign

guarantee

on

these

instruments. The prices of debt securities display a lower average volatility as compared to the prices of other financial securities and ensure the greater safety of accompanying investments. Debt securities enable wide-based and efficient portfolio diversification and thus assist in portfolio risk-mitigation. Yield Curve INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 200709

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The yield curve is the graphic portrayal of yields over the array of maturities, from shortest to longest. An example is shown on the following chart.

Notice that the plot above depicts two lines.

The blue line is the more

standard, upwardly sloping yield curve in which the longer-maturities feature higher yields. The spread between the long maturity issues over the short maturity ones is positive. The pink line, shows an inverted, or negatively sloped curve. A negatively sloped curve is often considered an indication of a pending downturn in the economy as the higher return on short term money will tend to prevent longer-term investment. Most fixed income securities have a par value that pays a specific rate of interest on that value, or otherwise has a knowable rate of return; hence the term fixed income security. In the most general sense, risk is the possibility of something undesirable. Since the goal of investing is to get the greatest return possible for the investment, investment risk is the possibility that the investor will get back INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 200709

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less than his investment or his expected return, or that he will get less than he could have had if he had invested his money elsewhere—what economists call opportunity costs. These risks associated with fixed income securities, however, are usually small compared to stocks, options, and other derivatives, which is why many people invest in them. It is not possible to lose more than your investment in fixed income securities, as you can buying stocks on margin, for instance, because it makes no sense to borrow money to pay for fixed income securities, since the interest rate that you would be paying would almost certainly be more than you could earn. And it is not likely that you will lose your initial investment because bondholders have priority over owners if the company goes bankrupt and usually receive periodic payments of interest, and many issuers of bonds are governments or their agencies, which have taxing power. And because the United States government not only has taxing power, but can print money, investments such as U.S. Treasuries, are virtually risk-free, at least in regards to principal and interest payments. Many of the risks in fixed income securities apply to other investments as well. Inflation risk, for instance, affects every investment. Not all risks apply to every fixed income security. In fact, many risks have an inverse relationship—when one goes up, the other goes down, which is best represented pictographically by a seesaw. Generally, the most important risk for fixed income securities is market risk or interest rate risk, because interest rates change continually, and this risk affects virtually every security. Fixed Income Yields and security prices generally change much more slowly than Stock Market prices and it can actually takes years for interest rates to move in either direction by a few points. At the same time, a trend in interest movements is likely to last longer than a trend in stock prices. There INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 200709

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is abundantly more economics than there is emotion involved with interest rates movements, creating a more stable playing field for the individual investor. Income Investing should be much easier than it is, and should rarely produce an anxious moment. If you are thinking long term, as you should be in this area, the rules become simple and few: •

RULE ONE is to always seek out the longest duration, Investment Grade Only, securities with the highest (reasonable) yields.

•

So long as you follow RULE ONE, RULE TWO is to focus on the Cost Basis of your Fixed Income Securities and ignore their Market Value fluctuations.

•

RULE THREE is to stay focused on the income generated by these securities, and to make decisions that grow that income annually.

All Interest Rate Sensitive Securities are Created Equal. This means that if your bonds are up or down in price, so are everyone else's. If your fund is down, Johnny's fund couldn't do better unless there are significant Quality or Duration differences involved. Therefore, don't ever switch from one Fixed Income Security to another for emotional (fear or greed) or other similarly superficial reasons. •

Investors should almost never switch from one fixed income fund to another, OR even worse, take losses on fixed income to move into something else entirely, typically a peaking Equity Market.

•

Another basic rule is to avoid yields that are a great deal higher than normal. Caveat Emptor! In one sense, Fixed Income Investing and Equity Investing are identical...Junk is Junk.

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To be a successful Fixed Income Investor you must get to the point where you understand that: •

Higher Interest Rates are a Good Thing, and

•

So, too, are Lower Interest Rates.

Fixed income refers to any type of investment that yields a regular (or fixed) return. For example, if you lend money to a borrower and the borrower has to pay interest once a month, you have been issued a fixed-income security. When a company does this, it is often called a bond or corporate bank debt (although “preferred stock” is also sometimes considered to be fixed income). Sometimes people misspeak when they talk about fixed income. Bonds actually have higher risk, while notes and bills have less risk because these are issued by government agencies. The term fixed income is also applied to a person's income that does not vary with each period. This can include income derived from fixed-income investments such as bonds and preferred stock or pension that guarantee a fixed income. When pensioners or retirees are dependent on their pension as their dominant source of income, the term "fixed income" can also carry the implication that they have relatively limited discretionary income or have little financial freedom to make large expenditures. Fixed-income securities can be contrasted with variable return securities such as stocks. To understand the difference between stocks and bonds, you have to understand a company's motivation. A company wants to raise money, and it doesn't want to wait until it has earned enough through ongoing operations (selling products or providing services). In order for a company to grow as a business, it often must raise money; to finance an INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 200709

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acquisition, buy equipment or land or invest in new product development. Investors will only give money to the company if they believe that they will be given something in return commensurate with the risk profile of the company. The company can either pledge a part of itself, by giving equity in the company (stock), or the company can give a promise to pay regular interest and repay principal on the loan (bond or bank loan) or (preferred stock). While a bond is simply a promise to pay interest on borrowed money, there is some important terminology used by the fixed-income industry: •

The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and pays the interest.

•

The principal (of a bond) is the amount that the issuer borrows.

•

The coupon (of a bond) is the interest that the issuer must pay.

•

The maturity is the end of the bond, the date that the issuer must return the principal.

•

The issue is another term for the bond itself.

•

The indenture is the contract that states all of the terms of the bond.

People who invest in fixed-income securities are typically looking for a constant and secure return on their investment. For example, a retired person might like to receive a regular dependable payment to live on, but not consume principal. This person can buy a bond with their money, and use the coupon payment (the interest) as that regular dependable payment. When the bond matures or is refinanced, the person will have their money returned to them. Interest rates change over time, based on a variety of factors, particularly rates set by the Federal Reserve. For example, if a company wants to raise $1 million and not a lot of people in the market have free cash to lend, the INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 200709

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company will have to offer a high rate of interest (coupon) to get people to buy their bond. If there are a lot of people in the market trying to get a return on their money, the company can offer a lower coupon. To complicate matters further, fixed income securities are actually traded on the open market, just like stocks. To understand this, first realize that bonds are usually created in round face values, for example $100,000. If the current yield (interest rate) of newly issued similar bonds is 6% per year, and you are buying a bond with a coupon rate below 6%, then you can get the bond at a discount (below face value of $100,000), which brings your rate of return on that bond to 6%. Similarly, if the coupon rate of the bond you are buying is greater than 6% you will have to pay a premium for the bond to bring the rate of return down to 6%. There are also index-linked, fixed-income securities. The most common and an example of the highest rated variety of this kind could include Treasury Inflation Protected Securities (TIPS). This type of fixed income is adjusted to the Consumer Price Index for all urban consumers (CPI-U), and then a real yield is applied to the adjusted principal. This means that the US Treasury issues fixed income that is backed by the full faith and credit of the US government to outperform the CPI (e.g. to outperform the inflation rate). This allows investors of all sizes to not lose the purchasing power of their money due to inflation, which can be very uncertain at times. For example, assuming 3.88% inflation over the course of 1 year (just about the 56 year average inflation rate, through most of 2006), and a real yield of 2.61% (the fixed US Treasury real yield on October 19, 2006, for a 5 yr TIPS), the adjusted principal of the fixed income would rise from 100 to 103.88 and then the real yield would be applied to the adjusted principal, meaning 103.88 x 1.0261, which equals 106.5913; giving a total return of 6.5913%. TIPS moderately outperform conventional US Treasuries, which yield just INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 200709

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5.05% for a 1 yr bill on October 19, 2006. By investing in such fixed income, index linked fixed income securities; consumers can exceed the pace of inflation, and gain value in real terms. All fixed income securities from any entity have risks including but not limited to: •

inflationary risk

•

interest rate risk

•

currency risk

•

default risk

•

repayment of principal risk

•

reinvestment risk

•

liquidity risk

•

maturity risk

•

streaming income payment risk

•

duration risk

•

convexity risk

•

credit quality risk

•

political risk

•

tax adjustment risk

•

market risk

•

climate risk

Fixed income securities offer a predictable stream of payments by way of interest and repayment of principal at the maturity of the instrument. The debt securities are issued by the eligible entities against the moneys borrowed by them from the investors in these instruments. Therefore, most debt securities carry a fixed charge on the assets of the entity and generally

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enjoy a reasonable degree of safety by way of the security of the fixed and/or movable assets of the company. •

The investors benefit by investing in fixed income securities as they preserve and increase their invested capital and also ensure the receipt of regular interest income.

•

The investors can even neutralize the default risk on their investments by investing in govt. securities, which are normally referred to as riskfree investments due to the sovereign guarantee on these instruments.

•

The prices of debt securities display a lower average volatility as compared to the prices of other financial securities and ensure the greater safety of accompanying investments.

•

Debt securities enable wide-based and efficient portfolio diversification and thus assist in portfolio risk-mitigation.

Fixed-income securities can be an excellent way to diversify your portfolio. They are also crucial for your tax planning. Fixed-income securities represent the debt of domestic financial institutions, companies, banks, and government issues. In essence, when you buy a fixed-income security, you are lending money to the issuer for a specified period of time. In return, you expect the issuer to make regular interest payments (annually, semi-annually, quarterly, or monthly) and to pay back the face amount on the maturity date (the end of the specified period for the loan). Fixed-income instruments in India typically include company bonds, fixed deposits and government schemes. 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. INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 200709

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Most fixed-income securities offer a relatively stable and predictable income flow. The amount of interest the issuer has agreed to pay, the coupon rate, is set at issuance and remains the same until maturity: hence, the term "fixed income." The different fixed-income vehicles in the market allow you to choose from a range of credit ratings and maturities. Fixed-income securities provide the flexibility to structure a portfolio tailored to your specific investment objectives and tolerance for risk. •

Most fixed-income securities offer a relatively safe and predictable income flow.

•

The coupon (the amount of interest the issuer has agreed to pay) is set at issuance and remains the same until maturity; thus, the term "fixed-income."

•

The different fixed-income vehicles in the market allow you to choose from a range of credit ratings and maturities (generally one day to 30 years, with some as long as 100 years). This diversity helps improve your management of risk.

•

Fixed-income securities provide the flexibility and liquidity needed to structure a portfolio tailored to your specific investment objective.

Securities are financial instruments that represent some value. A Debt or Fixed Income Security represents a creditor relationship with a corporation, government, bank, etc. Generally debt instruments represent agreements to receive certain cash flows depending on the terms contained within the agreement. Fixed-income securities are investments where the cash flows are according to a predetermined amount of interest, paid on a fixed schedule. The different types of fixed income securities include government securities, corporate bonds, debentures, etc. A brief detail about some of these

investment

options

are

given

below.

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Government Securities- Government Securities are issued by the Reserve Bank of India on behalf of the Government of India. Normally the dated Government Securities have a period of 1 year to 30 years. These are sovereign instruments generally bearing a fixed interest rate with interests payable semi-annually and principal as per schedule. Government Securities provide risk free return to investors. Corporate

Bonds-

Corporate

Bonds

are

issued

by

public

sector

undertakings and private corporations for a wide range of tenors normally up to 15 years although some corporate have also issued perpetual bonds. Compared to government bonds, corporate bonds generally have a higher risk of default. This risk depends, of course, upon the particular corporation issuing the bond, the current market conditions, the industry in which it is operating and the rating of the company. Corporate bond holders are compensated for this risk by receiving a higher yield than government bonds. Debentures – Debentures are instruments for raising loan by a Company. They evidence an acknowledgement of debt with an obligation to repay the sum specified along with interest as specified. They are subject to provisions of the Companies Act, 1956 and sections 117 to 123 relating to issue, appointment of debenture trustees, creation of Debenture Redemption Reserve Account, etc., specifically apply to them. As per section 125(4) of the Companies Act, registration of charge for purpose of issue of debentures is mandatory. Debentures form a part of the Company’s capital structure but not a part of the share capital.

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