Financial Institutions and

Markets
Session -6

1
•Bonds and Bond Markets

2
Bonds as securities … a quick recap

• A conventional or Plain Vanilla Bond :

• What is it ?
• A debt instrument ,usually paying a fixed rate of interest over fixed
period of time. It is a collection of cash flows as shown in the figure
below.
• In this example the bond is a six year issue that pays fixed interest
payments of C% of the nominal value ( par value or face value-) of
the bond on annual basis
Time
1 2 3 4 5 6
yrs
Proceeds of
the issue

$
$ $ $ $ $ C Maturity
C C C C C
payment
3
Bond Features

• Issue Price
• Face value
• Coupon Interest
• Coupon Frequency
• Maturity date
• Call/ put option
• Maturity / Redemption value
 Other Types of Bonds

• 1) Zero coupon bonds : A bond that pays no coupon at all. It is issued at a discount to the maturity value. Also
called ‘zeros’.

• 2) Floating rate bonds / Floaters : The coupon payments are functions of some prefixed interest rate
benchmark which itself may vary eg LIBOR + 0.5% or MIBOR + 0.5% etc.

• 3)Income bonds : are similar to conventional bonds, except that coupon payments are dependent on issuer’s
income. in this only face value of bond is promised. Coupon value will be paid iff issuer has enough income.

• 4) A convertible bond : can be swapped for a fixed number of shares of stock anytime before the maturity at
the holder’s option.

• 5) Callable bonds : The issuer has the option to call back or buy back all or part their bonds under specified
conditions before the maturity date. Main purpose is to keep the option open in case the interest rate falls.

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Types of Bonds…contd..
• 6)Capital Indexed Bonds : coupon rate set at the time of issue remains fixed for the term of the
security. The principal adjusts for inflation, but the inflation adjusted principal is not paid until
maturity.
• 7) Euro bonds : Long term bonds that are issued and sold outside the country in whose currency
the bond is denominated. Denominated in the currency not native to the country of issue.
Example : dollar denominated bonds issued in Europe or Asia will be an Eurobond. And it will
never be issed in America, whose denomination is dollar itself
• 8)Foreign Bonds : are long term bonds issued by the firms and governments outside the issuers
home country and are usually denominated in the currency of the country in which they are
issued, rather than the domestic currency. Countries sometimes name their foreign bonds to
denote the country of origin– example
• foreign bonds issued in US are called Yankee bonds,
• those issued in Japan are called Samurai bonds,
• those issued in UK --- bulldog bonds.

• Secured & Unsecured Bonds - ( Debentures) secured by the issuer pledge of asset as
collateral/unsec- no asset rather full faith and credit

6
Bond Pricing… a quick recap
• The price of a bond that pays regular (annual) coupons is given by :

c c c c M
P    ..........  
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) N
(1  r ) N
N
ci M
 
i 1 (1  r ) (1  r ) N
i

• Or,
c 1 M
P  [1  ]
r (1  r ) N
(1  r ) N

7
Bond Pricing… a quick recap
• The price of a bond that pays semi annual coupon payments is given
by ( N= number of yrs to maturity)
c c c c
2 2 2 2 M
P     .......... ....  
r r 2 r 3 r 2N r
(1  ) (1  ) (1  ) (1  ) (1  ) 2 N
2 2 2 2 2
c
2T
2 M
 
r r
i 1
(1  ) i (1  ) 2 N
2 2
 
c 1  M
 1  
r  r 2 N  r
(1  ) (1  ) 2 N
 2  2

8
Concept….Yield
• Coupon yield: refers to nominal interest payable on a fixed
income security like Government security.
• Illustration: Coupon: 8.24% , Face Value: Rs.100 ,Market Value:
Rs.103.00 , Coupon yield = 8.24/100 = 8.24%
• The coupon yield is simply the coupon payment as a percentage
of the face value
• Current Yield: Current yield = (Annual coupon rate / purchase
price)*100
• Illustration: The current yield for a 10 year 8.24% coupon bond
selling for Rs.103.00 per Rs.100 par value is calculated below:
• Annual coupon interest = 8.24% x Rs.100 = Rs.8.24 Current yield
= (8.24/Rs.103)*100 = 8.00%
Concept….Yield
• Yield to Maturity : the expected rate of return on a bond if it is
held until its maturity.
• Thus YTM is the discount rate which equates the present value of
the future cash flows from a bond to its current market price. In
other words, it is the internal rate of return (IRR) on the bond.
• Illustration: Taking the example of a two a year security bearing a
coupon yield of 8% and a price of say Rs. 102 per face value of
Rs. 100(Current Yield…8/102=7.84%). Semi annual Coupon
102 = 4/(1+r/2)1/2 + 4/(1+r/2)1 + 4/(1+r/2)3/2 + 104/(1+r/2)2 …
r is the YTM
 Yield To maturity (YTM)
YTM on a 10% ANNUAL Coupon Rate maturing in 10 years ( Face value-Rs 1000 )

Price of Bond (Rs) YTM ( % )

1,200 7.13
1100 8.48
1000 10.00
900 11.75
800 13.81

 1.When the coupon of Bond is priced at its face value,

the YTM equals the coupon rate.

 2.The price of the coupon Bond & the YTM is negatively related
when YTM rises the Bond price falls & If YTM falls Bond prices rises.

 3. The YTM is greater than Coupon rate when Bond price is below its face value.
11
 Concept..Price & Yield
• The yield of a bond is inversely related to its price.
• The relationship between yield to maturity and coupon rate may
be stated as follows:
• When the market price of the instrument is less than the face value,
i.e., the instrument sells at a discount, YTM > current yield > coupon
yield.
• When the market price of the instrument is more than its face value,
i.e., the instrument sells at a premium, coupon yield > current yield >
YTM.
• When the market price of the bond is equal to its face value, i.e., the
bond sells at par, YTM = current yield = coupon yield.
 
 Bond Price & Interest rate
One year return on Different maturity 10% Coupon rate Bonds when
interest rate rise from 10% to 20%.
Years to maturity Initial Current Initial price Price Next Rate of Rate of
when Bond is Yield (%)- (Rs) Year ( Rs) Capital Return (%)
purchased -1 2 3 -4 Gain ( % ) 5 6= (2+5)
30 10 1000 503 - 49.70 -39.70
20 10 1000 516 - 48.40 -38.40
10 10 1000 597 -40.3 -30.30
5 10 1000 741 -25.90 -15.90
2 10 1000 917 -8.30 + 1.70
1 10 1000 1000 0.0 +10.00

• A rise in interest rate is associated with fall in Bond prices- capital Loss
• The more distance is the Bonds maturity, Greater is the size of the price fall
And lower the return due to interest rate change.
• The return equals the initial YTM when the holding period is equal to
its time to maturity.
• Prices and return for long term Bonds are more volatile than those
for short-term Bonds- hence long term bonds are more risky(Interest rate Risk)
13
 Price Determination of Bond
When r changes, Bond price change as a movement on the same
Bond Price Demand & Supply curve implying imbalance in Demand supply conditions.
It does not shift either Demand / nor supply curve.
P=1000, r= 0%
Supply of Bonds
P=950,r= 5.3%
P=900,r=11.1%

P=850, r= 7.6%

P=800, r=25%

P=750, r =33.3% Demand For Bonds

100 200 300 400 500

Quantity of Bonds B
 Factor That Shifts the Demand curve For Bonds
Variables Change In Change in Quantity demanded Shift in Demand Curve
Variable at Each Bond Price

Wealth
P
B
Expected
interest rate
P

Expected
Inflation
P
Riskiness of
Bond Relative
to other Assets P
Liquidity of
Bonds Relative
to other assets P
B
 Factors that shift the Supply of Bonds
Variables Change In Change in Quantity supplyat Shift in Supply Curve
Variable Each Bond Price

Profitability of
investment
P

B
Expected
Inflation
P

B
Government
Deficit

B
Issuers of bonds
• Four principal types of issuers are there :
• A. Sovereign Governments and their agencies
• B. Local Government Authorities
• C. Supranational Bodies such as the World Bank
• D. Corporations
• Bonds issued by Sovereign Governments :
• Largest issuer among these is definitely the Government.

• Primarily issued for raising money for Govt. projects or meeting Fiscal
deficits.

• The core of any domestic capital market is usually the govt. bond market .In
US the Government bonds are called Treasury Bonds or simply Treasuries,
while those of UK are called the Gilts. In India they are generally called the
G –Secs..

17
No Coupon or Discount Bond
The discount/ no coupon bonds are usually sold
at discount to face value.

Example: A bond of face value of Rs 1000 sold

for Rs 900 for one year maturity.

What is the YTM?

return = (Future V – Present V)/ Present V

18
Solution

900 = 1000 / (1 + r)
(1+ r) 900 = 1000
900 + 900 r = 1000
900 r = 1000 – 900
r = (1000 - 900) / 900 = 0.111
= 11.10 %

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Issuer…contd..
• Bonds issued by Local Governments or
Municipalities :
• City corporations and Municipalities issue debt
securities regularly. Bonds issued by them are called
municipal bonds or ‘munis’.
• Broadly such issues may be grouped into the
following categories :
a. General Obligation Bonds ( GO s) : which are backed by the full
faith, credit and taxing power of the municipality.
b. Revenue bonds : Which derive their cash flows from specific
project revenues.

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Issuer…contd..
• Bonds issued by Supranational Bodies : World Bank( IBRD) :

• The International Bank for Reconstruction and Development

(IBRD), generally referred to as the World Bank, is
• one of the largest international borrowers
• one of the most frequent international bond issuers with hundreds of
transactions per year. 

•   Bonds issued by the World Bank are AAA-rated (highest

possible bond rating) by Moody´s and S&P.

21
Bond RATING
Moody’s Standard &Poor’s DESCRIPTIONS

Aaa AAA Highest Quality (Lowest

Default risk)
Aa AA High quality
A A Upper Medium Grade
Baa BBB Medium Grade
Ba BB Lower Medium grade
B B Speculative
Caa CCC,CC Poor (High Default risk)
C D Highly speculative

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• Corporate debt market

23
Issuer…contd..
• Bonds issued by corporates( Corporate Bonds)
• Corporate borrowers wishing to finance long term investments
can raise capital in various ways. The principal methods are :
• a. Retained earnings : not always available particularly if
required to pay dividends
• b. raising additional equity capital : expensive, plus dividends
are not tax deductible.
• c. bank loan : interest rate may be high plus interest rate may
fluctuate.
• d. Bonds :
• comparatively a cheaper way
• Coupon payments tax deductible
• fixes the rate of interest for a long term period,
• their tradability in secondary markets makes investors more willing
to lend funds to the company.

24
 Offer Disclosures & Issue Format
A summary term sheet shall be provided which shall include
brief information pertaining to the Secured / Unsecured Non
Convertible debt securities (or a series thereof) as follows
(where relevant):

• Issuer Company
• Minimum Subscription of Debentures and in multiples of __
Debentures thereafter
• Tenor __ Months from the Deemed Date of Allotment
• Coupon Rate / Coupon Date __% p.a. (payable __) on
__each year
• Redemption Date
• Put / Call option _________
• Proposed listing of the debt securities with ____ Stock
Exchange
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 Offer Disclosures & Issue Format:
• Issuance Physical /Demat mode
• Trading Demat mode only
• Depository _________
• Security
• Rating ___ by ___ (All the credit rating/s,including any
unaccepted credit ratings, shall be disclosed in the draft offer
document to be filed with SEBI)
• Settlement By way of [Insert details of payment procedure]
• Issue Schedule:
- Issue opens on: _________
- Issue closes on _________
• Pay-in date _________
• Deemed date of allotment

26
Public Issue of Debt Securities
Tightening of norms by SEBI:-

 Minimum Subscription of 75% for public issue of Debt Securities

Where as for Equity offer it is 90%.
 If issue fails ( below 75%), the money to be refunded
within 12 days of issue closure.
 A base issue size of Rs 100 crores.
 Over subscription can be retained up to 100% of issue size.
 In offer document to specify the “ object of the issue”
 Amount earmarked for “ General Corporate Purposes”
shall not exceed 25% of the issue.

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Corporate Debt Market
• Advantage of a well functioning Corporate Debt market :
• For the issuer :
– it provides low cost funds by bypassing the intermediary role of a bank.
Although corporations have to go through intermediaries like brokers,
underwriters in the debt market too, the intense competition amongst them
pushes down intermediation cost
– The cost of debt fund is locked up for a longer period of time. In case of bank
loans they are most likely to fluctuate unless a hefty premium is paid.
• For the Investor :
– there exists a yield premium opportunity in comparison to traditional deposits
at banking institutions
– also increases the investment opportunities in different type of instruments
and tailors risk reward profile according to his/her preferences
• Overall : The basic philosophy of developing a diversified financial
system with banks and non-banks operating in equity market and debt
market is that it enhances risk pooling and risk sharing opportunities for
investors and borrowers.
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Market Structure of the Indian Corporate
Debt Market

• Primary Corporate Debt market :

• Issuers :
• Large pvt. sector corporate ( paid up capital of 10crores or Mkt cap of 25
crores is the requirement for listing in WDM of NSE after the issue)
• Public sector undertakings( union as well as state)
• Financial institutions like banks ( scheduled banks or net worth of 50
crore or above for listing in WDM of NSE)
• Medium and small companies ( same as large corporates)
• Instruments :
• Plain vanilla Bonds
• Partly convertible debentures- part of it is redeemed by company, part of
it by equity/ preference share
• Fully convertible debentures
• Zero coupon bonds
• Floating rate bonds

29
Market Structure of the Indian Corporate Debt
Market… contd..
• Maturity:
– generally between 1 to 10 years with median around 4-5 years. The
maturity period depends on the outlook on interest rates. If expectation is
for a falling interest rate regime, people will tend to go for a shorter
MATURITY bond and vice versa.
• Modes of Issue:
– Private placement ( bilateral arrangements between issuer and investor)
– Public offer ( like a normal public issue requiring all regulatory compliances
and information disclosure , advertising etc.)
– In India Private placement route has been typically much more popular for
the following reasons:
• Deals can be tailor-made to suit requirements of both issuer and investor
• Mandatory lengthy issue procedure for public issues , in particular the information
disclosure requirements, was not applicable to private placement and this was a strong
motivation to go for private placement.
• It is observed that private placement route involves less issuance cost.

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Market Structure of the Indian Corporate
Debt Market… contd..
• Main Trading Platforms:
- NSE- Trading
- BSE - Trading
-OTCEI - Trading
FIMMDA is the Trading /Reporting Platform Exclusively for Negotiated Deals up to
• Intermediaries :
– Brokers
– Investment/merchant bankers
– NSDL / CSDL (Depositories)
• Investors :
– Mutual funds
– Other corporates
– Insurance cos.
– Pension funds
– Retail investors
Tradable lot Rs 1 lakh for all entities

31
Secondary Corporate debt
market .. Structure
• The principal features of the secondary corporate debt market are as follows :
• i) Trading platform : Corporate debt instruments are traded either as bi lateral agreements
between two counterparties or on a stock exchange through brokers. Globally majority of
transactions in corporate bonds are conducted in the OTC( –Over the counter by brokers
not traded )market by bi-lateral agreements. In India, corporate bonds are traded mostly
on the WDM-Wholesale debt market segment of NSE and BSE.

• NSE provides a fully automated screen based trading system called NEAT( National
Exchange for Automated Trading) which enables members across the country to trade
simultaneously through an order driven system, which matches best buy and sell orders
on a price time priority.

• BSE also provides a similar facility through its BOLT(BSE Online Trading) system.

• Trading system of NSE or BSE accommodates two market subtypes :

–Continuous automated trade
–Negotiated market

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Secondary Corporate debt
market .. Structure…. Contd..
• Trading platform…. Contd..
• i) Continuous automated trade :
• In continuous market the buyer and the seller do not know
each other and they put their best buy and sell orders
which are stored in the order book based on a price time
criteria until a matching order comes resulting a trade.
• ii) Negotiated Market : In the negotiated market trades are
normally decided by seller and the buyer, and reported to
the exchange through the broker. Thus deals negotiated
outside the exchange are disclosed to the market through
the NEAT or BOLT-WDM system.

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 Secondary Corporate debt market .. Structure…. Contd..

) Clearing and Settlement system :

• ii

•Prime responsibility of settling trades concluded in the WDM segment rests directly with the
participants and the exchange only monitors the settlement.

•These trades are settled on a gross basis directly between participants on delivery versus payment basis
and not through a clearing house mechanism. So the participants are exposed to counterparty risk.

•On the scheduled settlement date, the Exchange provides data/information to the respective
member/participant regarding trades to be settled on that day with details like security, counter party
and consideration.

•The Exchange closely monitors the settlement of transactions through the reporting of settlement details
by members and participants. In case of deferment of settlement or cancellation of trade, participants
are required to seek prior approval from the Exchange. For any dispute arising in respect of the trades
or settlement, the exchange has established arbitration mechanism for resolving the same.
•Settlement is done on a rolling basis .( No account period settlement) . Settlement periods range from
T+0 to T+2.

34
Corporate debt market ..
Regulatory system
• Listed corporate debt is under the regulation of SEBI.

• SEBI lays down guidelines to force the issuer to make the investors
aware of the risks of investment in the debt issue.

• Disclosure and Investor Protection (DIP) Guidelines are designed to

this extent

35
International Securities Identification
Numbers(ISIN)
International Securities Identification Numbers(ISIN
Number),

which has 12 characters, is used for uniquely

identifying securities like stocks, Bonds, Warrants,
Commercial papers.

36
 SEBI GUIDELINES

To deepen the Corporate Bond Market ,SEBI put in place

a new frame work for consolidation in debt securities market.

Generally investors trade in corporate bonds that

are freshly issued by a Particular issuer. As a result,
the outstanding securities of the same issuer becomes illiquid.
Give rise to Piling problem

37
Under the new framework(issued on 30th June, 2017by SEBI)
An issuer will be permitted a maximum of 17 ISINs maturing
per financial year.

A maximum of 12 ISINs will be allowed only

for plain Vanilla debt securities covering both secured &
Unsecured non-convertible Debentures.

Further an entity can issue up to five ISINs every fiscal

“ For structured Debt Instrument of a particular category”

38
 Liquidity in the Secondary market for the
corporate will be increased.
 Issuer’s ability to raise funds through debt
securities is also not curtailed.

39
Exceptions
These Restrictions would not be applicable
to Debt instruments:

o That are used for raising Regulatory Capital

o Affordable Housing
o Capital Gains Bonds

40
Primary Market in Debt
 There is a steady rise in primary issuance from
1.74 lakh crores in 2008-09
to 7.24 lakhs crores in 2016-17.

 The pick up in the Capital Market has to some extent off-set

in the fall of Credit growth in Banking sector.

 A bank dominated market is giving way to

“a market based financial system.”

41
Amount of Corporate Bond Issued

FINANCIAL Through Private Through Public Total

YEAR placement Route Issue route
2012-13 3,41,701 16,982 3,58,683
2013-14 2,67,652 42,383 3,10,053
2014-15 4,57,032 9,713 4,66,745
2015-16 4,68,997 33,812 5,02,809
2016-17 6,94,952 29,547 7,24,499

Source: Prime Data base & FSR – June, 2017 Report.

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  Corporate Bond market is dominated by Private Placement,
with 95% issuance on a bilateral basis.

 Private placement dominance is because of

Operational flexibility,
Cost and ease of issuance compared with public issues.

 The Regulators approach should be on initiating measures

to provide a boost to the Public issue route to channelize
retail savings to corporate bonds,
without Impacting the size and growth of private placement

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Secondary Trade in Corporate Bond
2016-17 witnessing growth of 26% in number of trades
& 44% in terms of volume over previous year.

FINANCIAL TOTAL AMOUNT TOTAL

YEAR ( RS IN LAKH NO. OF TRADES
CRORES)
2012-13 7.4 66,383
2013-14 9.7 70,887
2014-15 10.9 75,791
2015-16 10.2 70,123
2016-17 14.7 88495

Source: Prime Data base & FSR – June, 2017 Report.

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•THANKS