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Debt markets: The other alternative

Jun 23, 2001


When a nation has capital, it can utilize it in two ways: either consume the capital i.e. spend it on things that will not give any future benefit or invest the capital into capacity building that will help the economy to grow. Sustainable economic growth is dependent on the level of investment activity. Therefore, industries and the government need money to grow. Household savings that accounted for 18.5% of the GDP (1999) is one of the key supply avenues. And the job of financial markets is to channelize this money into the industrial sector. In 1999, 10.9% of household savings was in the form of financial assets. However, a majority of this comprised of fixed deposits with the banks.

Though the fixed deposits are undoubtedly the safest form of investments, they inherently have two disadvantages that work against the investor. Firstly, the amount available to the investor on the upside is always fixed. In a scenario where the interest rates are decreased by the central bank, the investor is the loser.

However, if the same investor would hold a bond that had fixed returns, the bond would become valuable in a scenario where interest rates declined. The retail investor in India did not have much of a choice. Either he was at the mercy of the banks for fixed deposits or at the mercy of the securities and the real estate market. Equities and real estates are risky. The numerous scams have time and again highlighted the so-called ‘credibility’ of the equities markets in the country. Also, due to the inherent uncertainty in returns, these markets did not suit the risk appetite of many investors. Therefore, the need of the hour was to have a market in which the price discovery was far more realistic, market determined and more in favour of the investor. Also, important was liquidity. The answer to this was debt markets, where instruments with fixed returns could be traded.

The development of these markets started in 1992, the year of glasnost (openness) and perestroika (restructuring) for India. The financial systems underwent changes as the country began its journey from a regulated to a free market economy. There were steps taken to de-regulate India’s financial system and as a result interest rates would be increasingly determined by the market forces and decreasingly the reserve bank. The government began to borrow from the markets at rates determined by the market forces by a system of auctions. Previously this was being done at pre-announced rates. Other reforms instituted by the RBI, in close coordination with Government of India included, introduction of new instruments such as zero coupon bonds, floating rate bonds and capital index bonds, introduction of Treasury Bills of varying maturities, conversion of Treasury Bills into dated securities. And setting up system so that trading in debt instruments could be facilitated. This included the establishment of specialised institutions such as DFHI (Discount and Finance House of India) and STCI (Securities Trading corporation of India) as primary dealers in government securities. When the government auctions the debt instruments through the RBI, primary dealers are allowed to bid.

However, as long as automatic monetisation (RBI would take up all of the Centre’s debt and print currency in exchange for it) existed, it was difficult to assure a framework for government securities market in terms of matching demand and supply through a price mechanism. Hence, the most significant development during 1997-98 has been the elimination of the practice of automatic monetisation of the Central Government budget deficit through ad hoc Treasury Bills with effect from April 1, 1997 and the introduction of a new scheme of Ways and Means Advances (WMA). WMA is the short-term credit from the central bank to the government, which allows the government to meet its immediate requirements. For FY01 the RBI set the government's WMA limits at Rs 100 bn for the first half and Rs 60 bn for the second half. WMA is comparable to an overdraft facility. If the government wants money above this it will have to borrow by issuing bonds, which are auctioned by the RBI.

The debt markets

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.

The debt market in India can be divided into two categories, firstly the government securities market or the G-Sec markets consisting of central government and state government securities (therefore loans being taken by the central and state governments); and bond market consisting of FI (financial institutions) bonds, PSU (public sector units) bonds and corporate bonds/debentures. The government securities segment is the most dominant category in the debt market.

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.

The government to finance its fiscal deficit floats the fixed income instruments. It borrows by issuing G-Secs that are sovereign securities and are issued by the Reserve Bank of India (RBI) on behalf of Government of India, in lieu of the Central Government's market borrowing programme.

(Rs bn)Internal FinanceExternal Finance
YearGross Fiscal
Other borrowings
and liabilities #
91 day
Treasury bills $
1991-92 363 75 165 69 54
1992-93 402 37 189 123 53
1993-94 603 289 153 110 51
1994-95 577 203 328 10 36
1995-96 602 331 170 98 3
1996-97 602 200 306 132 30
1997-98 889 325 563 (9) 11
1998-99 1,133 690 427 (2) 19
1999-00 (RE) 1,089 771 349 35 9
2000-01(BE) 1,113 764 349 - (0)
* Incl ZCB, lans in conv. of T-Bills, 364-Day TB etc. since 193-94
# Small savings, PF, specal deposit etc. W.e.f. 1999-00 small savings & PPF excl.
$ Variation in 91-day T- bills issued net of changes in cash balances with RBI up to March 31, 1997. Since April 1, 1997 these figures represent draw down of chas balances
Source : Central government budget doucments and Reserve Bank records

On the other hand FIs, PSU and corporates issue bonds to meet financial requirements at a fixed cost, thereby removing uncertainty in financial costs.

(Rs bn)No of issueAmountNo of issueAmountNo of issueAmount

The advantages

The most compelling reason for investing in the debt market is that the returns debt markets offer are as close to being risk free as possible, especially in the government securities. In the other debt instruments issued by corporates, FIs and PSUs, certain element of risk is associated with them and therefore, they are rated by credit rating agencies. Depending on the rating, which is a comment on the risk return profile of the instrument, the interest in the instrument varies. Of course, other benefits associated with the debt markets are that the liquidity is very high and loans are easily available from banks against government securities.

The downside

The returns being risk free are certainly not as high as the equities market. Also, the retail participation is very less, though it has increased considerably in the immediate past. These investments are through gilt funds. A retail debt market is not very well developed. Therefore, there are issues of liquidity and price discovery.

Types Of Government Securities
Dated securities

These instruments are of the face value of Rs 100, which the buyer has to pay upfront. The return is pre-decided. This is known as the coupon rate or the interest rate. The interest rate indicates the amount that will be paid out by the government every year till maturity. The time to maturity is also fixed. For example, 12% GOI 2005 is a bond that matures on in the year 2005 and has an interest rate of 12%. The buyer will have to pay Rs 100 to buy the instrument and will get Rs 12 every year as interest. And when the security matures the face value will be returned to the holder. As the interest rate is fixed the price of this instrument will fluctuate depending on the lending rates that are offered by the central bank. If the RBI lowers interest rates this instrument will become more expensive and if RBI hikes interest rates then the instrument will become cheaper.

Zero Coupon bonds (ZCBs)

ZCBs are available at a discount to their face value. There is no interest paid on these instruments but on maturity the face value is redeemed from the RBI. A bond of face value 100 will be available at a discount say at Rs 80 and the date of maturity is after two year in 2003. This implies an interest rate on the instrument. When the bonds are redeemed Rs 100 will be paid. The securities do no carry any coupon or interest rate i.e. unlike dated securities no interest is paid out every year. When the bond matures the face value is returned. The difference between the issue price (discounted price) and face value is the return on this security.

Capital indexed Bonds

Capital indexed bonds have interest rates as fixed percentage over the wholesale price index. The purpose is to provide investors with an effective hedge against inflation. The principal redemption is linked to the Wholesale Price Index (WPI). They are issued at face value. The coupon is fixed as a percentage over the WPI.The other instruments that have been issued by the government include Floating Rate Bonds (FRBs) and Partly Paid Stocks.

Fixed income instruments issued by corporates

The companies issue debentures, which have a face value and a fixed coupon rate. Debentures can be converted into shares depending on the type of the instruments. Those that cannot be converted are known as NCD (non-convertible debentures). Some of the debentures can be partly converted to stocks. These are known as PCDs (partly convertible debentures). Those debentures that can be fully converted into stocks are known as FCDs (fully convertible debentures).

Weighted average years to maturity6.597.7112.64
Weighted average yield %11.8211.8611.77
Yield %   
Yield ( years to maturitywise) %   
Less than 10 years   
Yield ( years to maturitywise) %   
10 years   
Yield ( Years to maturitywise)%   
Above 10 years   

The development of the debt market has been hindered by the lack of awareness amongst the retail investors. The investors have to be made aware that there is an avenue other an equities market where instruments can be traded just like equities. The interesting thing is that the amount of risk associated is far lower in the case of bonds/debentures as compared to equities. Also, the returns are better than those offered by fixed deposits in banks. These instruments also have high liquidity.

The other factors that have affected the growth of the debt market are the lack of infrastructure for price discovery and price information dissemination. The retail investors do not understand the mechanics of these markets as regards to pricing of the instruments. Once the retail participation comes in it would deepen the markets and improve the liquidity. Therefore, the areas that need attention are investor education and creating a robust system that will allow this market to develop. To read on how to measure returns on debt instruments please click here.

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