INDIAN BOND MARKET

mONEY MARKET
INSTRUMENT
BACHELOR OF COMMERCE FINANCIAL MARKET SEMESTER ACADEMIC YEAR - 2011-2012 SUBMITTED BY HEMANT HARI DOLAI ROLL NO. 08 UNDER THE GUIDANCE PROF. MANJIRI DATE

GURU NANAK KHALSA COLLEGE OF ARTS,SCIENCE &COMMERCE MATUNGA,MUMBAI -400019 UNIVERSITY OF MUMBAI

INDIAN BOND MARKET

Bachelor of Commerce
FINANCIAL MARKET
Semester VI
Submitted

In Partial Fulfillment of the requirement For the Award of Degree of Bachelor of Commerce FINANCIAL MARKET

HEMANT HARI DOLAI

By

Roll No. 08.

GURU NANAK KHALSA COLLEGE

OF ARTS, SCIENCE & COMMERCE MATUNGA, Mumbai 400 019.

CERTIFICATE

This is to certify that HEMANT HARI DOLAI of T.Y.B.Com FIANACIAL MARKET Semester VI (2010-11) has successfully completed the project on INDIAN BOND MARKET under the guidance of PROF. MANJIRI DATE

________________ Course Co-ordinator

_______________ Principal

_______________
Project Guide / Internal Examiner

______________
External Examiner

DECLARATION
I HEMANT HARI DOLAI the student of T.Y.B.Com. FIANACIAL MARKET Semester VI (2010-11) hereby declares that have completed the Project on INDIAN BOND MARKETS The information submitted is true and original to the best of my knowledge.

________________ Signature of Student

HEMANT HARI DOLAI ROLL NO -08

ACKNOWLEDGEMENTS
I WOULD LIKE VALUABLE EFFORTS TEACHINGSTAFF TO GRATEFULLY & SUGGESTIONS NON KHALSA ACKNOWLEDGE PROVIDED BY STAFF OF THE THE MY

& THE

TEACHING

INSTITUTION GURU NANAK

COLLEGE . TO COMLETE

THIS PROJECT ON INDIAN BOND MARKET

ACKNOWLEDGMENT ,PRINCIPAL - DR. AJIT SINGH VICE PRINCIPAL & H.O.D - ALLAN DSOUZA GUIDE OF THE PROJECT - PROF. MANJIRI DATE

INDEX
Sr. No. 01. 02. 03. 04. 05. 06. Contents introduction Features of bonds Types of bonds Types of bond instruments Indian bond Investing in bonds Page No.

INTRODUCTION
A bond is a nancial security that promises to pay a xed (known) income stream in the future Issued by governments, state agencies (municipal bonds), and corporations Bonds are characterized by Maturity date Face, par or principal value (i.e., the notional amount typically 1000) Coupon rate number of coupon payments/ year (typically 2) Bjorn Eraker Introduction to Bond Markets Repayment types Pure discount or zero coupon bonds: Bonds that pay no interest (coupon). They sell at a discount (price below par) to provide investor with positive return. Coupon bonds pays xed coupon at known times. For example, A November 2021 maturity, 8% government bond will pay its owner 40 = 8% 1000=2 every April 15th and November 15th in addition to 1000 at expiration on November 15th, 2021. Floating rate pays variable rate coupons linked to some benchmark rate. Example: Ination indexed bonds (I-bonds) coupon rate is determined by the level of ination (as measured by the relative change in the CPI)

Bjorn Eraker Introduction to Bond Markets Government Bonds US government bonds are interesting because

The default risk is thought of as zero (although it may not be) They are highly liquid They provide a basic benchmark for other xed income securities including other sovereign bonds, corporate, munis, etc.

Despite the complexity associated with the bond market, a bond is simple and it might be consider a bit boring when compared with a stock. After all, a stock represents a piece of a company's wealth. An evaluation of a stock requires an evaluation of the entire company's worth. An ordinary bond is an agreement that merely entitles one party to make and another to receive a series of cash flows. While differences among forms of equity are small, there is a wide range of bonds; innovative financial engineers are creating new fixedincome securities almost continuously.

Features of bonds
The most important features of a bond are:

Nominal, Principal or Face Amount the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. Some structured bonds can have a redemption amount which is different from the face amount and can be linked to performance of particular assets such as a stock or commodity index, foreign exchange rate or a fund. This can result in an investor receiving less or more than his original investment at maturity. Issue Price the price at which investors buy the bonds when they are first issued, which will typically be approximately equal to the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees. Maturity Date the date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligation to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds have been issued with maturities of up

to one hundred years, and some do not mature at all. In the market for U.S. Treasury securities, there are three groups of bond maturities:

Short term (bills): maturities between one to five year; (instruments with maturities less than one year are called Money Market Instruments) Medium term (notes): maturities between six to twelve years; Long term (bonds): maturities greater than twelve years.

Coupon the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such asLIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.

TYPES OF BOND

Fixed rate bonds have a coupon that remains constant Floating rate notes (FRNs) have a variable coupon that linked to a reference For rate of the interest, coupon such be example may

throughout the life of the bond.

is

as LIBOR or Euribor.

defined as three month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically every one or three months.

Zero-coupon bonds pay no regular interest. They are

issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity (and usually taxed as such). The bondholder receives the full principal amount on the redemption date. An example of zero coupon bonds is Series E savings bonds issued by the U.S. government. Zero-coupon bonds may be created from fixed rate bonds by a financial institution separating ("stripping off") the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond may be traded separately. See IO (Interest Only) and PO (Principal Only).

Inflation linked bonds, in which the principal amount

and the interest payments are indexed to inflation. The interest rate is normally lower than for fixed rate bonds with a comparable maturity (this position briefly reversed itself for short-term UK bonds in December 2008). However, as the principal amount grows, the payments increase with

inflation. The United Kingdom was the first sovereign issuer to issue inflation linked Gilts in the 1980s. Treasury and I-bonds are Inflation-Protected government.

Securities (TIPS)

examples of inflation linked bonds issued by the U.S. Other indexed bonds, for example equity-linked

notes and bonds indexed on a business indicator (income, added value) or on a country's GDP.

Asset-backed securities are bonds whose interest and

principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized (CDOs).

Subordinated bonds are those that have a lower priority

than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later.

Perpetual bonds are also often called perpetuities or

'Perps'. They have no maturity date. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today, although the amounts are now insignificant. Some ultra-long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century) are virtually perpetuities from a financial point of view, with the current value of principal near zero.

Bearer bond is an official certificate issued without a

named holder. In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets. U.S. corporations stopped issuing bearer bonds in the 1960s, the U.S. Treasury stopped in 1982, and state and local taxexempt bearer bonds were prohibited in 1983.

Registered bond is a bond whose ownership (and any

subsequent purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner.

Treasury bond, also called government bond, is issued by the Federal government and is not exposed to default risk. It is characterized as the safest bond, with the lowest interest rate. A treasury bond is backed by the full faith and credit of the federal government. For that reason, this type of bond is often referred to as risk-free.

Municipal bond is a bond issued by a state, U.S. Territory, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.

Build America Bonds (BABs) is a new form of municipal by the American Recovery and

bond authorized

Reinvestment Act of 2009. Unlike traditional municipal bonds, which are usually tax exempt, interest received on BABs is subject to federal taxation. However, as with municipal bonds, the bond is tax-exempt within the state it is issued. Generally, BABs offer significantly higher yields (over 7 percent) than standard municipal bonds.

Book-entry bond is a bond that does not have a paper

certificate. As physically processing paper bonds and interest coupons became more expensive, issuers (and banks that used to collect coupon interest for depositors) have tried to discourage their use. Some book-entry bond issues do not

offer the option of a paper certificate, even to investors who prefer them.

Lottery bond is a bond issued by a state, usually a but the issuer will redeem randomly selected

European state. Interest is paid like a traditional fixed rate bond, individual bonds within the issue according to a schedule. Some of these redemptions will be for a higher value than the face value of the bond.

Serial bond is a bond that matures in installments over a

period of time. In effect, a $100,000, 5-year serial bond would mature in a $20,000 annuity over a 5-year interval.

Revenue bond is a special type of municipal bond

distinguished by its guarantee of repayment solely from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds. Revenue bonds are typically "non-recourse," meaning that in the event of default, the bond holder has no recourse to other governmental assets or revenues.

Climate bond is a bond issued by a government or

corporate entity in order to raise finance for climate change mitigation or adaptation related projects or programs.

Type of Bond Instruments

The variety of bonds offered to the international or even domestic investor is amazing due to the recent development of bonds with variable interest rates and complex optional clauses. (For a review of the basic concepts and techniques behind bonds, see Appendix XII.) Most issues on the international bond market, however, are fixed interest bonds, see Table XII.A. The most popular instruments in international bond markets are: Straight or fixed income bonds: a fixed income bond is a financial instrument with specific interest payments on specified dates over a period of years. On the last specified date, or maturity, the payment includes a repayment of principal. The interest rate or coupon is expressed as a percentage of the issue amount and is fixed at launch. For the issuer, the attraction of these bonds is the knowledge of level payments on interest and a set repayment schedule. For investors, the attraction of straight bonds lies in a known income.

Straight bond.

In January 2004, Companhia Vale do Rio Doce (CVRD) issued straight coupon Eurobonds, with the following terms: Amount: USD 500 million. Maturity: January 2034 (30 years). Issue price: 100% Coupon: 8.25% payable annually

YTM: 8.35% (Brazils government bonds traded at YTM 9.02% at the time) Partly-paid bonds: these are standard straight bonds in all respects but for the payment of principal by investors on the closing date of the issue -which is limited to 0-33 percent of the principal amount, with the balance falling due up to six months later. These bonds are popular with issuers who can tailor the second payment to their cash flow requirements.

Partly-paid bonds.

In April 1998, the European Investment Bank (EIB) issued a partly-paid GBP bond in which investors only hand over 25% of the principal. The remaining 75% will be paid in 12 months. The GBP bond raised GBP 300 million and was aimed at overseas investors attracted by the relatively high yield on offer in the UK but concerned about the unusually strong GBP. Zero-coupon bonds: a zero-coupon bond is a straight bond with no schedule of periodic interest payments. The cash flow consists of two payments, the receipt of the proceeds on issue date and the repayment of principal on maturity. For the issuer, zero coupon bonds are an ideal financing instrument for a project, which generates no income for some years. On the other hand, the loading of the debt service of the bond into a single payment some years later creates a higher credit risk. For this reason the market is confined to highly rated borrowers. Investors are attracted to zero-coupon bonds to meet future liabilities.

Zero-coupon bonds ("zeros").

June 1981, PepsiCo Overseas issued zero-coupon

In

Eurobonds, with the following terms: Amount: USD 100 million. Maturity: June 1984 (3 years). Issue price: USD 67.255. Redemption price: 100% Since the bonds would be repaid in three years at 100 percent of face value, the compounded annual interest yield was (100/67.25) 1/3 - 1 = 14.14%. By contrast, in 1985, Deutsche Bank Finance N.V. issued a zero-coupon bond with the following terms: Amount: USD 200 million Maturity: 10 years. Issue price: USD 100. Redemption price: 287% The interest yield on this issue by Deutsche Bank Finance was: (287/100) 1/10 - 1 = 11.12%. XII.8 Floating rate notes (FRNs): FRNs are a medium-term instrument similar in structure to straight bonds but for the interest base and interest rate calculations. The coupon rate is reset at specified regular intervals, normally 3 months, 6 months, or one year. The coupon comprises a money market

rate (e.g., the London Interbank Offered Rate for 6-month deposits, or LIBOR) of plus the a margin, FRNs which reflects carry the a creditworthiness issuer. usually

prepayment option for the issuer. Issuers like FRNs because they combine the lower pricing of a bank loan and larger maturities than the straight bond market. Investors are attracted to FRNs because the periodic resetting of the coupon offers the strongest protection of capital.

FRNs ("floaters").

In January 2004, The United Mexican States (UMS) issued a USD Eurobond, with the following terms: Amount: USD 1,000 million. Maturity: January 2009 (5 years). Issue price: 99.965 Coupon: 6-mo LIBOR + 70 bp payable quarterly. At the time the notes were offered, 6-mo LIBOR was 3.64 percent. So for the first three months Christiania Bank paid an interest at an annual rate of 3.64% + .70% = 4.64%. Afterward, at the end of each six-month period the interest rates on the bonds are updated to reflect the current 6-mo LIBOR rate for dollars. Perpetual FRNs: They are FRNs but have no maturity date. Issuers have a call option to prepay investors. Perpetual FRNs usually have investors put options or options to exchange the undated bonds for bonds with finite maturity. Perpetual FRNs have subordinated status and in some cases junior

subordinated status, so they can rank close to equity. As a quasi-equity instrument, they qualify as capital, and for the purposes of capital adequacy, are treated as equity.

Convertible bonds:

A convertible bond is a bond that can usually be exchanged or converted at the option of the holder into other assets at a fixed conversion rate set at time of launch. Convertible bonds are usually launched in conditions of poor fixed-rate bond markets, high interest rates and an expectation of falling rates. Issuers benefit from (1) The lower funding costs relative to short-term money markets and (2) The possibility of no repaying the principal if the conversion right is exercised. Investors benefit because they receive the benefit of regular coupon payments plus the option of locking in to a better yield later.

Convertible bonds ("convertibles").

In March 2000, the Swiss company Roche Holdings issued convertible bonds (Sumo bond) with the following terms: Amount: JPY 104,600,000,000. Maturity: March 2005 (5 years). Coupon: 0.25% payable annually. Issue Price: 96.4%XII.9 Conversion structure: Each bond of JPY 1,410,000 par value is exchangeable for one non-voting equity security of Roche Holding Ltd at an exchange ratio of 1.03292. Conversion period: At any time after the first interest payment.

That is, if the conversion right is exercised each USD 10,000 bond would buy 597.13 ADRs.

Convertible bonds into other bond.

In May 1983, CEPME issued Eurobonds with the following terms: Amount: GBP 35 million. Maturity: May 1995 (12 years). Denominations: GBP 1,000 Coupon: 11.25% payable annually. Conversion structure: Each bond is convertible at the bondholder's option into a USD 12-year FRN paying semiannual dollar interest equal to six-month LIBOR. Conversion exchange rate: 1.55 USD/GBP Conversion period: At any time after the first interest payment. That is, if the conversion right is exercised each bond would buy a USD 1550 12-year FRN. Bonds with warrants: Bonds with warrants resemble convertibles except that the warrant can be traded separately. The proceeds from the warrants are applied to the reduction of the cost of the host bond. Bonds can have equity warrants, bond warrants, or commodity warrants attached. Bonds with equity warrants differ from convertible bonds in one other aspect: when the warrants are exercised new money is normally used to subscribe for the shares, and the total capitalization of the borrower increases. This is unlike the conversion of a convertible bond, which merely shifts debt capital into equity capital. The equity

warrant is effectively a call option on the underlying stock. Therefore, pricing a warrant relies on (1) Variations of the Black-Scholes formula, and (2) A market view based on supply and demand. Example XII.9: Bonds with equity warrants. In May 1990, Cannon issued Euro-USD bonds with equity warrants attached. The terms of the issue are as follows: Amount: USD 370 million. Maturity: May 31, 1995 (5 years). Denominations: USD 5,000 Coupon: 4% Number of warrants: 74,000 Warrants per bond: 1 Shares per warrant: 468.06 Exercise price: JPY 1487 Conversion exchange rate: 139.2 JPY/USD Exercise period: At any time after the first interest payment, ending one week before the maturity of the bond. Almost all Japanese Euro-USD bonds with equity warrant attached (USD Euro warrants) have similar terms to the Cannon's issue. Euro warrants dominated Japanese new issue financing during the Japanese bull market of the late 1980s. Japanese warrants, as they were called, were issued in USD, DEM, CHF, FRF, NLG, GBP, ECU, and JPY. Almost all Japanese warrants have been issued outside Japan, and as such are principally traded OTC in various European centers.

 Dual-currency bonds: Dual-currency bonds are bonds that are purchased in terms of one currency but pay coupons or repay principal at maturity in terms of a second currency. Japanese firms have frequently issued CHF-denominated bonds convertible into common shares of a Japanese company. A foreign investor can benefit from purchasing this bond in any one of three situations: (1) A drop in the market interest rate on CHF bonds (as on any straight CHF bond). (2) A rise in the price of the company's stock (because the bonds are convertible into stocks). (3) A rise in the JPY relative to the CHF (because the bond is convertible into a JPY asset). Dual currency bonds represent a combination of an ordinary bond combined with one or more forward contracts.

Dual-currency bonds.

In July 1985, Swiss Bank Soditic led the issue of a dual currency bond for First City Financial. Each bond could be purchased for its full face value of CHF 5000. Interest on these bonds is paid on CHF. At maturity, at the end of ten years, the bond principal will be repaid in the amount of USD 2,800. At the time of the issue, this bond could be view as the combination of (a) An ordinary ten-year CHF bond that would repay principal in the amount of CHF 5000, plus (b) A ten-year forward contract to buy USD 2800 at 1.7857 CHF/USD (=CHF 5000/USD 2800).

These securities have been sold outside the United States of America and Japan. This announcement appears as a matter of record only.

Investing in bonds
Bonds are bought and traded mostly by institutions like central banks, sovereign wealth funds, pension funds, insurance companies and banks. Most individuals who want to own bonds do so through bond funds. Still, in the U.S., nearly 10% of all bonds outstanding are held directly by households. Sometimes, bond markets rise (while yields fall) when stock markets fall. More relevantly, the volatility of bonds (especially short and medium dated bonds) is lower than that of stocks. Thus bonds are generally viewed as safer investments than stocks, but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks, and bonds' interest payments are often higher than the general level of dividend payments. Bonds are liquid it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks and the comparative certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive the some money back (the recovery ends up amount), valueless. whereas company's stock often

However, bonds can also be risky but less risky than stocks:

Fixed rate bonds are subject to interest rate risk, meaning

that their market prices will decrease in value when the generally prevailing interest rates rise. Since the payments are fixed, a decrease in the market price of the bond means

an increase in its yield. When the market interest rate rises, the market price of bonds will fall, reflecting investors' ability to get a higher interest rate on their money elsewhere perhaps by purchasing a newly issued bond that already features the newly higher interest rate. Note that this drop in the bond's market price does not affect the interest payments to the bondholder at all, so long-term investors who want a specific amount at the maturity date do not need to worry about price swings in their bonds and do not suffer from interest rate risk. Bonds are also subject to various other risks such as call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk,sovereign risk and yield curve risk. Price changes in a bond will also immediately affect mutual funds that hold these bonds. If the value of the bonds held in a trading portfolio has fallen over the day, the value of the portfolio will also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers (irrespective of whether the value is immediately "marked to market" or not). If there is any chance a holder of individual bonds may need to sell his bonds and "cash out", interest rate risk could become a real problem (conversely, bonds' market prices would increase if the prevailing interest rate were to drop, as it did from 2001 through 2003). One way to quantify the

interest rate risk on a bond is in terms of its duration. Efforts to control this risk are called immunization or hedging.

Bond prices can become volatile depending on the credit & Poor's and Moody's upgrade or

rating of the issuer for instance if the credit rating agencies like Standard downgrade the credit rating of the issuer. A downgrade will cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.

A company's bondholders may lose much or all their

money if the company goes bankrupt. Under the laws of many countries (including the United States and Canada), bondholders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank) and trade creditors may take precedence.