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logo   FIXED INCOME INSTRUMENTS
   
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  Traditionally when a borrower takes a loan from a lender, he enters into an agreement with the lender specifying when he would repay the loan and what return (interest) he would provide the lender for providing the loan. This entire structure can be converted into a form wherein the loan can be made tradable by converting it into smaller units with pro rata allocation of interest and principal. This tradable form of the loan is termed as a debt instrument.
  Therefore, debt instruments are basically obligations undertaken by the issuer of the instrument as regards certain future cash flows representing interest and principal, which the issuer would pay to the legal owner of the instrument. Debt instruments are of various types. The key terms that distinguish one debt instrument from another are as follows:
 
  • Issuer of the instrument
  • Face value of the instrument
  • Interest rate
  • Repayment terms (and therefore maturity period/tenor)
  • Security or collateral provided by the issuer
  Different kinds of debt instruments and their key terms and characteristics are discussed below.
   
  Money market instruments:
  By convention, the term "money market" refers to the market for short-term requirement and deployment of funds. Money market instruments are those instruments, which have a maturity period of less than one year. The most active part of the money market is the market for overnight and term money between banks and institutions (called call money) and the market for repo transactions. The former is in the form of loans and the latter are sale and buy back agreements - both are obviously not traded. The main traded instruments are commercial papers (CPs), certificates of deposit (CDs) and treasury bills (T-Bills). All of these are discounted instruments ie they are issued at a discount to their maturity value and the difference between the issuing price and the maturity/face value is the implicit interest. These are also completely unsecured instruments. One of the important features of money market instruments is their high liquidity and tradability. A key reason for this is that these instruments are transferred by endorsement and delivery and there is no stamp duty or any other transfer fee levied when the instrument changes hands. Another important feature is that there is no tax deducted at source from the interest component. A brief description of these instruments is as follows:
   
  Commercial Paper (CP):
  These are issued by corporate entities in denominations of Rs.2.5mn and usually have a maturity of 90 days. CPs can also be issued for maturity periods of 180 and one year but the most active market is for 90 day CPs.
  Two key regulations govern the issuance of CPs-firstly, CPs have to be compulsorily rated by a recognized credit rating agency and only those companies can issue CPs which have a short term rating of at least P1. Secondly, funds raised through CPs do not represent fresh borrowings for the corporate issuer but merely substitute a part of the banking limits available to it. Hence, a company issues CPs almost always to save on interest costs ie it will issue CPs only when the environment is such that CP issuance will be at rates lower than the rate at which it borrows money from its banking consortium.
   
  Certificates of Deposit (CD):
  These are issued by banks in denominations of Rs0.5mn and have maturity ranging from 30 days to 3 years. Banks are allowed to issue CDs with a maturity of less than one year while financial institutions are allowed to issue CDs with a maturity of at least one year. Usually, this means 366 day CDs. The market is most active for the one year maturity bracket, while longer dated securities are not much in demand. One of the main reasons for an active market in CDs is that their issuance does not attract reserve requirements since they are obligations issued by a bank.
   
  Treasury Bills (T-Bills):
  These are issued by the Reserve Bank of India on behalf of the Government of India and are thus actually a class of Government Securities. At present, T-Bills are issued in maturity of 14 days, 91 days and 364 days. The RBI has announced its intention to start issuing 182 day T-Bills shortly. The minimum denomination can be as low as Rs.100, but in practice most of the bids are large bids from institutional investors who are allotted T-Bills in dematerialized form. RBI holds auctions for 14 and 364 day T-Bills on a fortnightly basis and for 91 day T-Bills on a weekly basis. There is a notified value of bills available for the auction of 91 day T-Bills which is announced 2 days prior to the auction. There is no specified amount for the auction of 14 and 364 day T-Bills. The result is that at any given point of time, it is possible to buy T-Bills to tailor one's investment requirements.
  Potential investors have to put in competitive bids at the specified times. These bids are on a price/interest rate basis. The auction is conducted on a French auction basis ie all bidders above the cut off at the interest rate/price which they bid while the bidders at the clearing/cut off price/rate get pro rata allotment at the cut off price/rate. The cut off is determined by the RBI depending on the amount being auctioned, the bidding pattern etc. By and large, the cut off is market determined although sometimes the RBI utilizes its discretion and decides on a cut off level which results in a partially successful auction with the balance amount devolving on it. This is done by the RBI to check undue volatility in the interest rates.
  Non-competitive bids are also allowed in auctions (only from specified entities like State Governments and their undertakings and statutory bodies) wherein the bidder is allotted T-Bills at the cut off price.
  Apart from the above money market instruments, certain other short-term instruments are also in vogue with investors. These include short-term corporate debentures, Bills of exchange and promissory notes.
  Like CPs, short-term debentures are issued by corporate entities. However, unlike CPs, they represent additional funding for the corporate ie the funds borrowed by issuing short term debentures are over and above the funds available to the corporate from its consortium bankers. Normally, debenture issuance attracts stamp duty; but issuers get around this by issuing only a letter of allotment (LOA) with the promise of issuing a formal debenture later - however the debenture is never issued and the LOA itself is redeemed on maturity. These LOAs are freely tradable but transfers attract stamp duty.
  Bills of exchange are promissory notes issued for commercial transactions involving exchange of goods and services. These bills form a part of a company's banking limits and are discounted by the banks. Banks in turn rediscount bills with each other.
   
  Long term debt instruments:
  By convention, these are instruments having a maturity exceeding one year. The main instruments are Government of India dated securities (GOISEC), State Government securities (state loans) public sector bonds (PSU bonds), corporate debentures etc.
  Most of these are coupon bearing instruments ie interest payments (called coupons) are payable at pre specified dates called "coupon dates". At any given point of time, any such instrument has a certain amount of accrued interest with it ie interest which has accrued (but is not due) calculated at the "coupon rate" from the date of the last coupon payment. eg if 30 days have elapsed from the last coupon payment of a 14% coupon debenture with a face value of Rs 100, the accrued interest will be
  100*0.14*30/365 = 1.15
  Whenever coupon-bearing securities are traded, by convention, they are traded at a base price with the accrued interest separate - in other words, the total price would be equal to the summation of the base price and the accrued interest.
  A brief description of these instruments is as follows:
   
  Government of India dated securities (GOISECs):
  Like treasury bills, GOISECs are issued by the Reserve Bank of India on behalf of the Government of India. These form a part of the borrowing program approved by Parliament in the Finance Bill each year (Union Budget). They are issued in dematerialized form but can be issued in denominations as low as Rs.100 in physical certificate form. They have maturity ranging from 1 year to 30 years. Very long dated securities ie those having maturity exceeding 20 years were in vogue in the seventies and the eighties while in the early nineties, most of the securities issued have been in the 5-10 year maturity bucket. Very recently, securities of 15 and 20 years maturity have been issued.
  Like T-Bills, GOISECs are most commonly issued in dematerialized form in the "SGL" account although it can be issued in physical certificate form on specific request. Tradability of physical securities is very limited. The SGL passbook contains a record of the holdings of the investor. The RBI acts as a clearing agent for GOISEC transactions by being the custodian and operator of the SGL account. GOISECs are transferable by endorsement and delivery for physical certificates. Transactions of securities held in SGL form are effected through SGL transfer notes. Transfer of GOISECs does not attract stamp duty or transfer fee. Also no tax is deductible at source on the coupon payments made on GOISECs.
  Like T-Bills, GOISECs are issued through the auction route. The RBI pre specifies an approximate amount of dated securities that it intends to issue through the year. However, it has broad flexibility in exceeding or being under that figure. Unlike T-Bills, it does not have a pre set timetable for the auction dates and exercises its judgement on the timing of each issuance, the duration of instruments being issued as well as the quantum of issuance.
  Sometimes the RBI specifies the coupon rate of the security proposed to be issued and the prospective investors bid for a particular issuance yield. The difference between the coupon rate and the yield is adjusted in the issue price of the security. On other occasions, the RBI just specifies the maturity of the proposed security and prospective investors bid for the coupon rate itself. In either case, just as in T-Bills, the auction is conducted on a French auction basis. Also, the RBI has wide latitude in deciding the cut off rate for each auction and can end up with unsold securities, which devolve on itself.
  Apart from the auction program, the RBI also sells securities in its open market operations (OMO) which it has acquired in devolvements or sometimes directly through private placements. Similarly, it also buys securities in open market operations if it feels fit.
   
  New types of GOISECs
  Earlier, the RBI used to issue straight coupon bonds ie bonds with a stated coupon payable periodically. In the last few years, the RBI has been innovative and new types of instruments have also been issued. These include
   
  Inflation linked bonds:
  These are bonds for which the coupon payment in a particular period is linked to the inflation rate at that time - the base coupon rate is fixed with the inflation rate (consumer price index-CPI) being added to it to arrive at the total coupon rate. Investors are often loath to invest in longer dated securities due to uncertainty of future interest rates. The idea behind these bonds is to make them attractive to investors by removing the uncertainty of future inflation rates, thereby maintaining the real value of their invested capital.
   
  Zero coupon bonds:
  These are bonds for which there is no coupon payment. They are issued at a discount to face value with the discount providing the implicit interest payment. In effect, these can be construed as long duration T - Bills or as bonds with cumulative interest payment.
   
  State government securities (state loans):
  These are issued by the respective state governments but the RBI coordinates the actual process of selling these securities. Each state is allowed to issue securities up to a certain limit each year. The planning commission in consultation with the respective state governments determines this limit. While there is no central government guarantee on these loans, they are deemed to be extremely safe. This is because the RBI debits the overdraft accounts of the respective states held with it for payment of interest and principal. Generally, the coupon rates on state loans are marginally higher than those of GOISECs issued at the same time.
  The procedure for selling of state loans, the auction process and allotment procedure is similar to that for GOISEC. They also qualify for SLR status and interest payment and other modalities are similar to GOISECs. They are also issued in dematerialized form and no stamp duty is payable on transfer. The procedure for transfer is similar to GOISECs. In general, state loans are much less liquid than GOISECs.
   
  Public Sector Undertaking Bonds (PSU Bonds):
  These are long term debt instruments issued by Public Sector Undertakings (PSUs). The term usually denotes bonds issued by the central PSUs (ie PSUs funded by and under the administrative control of the Government of India). The issuance of these bonds began in a big way in the late eighties when the central government stopped/reduced funding to PSUs through the general budget. Typically, they have maturities ranging between 5-10 years and they are issued in denominations (face value) of Rs.1,000 each. Most of these issues are made on a private placement basis to a targeted investor base at market determined interest rates. Often, investment bankers are roped in as arrangers for these issues.
  These PSU bonds are transferable by endorsement and delivery and no tax is deductible at source on the interest coupons payable to the investor (TDS exempt). In addition, from time to time, the Ministry of Finance has granted certain PSUs, an approval to issue limited quantum of tax-free bonds ie bonds for which the payment of interest is tax exempt in the hands of the investor. This feature was introduced with the purpose of lowering the interest cost for PSUs which were engaged in businesses which could not afford to pay market determined rates of interest eg Konkan Railway Corporation was allowed to issue substantial quantum of tax free bonds. Thus we have taxable coupon PSU bonds and tax free coupon PSU bonds.
   
  Bonds of Public Financial Institutions (PFIs):
  Apart from public sector undertakings, Financial Institutions are also allowed to issue bonds, that too in much higher quantum. They issue bonds in 2 ways - through public issues targeted at retail investors and trusts and also through private placements to large institutional investors. Usually, transfers of the former type of bonds are exempt from stamp duty while only part of the bonds issued privately have this facility. On an incremental basis, bonds of PFIs are second only to GOISECs in value of issuance.
  Retail bond issues of PFI bonds have become a big rage with investors in the last three years. PFIs have also been offering bonds with different features to meet differing needs of investors eg monthly return bonds (which pay monthly coupons), cumulative interest bonds, step up coupon bonds etc
   
  Corporate debentures:
  These are long term debt instruments issued by private sector companies. These are issued in denominations as low as Rs.1,000 and have maturities ranging between one and ten years. Long maturity debentures are rarely issued, as investors are not comfortable with such maturities. Generally, debentures are less liquid as compared to PSU bonds and the liquidity is inversely proportional to the residual maturity.
  A key feature that distinguishes debentures from bonds is the stamp duty payment. Debenture stamp duty is a state subject and the quantum of incidence varies from state to state. There are two kinds of stamp duties levied on debentures viz issuance and transfer. Issuance stamp duty is paid in the state where the principal mortgage deed is registered. Over the years, issuance stamp duties have been coming down and are reasonably uniform. Stamp duty on transfer is paid to the state in which the registered office of the company is located. Transfer stamp duty remains high in many states and is probably the biggest deterrent for trading in debentures resulting in lack of liquidity.
   
  Pass Through Certificates (PTCs):
  Pass through certificate is an instrument with cash flows derived from the cash flow of another underlying instrument or loan. Most commonly, they have been issued by foreign banks like Citibank on the basis of their car loan or mortgage/housing loan portfolio. The issuer is a special purpose vehicle which just receives money from a multitude of (may be several hundreds or thousands) underlying loans and passes the money to the holders of the PTCs. This process is called securitization. Legally speaking PTCs are promissory notes and therefore tradable freely with no stamp duty payable on transfer. Most PTCs have 2-3 year maturity because the issuance stamp duty rate of 0.75% makes shorter duration PTCs unviable.
  Some corporates have also issued zero coupon like debentures. The best example is Tata Steel's Secured Premium Notes (SPNs). These debentures had 4 bullet payments of principal and interest combined after a wait period of 4 years.
   
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