1

Gilt-edged Securities in India

SUSHMAN DAS (22) CHINTAMANENI SATYA BHUSAN(35)

MOIZ AKHTAR MIR(81)SWOYAN SATYENDU (92)
MOHD NAUMAN KHALID (182)
MONEY AND FINANCIAL MARKETS PROJECT
ECONOMICS HONOURS SEMESTER V - GROUP 7
SHRI RAM COLLEGE OF COMMERCE
OCTOBER 2014

Table of Contents

1.Acknowledgements.....................................................................................................5
2.Introduction.................................................................................................................6
3. Gilt-edged Securities: Features of Government Securities and type of Government
Securities By Sushman Das ..........................................................................................7
3.1)Instrument Development in Government Securities Market...............................9
3.2) Types of government Securities.........................................................................10
3.3)Dated Instruments...............................................................................................12
3.4)Forms of Central and State Government Securities...........................................14
3.5)Participants in Gilt-edged Securities Market......................................................15
3.6)Denomination of Government Securities...........................................................15
3.7)Prices & Yields...................................................................................................15
4. Auctions of Government Securities,Procedure for Application & Payment of Interest by
Moiz Akhtar Mir...........................................................................................................17
4.1)Auction of Government Securities ....................................................................17
4.2)How are the Government Securities issued? .....................................................18
4.3)Different types of auctions used for issue of securities ....................................18
4.4)Design of Government Securities Auction in India ..........................................22
4.5)Procedure for Application to purchase Government Securities .......................23
4.6)Payment of Interest in Government Securities .................................................23

5.Minimum Subscription,Importance of Investing in Government Securities & Gilt Funds in

India by Md.Nauman Khalid.............................................................................................24
5.1)Minimum Subscription ...........................................................................................24
5.2)Importance of Investing in Government Securities Market....................................25
5.3)Gilt Funds:What are they?

..................................................................................26

5.4)Gilt Switching.........................................................................................................32
5.5)Gilt Funds in India ..................................................................................................32
5.6)Government Secuirites Market : Analysis & Assessment.......................................34
6. Developments in Government Securities Market in India by Chintamaneni Satya
Bhushan.............................................................................................................................38
6.1)Policy Developments...............................................................................................39
6.1.1)Develoments in Primary Markets .....................................................................40
6.1.2)Reforms in Secondary Markets ........................................................................45
6.1.3)Developments in Market Infrastructure ...........................................................46
6.2)Developments at a Glance ......................................................................................48
7. Gilt-edged Securities in other countries : A Case Study of UK by Swoyan Satyendu..50
7.1)Gilt-edged Securities in other countries:A Case Study of UK ...............................50
7.2)A Brief History of British Gilt-edged Securities ....................................................51
7.3)Types of UK-GILT Securities..................................................................................52
7.4)Present Status of UK-Gilts Market..........................................................................58
8.Conclusion......................................................................................................................59

1. ACKNOWLEDGEMENTS
We take this opportunity to express our profound gratitude and deep regards to our
guide Dr. Ritu Ranjan, for his exemplary guidance, monitoring and constant
encouragement throughout the course of this project. The blessing, help and
guidance given by him time to time shall carry us a long way in the journey of life on
which we are about to embark.
He has shown the attitude and the substance of a genius. He continually and
persuasively conveyed a spirit of adventure in regard to research and an excitement
in regard of teaching. Without his supervision this project would not have been
possible.
Individual commitment to a group effort - that is what makes a team work. We are
also thankful to our team mates for their dedication and commitment towards the
project, where we all exchanged our own interesting ideas, thoughts and made it
possible to complete the project with all accurate information. All the team mates
were equally competent and co-operating thus making the preparation of this report
hassle-free and highly productive.
Last but not the least, to the tireless efforts of all researchers and economists who
work exceptionally hard to produce excellent study material for undergraduates like
us to benefit from their labour expand our knowledge about pertinent matters about
the country.
Getting deep insights into the importance of the Government Securities Market in
India to realize national aspirations and to keep pace with the changing times has
been a tremendous journey for us.
Sushman Das
Chintamaneni Satya Bhushan
Moiz Akhtar Mir
Swoyan Satyendu
Mohd Nauman Khalid

2. Introduction
The government securities market is at the core of financial markets in most countries. It deals with
tradable debt instruments issued by the Government for meeting its financing requirements. The
development of the primary segment of this market enables the managers of public debt to raise
resources from the market in a cost effective manner with due recognition to associated risks. A vibrant
secondary segment of the government securities market helps in the effective operation of monetary
policy through application of indirect instruments such as open market operations, for which
government securities act as collateral. The government securities market is also regarded as the
backbone of fixed income securities markets as it provides the benchmark yield and imparts liquidity to
other financial markets. The existence of an efficient government securities market is seen as an
essential precursor, in particular, for development of the corporate debt market. Furthermore, the
government securities market acts as a channel for integration of various segments of the domestic
financial market and helps in establishing inter-linkages between the domestic and external financial
markets.
Recognising the need for a well developed government securities market, the Reserve Bank, in
coordination with the Government, initiated a series of measures from the early 1990s to deregulate the
market of administered price and quantity controls. Consequently, the government securities market has
witnessed significant transformation in various dimensions, viz., market-based price discovery, widening
of investor base, introduction of new instruments, establishment of primary dealers, and electronic
trading and settlement infrastructure. This,in turn, has enabled the Reserve Bank to perform its functions
in tandem with the evolving economic and financial conditions.
The government debt policy today emphasizes maintaining stable, sustainable,prudent, and
market-oriented active debt management and broadening the investor base to develop a competitive
market. The importance and role of the gilt-edged market has undergone a great change in the last
decade. The volume and timing of official debt sales has become a matter of public concern as monetary
growth has come to be seen as a central aspect of economic management.Recent events like RBIs
decision to sell $2.3 billion in government debt through the unpopular 'multiple pricing' method in July
2014 rather than through the more popular uniform pricing method have attracted criticism while
measures like introduction of inflation-indexed bonds have attracted applauds. Understanding of the
influence of financial markets and of the importance of monetary growth has increasingly become more
crucial in the post-crisis world.
Major participants in the Government securities market historically have been large institutional
investors.However,with the various measures for development, the market has also witnessed the entry
of smaller entities such as co-operative banks, small pension and other funds etc. These entities are
mandated to invest in Government securities through respective regulations.The Reserve Bank of India
has also taken several initiatives to bring awareness about the Government securities market among
small investors. These include workshops on the basic concepts relating to fixed income securities/
bonds like Government securities, existing trading and investment practices, the related regulatory
aspects and the guidelines.
Through this paper,we seek to analyze the vibrant Government securities market in India and its role as
an instrument of participatory growth for citizens in the country.

3. Gilt-edged Securities: Features of Government Securities and

types of Government Securities
Government securities are tradeable debt-instruments issued by the government for meeting financial
requirements.The gilt-edged market refers to the market for Government and semi-Government
securities,backed by the Government of India.Gilt-edged securities are bonds issued by certain national
governments. The term is of British origin, and originally referred to the debt securities issued by the
Bank of England, which had a gilt (or gilded) edge. Hence, they are known as gilt-edged securities, or
gilts for short. Today the term is used in the United Kingdom as well as some Commonwealth nations,
such as South Africa and India.Colloquially, the term "gilt-edged" is sometimes used to denote
high-grade securities, consequently carrying low yields, as opposed to relatively riskier, below
investment-grade securities.
The term gild-edged means of best quality. Government securities do not suffer from risk of default
and are highly liquid as they can be easily sold in the market at their current price.The open market
operations of the Reserve Bank of India are also conducted in such securities. The term "gilt account" is
also a term used by the Reserve Bank of India to refer to a constituent account maintained by a custodian
bank for maintenance and servicing of dematerialized government securities owned by a retail customer.
Major participants in the Government securities market historically have been large institutional
investors. With the various measures for development, the market has also witnessed the entry of smaller
entities such as co-operative banks, small pension and other funds etc. These entities are mandated to
invest in Government securities through respective regulations. However, some of these new entrants
have often found it difficult to understand and appreciate various aspects of the Government securities
market. The Reserve Bank of India has, therefore, taken several initiatives to bring awareness about the
Government securities market among small investors. These include workshops on the basic concepts
relating to fixed income securities/ bonds like Government securities, existing trading and investment
practices, the related regulatory aspects and the guidelines.
Government securities are short term (usually called treasury bills, with original maturities of less than
one year) or long term (usually called Government bonds or dated securities with original maturity of
one year or more). In India, the Central Government issues both, treasury bills and bonds or dated
securities while the State Governments issue only bonds or dated securities, which are called the State
Development Loans (SDLs). Government securities carry practically no risk of default and, hence, are
called risk-free gilt-edged instruments. Government of India also issues savings instruments (Savings
Bonds, National Saving Certificates (NSCs), etc.) or special securities (oil bonds, Food Corporation of
India bonds, fertiliser bonds, power bonds, etc.). They are, usually not fully tradable and are, therefore,
not eligible to be SLR securities.

Pic : A Government of India Security Certificate

3.1. Instrument Development in Government Securities Market:

The profile of government securities differs across countries in terms of (i) maturity; (ii) ways of fixing
coupon and principal payment; (iii) methods of coupon and principal settlement; and (iv) investor
orientation. An analysis of evolution of various instruments in the government bond markets shows that
normally countries in the nascent stage of development of government bond markets preferred to
concentrate exclusively on simple and standardised instruments. Over the years, they moved towards a
mix of conventional and, more advanced and complex instruments. The instrument development has
become increasingly more sensitive to various risks associated with trading in government bonds.
Most of the government securities markets in developed countries are characterised by instruments with
tenors ranging from short to long-term. For instance, the US treasuries market primarily offers two types
of conventional government bonds, viz.,treasury notes (maturing between two and 10 years) and bonds
(with maturity of 10 years or above) with a semi-annual coupon or interest payment. The 10-year
Diversification of available instruments encourages participation of varied investors, as different
categories of investors require different kinds of instruments to meet their specific needs.
While banks require government securities for their asset liability management in addition to
maintaining the prescribed SLR, insurance companies and provident funds require long-term
investments to match their liabilities. Prior to the reforms initiated in the early 1990s, most of the
government bonds were in the form of plain vanilla fixed coupon securities. Since 1994, the Reserve
Bank has been developing a range of instruments to cater to the diversified requirements and hedging
needs of investors. These include zero coupon bonds, capital indexed bonds, floating rate bonds and
bonds with call and put options.

3.2. Types of Government Securities:

State Development Loans:
State Governments also raise loans from the market. SDLs are dated securities issued through an auction
similar to the auctions conducted for dated securities issued by the Central Government (see question 3
below). Interest is serviced at half-yearly intervals and the principal is repaid on the maturity date. Like
dated securities issued by the Central Government, SDLs issued by the State Governments qualify for
SLR. They are also eligible as collaterals for borrowing through market repo as well as borrowing by
eligible entities from the RBI under the Liquidity Adjustment Facility (LAF).
Dated Instruments:
These are generally fixed maturity and fixed coupon securities usually carrying semi-annual
coupon.These are called Dated Securities because these are identified by their date of maturity and the
coupon. Eg: 11.03% is a Central Government security maturing in 2012,which carries a coupon of
11.3% payable half-yearly.Dated Instruments include Fixed Rate Bonds,Floating Rate Bonds,Zero
Coupon Bonds,Capital-Indexed Bonds,bonds with Call/Put Options,special securities to Oil PSUs/FCIs
and new Instruments like STRIPS.
Cash Management Bills:
Government of India, in consultation with the Reserve Bank of India, has decided to issue a new
short-term instrument, known as Cash Management Bills (CMBs), to meet the temporary mismatches in
the cash flow of the Government. The CMBs are issued for maturities less than 91 days.They are issued
at a discount and redeemed at face value at maturity. The tenure, notified amount and date of issue of the
CMBs depends upon the temporary cash requirement of the Government. The announcement of their
auction is made by Reserve Bank of India through a Press Release which will be issued one day prior to
the date of auction. The settlement of the auction is on T+1 basis.These instruments are tradable and
qualify for ready forward facility.First set of CMBs were issued on May 12, 2010.
Treasury Bills:
Treasury Bills(T-Bills)offer short-term investment opportunities,generally upto one year.At present,the
Government of India issues 3 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.25,000 and in multiples of Rs.25,000.Treasury bills are issued at a discount and
redeemed at par.While 91-day T-bills are auctioned every week on Wenesdays,182-day and 364-day
T-Bills are auctioned every alternate week on Wednesdays.The RBI 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 custodians current
account.Banks,Primary Dealers,State Governments,Provident Funds,Financial Institutions,Insurance
Companies,NBFCs,FIIs(as per prescribed norms),NRIs and OCBs can invest in T-Bills.

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Fixed Rate
Bonds
Floating Rate
Bonds

Government
Securities

State
Development
Loans

Zero Coupon
Bonds

Dated
Instruments

Capital-Indexed
Bonds

Cash
Management
Bills

Bonds with
Call/Put
Options

Treasury Bills

Special
Securities to
Oil-PSUs,FCI
etc
New
Instruments like
STRIPS

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3.3. Dated Instruments:

1) 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.There were four issuances of ZCBs between 1994 and 1996
2) 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.
3) 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 par ticipants, with some modification in the structure.
There were 10 issuances of the FRBs till October 9, 2004. 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. In the secondary market, liquidity in FRBs, is low due to (i)
low trading interest of market participants in FRBs as such instruments, by design, are hedging
instruments and offer limited scope for trading gains;(ii) no reissuance of FRBs on account of
complexities associated with pricing; (iii) preference of commercial banks to place these bonds under
held to maturity (HTM) category, reducing the availability of bonds for trading; and (iv) complex
pricing method which deterred market participants from undertaking outright transactions in FRBs.
4) Capital Indexed Bonds: These are bonds, the principal of which is linked to an accepted index of
inflation with a view to protecting the holder from inflation. A capital indexed bond, with the principal
hedged against inflation, was issued in December 1997. These bonds matured in 2002. The
government is currently working on a fresh issuance of Inflation Indexed Bonds wherein payment of
both, the coupon and the principal on the bonds, will be linked to an Inflation Index (Wholesale Price
Index). In the proposed structure, the principal will be indexed and the coupon will be calculated on
the indexed principal. In order to provide the holders protection against actual inflation, the final WPI
will be used for indexation.
5) Bonds with Call/ Put Options: Bonds can also be issued with features of optionality wherein the
issuer can have the option to buy-back (call option) or the investor can have the option to sell the bond
(put option) to the issuer during the currency of the bond. 6.72%GS2012 was issued on July 18, 2002
for a maturity of 10 years maturing on July 18, 2012. The optionality on the bond could be exercised
after completion of five years tenure from the date of issuance on any coupon date falling thereafter.
The Government has the right to buyback the bond (call option) at par value (equal to the face value)
while the investor has the right to sell the bond (put option) to the Government at par value at the time
of any of the half-yearly coupon dates starting from July 18, 2007.

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6)New Instruments like STRIPS: Steps are being taken to introduce new types of instruments like
STRIPS (Separate Trading of Registered Interest and Principal of Securities). Accordingly, guidelines
for stripping and reconstitution of Government securities have been issued. STRIPS are instruments
wherein each cash flow of the fixed coupon security is converted into a separate tradable Zero
Coupon Bond and traded. For example, when Rs.100 of the 8.24%GS2018 is stripped, each cash flow
of coupon (Rs.4.12 each half year) will become coupon STRIP and the principal payment (Rs.100 at
maturity) will become a principal STRIP. These cash flows are traded separately as independent
securities in the secondary market. STRIPS in Government securities will ensure availability of
sovereign zero coupon bonds, which will facilitate the development of a market determined zero
coupon yield curve (ZCYC). STRIPS will also provide institutional investors with an additional
instrument for their asset- liability management. Further, as STRIPS have zero reinvestment risk,
being zero coupon bonds, they can be attractive to retail/non-institutional investors. The process of
stripping/reconstitution of Government securities is carried out at RBI, Public Debt Office (PDO) in
the PDO-NDS (Negotiated Dealing System) at the option of the holder at any time from the date of
issuance of a Government security till its maturity. All dated Government securities, other than
floating rate bonds, having coupon payment dates on 2nd January and 2nd July, irrespective of the
year of maturity are eligible for Stripping/Reconstitution. Eligible Government securities held in the
Subsidiary General Leger (SGL)/Constituent Subsidiary General Ledger (CSGL) accounts maintained
at the PDO, RBI, Mumbai. Physical securities shall not be eligible for stripping/reconstitution.
Minimum amount of securities that needs to be submitted for stripping/reconstitution will be Rs. 1
crore (Face Value) and multiples thereof.

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3.4. Forms of Central and State Government Securities

These securities can be issued in three forms:
1. Inscribed stock or stock certificate
2. Promissory note
3. Bearer Bond
Bearer bonds are generally not issued in India and stock certificates are not popular with investors. Most
government securities are in the form of a promissory note. Of course, promissory notes of a loan can be
converted into stock certificates of any other loan and vice versa.
Stock certificates have some benefits over promissory notes, such as, (i) the name of the holder of stock
certificate is registered in the books of Public Debt Office (PDO) and hence these are safer, (ii) these are
sent to the applicant directly by registered post by the PDO, (iii) the half-yearly interest is directly
remitted to the holder by an interest warrant drawn at par on any treasury or State Bank of India branch
specified by the holder or is remitted by money order, if the holder so desires, and (iv) it can be sold by
singing the transfer for on the reserve of the certificate. Despite these advantages stock certificates are
not popular because their lack of quick transferability and negotiability, these cannot be transferred by
endorsement. The procedure for their transfer is relatively more complex.

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3.5. Participants in Gilt-edged Securities Market:

Participants in government securities market belong to the following categories:
1.Central and State governments. Their holdings represent inter-government transfer of resources.
2.Banking Sector, comprising

commercial banks and co-operative banks.

3.Insurance companies including both Life Insurance Corporation and general insurance companies.
4.Provident funds, both statutory and non-statutory
5.Other institutions including special financial institutions, joint stock companies, local authorities,
trusts, individuals and non-residents.

3.6. Denomination of Government Securities:

1.In case of Central Government Securities,the minimum is Rs.10,000 and trading takes place in
multiples of Rs.5 crores.
2.In case of State Government Securities,the minimum is Rs.1,000 and trading takes place in
multiples of Rs.1-5 crores.
3.Government Bonds-the minimum is Rs.5000 and trading takes place in its multiples.

3.7. Prices and Yields

Three types of prices are prevalent in gilt-edged securities market:
RBI prices. These are prices for deals with RBI. These are not cash prices. RBI publishes a price list
from time to time for securities dealt in by it. These prices are so aligned that the yield on these
securities for the remaining maturity period is the same as on the bonds of similar maturity which are
currently issued.
Prices prevailing in the secondary market at which deals take place between different operators.
Artificial or loaded prices fixed by the brokers for producing deals in securities. For helping banks to
show higher book profits the dealers buy depreciated securities at an inflated price above the market
price and sell the same amount of some other security to the bank again at inflated price so as to
neutralize its loss on purchase. Such artificial prices distort computation of yield on securities.

15

16

4.1. Auction of Government Securities

The Government of India issues debt securities to finance the Public Debt. Reserve Bank of India
conducts the auctions of the Government securities such as auctions of Treasury Bills and fixed coupon
earning dated securities, floating rate bonds, capital index bonds by following a pre-announced
half-yearly calendar. Dated securities are issued by either conducting yield-based auctions for issue of
new securities wherein coupon rates emerge on the basis of competitive bidding, or price-based auctions
for re-issue of existing securities. With the reform process initiated in the 1990s, auctioning government
securities evolved out since the first auction of dated security was conducted on June 03, 1992.
Auction is a price building process driven by a competitive bidding process, wherein the seller receives a
collective assessment of prospective empirical data on bidders behavior when different units of goods
get allocated at accepted bid prices. The importance of periodic empirical evaluation of bidding behavior
helps reset the assumptions that go behind designing auctions, specially the traditionally evolved out
complex designs like those of Treasury security auctions. As underlying raw bid price distributions
govern a priori the bidders demand and information about quantum and price, an empirical
understanding of the bid data in the form of panel data analysis of locally differentiated form of a variety
of the empirical frequency distributions, concentration analysis of bids as also evidences of localized
mean reverting bell shaped (near-normal) pricing behavior, provide valuable insights about overall
performance of the auction design.
The major participants in these auctions in India are the banks, insurance companies, mutual funds and
primary dealers. Banks and insurance companies participate actively in the auctions to meet their
statutory requirements while primary dealers participate in the auction for market making and
positioning the securities for further sale in the secondary market. Auction data reveal the competitive
behaviour of various investor-groups in terms of success ratios, bid shading, total amount of bonds
demanded, bid amount distribution as against respective bid prices, dispersion as well as concentration
of bids around multi-modal bids that could be expected within a heterogeneous cluster of bidders. Panel
empirical analysis for a similar set of auctions would elucidate the bidding pattern and help evaluate the
overall efficiency of the auctioning process.

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4.2. How are the Government Securities issued?

Government securities are issued through auctions conducted by the RBI. Auctions are conducted on the
electronic platform called the Public Debt Office Negotiated Dealing System (PDO-NDS).
Commercial banks, scheduled urban cooperative banks, Primary Dealers, insurance companies and
provident funds, who maintain funds account (current account) and securities accounts (SGL account)
with RBI, are members of this electronic platform. All members of PDO-NDS can place their bids in the
auction through this electronic platform. All non-NDS members including non-scheduled urban
co-operative banks can participate in the primary auction through scheduled commercial banks or
Primary Dealers. For this purpose, the urban co-operative banks need to open a securities account with a
bank / Primary Dealer such an account is called a Gilt Account. A Gilt Account is a dematerialized
account maintained by a scheduled commercial bank or Primary Dealer for its constituent (e.g., a
non-scheduled urban co-operative bank).
The RBI, in consultation with the Government of India, issues an indicative half-yearly auction calendar
which contains information about the amount of borrowing, the tenor of security and the likely period
during which auctions will be held. A Notification and a Press Communique giving exact particulars of
the securities, viz., name, amount, and type of issue and procedure of auction are issued by the
Government of India about a week prior to the actual date of auction. RBI places the notification and a
Press Release on its website (www.rbi.org.in) and also issues an advertisement in leading English and
Hindi newspapers. Information about auctions is also available with the select branches of public and
private sector banks and the Primary Dealers.

4.3. Different types of auctions used for issue of securities:

Prior to introduction of auctions as the method of issuance, the interest rates were administratively fixed
by the Government. With the introduction of auctions, the rate of interest (coupon rate) gets fixed
through a market based price discovery process.
An auction may either be yield based or price based.
i. Yield Based Auction: A yield based auction is generally conducted when a new Government security
is issued. Investors bid in yield terms up to two decimal places (for example, 7.85 per cent, 7.87 per cent,
etc.). Bids are arranged in ascending order and the cut-off yield is arrived at the yield corresponding to
the notified amount of the auction. The cut-off yield is taken as the coupon rate for the security.
Successful bidders are those who have bid at or below the cut-off yield. Bids which are higher than the
cut-off yield are rejected. An illustrative example of the yield based auction is given below:

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ii. Price Based Auction: A price based auction is conducted when the Government of India re-issues
securities already issued earlier. Bidders quote in terms of price per Rs.100 of face value of the security
(e.g., Rs.101.02, Rs.100.95, Rs.99.80, etc., per Rs.100/-). Bids are arranged in descending order and the
successful bidders are those who have bid at or above the cut-off price. Bids which are below the cut-off
price are rejected. An illustrative example of price based auction is given below:

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Depending upon the method of allocation to successful bidders, auction could be classified as Uniform
Price based and Multiple Price based. In a Uniform Price auction, all the successful bidders are
required to pay for the allotted quantity of securities at the same rate, i.e., at the auction cut-off rate,
irrespective of the rate quoted by them. On the other hand, in a Multiple Price auction, the successful
bidders are required to pay for the allotted quantity of securities at the respective price / yield at which
they have bid. In the example under (ii) above, if the auction was Uniform Price based, all bidders would
get allotment at the cut-off price, i.e., Rs.100.20. On the other hand, if the auction was Multiple Price
based, each bidder would get the allotment at the price he/ she has bid, i.e., bidder 1 at Rs.100.31, bidder
2 at Rs.100.26 and so on.
An investor may bid in an auction under either of the following categories:

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i. Competitive Bidding: In a competitive bidding, an investor bids at a specific price / yield and is
allotted securities if the price / yield quoted is within the cut-off price / yield. Competitive bids are made
by well informed investors such as banks, financial institutions, primary dealers, mutual funds, and
insurance companies. The minimum bid amount is Rs.10, 000 and in multiples of Rs.10, 000 thereafter.
Multiple bidding is also allowed, i.e., an investor may put in several bids at various price/ yield levels.
ii. Non-Competitive Bidding: With a view to providing retail investors an opportunity to participate in
the auction process, the scheme of non-competitive bidding in dated securities was introduced in January
2002. Non-competitive bidding is open to individuals, HUFs, RRBs, co-operative banks, firms,
companies, corporate bodies, institutions, provident funds, and trusts. Under the scheme, eligible
investors apply for a certain amount of securities in an auction without mentioning a specific price /
yield. Such bidders are allotted securities at the weighted average price / yield of the auction. In the
illustration given under (ii) above, the notified amount being Rs.1000 crore, the amount reserved for
noncompetitive bidding will be Rs.50 crore (5% of the notified amount). Noncompetitive bidders will be
allotted at the weighted average price which is Rs.100.26 in the given illustration. The participants in
non-competitive bidding are, however, required to hold a gilt account with a bank or PD. Regional Rural
Banks and co-operative banks which hold SGL and Current Account with the RBI can, also, participate
under the scheme of non-competitive bidding without holding a gilt account.
In every auction of dated securities, a maximum of 5 per cent of the notified amount is reserved for
non-competitive bids. In the case of auction for Treasury Bills, the amount accepted for non-competitive
bids is over and above the notified amount and there is no limit placed. However, non-competitive
bidding in Treasury Bills is available only to State Governments and other select entities and is not
available to the co-operative banks. Only one bid is allowed to be submitted by an investor either
through a bank or Primary Dealer. For bidding under the scheme, an investor has to fill in an
undertaking and send it along with the application for allotment of securities through a bank or a
Primary Dealer. The minimum amount and the maximum amount for a single bid is Rs. 10, 000 and Rs.
2 crore respectively in the case of an auction of dated securities. A bank or a Primary Dealer can charge
an investor up to maximum of 6 paise per Rs.100 of application money as commission for rendering
their services. In case the total applications received for non-competitive bids exceed the ceiling of 5 per
cent of the notified amount of the auction for dated securities, the bidders are allotted securities on a
pro-rata basis.

21

4.4. Design of Government Securities Auction in India

The auction procedure followed by RBI is the commonly used multiple-price sealed-bid auction. The
bidders electronically submit sealed competitive bids specifying the price they are willing to pay for a
particular amount of debt security. For dated securities auctions, investors belonging to eligible
categories may also submit non-competitive bids up to a ceiling of Rs.2 crore without specifying price.
These bids are accepted at the average price of bids accepted in the auction. The total amount of
non-competitive bids is subtracted from the total issue-size for allocation to competitive bids. An initial
ceiling of 5 per cent of issue size is kept on the total non-competitive amount but the ceiling limit is
rarely touched. Once all the bids are received during the bidding time, RBI allocates the competitive
bids starting from highest price bid and moving down until entire amount is allocated. In a multiple
price-auction, each successful bidder pays the price stated in his bid. In case of uniform price auctions,
all successful bidders pay the same price that is cut-off price at which the market clears the issue. The
method of auction is announced well in advance in the issue announcement notification.
In India, the banks and insurance companies are required to invest in government securities as per
statutory reserve requirements. Main auction bidding strategy of the banks and the insurance companies
is to price their bids in such a way that it is beneficial to them than buying from secondary market to
meet their growing reserve requirement. Their buying demand in secondary market may increase the
price in secondary market. Therefore, these bidders being long-term investor have to price their bids
based on their own values of the security in longer time horizon as against the bidding strategy of other
bidders like the primary dealers who acquire securities in auction mainly to sale later in the secondary
market and thus their bid pricing would have valuation of shorter-term. The intermediaries like the
primary dealers would like to earn quick profit by acquiring securities in the primary auctions and
selling in the secondary market.
On the other hand, primary dealers have the obligation of underwriting the auction issue and get the
incentive in the form of underwriting commission. Thus, the primary dealers would have of different bid
pricing strategy. Moreover, on account of size (capacity) constraint, the bidding strategy of the primary
dealers would be different than the banks and insurance companies. The primary dealers are smaller
entities as compared to banks and insurance companies, which have higher financial capacities.
India follows the by and large universally adopted auction method with most of the auctions being
multi-price (or discriminatory price) auctions. Uniform price auctions were also undertaken in the past
(RBI Annual Report, 2002-03). Countries that follow regularly similar auction designs include the UK,
Italy, Canada, Germany and Sweden (Keloharju
M et al, 2005).
Even though the traditional Treasury procedures have theoretical drawbacks, it is difficult to prescribe
the best way to auction government securities. The Treasury is obliged to provide easy entry into the
auctions, broadening, where possible, the ownership of the public debt; and it must adhere closely to a
crowded schedule of borrowing. While the Treasury may not always get the top revenue amounts for the
issuances, the prevailing auction system help the conduct of monetary policy and ensure a deep and
active secondary market in government obligations.

22

4.5. Procedure for Application to purchase Government

Securities
Offers for the purchase of Government Securities are submitted by interested persons in the form of an
application (including electronic form) as specified by the Reserve Bank of India from time to time.
Foreign Institutional Investors, Non-Resident Indians and Overseas Corporate bodies predominantly
owned by NRIs, however, submit their applications through the designated banks which have been
authorized by the Reserve Bank of India to act as a banker to FIIs or authorized to deal in Foreign
Exchange as the case may be. Applications duly filled in are then submitted to the office of Reserve
Bank of India or any other institution notified for the purpose, before the close of banking hours on the
specified date/s. Interested persons submitting applications for purchase of Government Securities are
then bound by the terms and conditions as indicated in the specified form of application.

4.6. Payment of Interest on Government Securities

Interest on Government Securities is paid at the Public Debt Offices of the Reserve Bank of India at
Ahmedabad, Bangalore, Bhubaneswar, Kolkata, Chennai, Guwahati, Hyderabad, Jaipur, Kanpur,
Mumbai, Nagpur, New Delhi, Patna and Thiruvananthapuram, or any other Office of the Reserve Bank
of India notified for this purpose from time to time, or at branches of State Bank of India and Associate
banks conducting Government business or at any Treasury or Sub Treasury served by the Public Debt
Office where there is no Office of the Reserve Bank of India or branch of State Bank of India or its
associates except the States of Jammu & Kashmir and Sikkim. Interest on securities held in Bond Ledger
Account with any of the Offices of the Reserve Bank of India/Agency as specified by the Reserve Bank
of India in this behalf, is paid at such Office/Agency.
Interest is paid after rounding off the amount to the nearest whole rupee. For this purpose, amount of
interest less than fifty paise is ignored and fifty paise or more is rounded off to the next rupee.

23

5.1. Minimum Subscription

Section 69 of the Companies Act, 1956 specifies that no allotment shall be made of any share capital of
a company, offered to the public for subscription, unless the amount stated in the prospectus as the
minimum amount has been subscribed. As per Schedule II to the Companies Act, 1956, the issuer is
required to make a declaration about refund of the issue, if minimum subscription of 90% of the issue
size is not received.
However, for public issue of non-convertible debentures (NCDs), no such requirement is specified under
Companies Act, 1956. Further, as per Regulation 12 of SEBI (Issue and Listing of Debt Securities)
Regulations, 2008 (SEBI ILDS Regulations), the issuer may decide the amount of minimum
subscription, which it seeks to raise from public through issue of NCDs and disclose the same in the
offer document.
Companies Act, 2013 and (draft) Rules made there under also do not specify the quantum of minimum
subscription needed in case of public issues (both for equity and debt), but only requires disclosure of
the same in the offer document.
In view of the above, it has been decided that the minimum subscription for public issue of debt
securities shall be specified as 75% of the base issue size for both NBFCs and Non NBFC issuers.
Further, if the issuer does not receive minimum subscription of its base issue size (75%), then the entire
application monies shall be refunded within 12 days from the date of the closure of the issue. In the
event, there is a delay, by the issuer in making the aforesaid refund, then the issuer shall refund the
subscription amount along with interest at the rate of 15% per annum for the delayed period.
However, the issuers issuing tax-free bonds, as specified by CBDT, shall be exempted from the above
proposed minimum subscription limit.

24

5.2. Why Should One Invest in Govt. Securities?

Government securities are issued by RBI on behalf of Government of India and state governments in
India. Government securities have always been considered as an investment option which is suitable
only for banks, financial institutions and corporate. However, the fact remains that these securities are
one of the best options for investment for common investors as well. Unfortunately retail investors have
not shown interest in these securities due to lack of information and understanding about process of
investment in government securities. However, things seem to be changing gradually. Both regulator i.e.
RBI and banks are pitching these products as an attractive option for retail investors as well. Retail
investors can invest in government securities both through primary market as well as secondary market
route. RBI allows retail investors to offer their bids in auction of government securities through
non-competitive bidding. On the other hand, banks have started providing option to invest in these
securities with IDBI Bank being the first bank to provide an online option for investment in government
securities.
There are many positives of investing in government securities. Though there are various reasons for
investing in government securities, five most obvious reasons are as follows:
Government Securities are risk free: Government securities have always been an ideal example of risk
free security. Though this is being widely debated in wake of what is going on in Greece and other
European countries, the fact remains that government securities in Indian context are risk free. For
investors looking for risk free investment, government securities are best option.
Government Securities offer decent yield for longer duration: Currently government securities offer
yield ranging from 8.5% to 9%. The 8.83% Government Bond maturity in 2041 is having an yield of
close of 8.6% while GOI FRB 2020 offers an yield of 9.35% currently. These returns are as good as the
bank deposits; however unlike bank deposits these deposits are available for longer duration. Today an
investor can block his money for 30 years in a government security while in bank deposits the
maximization duration is 10 years. If you are assured for 8.5% yield for 30 years while investing in
government securities, it is indeed a good return for long term.
Government Securities offer prospect of capital gains: There is an inverse relationship between
bond price and interest rate. It is believed that rate of interest in India has already peaked. The
government bonds are offering decent yield currently for very long period of time. If an investor parks
money in these bonds now, there is a prospect of good returns as and when interest rate falls. The price
of these bonds will go up when interest rate falls and the investment can exist from his investment in
bonds by booking good capital gains.
Government Securities have good liquidity: Government securities can be bought and sold like equity
products on NDS-OM (Negotiated Dealing System- Order Matching) platform of CCIL. The liquidity in
these securities is good as banks and financial institutions regularly participate in this market. As retail
investors, trading can be done through a SGL member of RBI. Many banks and primary dealers provide
this facility of trading in government security.

25

Government Securities help diversify portfolio: Last but not the least with addition of government
security in portfolio, the portfolio gets well diversified and the risk gets mitigated because government
securities are considered as risk free.

5.3. GILT Funds

Simply put, gilt funds are mutual funds that predominantly invest in government securities (G-Secs).
Unlike conventional debt funds that invest in debt instruments across the board, gilt funds target just a
given category of debt instruments i.e. G-Secs. The latter are securities issued by the Reserve Bank of
India (RBI) on behalf of the Government of India. Being sovereign paper, they do not expose investors
to credit risk. Since the market for G-Secs (as is the case with most debt instruments) is largely
dominated by institutional investors, gilt funds offer retail investors a convenient means to invest in
G-Secs. Depending on their investment horizon, investors can choose between short-term and long-term
gilt funds.
5.3.1. Advantages of GILT Funds:
Less Credit Risk: As they are backed by govt. there is almost no credit risk.
Tax Benefits: Investors should note that not only are these returns higher than those offered by
traditional investment avenues like bank fixed deposits, but they are also more efficient in terms of tax
benefits. GILT funds are given the same treatment as debt funds and thus are eligible for the benfits of
indexation on capital appreciation.
Open to retail investors: Only institutional investors can invest in G-sec market but GILT funds
provide retail investors a low cost way to invest in G-sec, which otherwise was open only to large
players.
Easiness: Just like stocks and bonds, govt securities are traded in both the primary and the secondary
market. This means that as a small individual investor it is possible to do the buying selling and trading
of securities yourself.
Diversification: Investment in Gilt funds provides for effective diversification.
5.3.2. Disadvantage of GILT Funds:
Interest rate risk: If the interest rate increases the price of Gsec fal which is a big risk to the investor.
Not Liquid: Investors have to keep in mind that git funds are not as liquid as other debt funds as G-secs
are not actively traded Moreover, if there is a sudden redemption pressure, fund houses will have no
other means but resort to a distress sale. Also, investors must avoid those gilt funds that have a small
corpus becaise these funds are not able to perform well in case of sudden volatiity in interest rates and if

26

there is a sudden redemption pressure. Underlying securities are illiquid as they are not frequently traded.
So if the fund manager opts for distress sell, to relieve redemption pressure, the fund may suffer loss.
Mostly ldeal for short term investment: Makes ideal short-term investment as most of the funds tend
to be volatie over longer investment time frame and equity scores over gilt in the long term.
Complicatlons: The paperwork and intricacies of these transactions can be very complicated. however,
so gilt funds provide the benefit of pooling money with other investors and having larger buyers take
care of the transaction logistics.
5.3.3. Trends:
The most noticeable tends in the gilt market in recent years have been:

10 Year Bond Yield in percentage

27

90
80
70
60
50
40
Per
30cent
20
10
0
1980-81

1990-91

1996-97

Centre

2000-01

States

2004.05

2006-07
(BE)

Total

Trends in Govt Debt to GDP Ratio

100.0
80.0
60.0
Per40.0
cent
20.0
0.0

1950-51 1980-81 1990-91 2000-01 2006-07

(BE)

Domestic Liabilities

External Liabilities

Trend in External Borrowings

28

5.3.4. Why are gilt funds in the news?

First, lets understand the relationship between bond prices and the interest rates. The two are inversely
related. Hence a fall in interest rates, leads to a rise in bond prices. In racent times, the RBI has
undertaren a series of rate cuts to infuse liquidity into the system. The falling interest rates have
translated into an appreciation in prices of long-term bond; and G-secs alike. Expectedy, funds that are
invested in such secuities have benefited.
Average maturity:
Mostly, the average maturity and duration of such funds is on the higher side. Average maturity indicates
the tenor of a portfolio and duration measures how sensitive the price of a fixed income security is in
relation to change in interest rates. While the investment objective does not define the average maturity,
typicaly it ranges from a low two-year to as high as 15 years in some cases. The maturity of gilts is
defined by the DMO is as follows: short 0-7 years, medium 7-15 years and long 15 years+. Gilts with a
maturity of less than three years are also referred to as ultra short, whie the new gilts issued since 2005
with a maturity of 50 years have been referred to as ultra long.
Advisability of investment duration:
In case of bonds, if interest rates rise, bond prices fall and vice-versa. Let's say there is a 10-year bond
issue in Apri 2012 with an annual coupon of 8% and face value of Rs.100. If interest rates were to be
lowered in the next couple of months, subsequent bond issues of 10-year tenor are likely to have a lower
coupon rate. Now, this wil increase the demand for the former 8% corpon bond, which now has a
residual mattrity of around 9 years: hence, the price would increase.
Also, the longer the duration, the higher would be the impact on prices due to change in interest rates.
This happens simply because higher duration means the matuity date of the bond or portfolio of bonds
is farther away (from any new bond issuances today) and hence, the advantage of the relatively higher
irterest rate is more. In the above example, if the residual maturity of the 8% coupon bond was only one
year, the advantage of a comparatively higher coupon will be for another year, Iimiting the price rise.
Keep in mind though that this is also true in case the reverse happens. So if interest rates rise, bond
prices will fall and the impactor extent of damage will be greater where a fund has a high duration. In
the past, gift funds have seen negative returns in rising rate environment.
How are these investments taxed?
Simiar to any other Debt Fund, Dividends are Tax Free in the hands of the investor. Units if held for a
period of one year & above are eligble for indexation benefits as per the current tax ruling. lf you sell the
unit in less than a year, the retuns are added to your income and taxed according to the slab you fall
under (short-term capital gains tax). If you sell it after a year long-term capital gains tax is applied. It
should be noted that these are debt funds and not subject to the securities transaction tax.
How investing in GILT Fund is a better investment than investing in Fixed Deposits?
FD is for an investor with low risk appetite and who wants a stable fixed return. In a gilt fund one could
generate higher than FD returns but there is an element of risk due to movement in interest rates in the
market. Redemption from a GILT fund after a certain period (in our case one month) would not attract
any exit load thus the investor has the option of redeeming the money without any additional charges

29

unlike an FD where there could be a penalty for premature withdrawal. FD as per current income tax
rules is sutject to a tax as per the applicable income tax bracket. However any gains from a gilt fund is
considered as capital gains and hence taxed at a lower rate. Investment in an FD does involve an element
of credit risk as one relies on the ability of the bank to repay the FD as per schedule.
What major events affect the gilt funds performance in a big way?
I.
II.
III.
IV.
V.
VI.

RBI monetary poicy

Supply / Maturity of government debt
Inflation & Inflationary expectations
Economic growth outlook
Deposit Growth/Credit growth
Global bond yields

When do these investments perform well?

Gilt funds give good returns when other asset classes like equity are not doing well but to invest
successfuly in gilt funds, it is essertial to watch the economic indicators that can predict the decrease in
inerest rates. Some essential factors leading to interest rate reduction are peaking of inflation, reduction
in IIP (Index of Industrial Production), slow GDP growth and likelihood of reduction in corporate
earnings. At the same time you must also consider your capacity to take risk, goals and funds track
record you are investing in. Investors would do well to keep an eye on indicators that can be precursors
to a fall in interest rates. A slowdown in GDP growth, rising inflation, a decline in IIP (Index of
Industrial Production) and expectations of a fall in corporate earnings, to name a few. Broady speaking,
a situation when inerest rates have peaked and a downturn seems imminent, would be an opportune time
to invest in gilt funds. Of course, investors must understand that to make the most of their gilt fund
investments, being invested for the long haul (to cover an interest rate cycle) is important.
Are gilt funds really risk free?
While a gilt fund is sometimes thought of as being free of any risk, this is not strictly the case. Many of
these types of funds are structured to include investments that carry a variable or floating rate of interest.
This means that if the average interest rate should fall, the amount of returns generated for the fund may
be less than anticipated. From this perspective, the investor in a gilt fund does carry the risk of possibly
making less from the investment than originaly projected. Depending on how severe the shift in interest
rates happen to be, this could mean the investor would do better to withdraw and invest in a different
type of mutual fund.
Increasingly, gilt funds are being promoted by fund houses and investment advisors, by emphasising on
their risk free nature. That isnt entirely correct. We have already discussed how the underlying
instruments i.e. G-Secs do not expose investors to any credit risk. However, that doesnt make gilt funds,
risk free investment avenues in the conventional sense. Unlike small savings schemes wherein investors
enjoy both safety of capital and assured returns, gilt funds are not equipped to offer assured returns.
For instance, investments in gilt funds are vulnerable to interest rate risks. When interest rates rise,
prices of govemment securities fall; this in turn has an adverse impact on the performance of gilt funds.
Typicaly, higher the fund's average maturity, more it is prone to volatility.

30

A security is termed as liquid, if it can be easily bought and sold. It can be broady stated that higher the
liquidity, lower is the risk. A gilt fund can be invested in a G-Sec paper which isnt actively traded i.e. it
is illiquid. Now consider a scenario wherein to meet redemption pressure, the fund manager is forced to
make a distress sale i.e. incur a loss. This in turn will adversely affect the fund's performance.
One strong benefit of a gilt fund that does limit volatility is that the investments acquired for the fund
tend to be covered with some type of investment insurance. What this means is that even if
circumstances occur that preclude the delivery of any type of retum from the fund, investors are highly
likely to at least recoup the original contribution. Since trade laws and regulations vary from one nation
to the next, it is important to review the terms and conditions associated with a particular gilt fund and
find out exactly what type of protections are in place before choosing to participate in the fund.
What should investors do?
The question is - should investors consider investing in gilt funds? That would ideally depend on their
risk appetite, investment objective and existing portfolio, among a host of other factors. An investment
avenue that is apt for one investor could be grossly unsuitable for another. Therefore, investors would do
well to consult their investment advisors/financial planners to determine the suitabiity of gilt funds in
their portfolios. Price change in long duration bonds result in sharp moves in net asset value. Of course,
if you hold the fund for the stated average maturity, you are likely to eam the yield on the securities and
you will not lose money, but that can mean remaining invested for as long as 10 years. Some gilt funds
have an exit load extending up to a year. If you are looking for accrual income from fixed income, such
funds are not for you.
Thus, the factors an investor considers in selecthg the 'Best Gilt Fund' are:
1. Expense ratio
2. Loadcharges and load period
3. Past Performance (though not an indicator for future performance)
4. Fund size (at times a very large fund wodd be a disadvantage in case of extreme volatility)

31

5.4. Gilt-Edged Switching

It is the selling and repurchasing of certain high grade stocks or bonds to captue profits. Gilt-edged
switching involves gilt edged security, which can be highgrade stodr or bond issued by a financialy
stable company such as the Blue Chp companies or by certain governmems. They are considered to be
low-risk investments because they are backed by strong, established entities. Gilt edged secuities are
generaly inversely Iirked to interest rates, and therefore experience price fluctuations.
Git-edged switching is utiized by governments like those of the United Kingdom, South Africa and
Ireland. An example of a Gilt-edged switching is selling one bond in favor of another one.
Higher-yielding bonds may increase the potential for profit. Gilt edged switdiing may also involve
selling one bond at a discount in order to purchase a more favorably yielding investment.

5.5. GILT Funds in INDIA

The first gilt fund in India was set up in December 1998. The Reserve Bank of India is the governing
body of al gilt funds ever since. 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.
Govemment securities mean and include central government dated securities, state government
securities and treasury bills.
Reserve Bank and the Government Securities Market Legal Framework
Reserve Banks operations in the government securities market are governed by Sections 20, 21 and 21A
of the Reserve Bank of India Act, 1934. Under these provisions, the Reserve Bank is entrusted with the
function of management of public debt and issue of new loans of the Union Government and the State
Governments. The legal framework for Reserve Banks conduct of open market operations is provided
under Section 17(8) of the Reserve Bank of India Act, 1934, under which the Reserve Bank is authorised
to purchase and sell securities of the Union Government or a State Government of any maturity and the
security of a local authority specified by the Central Government on the recommendations of the Central
Board of the Reserve Bank. Central Government securities are used by the Reserve Bank for its open
market operations and liquidity adjustment facility (LAF). Effective April 3, 2007, the State
Development Loans were also permitted as eligible securities for LAF operations. The new Chapter
III-D of the Reserve Bank of India (Amendment) Act, 2006 has empowered the Reserve Bank to
determine policy relating to interest rate products and regulate the agencies dealing, inter alia, in
securities.
The Reserve Bank derives its regulatory power over the government securities market from Section 16
of the Securities Contract (Regulation) Act (SCRA), 1956, amended in March 2000, under which the
Government has delegated the powers exercisable by it to the Reserve Bank. The Reserve Bank is, thus,
authorised to regulate dealings in government securities, money market securities, gold related securities
and securities derived from these securities as also ready forward contracts in debt securities.

32

The Government Securities Act, which seeks to replace the Public Debt Act, 1944, was passed in August,
2006. This Act envisages the consolidation and amendment of the law relating to issue and management
of government securities by the Reserve Bank. The Act includes the provisions of the erstwhile Public
Debt Act relating to issuance of new loans, payment of half-yearly interest, retirement of rupee loans and
all matters pertaining to debt certificates and registration of debt holdings. Besides, the new Act gives
flexibility for holding government securities in depositories, while at the same time specifically
excluding government securities from the purview of the Depositories Act, 1996. The Act enables lien
marking and pledging of securities for raising loans against government securities, recognises electronic
form of record maintenance, enlarges dematerialisation facility through Bond Ledger Account and
liberalises norms relating to nomination and legal representation. The Act also provides the Reserve
Bank with substantive powers to design and introduce an instrument of transfer suited to the computer
environment. It also allows the Reserve Bank to issue duplicate securities, new securities on conversion,
consolidate with other like government securities, subpide the securities and renew, strip (separately for
interest and principal) or reconstitute the securities. The Act, however, is yet to come into force, pending
notification of Rules under it.
Recognising the impor tance of the government securities market, the Reserve Bank, in consultation
with the Government, undertook wide ranging reforms to develop this market. The major objectives of
reforms were to (i) grant operational autonomy to the Reserve Bank; (ii) improve institutional
infrastructure; (iii) impart liquidity and increase the depth of the market; (iv) improve market
microstructure; (v) create an enabling sound legal and regulatory framework; and (vi) increase
transparency. Keeping these objectives in view, reforms were undertaken to strengthen the primary and
the secondary segments of the government securities market. In the primary segment, measures were
taken to raise resources from the market in a cost effective manner, particularly in the light of the
transition to market related interest rate structure from the administered interest rate regime. In the
secondary segment, measures were initiated to improve liquidity in the market. Measures were also
undertaken to improve the trading systems, clearing and settlement infrastructure and the risk
management framework.
Facilities from Reserve Bank India:
The Reserve Bark provides liquidity support and other facilities, such as, SGL and current accounts,
transfer of funds through the Reserve Bank's Remittance Facility Scheme and access to call money
market to dedicated gilt funds. These faciities are provided to encourage gilt funds to create a wider
investor base for government securities market. The facilities provided to git funds include:
1.

2.

Liquidity support: The objective of extending support to dedicated gilt funds is to support
short-term liquidity requirements of such mutual funds. The Reserve Bank of India provides
liquidity support to gilt funds by way of reverse repurchase agreements (reverse repos). Reverse
repos are done in government of India dated securities eligible for repo transactions and
treasury bills of al maturities. The quantum of liquidity support on any day is up to 20 per cent
of the outstanding stock of government securities, includng treasury bills, held by the gilt funds
as at the end of the previous working day.
SGL and current accounts: The Reserve Bank opens one subsidiary general ledger (SGL)
account and one current account for git funds own transactions at all centers of the Reserve
Bank wherever desired by the gilt funds.

33

3.

4.
5.

Funds Insist faculty: The gilt funds are given the facility of tansfer of funds from one center to
another under the Remittance Facility Scheme of the Reserve Bark. The gilt funds are also
given the facility of clearing of cheques arising out of government securities transactions,
tendered at the Resenre Bank counters.
Access to call market: Gilt funds can access the call money marketas lenders.
Ready forwards: The Reserve Bank of India will also recommend to the Government of India
to permit the gilt funds to undertake ready forward transactions in Government securities
market.

5.6. GOVERNMENT SECURITIES MARKET IN INDIA: ANALYSIS

AND ASSESSMENT
An assessment of the impact of the measures taken to develop the government securities market since
the early 1990s reveals significant growth of the market in terms of both size and liquidity. The
outstanding stock of government securities has increased significantly, both in absolute terms and in
relation to GDP, in tandem with the growing financing requirement of the Government. Significant
changes in the primary market have also been observed in terms of wider participation and better price
discovery. The system of PDs has emerged as an important element, both in the primary and secondary
segments of the government securities market.
Magnitude of Government Securities
With the phasing out of ad hoc Treasury Bills and earmarking of small saving collections for the States,
the Central Government has been financing its deficit largely through market borrowings. Accordingly,
the share of market borrowings in financing Central Governments gross fiscal deficit increased to
around 70 per cent in 2005-06 from around 18 per cent in 1990-91. The share of market borrowings in
financing the gross fiscal deficit of the State Governments, however, showed a modest increase on
account of availability of other sources of financing such as small savings. As a result, market
borrowings financed around 46 per cent of combined gross fiscal deficit of the Centre and States in
2005-06 as compared with around 20 per cent in 1990-91. Accordingly, the outstanding stock of both the
Central and State Governments securities has increased significantly over the years. Implementation of
the MSS from 2004-05 has also contributed to the growth of outstanding government securities in recent
years .

34

Table 5.2: Government Securities Market in India*

Indicator

1991-92

1995-96

2000-01

2003-04

2004-05

2005-06

Outstanding
stock
(end-March)
(Rs. crore)

76,908

1,69,526

4,53,668

8,24,612

9,29,612

10,32,296

11.8

14.3

21.6

29.8

29.7

28.9

49.7

115.2

56.7

37.9

5.70

10.6

14.94

14.13

16.89

11.78

13.75

10.95

5.71

6.11

7.34

a) Primary
market

51.47

52.88

40.36

b)
Secondary
market
turnover

23.91

28.24

31.13

Outstanding
stock as
ratio of GDP
(end-March)
(Per cent)
Turnover /
GDP (Per
cent)
Average
maturity of
the
securities
issued
during the
year (Years)
Weighted average cost of
the securities
issued
during the
year (Per
cent)
PD share in
government
securities
market #
(Per cent)

* : Central Government securities.

# : Pertain to Central and State Governments.

35

Elongation of Maturity Profile

As part of prudent debt management strategy, the Reserve Bank has elongated the maturity profile of the
outstanding stock of government securities by issuing securities of longer maturity. The weighted
average maturity of primary issuances of the Central Government securities increased to 14-15 years
during the first half of the current decade as compared with 6.6 years in 1997-98. Mirroring this pattern,
the weighted average maturity of outstanding stock of government securities increased to 9.9 years at
end-March 2006 from 6.5 years at end-March 1998 .
In pursuance of the policy of elongating the maturity of government securities, the maximum maturity of
securities issued was extended to 25 years in 2001-02 and further to 30 years in 2002-03. Long-dated
securities with residual maturity of 20 years and above increased from a mere two securities out of 32
issuances in 1998-99 to 12 securities in 2005-06, indicating the growing appetite for these securities
among insurance companies and pension funds. The weighted average maturity of securities issued
during 2002-03 declined marginally mainly because of the issuance of securities for prepayment of
foreign debt on a maturity matched basis for an average tenor of 9.3 years. Apart from the objective of
smooth debt management, the maturity profile was also elongated keeping in view the investor response,
particularly the non-bank investors such as insurance companies. The share of securities with maturities
of more than 10 years constituted 74 per cent of total issuances during 2005-06, while securities issued
below
5-year
maturity
were
insignificant
.
Reflecting the elongation of maturity of the primary issuances, the composition of outstanding
government securities has undergone a transformation with the sharp increase in the share of securities
with more than 10-year maturity in total outstanding stock since 1998-99. Elongation of maturity profile
has enabled the formation of yield curve for a longer horizon.
Yields on Government Securities in the Primary Market
The process of maturity elongation was facilitated by the benign interest rate regime which prevailed
during the first half of the current decade. This brought down the cost of resources raised for financing
the Government deficit. The weighted average yields, which started moderating from 1996-97, declined
to 5.7 per cent and 6.1 per cent for the Central and State Government securities, respectively, by 2003-04.
The weighted average yield on government securities, however, took an upturn in 2004-05 and
continued to rise in 2005-06. This was on account of the hardening of interest rates due to uncertainty
surrounding international oil prices, upturn in global interest rate cycle, buoyant domestic growth and
rise in domestic inflation. As discussed above, the average maturity of the primary issuances increased
mainly due to encouraging investor response.

36

Table 5.6: Weighted Average Interest Rate on

Government Securities
(Per cent)
Year

Centre

States

1990-91

11.4

11.5

1991-92

11.8

11.8

1992-93

12.5

13.0

1993-94

12.6

13.5

1994-95

11.9

12.5

1995-96

13.8

14.0

1996-97

13.7

13.8

1997-98

12.0

12.8

1998-99

11.9

12.4

1999-00

11.8

11.9

2000-01

11.0

11.0

2001-02

9.4

9.2

2002-03

7.3

7.5

2003-04

5.7

6.1

2004-05

6.1

6.4

2005-06

7.3

7.6

37

6. DEVELOPMENTS IN GOVERNMENT SECURITIES MARKET IN

INDIA
The evolution of the government securities market in India has been in line with the developments
in other countries. Slow development of the market in the 1970s and the 1980s was shaped by the need
to meet the growing financing requirements of the Government. This essentially resulted in financial
repression as progressively higher statutory requirements were stipulated, mandating banks to invest in
government securities at administered interest rates. Although this captive financing provided low cost
resources to the Government, it impeded the development of the market and distorted the interest rate
structure. Furthermore, such arrangements, along with automatic monetisation of Government deficits,
hampered the conduct of monetary policy.Recognising the need for a well developed government
securities market, the Reserve Bank, in coordination with the Government, initiated a series of measures
from the early 1990s to deregulate the market of administered price and quantity controls. Consequently,
the government securities market has witnessed significant transformation in various dimensions, viz.,
market-based price discovery, widening of investor base, introduction of new instruments, establishment
of primary dealers, and electronic trading and settlement infrastructure. This, in turn, has enabled the
Reserve Bank to perform its functions in tandem with the evolving economic and financial conditions.
Wide ranging reforms in the government securities market were largely undertaken in response to the
changing economic environment. Increased borrowing requirements of the Government, stemming from
high fiscal deficits, had to be met in a cost effective manner without distorting the financial system. The
underlying perspective of the reform process was, therefore, to raise government debt at market related
rates through an appropriate management of market borrowing. There was also a need to develop a
benchmark for other fixed income instruments for the purposes of their pricing and valuation. An active
secondary market for government securities was also needed for operating monetary policy through
indirect instruments such as open market operations and repos. Reforms, therefore, focussed on the
development of appropriate market infrastructure, elongation of maturity profile, increasing the width
and depth of the market, improving risk management practices and increasing transparency.
Governments issue securities with maturities ranging from less than a year to a very long-term stretching
up to 50 years. Typically, short-term maturities up to one year, viz., Treasury Bills, form a part of the
money market and facilitate the Government's cash management operations, while bonds with maturities
more than a year facilitate its medium to long-term financing requirements.
As stipulated under the Fiscal Responsibility and Budget Management Act, 2003, the Reserve Bank has
withdrawn from participating in the primary market for government securities from April 1, 2006. The
increasing move towards fuller capital account convertibility as recommended by the Committee on
Fuller Capital Account Convertibility (FCAC) (Chairman: Shri S.S. Tarapore) would necessitate
measures that promote greater integration of the domestic financial markets with global markets. The
deepening of the government securities market is, therefore, essential not only for transmission of policy
signals but also for developing the derivatives market which would meet future challenges thrown up by
further liberalisation of the capital account. Moreover, an environment of freer capital flows will also
necessitate widening of the government securities market with further persification of the investor base.

38

6.1. POLICY DEVELOPMENTS

The development of the government securities market in India in the pre-reform period was mainly
constrained, like in most developing countries, by almost unlimited automatic monetisation of the
Central Government budget deficits, captive investors (predominantly banks and insurance companies)
and administered coupon rates on government securities at artificially low levels. As a result, the
secondary market for government securities was almost nonexistent. This impinged on the price
discovery process, which is crucial for the development of any market. Since interest rates were kept
low in order to ensure low cost of Government borrowing, real rates of return remained negative for
several years. Artificially low yields on government securities affected the interest rate structure in the
system. In order to compensate for low yield on government securities, banks charged higher interest
rates to the commercial sector.
Higher interest rates for the private commercial sector not only adversely impacted investment activity
and economic growth, but also affected the financial health of the banking system as bad debts mounted
over time. Low economic growth resulted in lower revenues for the Government, both tax and non-tax,
necessitating higher borrowing. This was largely met through the mechanism of ad hoc Treasury Bills
issued by the Government to the Reserve Bank and the progressive increase in SLR, as a result of which
the government securities market remained dormant. Driven by the compulsions of automatic
monetisation, which resulted in expansion of monetary base, the Reserve Bank had to progressively
raise the cash reserve ratio (CRR) of banks for monetary management. In the face of large government
borrowings and the need to restore the health of the financial system, the Reserve Bank, in consultation
with the Government, initiated reforms in the government securities market as a part of financial sector
reforms in the early 1990s. These reforms were broadly aimed at removing the imperfections in the
market and creating enabling conditions for its development.

39

6.1.1. Developments in Primary Markets

In the primary market, a price discovery mechanism was activated by introducing an auction system.
Efforts were also made to broaden the investor base and promote voluntary subscriptions in government
securities. To provide a wider menu, new instruments were introduced from time to time to suit the
investor requirements.

Issuance Procedures
In the initial phase of reforms, the focus was on migration from the administered interest rate regime to a
market oriented price discovery mechanism. Accordingly, a system of auctions was introduced in 1992
for Central Government securities whereby the amount is notified but the coupon rate is auction
determined. Tap issuances, for which the coupon rate was pre-determined but the amount was not
notified, were also conducted from time to time up to 2000.Since the inception of the auction system,
multiple price auction system has been used for dated securities. The uniform price auction format,
followed for the issuance of 91-day Treasury Bills from November 1998, was extended to auctions of
Central Government dated securities on a selective basis from 2001. While both methods of pricing are
used, multiple price auction is the most frequently used selling technique for issuance of dated securities.
The uniform pricing technique is used when there is market uncertainty. It is also used for issuing new
instruments, such as floating rate bonds and bonds with embedded options, as well as bonds with long
tenor as in such cases the market does not have a reference rate.
Auctions of government securities between 1992-93 and 1998-99 were conducted solely on the basis of
yield (coupon). In order to consolidate outstanding loans for ensuring sufficient volumes and liquidity in
any one issue, price-based auctions were introduced in May 1999, whereby new loans are raised through
re-issuances of existing securities with predetermined coupons. This helps the price discovery of a
security already in existence in the market. Yield-based auctions are, thus, employed in respect of new
issuances, and price-based auctions in respect of reissue of existing securities.Apart from allotment
through auction, a system of non-competitive bidding was introduced in January 2002 to encourage
retail investors who do not have sufficient expertise in such bidding. The Reserve Bank also participated
on a non-competitive basis in the government securities auctions up to April 1, 2006 to primarily take up
some part of the issues in the case they were not fully subscribed.
Unlike Central Governments market borrowings, a predominant share of State Governments market
borrowings was conducted by way of tap issues up to 2005-06. The traditional tranche method (under
which government securities were issued with a pre-determined coupon and notified amounts for each
State) was employed between 1991-92 and 1997-98. Beginning 1998-99, a combination of the auction
method and tap method has been employed. The State Governments could opt for auction route
between 5 to 35 per cent of the allocated market borrowings (subsequently raised to 50 per cent). The
umbrella tap tranche method was introduced during 2001-02 to avoid the risk of under-subscription of
any issue of the State Governments. Under this method, after receiving the concurrence of the State
Governments, the Reserve Bank announces the name of the States participating in the tap, the aggregate
targeted amount to be raised and the coupon rate which is fixed uniformly for all the States. The targeted
amount in respect of individual States is not separately announced. Up to December 2002, the tap was

40

normally kept open till the targeted amount was received for each State. This resulted in keeping the tap
open for more than two days in respect of a few States. As this procedure subjected the States to
reputational risk, which varied with the number of days taken to close the tap, it was decided in January
2003 to close the tap at the end of the second day even if the targeted amount is not mobilised. The
names of the States whose issues are not fully subscribed as well as the amount of under-subscription are
not disclosed.
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 non-scheduled 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 individual gilt fund,
however, should not exceed five per cent of its total portfolio at any point of time.
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
41

oriented mutual funds. From April 1, 2007, the entire ALD is required to be invested in directed
investments only.
Primary Dealer System
A system of market intermediaries in the form of PDs was made functional in 1996 with the objectives
of supporting the market borrowing programme of the Government, strengthening the securities market
infrastructure and improving the secondary market liquidity in government securities. PDs were also
expected to encourage voluntary holding of government securities among investors. The PD system was
essentially conceived for institutions whose basic interest is not to hold securities but to participate in
primary auctions with the intent to access the securities in the secondary market. PDs are responsible for
ensuring the success of primary auctions. To discharge their obligations effectively, PDs have been
given privileges in terms of provision of current account and SGL facilities with the Reserve Bank. They
also have access to the liquidity adjustment facility (LAF) of the Reserve Bank. 5.80 Prior to April 2006,
the success of PDs in the primary auctions was ensured through a scheme of underwriting, and a system
of bidding commitments and success ratios in the auctions. Underwriting commitments were separately
decided prior to the actual auction for primary issuance, with the PDs bidding to underwrite various
amounts at various commission rates. The Reserve Bank decided the actual allotment of the
underwriting commitment, taking into account various factors such as the likelihood of devolvement and
the commission sought. The full notified amount was rarely allotted in underwriting auctions. Since
underwriting was a purely voluntary responsibility, the success of primary auctions was sought to be
achieved through bidding requirements, which were set at the beginning of the fiscal year for each PD,
depending mainly on its capital size. In order to ensure against defensive bidding, the stipulation of a
success ratio of 40 per cent of bidding commitments was mandated. The performance of PDs in respect
of bidding commitments and success ratios were monitored cumulatively over the year.
The presence of PDs in the government securities market has brought about an element of dynamism,
both in the primary and the secondary segments. PDs have been actively participating in the auctions of
government securities. By providing continuous two-way quotes, PDs act as market makers in the
secondary market. The liquidity in the secondary market, in turn, lends support to the success of primary
market operations. The PD system also facilitates open market operations of the Reserve Bank, besides
taking over the responsibility of market making from the Reserve Bank.
Retail Investors
Since the process of bidding in the auctions requires technical expertise, generally it is the large and
informed investors such as banks, PDs, financial institutions, mutual funds and insurance companies that
participate in the auctions. As a large section of medium and small investors remained out of the primary
market for government securities, a scheme of non-competitive bidding was introduced in January 2002
to enable small and medium investors to participate in the primary auction of government securities
without having to quote the yield or price in the bid. Apart from encouraging wider participation and
retail holding of government securities, this scheme enables individuals, firms and other mid-segment
investors, who do not have the expertise to bid competitively in the auctions, to get a fair chance of
assured allotments at the rate which emerges in the auction. The scheme provides for allocation up to 5
per cent of the notified amount in the specified auctions of dated securities at weighted average rate of
accepted bids. The investor is permitted to make only a single bid per auction and the size of the bid can
vary from a minimum of Rs.10,000 to Rs.2 crore. Eligible investors have to come through a bank or PD
42

for auction. In view of their statutory obligations, RRBs, UCBs and NBFCs can also apply under this
Scheme within the ceiling of Rs.2 crore.
To ensure higher retail participation, it is important to improve liquidity in the secondary market.
Towards this end, the Reserve Bank has been encouraging PDs to offer two-way quotes to retail
investors and become members of the stock exchanges. Screen-based order driven trading in stock
exchanges was also introduced in January 2003 to encourage retail participation in the government
securities market.
Instruments
Persification of available instruments encourages participation of varied investors, as different categories
of investors require different kinds of instruments to meet their specific needs. While banks require
government securities for their asset liability management in addition to maintaining the prescribed SLR,
insurance companies and provident funds require long-term investments to match their liabilities. Prior
to the reforms initiated in the early 1990s, most of the government bonds were in the form of plain
vanilla fixed coupon securities. Since 1994, the Reserve Bank has been developing a range of
instruments to cater to the persified requirements and hedging needs of investors. These include zero
coupon bonds, capital indexed bonds, floating rate bonds and bonds with call and put options
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. There were four
issuances of ZCBs between 1994 and 1996.
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. There were 10 issuances of
the FRBs till October 9, 2004. 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. In the secondary market, liquidity in FRBs, is low due to (i) low trading interest of market
participants in FRBs as such instruments, by design, are hedging instruments and offer limited scope for
trading gains; (ii) no reissuance of FRBs on account of complexities associated with pricing; (iii)
preference of commercial banks to place these bonds under held to maturity (HTM) category, reducing
the availability of bonds for trading; and (iv) complex pricing method which deterred market
participants from undertaking outright transactions in FRBs.
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 lacklustre 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
43

principal repayments at maturity. The coupon rate for the bonds would be specified in real terms. This
rate would be applied to the inflation-adjusted principal to calculate the periodic semi-annual coupon
payments. The principal repayment at maturity would be the inflation-adjusted principal amount or its
original par value, whichever is greater. Thus, there is an in-built insurance that at the time of
redemption the principal value would not fall below the par value. 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).
When Issued Market
A when issued (WI) market facilitates efficient distribution of auctioned stock by stretching the actual
distribution period for each issue and allowing the market more time to absorb large issues without
disruption. It also facilitates an efficient price discovery process for both the issuer and the investor as it
reduces uncertainties surrounding auctions by enabling bidders to gauge the market demand and
accordingly price the securities being offered. PDs are also able to manage their auction risk by selling
in WI markets even before the auction. As part of the restructuring of the debt issuance framework,
guidelines for trading in WI market were issued by the Reserve Bank in May 2006. A limit of 5 per
cent (only buy side) of notified amount was prescribed for banks and 10 per cent (both buy and sell) for
PDs. WI trading, which commenced in August 2006, was initially permitted in reissued securities. It
takes place from the date of announcement of auction till one day prior to allotment of auctioned
securities. The revised guidelines extending WI trading to new issuances of Central Government
securities on a selective basis were issued in November 2006. WI trading in new issuances will come
into effect after the necessary software modifications are carried out in the NDS-OM trading platform.

44

6.1.2. Reforms in Secondary Markets

The development of primary market for government securities with persified investor base also hinges
upon the existence of a well-developed secondary market. This, in turn, requires participants with varied
liquidity requirements and differing perceptions regarding the future movement of interest rates. A deep
and liquid market is efficient and less volatile. Hence, the Reserve Bank has been taking parallel
measures to develop the secondary segment of government securities as well.
The Reserve Bank has been pursuing a policy of passive consolidation through re-issuance/ re-openings
of existing securities since April 1999 in order to benchmark securities across the yield curve and
improve liquidity of securities. The reissues are, however, limited by the maximum outstanding amount
that is perceived as manageable in terms of redemption in the year of maturity. While re-issuance has
achieved some degree of consolidation, there are still a large number of small sized securities, most of
which are not actively traded in the market. The lack of liquidity underscores the need for adequate
number of securities with sufficient stock.
Sale of auctioned Stock
In order to deepen the government securities market and enable the mitigation of price risk, the Reserve
Bank permitted from October 2000, the sale of government securities allotted to successful bidders in
primary issues on the day of allotment to entities having SGL account. These are settled under the
Reserve Banks DvP system, thereby removing restriction on the period between sale and purchase. This
facility was extended in respect of sale to constituent subsidiary general ledger (CSGL) account holders
and sale between CSGL account holders, effective May 11, 2005.
Short Selling in Government Securities
In the absence of a facility of short selling in government securities, par ticipants generally refrained
from taking positions in a falling market, which resulted in drying up of volumes. Trading activity,
which normally peaked during the bullish times, petered out when the yields started moving up. To keep
the markets liquid and active even during the bearish times, and more importantly, to give the
participants a tool to better manage their interest rate risk, intra-day short selling in government
securities was permitted among eligible participants, viz., scheduled commercial banks (SCBs)
and PDs in February 2006 on the basis of the recommendations of the Technical Group on the Central
Government Securities Market. The introduction of short selling also paved the way for when issued
trading in August 2006. As part of the phased introduction of short sale, the short positions have been
permitted to be carried beyond intra-day for a period of five trading days, effective January 31, 2007. As
this arrangement results in carrying short positions across settlement cycles, participants are allowed to
deliver a shorted security by borrowing it from the repo market.

45

6.1.3. Developments in Market Infrastructure

As part of financial sector reforms, the Reserve Bank has taken several initiatives for developing the
technological infrastructure for the efficient functioning of the government securities market. These
measures were accompanied by an assessment of the risk management systems under the new
institutional arrangements.
Trading Infrastructure
A well-developed government securities market requires a system of transparent pricing and allotment
mechanism which reduces transaction cost and improves market efficiency. In June 1994, the National
Stock Exchange (NSE) introduced a transparent fully automated screen-based trading system known as
National Exchange for Automated Trading (NEAT) in the wholesale debt market (WDM) segment for
facilitating trading in various debt instruments, including government securities.Although the WDM
segment of the National Stock Exchange has the facility to match trades, it has been used mostly for
reporting of negotiated deals intermediated by the brokers registered with the exchange. The settlement
of these deals is, however, done between the counter parties and without the involvement of the stock
exchange. Participants in the secondary market are limited to banks, financial institutions, mutual funds,
FIIs and Trusts.
In order to facilitate easier access, wider reach and active participation in the government securities
market, a facility of retail trading in stock exchanges, viz., National Stock Exchange (NSE), Bombay
Stock Exchange (BSE) and Over the Counter Exchange of India (OTCEI) was provided from January 16,
2003. Primary (urban) co-operative banks and FIs were permitted to transact in dated Central
Government securities in dematerialised form on automated order driven systems of stock exchanges
from March 13, 2003 and from June 1, 2003, respectively. For this purpose, banks and financial
institutions have been permitted to open demat accounts with depository participants in addition to their
SGL accounts. The minimum order size has been kept low at Rs.1,000 (face value) to take care of the
interests of the small investors. Trades in government securities are cleared by the respective clearing
corporations of the exchanges. The settlement procedure through settlement banks and demat accounts
with depository participants (institutions permitted by the SEBI to open demat accounts) is akin to any
other transaction on the exchange. However, despite the presence of technological infrastructure, trading
through stock exchanges has not shown marked improvement.
The Reserve Bank introduced the Negotiated Dealing System (NDS) in February 2002 with the
objectives of (a) ushering in an automated electronic reporting and settlement process; (b) facilitating
online electronic bidding in primary auctions; and (c) providing an electronic dealing platform for
trading in government securities in the secondary market. The NDS, which is available on a secure
network, i.e., Indian Financial Network (INFINET) to a closed user group, facilitates straight-through
settlement of secondary market transactions, thereby enhancing transparency and transactional
efficiency. The NDS has greatly enhanced operational efficiency of the market by automating the flow
of traded data into the settlement system. It has also facilitated dissemination of price information almost
on a real time basis to market participants, enabling them to execute trading decision more effectively.
The NDS has, however, gained popularity more as a reporting platform for the trade concluded
bilaterally in OTC markets than as a trading platform as originally envisaged.

46

The CCIL was established on February 15, 2002 to act as the clearing house and as a central
counterparty through novation for transactions in government securities. The CCIL has 154 members
participating in the securities settlement segment. The establishment of CCIL has ensured guaranteed
settlement of trades in government securities, thereby imparting considerable stability to the markets.
Through the multilateral netting arrangement, this mechanism has reduced funding requirements from
gross to net basis, thereby reducing liquidity risk and greatly mitigating counterparty credit risk. The
CCIL has been equipped with the risk management system to limit the settlement risk. Operational
guidelines were issued to the CCIL in April 2003 for a limited purpose government securities lending
scheme. Accordingly, the CCIL has been permitted to enter into an arrangement with any of its members
for borrowing government securities for the purpose of handling securities shortage in settlement. All
transactions in government securities concluded or reported on NDS as well as transactions on the
NDS-OM have to be necessarily settled through the CCIL. The net obligations of members are arrived at
by the CCIL for both funds and securities and then sent to the Reserve Bank for settlement under the
DvP mechanism.
Risk Management
Marking to market of securities is essential to establish the current value and recognise profits or losses
in the books of account. In terms of the Reserve Banks guidelines, the investment portfolio of banks is
required to be classified into three categories, viz., held for trading (HFT), available for sale (AFS)
and held to maturity (HTM). Securities classified under HFT are to be marked to market on a monthly
basis, if not more frequently. Securities in the AFS category are to be marked to market at year-end, if
not more frequently. Securities in the HTM category can be carried at book value, subject to certain
conditions. Banks are not allowed to book the mark to market gains. As government securities are
exposed to market risks, the Reserve Bank has been prescribing norms to ensure that banks and other
entities regulated by it maintain adequate cover against such risks. As an initial step towards prescribing
capital charge for market risk, the Reserve Bank had stipulated that banks assign a risk-weight of 2.5 per
cent to cover market risk in respect of government securities from the year ended March 2001. However,
subsequently banks were required to charge capital for market risk in terms of Basel norms. Accordingly,
banks were required to maintain capital charge for market risk for the HFT category from March 2005
and for AFS category from March 2006. They are required to measure the general market risk charge for
interest rate risk by calculating the price sensitivity (modified duration) of each position separately. The
capital requirements are to be maintained on a continuous basis and banks are required to maintain risk
management systems to monitor and control intra-day exposures to market risks.
Conclusion
The government securities market in India has evolved over the years. Several measures have been
initiated since the early 1990s to develop a deep and liquid government securities market for reducing
the cost of government market borrowings, providing appropriate benchmarks for pricing other financial
instruments and conducting monetary policy in a flexible manner. While significant progress has been
made in this direction, the evolving economic conditions and the move towards fuller capital account
convertibility necessitate further fine-tuning of the operating framework so as to ensure smooth debt
management operations.

47

6.2. Developments at a glance

48

49

7.1. Gilts - UK Government Bonds

UK Government Bonds are also called gilt-edge securities, or giltsand sometimes Treasury Stock.
Gilts are issued by the UK Debt Management Office on behalf of Her Majestys Treasury and they are
listed on the London Stock Exchange. These government bonds are called gilts because originally the
certificates for these securities were edged in gilt. Most gilts are sold with a fixed rate of interest for the
life of the bond, paid semi-annually, with full repayment of the face value on maturity (sometimes called
bullets). UK government securities are considered one of the highest quality bonds in the world
because the UK has never defaulted on an issue (although past results are not a guarantee that there will
be no default in the future).
Gilts are issued in pound sterling 100 units but can be traded in smaller units. Gilts are issued for periods
between 1-50 years. Gilts cannot be cashed in before their official maturity date however an investor can
sell them in the bond market (see Buying and Selling Gilts). There are also a few undated gilts which
have no redemption date.
UK gilts are characterised by the number of years left to maturity. Gilts are short dated if they have
less than seven years to maturity; medium dated if the bonds have between 7 and 15 years to maturity;
and long dated if the date to maturity is more than 15 years. Individual investors should note that this
differs from convention in the US, where bond markets specify maturities by using the number of years
to maturity when issued.
Gilts have various tax advantages and requirements. Consult your tax advisor; the UK Debt
Management Website or the UK Tax Authority via the link in the Resource Centre.

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7.2. A Brief History Of British Gilt Edged Securities

The history of British gilt edged securities can be traced back to the need for governments to raise
capital. In essence, these gilts are bonds that are issued by a government to fund the shortfall between its
tax revenues and its expenditure.
The term gilt edged securities is actually a British phrase that was initially a reference to debt
securities that were issued by the Bank of England. These original debt securities featured a gilded edge,
leading to the name of gilt edged securities.
In the present day, the phrase gilt edged securities is used in the UK, but also in some of the
Commonwealth countries like India and South Africa. However, when a security is referred to as a gilt,
it is generally a reference to the bonds issued by the UK government.
While these gilts were originally certificates with gold-leaf trimming, today they are traded in electronic
form. Conventional Gilts are the simplest version of UK government bonds and account for the largest
portion of outstanding UK government debt, at just over 81 per cent, according to the data from the Debt
Management Office.
These conventional gilts have been around for some time according to The Gilt-Edged Market by
Choudhry, Cross and Harrison, the first fund raising that could be considered a gilt issue was in 1694
when King William III borrowed 1.2m to fund a war against France.
However, specific kinds of gilts, at least in the UK, such as index-linked gilts were first issued in 1981,
with the UK being one of the first developed economies to do this. Index-linked gilt edged securities
account for the next largest proportion of the UK government debt, at around 18%.
As it stands today, the UK government is raising around 170 billion pounds gross every year (around
115 to 130 billion pounds net issuance) through gilt auctions. This increased significantly following the
financial crisis in 2008 and peaked at 227 billion pounds gross issuance in the Financial Year 2009 /
2010.
From the very first gilt issuance way back in 1694, the size of the national debt of the UK has grown,
which is similar to many developed economies. This growth has been more extreme in recent years
however. To illustrate this, in March 1998, the total stock of outstanding gilts was 418 billion pounds.
However, as at November 2012, the outstanding stock of gilts has increased to just under 1.2 trillion
pounds an increase of 187% in just over 14 years.
Today, the statistics also provide a very reliable picture of which investors hold UK gilt edged securities,
with around two thirds of all UK gilts now being owned by either pension funds or insurance companies.
Since 2009, there have also been large amounts of gilts issued and re-purchased by the Bank of England
by way of its policy of quantitative easing.
Investors who are interested in gilt edged securities are able to invest through their brokers or via a fund.
It is also possible to invest in gilts directly through the Debt Management Office, which replaced the
Bank of England as the issuer of these gilts in April 1998.

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7.3. TYPES OF GILTS SECURITIES

There are many types of gilts, but 99% of gilt issues are in two major types: conventional gilts and
index-linked gilts.
These are the simplest form of UK government bond and make up the largest share of UK government
debt (30% as of March 2008). A conventional gilt is a bond issued by the UK government which pays
the holder a fixed cash payment (or coupon) every six months until maturity, at which point the holder
receives his final coupon payment and the return of the principal.
Coupon rate
Conventional gilts are denoted by their coupon rate and maturity year, e.g. 4% Treasury Gilt 2055. The
coupon paid on the gilt typically reflects the market rate of interest at the time of issue of the gilt, and
indicates the cash payment per 100 that the holder will receive each year in two payments. (Historically
some gilts, intended primarily for higher rate taxpayers, were issued with coupons below the market rate.
A few undated gilts pay quarterly interest.)
Gilt names
Historically, gilt names referred to their purpose of issuance, or signified how a stock had been created,
such as 10% Conversion Stock 1999. In more recent times, gilts have been generally named Treasury
Stocks. Since 2005-2006, all new issues of gilts have been called Treasury Gilts.
Trends
The most noticeable trends in the gilt market in recent years have been:
I.

a substantial and persistent decline in market yields as the currency has stabilised compared to
the 1970s and more recently UK gilts are seen as a safe haven compared to certain other
government bonds
II. a decline in coupons: several gilts were issued in the 1970s with coupons of around 15% per
annum, but these have now matured
III. an increase in the volume of issuance as the Public Sector Borrowing Requirement has
increased
IV. a large volume of gilts have been repurchased by central government under its quantitative
easing programme

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Index-linked gilts These account for around a quarter of UK government debt within the gilt market.
The UK was one of the first developed economies to issue index-linked bonds in 1981. Initially only
tax-exempt pension funds were allowed to hold these bonds. The UK has issued around 20 index-linked
bonds since then. Like conventional gilts, index-linked gilts pay coupons which are initially set in line
with market interest rates. (Recently, real market interest yields for many index-linked gilts have been
negative but the coupons for new issues have been constrained to be at least +0.125%.) However, their
semi-annual coupons and principal payment are adjusted in line with movements in the General Index of
Retail Prices (RPI).
In September 2005, the UK Government issued the longest ever index-linked government bond, 1%
Index-linked Treasury Gilt 2055, maturing on 22 November 2055. Further ultra-long index-linked bonds,
maturing in 2062 and 2068, were issued in October 2011 and September 2013 respectively.
Indexation lag
As with all index-linked bonds, there is a time lag between the collection of prices data, the publication
of the inflation index and the indexation of the bond. From their introduction in 1981, index-linked gilts
had an eight-month indexation lag (between the month of collection of prices data and the month of
indexation of the bond). This was so that the amount of the next coupon was known at the start of each
six-month interest accrual period. However in 2005 the UK Debt Management Office announced that all
new issues of index-linked gilts would use a three-month indexation lag, first used in the Canadian Real
Return Bond market, and the majority of index-linked gilts now in issue are structured on that basis.
Index-linked Gilts
Index-linked gilts (IGs), sometimes known as inflation-linked bonds, were an innovation of the UK that
has since been copied by other Governments, such as with US Treasury TIPS LINK. Index-linked gilts
have coupon payments and principal that are adjusted in line with the UK Retail Price Index (RPI); in
other words, the coupon payment and the principal are adjusted to take account of accrued inflation
since the gilt was first issued. Each coupon payment on Index-linked gilts contains half the amount of
the annual real interest rate coupon (listed in the title of the gilt) and the adjustment applied to the real
coupon payment amount to take account of increases in RPI since the gilts issue.
Factors in calculation of index-linked gilts:
Time lag: Newer issues of index-linked gilts are calculated on a three month indexation so-called lag
structure. Older issues were calculated on an eight month lag.
Methodology of indexation: The methodology of the indexation is also different between these two
types of index linked gilts.
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The UK Debt Management Office has a section of data related to index linked gilts on its website.
Information on formulae for calculating gilt prices from Yields and Daily Index ratios and reference
RPIs on its website.
Double-dated gilts
In the past, the UK government issued many double-dated gilts, which had a range of maturity dates at
the option of the government. The last remaining such stock was the 12% Exchequer Stock 2013-2017, a
"rump gilt" with a relatively small amount outstanding and a very limited market, and this was redeemed
on 12 December 2013.

Undated gilts
There exist eight undated gilts, which make up a very small proportion of the UK government's debt.
They have no fixed maturity date. These gilts are very old: some, such asConsols, date from the 18th
century. The largest, War Loan, was issued in the early 20th century. The redemption of these bonds is at
the discretion of the UK government, but because of their age, they all have low coupons, and for a long
time there has therefore been little incentive for the government to redeem them. However in early 2009,
and again in late 2011, and at various times since then, the yield on these gilts, and in some cases also
the coupon, has been higher than the redemption yield on long-dated redeemable gilts, which implies
that the market is pricing in the chance that the government might redeem these gilts at some point. The
question of the redemption of War Loan has now been publicly raised. Because the outstanding amounts
are relatively very small, there is a very limited market in most of these gilts. In May 2012 the Debt
Management Office issued a consultation document which raised the possibility of issuing new undated
gilts, but there was little support for this proposal.
Gilt STRIPS
STRIPS is an acronym for Separate Trading of Registered Interest and Principal Securities. Gilts that
can be traded this way refers to stripping a gilt into its principal and coupon segments which can then
be held separately or traded separately as non-interest bearing (or zero-coupon) bonds. STRIPS are
called zero coupon bonds because they do not pay interest on the maturity date of the STRIP; the
holder receives a payment for the strips nominal value. Because of this, such bonds trade at a discount
to face value prior to maturity. All strippable gilts are currently conventional fixed coupon bonds. UK
Debt Management Office states that it intends that all issues of new conventional gilts will be strippable.
More information on details Gilt STRIPS is available through the UK Debt Management Office.
Individual investors can invest in STRIPSin some cases, directly--but individual investors should
consult a financial advisor or broker before investing in STRIPS as this is a product that has been aimed
more at the market professional.

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SOME MAJOR GILTS ISSUED BY UK GOVT.

SECTORAL HOLDINGS OF GILTS SECURITIES

55

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OVERSEAS HOLDING OF UK GILTS

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7.4. PRESENT STATUS OF UK GILTS MARKET

The UK gilt yield curve (depicted in orange) is currently very steeply upward sloped - from 0.5% at the
short end to over 4% at the long end of the curve. The real yield curve (depicted in white) is also upward
sloped and very low across all terms. It is between 0.5% and 1% at longer terms therefore future
inflation expectations are at about 3-4% across the curve.The short end of the curve reflects the Bank of
England (BOE) base rate which has been set at a record low to stimulate the economy. In addition, a
quantitative easing programme (QE) was put into action last year whereby the BOE purchased gilts
using new money which it electronically printed. At the time QE was introduced this increased the
demand side in the gilts market, lowering gilt yields.In addition to monetary policy, government fiscal
policy has loosened to assist the situation. There has been stimulus via tax breaks e.g. the rate of VAT
was temporarily cut to 15%, the government offered cash for clunkers in a scheme intended to help
raise demand for new cars and planned future government spending has been brought forward to act as
an economic stabiliser. Due to the state of the economy, tax receipts have fallen. This situation has led to
higher budget deficits - financed in the short term by higher government borrowing.
In the latest decision by the BOE on interest rate policy in February 2010, base rates were held at 0.5%
and QE was held at 200bn.

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Conclusion
The government securities market is typically the seminal and organic component of financial
markets in most countries. It is a veritable public good in the sense that all credit/debt market
instruments, including derivatives are typically priced on the basis of this market. Various
measures, therefore, have been initiated by the authorities to develop and foster deep, liquid
and efficient government securities markets in several countries.
First, while the large size of issuances of government securities contributes to market
liquidity, countries facing fixed or declining borrowing requirements have proactively
enhanced market liquidity by enlarging issuances of benchmark securities at key maturities
and weeding out others.For instance, when government financing needs declined in the US in
1997, the issuances of 3-year Treasury notes were discontinued, instead of cutting the overall
issue size throughout the yield curve.Alternatively, some countries have also reduced the
frequency of new issuances to enhance the issue size to promote liquidity of the market.
Second, a key strategy has also been to infuse competition among dealers for efficient price
discovery. Dynamic competition among the exchanges on the one hand,and between OTC
and organised exchanges on the other, contribute to market liquidity.
Third, countries are also becoming more transparent in terms of issuance schedule and
dissemination of market information.
Fourth, several countries including India have enhanced safety in trading and settlement of
government security transactions by shortening and standardising settlement lags and
adopting the DvP system. They have also allowed short sales to promote market making. In
this context, they have standardised rules and practices for failed deliveries and have opened
windows for special security lending and/or repo facilities through which authorities can
provide securities in short supply.
A great deal of development has taken place in Indias government securities market but it
still needs to acquire more depth and liquidity across all the maturities so as to generate a
meaningful yield curve over the whole range. Some of the major issues that need to be
addressed for further developing the government securities market are set out below.
Consolidation and Liquidity
Liquidity is an essential feature of a vibrant government securities market. Trading in the
government securities market in India is limited to a few securities. The yield curve is kinked
due to the presence of a large number of securities attracting illiquidity premium, whereby
two government securities having similar maturity and coupon may trade at different yields.
While the process of passive consolidation has improved liquidity, there is a need to pursue
the strategy of active consolidation by way of buyback of illiquid securities and issuances of
liquid securities. This strategy, however, needs to be in tune with the market requirements so
as to provide adequate menu for choice. From the perspective of the issuer, it is important to
note that creation of a few benchmarks may lead to the associated problem of bunching of
repayments and rollover. Thus, while pursuing the strategy of active consolidation, there
would be a need to closely monitor the trade-off between creation of benchmarks across a
few maturities and the repayment schedule.

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Price Discovery and Short Sale

Activity in the government securities market in India has been characterised by asymmetric
response of participants to the interest rate cycle,i.e., market turnover spurts during an interest
ratedownturn but slumps during the cycle of rising interest rates. This is partly because
participants are not allowed to undertake short sale in government securities. Lack of ability
to sell short prevents a two-way expression of interest rate views. On the one hand, investors,
who expect the interest rate to decline, take only long position, thereby exposing themselves
to possible capital losses in case expectations are not met. On the other hand, investors
expecting interest rate to increase cannot express their expectations due to lack of short sale
facility. This situation also results in over-pricing/ under-pricing across different segments
due to demand and supply imbalances. In this context, intraday short selling was permitted
only from February 2006 and the period was recently extended to five trading days effective
January 31, 2007. There is a need to monitor the functioning of short sales, before
contemplating the removal of the five-day limit.
Promoting Retail Segment for Government Securities
There is a need to promote retail and midsegment investors. Although retail investors
constitute a small portion of the government securities market, they, as long-term investors,
impart stability to the market. This will also benefit small investors by providing them access
to risk free gilt edged securities. Retail investment in government securities may be promoted
directly or through gilt mutual funds. Although a system has been put in place whereby
commercial banks can have a constituent SGL account for holding government securities on
behalf of their customers in safe custody in demat form, many of them have yet to make this
facility available to their branch customers. PDs also need to make a greater effort to promote
the mid-segment investors such as provident and pension funds, co-operative banks and trusts.
In this context, the Internal Technical Group on Central Government Securities Market
recommended that PDs must make at least 10 percent of their secondary market transactions
(outright) with non-NDS members. Implementing this recommendation would help in
widening the investor base for government securities. It may, therefore, be desirable to
implement policies and processes whereby banks and PDs can operate as active market
makers and encourage greater participation by retail investors, both individuals and
institutions,in the government securities market.
The government securities market in India has evolved over the years. Several measures have
been initiated since the early 1990s to develop a deep and liquid government securities
market for reducing the cost of government market borrowings, providing appropriate
benchmarks for pricing other financial instruments and conducting monetary policy in a
flexible manner. While significant progress has been made in this direction, the evolving
economic conditions and the move towards fuller capital account convertibility necessitate
further fine-tuning of the operating framework so as to ensure smooth debt management
operations.Illiquidity in State Government securities affects the cost of borrowing for the
State Governments. Therefore, there is a need to extend measures taken for enhancing
liquidity in Central Government securities to State Government securities as well.

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