Financial Markets, Institutions and Services

Content: Money Markets & Debt Markets in India: Market for Government/Debt
Securities in India. Secondary Market for Government/Debt Securities, Over Subscription
and Devolvement of Government Securities, Government Securities Issued By State
Governments, Municipal Bonds, Corporate Bonds Vs. Government Bond

Money Market: Money Market is a segment of the financial market in India where borrowing
and lending of short-term funds take place. The maturity of money market instruments is from
one day to one year. In India, this market is regulated by both RBI (the Reserve bank of India)
and SEBI (the Security and Exchange Board of India). The nature of transactions in this market
is such that they are large in amount and high in volume. Thus, we can say that the entire market
is dominated by a small number of large players.

Objectives of the money market in India

The following are the important objectives of an Indian money market –
 Facilitate a parking place to employ short-term surplus funds.
 Aid room for overcoming short-term deficits.
 To enable the Central Bank to influence and regulate liquidity in the economy through its
intervention in this market.
 Help reasonable access to users of short-term funds to meet their requirements quickly,
adequately and at reasonable costs.

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Scope of India Money Market

The India money market is a monetary system that involves the lending and borrowing of short-
term funds. India money market has seen exponential growth just after the globalization initiative
in 1992. It has been observed that financial institutions do employ money market instruments for
financing short-term monetary requirements of various sectors such as agriculture, finance and
manufacturing. The performance of the India money market has been outstanding in the past 20
years. Central bank of the country - the Reserve Bank of India (RBI) has always been playing the
major role in regulating and controlling the India money market. The intervention of RBI is
varied - curbing crisis situations by reducing the cash reserve ratio (CRR) or infusing more
money in the economy.
Segments of the Indian money market
The Indian money-market has the following two segments. The existence of the unorganized
market, though illegal, yet operates.
1. Unorganized money-market
The unorganized money market is an old and ancient market, mainly it made of indigenous
bankers and money lenders, etc.
2. Organized money-market
The organized money market is that part which comes under the regulatory ambit of RBI &
SEBI. Governments (Central and State), Discount and Finance House of India (DFHI), Mutual
Funds, Corporate, Commercial or Cooperative Banks, Public Sector Undertakings, Insurance
Companies, and Financial Institutions and Non-Banking Financial Companies (NBFCs) are the
key players of the organized Indian money market.
Structure of organized money market of India
The organized money market in India is not a single market. It is a combination of markets of
various instruments. The following are the instruments that are integral parts of the Indian money
market system.
1. Call money or notice money
Call money, notice money, and term money markets are sub-markets of the Indian money
market. These markets provide funds for very short-term. Lending and borrowing from the call
money market for 1 day.
Whereas lending and borrowing of funds from notice money market are for 2 to 14 days. And
when there are borrowing and lending of funds for the tenor of more than 14 days, it refers to
―Term Money‖.
2. Treasury bills
The Bill market is a sub-market of this market in India. There are two types of the bill in
the money market. They are treasury bills and commercial bill. The treasury bills are also known

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 as T-Bills, T-bills are issued by the Central bank on behalf of Government, whereas Commercial
Bills are issued by Financial Institutions.
Treasury bills do not yield any interest, but it is issued at discount and repaid at par at the time of
maturity. In T-bills there is no risk of default; it is a safe investment instrument.
3. Commercial bills
Commercial bill is a money market instrument which is similar to the bill of exchange; it is
issued by a Commercial organization to raise money for short-term needs. In India, the
participants of the commercial bill market are banks and financial institutions.
4. Certificate of deposits
Certificate of Deposits also known as CDs. It is a negotiable money market instrument. It is like
a promissory note. Rates, terms, and amounts vary from institution to institution. CDs are not
supposed to trade publically neither it is traded on any exchange.
In general institutions issue certificate of deposit at discount on its face value. The banks and
financial institutions can issue CDs on a floating rate basis.
5. Commercial paper
The commercial paper is another money market instrument in India. We also call commercial
paper as CP. CP refers to a short-term unsecured money market instrument. Big corporations
with good credit rating issue commercial paper as a promissory note. There is no collateral
support for CPs. Hence, only large firms with considerable financial strength can issue the
instrument.
6. Money market mutual funds (MMMFs)
The money-market mutual funds were introduced by RBI in 1992 and since 2000 they are
brought under the regulation of SEBI. It is an open-ended mutual fund which invests in short-
term debt securities. This kind of mutual fund solely invests in instruments of the money market.
7. Repo and the reverse repo market
Repo means ―Repurchase Agreement‖. It exists in India since December 1992. REPO means
selling a security under an agreement to repurchase it at a predetermined date and rate. Those
who deal in government securities they use the repo as an overnight borrowings.
Features of the Indian money market
The following are the important features of the money market in India –

1. The money market is purely for short-term funds or assets called near money.
2. All the instruments of the money market deal only with financial assets that are financial in
nature. Also, such instruments have maturity period up to one year.
3. It deals assets that can convert into cash readily without much loss and with minimum
transaction cost.

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4. Generally, transactions take place through oral communication (for eg. phone or mobile). The
exchange of relevant documents and written communications take place subsequently. There is
no formal place for the trading ( like a stock exchange).
5. Brokers free transactions are there.
6. The components of a money market are the Central Bank, Commercial Banks, Non-banking
financial companies, discount houses, and acceptance house. Commercial banks are dominant
player of this market.
Discount and Finance House of India (the DFHI)
The RBI establishes DFHI in 1988. RBI, Public Sectors Banks, and other Indian financial
institutions jointly own DFHI. The DFHI paid-up capital consists of the contribution of these
institutions jointly. DFHI plays an important role in developing an active secondary market. It
deals in T-Bills, Commercial bills, CDs, CPs, call money market, and government securities.
After learning the structure of the money-market in India and various instruments that are
available for an investor in this market, let us understand the function of money market in India.
Functions of Indian money markets
The instruments of this market are liquid when we compare it with other financial instruments.
We can convert these instruments into cash easily. Thus, they are able to address the need for the
short-term surplus funds of the lenders and short-term fund requirements of the borrowers.
The major functions of such market instrument are to cater to the short-term financial needs of
the economy. Some other functions are as following:
It helps in effective implementation of the RBI’s monetary policy.

1. This market helps to maintain demand and supply equilibrium with regard to short-term funds.
2. It also meets the need for short-term fund requirement of the government.
3. It helps in maintaining liquidity in the economy.
One important consideration about money market investment is that retail investors have very
limited scope for directly participating in it. Recently with NSE being offering some instruments
of the money market for retail investors. However, due to the large ticket size of trade and low
liquidity, it is out of reach of retail investors. But nothing to worry much on this front. As retail
investors of India, you can passively invest in any of such instruments through money market
mutual funds.

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Indian Debt Market

Debt market refers to the financial market where investors buy and sell debt securities, mostly in
the form of bonds. These markets are important source of funds, especially in a developing
economy like India. India debt market is one of the largest in Asia. Like all other countries, debt
market in India is also considered a useful substitute to banking channels for finance.

The most distinguishing feature of the debt instruments of Indian debt market is that the return is
fixed. This means, returns are almost risk-free. This fixed return on the bond is often termed as
the 'coupon rate' or the 'interest rate'. Therefore, the buyer (of bond) is giving the seller a loan at
a fixed interest rate, which equals to the coupon rate

Classification of Indian Debt Market

Indian debt market can be classified into two categories:
Government Securities Market (G-Sec Market): It consists of central and state government
securities. It means that, loans are being taken by the central and state government. It is also the
most dominant category in the India debt market.
Bond Market: It consists of Financial Institutions bonds, Corporate bonds and debentures and
Public Sector Units bonds. These bonds are issued to meet financial requirements at a fixed cost
and hence remove uncertainty in financial costs
Advantages
The biggest advantage of investing in Indian debt market is its assured returns. The returns that
the market offer is almost risk-free (though there is always certain amount of risks, however the
trend says that return is almost assured). Safer are the government securities. On the other hand,
there are certain amounts of risks in the corporate, FI and PSU debt instruments. However,
investors can take help from the credit rating agencies which rate those debt instruments. The
interest in the instruments may vary depending upon the ratings.
Another advantage of investing in India debt market is its high liquidity. Banks offer easy loans
to the investors against government securities.
Disadvantages

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As there are several advantages of investing in India debt market, there are certain disadvantages
as well. As the returns here are risk free, those are not as high as the equities market at the same
time. So, at one hand you are getting assured returns, but on the other hand, you are getting less
return at the same time.
Retail participation is also very less here, though increased recently. There are also some issues
of liquidity and price discovery as the retail debt market is not yet quite well developed.

Over Subscription and Devolvement of Government Securities

Over Subscription of Government Securities

Devolvement of Government Securities

What Is Devolvement?
Devolvement refers to a situation when a security or debt issue is undersubscribed, forcing an
underwriting investment bank to purchase unsold shares during the offering. In the underwriting
process, an investment bank will help to raise capital for the issuing companies. The bank may
include making a commitment to the company to sell all shares of the issue.
However, if investors do not purchase those securities, the responsibility for the unsold shares
may devolve to the underwriters. Devolvement may happen in the issue or selling of company
debt and also through selling an initial public offering (IPO).
KEY TAKEAWAYS
 Devolvement is when an underwriting investment bank is forced to buy unsold shares of
a security or debt issue, sometimes resulting in a financial loss for the bank.
 In some circumstances, an investment bank may be contractually obligated to purchase
these unsold shares, even if it means buying them at a price that is greater than market
value.
 Devolvement may indicate that the market sentiment toward the issuing company is
negative.
 Investment banks may attempt to reduce their devolvement risk by entering into a best-
efforts deal.

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  A best-efforts deal means investment banks do not have to purchase any of the IPO
shares, although they guarantee they will use their "best efforts" to sell the issue to the
investing public at the best price possible.
Understanding Devolvement
Devolvement poses a substantial risk to an underwriting investment bank. In those instances
where the investment bank is contractually obligated to purchase unsubscribed shares of an issue,
it often will need to do so at a price that is higher than the market-value price. Typically, the
investment bank will not hold onto the floundering issue for long but will sell the shares on
the secondary market.
Many times, the bank will experience a financial loss if they are unable to sell all the securities
available and devolvement occurs. For this reason, investment banks may attempt to mitigate
their exposure by including clauses in their contracts with issuing companies that eliminate or
limit their devolvement risk.
Types of Devolvement Risk
Investment underwriters do not necessarily guarantee that a total issue will sell. It will depend on
the underwriting agreement the bank and the issuing company agree upon. Different types of
contracts will involve varying levels of devolvement risk.
Firm Commitment
In a firm commitment deal, an underwriter agrees to assume all inventory risk and purchase all
shares of a debt or stock offering directly from the issuer for sale to the public. This is also
known as a bought deal. The underwriter purchases a company's entire IPO issue and resells it to
the investing public. The bank will receive the shares for a reduced price. Compensation comes
from the difference between what they can sell the shares for and what they paid.
Best Effort
In a best-efforts deal, the underwriter does not necessarily purchase any of the IPO issues.
Instead, it only makes a guarantee to the business issuing the stock that it will use its "best
efforts" to sell the issue to the investing public at the best price possible.
Standby Underwriting
Standby underwriting is a type of agreement to sell shares in an IPO in which the underwriting
investment bank agrees to purchase whatever shares remain after it has sold all of the shares it
can to the public. Risk will transfer from the company to the underwriting investment bank.
Because of this additional risk, the underwriter's fee may be higher.

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Market Out Clause
A market out clause reduces risk exposure by allowing the underwriter to cancel the agreement
without incurring a penalty and without having to purchase any unsold shares. The reasons for
withdrawing from the agreement must be clearly stipulated in the contract. For example, the
underwriter may cancel if they are having difficulty selling the company's stock due to a lack of
investor interest or if market conditions have deteriorated over the course of time.

What Is a Municipal Bond?

The term municipal bond refers to a type of debt security issued by local, county, and state
governments. They are commonly offered to pay for capital expenditures, including the
construction of highways, bridges, or schools. Municipal bonds act like loans, with bondholders
becoming creditors. In exchange for borrowed capital, bondholders/investors are promised
interest on their principal balance—the latter being repaid by the maturity date. Municipal bonds
are often exempt from most taxes, which makes them attractive to people in higher income tax
brackets. Types of municipal bonds include government obligations and revenue bonds.

KEY TAKEAWAYS

 Municipal bonds (“munis”) are debt securities issued by state and local governments.
 These can be thought of as loans that investors make to local governments, and are used to fund public works such as parks, libraries, bridges and
roads, and other infrastructure.
 Interest paid on municipal bonds is often tax free, making them an attractive investment option for individuals in high tax brackets.
 General obligation (GO) munis provide cash flows generated from taxes collected on a project.
 Revenue munis return cash flows generated from the project itself.

Understanding Municipal Bonds

A municipal bond is a debt obligation issued by a nonprofit organization, a private-sector
corporation, or another public entity using the loan for public projects, such as constructing
schools, hospitals, and highways. Municipal bonds, which are also known as muni bonds or
munis, can generate tax-free income for qualified residents but pay lower coupon (interest) rates
as a result compared with taxable bonds.

Types of Municipal Bonds

A municipal bond is categorized based on the source of its interest payments and
principal repayments. A bond can be structured in different ways, offering various benefits, risks,
and tax treatments. Income generated by a municipal bond may be taxable. For example, a

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municipality may issue a bond not qualified for federal tax exemption, resulting in the generated
income being subject to federal taxes.

 A general obligation bond (GO) is issued by governmental entities and not backed by
revenue from a specific project, such as a toll road. Some GO bonds are backed by
dedicated property taxes; others are payable from general funds.
 A revenue bond secures principal and interest payments through the issuer or via sales,
fuel, hotel occupancy, or other taxes. When a municipality is a conduit issuer of bonds, a
third party covers interest and principal payments.

Municipal Bond Risks

Default risk is low for municipal bonds compared with corporate bonds. However, revenue
bonds are more vulnerable to changes in consumer tastes or general economic downturns than
GO bonds. For example, a facility delivering water, treating sewage, or providing other
fundamental services has more dependable revenue than a park’s rentable shelter area.

As a fixed-income security, the market price of a municipal bond fluctuates with changes in
interest rates: When interest rates rise, bond prices decline; when interest rates decline, bond
prices rise. In addition, a bond with a longer maturity is more susceptible to interest rate changes
than a bond with a shorter maturity, causing even greater changes in the municipal bond
investor’s income. Furthermore, the majority of municipal bonds are illiquid; an investor needing
immediate cash has to sell other securities instead.

Many municipal bonds carry call provisions, allowing the issuer to redeem the bond prior to
the maturity date. An issuer typically calls a bond when interest rates drop and reissues
municipal bonds at a lower interest rate. When a bond is called, investors lose income from
interest payments and face reinvesting in a bond with a lower return.

What are the SEBI Guidelines on Municipal Bonds?

The new guidelines as mandated by SEBI are –

 The municipal body should not have a history of defaulting at repayments of loans or
debt instruments acquired from financial institutions in the past year.
 It should possess a positive net worth in all the three years preceding the issuance of
municipal bonds.

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  Such municipal entity, its Group Company or directors, and promoters shall not be
mentioned in the willful defaulters’ list published by the Reserve Bank of India.
Municipal bonds having a credit rating of BBB and higher as declared by top credit rating
agencies in India (e.g. CRISIL) can be issued to the public. These ratings have been assigned in
an attempt to substantiate and popularise these bonds’ credibility and to incite investors’
confidence in them.

However, it might be so that after these bonds are issued in the market and subsequently traded
in the secondary market, i.e. stock exchange, their credibility might falter due to the concerned
municipality’s waning financial performance. This might lead to a decrease in such bond prices.
On the other hand, if a municipal corporation performs well after such issuance, its bond prices
shall appreciate.

What's the Minimum Amount You Need to Invest in Municipal Bonds?

Most municipal bonds are issued in $5,000 increments. Municipal bonds may be included in
some exchange-traded funds (ETFs) as well as mutual funds, allowing investors to purchase
bond fractions.2

What Term Lengths Are Available for Municipal Bonds?

Municipal bonds are available in a variety of terms ranging from two to 30 years.3

What Are the Benefits of a Municipal Bond?

Although municipal bonds may have lower interest rates than riskier investments like corporate
bonds or stocks, they offer stability for your capital with low default rates. Interest from munis is
also federally tax-exempt, making it an attractive investment.

What are the Advantages of Municipal Bonds?

There are multiple advantages of investing in such bonds which include –

 Transparency

These bonds that are issued to the public are rated by renowned agencies such as CRISIL, which
allows investors transparency regarding the credibility of the investment option.

 Tax benefits

In India, municipal bonds are exempted from taxation if the investor conforms to certain
stipulated rules. In addition to such conformation, interest rates generated on such investment
tools are also exempt from taxation policy.

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  Minimal risk

These are issued by municipal authorities, implying involvement of minimal risk with these
securities.

What are the Disadvantages of Municipal Bonds?

The disadvantages of these bonds are enumerated below –

 Long maturity period

Municipal bonds come with a lock-in period of three years, imposing a burden on the liquidity
requirements of investors. Nonetheless, selling such securities prematurely in the secondary
market can be challenging if the bonds are issued by an unpopular municipal corporation. It is
because, in such cases, entities are uncertain about their credibility and yielding capacity.

 Low-interest rates

Even though interest rates on these bonds, in some cases, are higher than other debt instruments,
these rates are considerably low when compared to returns from market-linked financial
instruments such as equity shares.

Entities looking to invest in best municipal bonds should consider different variables such as
their risk appetite, investment objectives, investment portfolio, etc. in tandem with a municipal
body’s credibility and a bonds’ credit rating to ascertain its liquidity and repayment.

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