Rajen Gala

WHAT IS COUPON…? The term \”coupon\” is derived from the historical use of actual coupons for periodic interest payment collections. The coupon rate is the interest rate paid on a bond by its issuer for the term of the security. ZERO COUPON BOND Zero coupon bonds is a bond that is issued at a discounted price and redeemed at par at the time of maturity. Example Rahul has invested Rs. 920/- in a zero coupon.    Assume that  after  1 year  he  would  receive Rs. 1000/- . In the   instant  case Rahul pays  920/-  (Discounted price)  and  he would receive   Rs. 1000/- (Par value) after 1 year. Return (yield)   on   the   bond for Rahul is  70%  and  can be  arrived  as  follows  (1000 – 920) / 920. Thus Zero Coupon Bond is nothing but  a  terminology used for a bond that is issued at  a  discounted  price  and redeemed at par on maturity.

What Is Debt…? Debt is an amount of money borrowed by one party from another. Debt is used by many corporations and individuals as a method of making large purchases that they could not afford under normal circumstances. A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest. Risks in Debt Credit Risk Default Risk Interest Rate Risk Credit Risk Credit risk is better termed “Credit RATING RISK” which is the risk that a bond gets its credit rating changed. If bond ratings changes from AAA to A, it means there is a large increase in risk, usually due to a worsening financial or political situation. Let us take an example of a company TCS TCS issues a bond for ₹100/- per bond at 9% interest. Suppose the credit ratings of TCS Bond is AA. If credit rating improves from AA to AAA the bond can trade at ₹105/- instead of ₹100/-. If the credit rating impared from AA to A then the bond can trade at ₹95/- instead of ₹100/-. Now, this is called credit risk. Default Risk Default risk is the risk that a borrower fails to make Principle or interest payments when they are due. Default risk affects the interest rate charged on a debt instrument. The greater the default risk, the higher the interest rate charged by lenders. Interest Rate Risk The risk of value depreciation of bonds and other fixed-income investments is known as interest rate risk. Primarily due to depreciation in their interest rates, this happens because of market fluctuations. Such risk affects many types of investments, though it primarily affects fixed-income investments. Effects of Interest Rates on Bond Prices and Debt Fund Net Asset Value (NAV) Interest Rates        ↑                  Bond Value        ↓                  Debt Fund NAV        ↓   Interest Rates        ↓                  Bond Value        ↑                  Debt Fund NAV        ↑   Let us take an example of the Company TCS TCS issues a 5 year bond for ₹100/- per bond at 9% interest. If the interest rate comes down to 8% the price of the bond can rise to ₹105/- and if the interest rate rise to 10% the price of the bond can depreciate to ₹95/-. Types of Debt:- Money Market Long Term Fixed Income Invests for less than one Year Invests for More than one year Treasury Bill (TBill’s) Commercial Papers (CP’s) Certificate of Deposits (CD’s) Bonds ·         Government of India & State Development Loans (SDL’s) ·         Corporate Securities Collaterized Borrowing and Lending Obligation (CBLO), Triparty Repo (TREP’s) Non-Convertible Debentures (NCD’s), Pass Through Certificates (PTC’s) Do you know? Why Debt have different names like TBill’s, CP’s, CD’s, CBLO, Gsec, SDL’s, NCD’s, PTC’s? Because the tenure of the product is different and Borrowers are different.   Borrowers Money Market Long Term Fixed Income Tenure Invests for less than one Year Invests for More than one year Central Government Treasury Bill (TBill’s) Government Securities (Gsec), State Development Loans (SDL’s) Banks Certificate of Deposits (CD’s) Fixed Deposits Corporates Commercial Papers (CP’s) NCD’s, Debentures, Corporate Securities Is there any risk associated with the Money Market and Long-Term Fixed Income instruments? Product Borrowers Can Default or not Treasury Bill (TBill’s) Central Government No Commercial Papers (CP’s) Corporates Yes Certificate of Deposits (CD’s) Banks No CBLO / TREPS Banks No NCD’s, Debentures, Corporate Securities Corporates Yes Gsec, SDL’s Central / State Government No Since Guaranteed by RBI  Collateralized Borrowing and Lending Obligation (CBLO) CBLO is a money market instrument that represents an obligation between a borrower and a lender concerning the terms and conditions of a loan. These instruments are operated by the Clearing Corporation of India Ltd. (CCIL) and Reserve Bank of India (RBI), with CCIL members being institutions with little to no access to the interbank call money market in India. The instrument works like a bond where the lender buys the CBLO and a borrower sells the money market instrument with interest. CBLOs allow those restricted from using the interbank call money market in India to participate in the short-term money markets. State Development Loans (SDL) State Development Loans (SDL) are debt issued by state governments to fund their fiscal deficit. SDL issues are managed by the RBI, which also makes sure that the SDL\’s are serviced by monitoring escrow accounts for payment of interest and principal. The SDL market is similar to that of the government bond market. SDL\’s are traded electronically on the NDS-OM (Negotiated Dealing System-Order Matching) and traded in the voice market (NDS). Triparty Repo (TREPs) Transactions in the overnight triparty Repo Dealing and Settlement (TREPs) are being done by banks, mutual funds, NBFCs and others with government securities as collateral. These transactions can be done for various duration ranging from overnight to as long as 365 days. Pass Through Certificate (PTC) Pass Through Certificates are high quality debt instruments that represents ownership in a pool of assets and derive monthly principle and interest payments from those assets. PTC’s are nothing but securitization i.e. transforms illiquid assets in to liquid assets. Modified Duration Modified duration is a formula that expresses the measurable change in the value of a security in response to a change in interest rates. Modified duration follows the concept that interest rates and bond prices move in opposite directions. Let us take an example where interest decreases, what will be the effect on the Fund. Interest Rate Decreases by Fund A Modified Duration 5 Years Fund B Modified Duration 2 Years 1% 1% * 5 Years = 5% Yield to Maturity + 5% 1% * 2 Years = 2% Yield to Maturity + 2% 0.5% 0.5% * 5 Years = 2.5% Yield to Maturity + 2.5% 0.5% * 2 Years = 1% Yield to Maturity + 1% When Interest rates falls invest in medium duration or long duration debt funds. Let us take another example where interest increases, what will be the effect on the Fund. Interest Rate Increases by Fund A Modified Duration

Duration Management Debt funds invest in debt papers which need to give good fixed returns & be of good quality. Based on the interest rate outlook, the fund manager decides whether to invest in long duration papers or short duration papers.   But how is his decision of selecting long duration papers or short duration papers connected with the interest rate outlook..?   Simply speaking, when interest rates are expected to go up, the debt fund manager would invest in shorter duration papers but if interest rates are expected to come down, then he would do the opposite and invest in longer duration papers.   When a fund manager thinks that interest rates are likely to go up in the near future, it means that debt papers in the future will offer better rates of return. Even he observes that as the interest rates are likely to rise soon and debt papers gives a higher interest rates which would become available, he invests in papers with shorter maturities, so that by the time the interest rates rise, his papers have matured and he has cash to invest in the new papers.   Now what happens when the debt fund manager believes that interest rate is more likely to come down…? He just reverses his strategy and invests in long duration papers. so, his money stays invested in higher interest bearing papers even in a lower interest rate regime. The value of the higher interest bearing papers too would go up and the fund manager too could extract a higher price by selling it in the market…!

Commercial Paper & Treasury Bill A Commercial Paper (CP) is an unsecured, short-term debt instrument issued by a Corporation, in the form of promissory note or in dematerialised form, typically for meeting short-term liabilities. COMMERCIAL PAPER A Commercial Paper (CP) is A money-market instrument Issued by corporates and Financial Institutions To garner money from the market To meet short term needs. When & why was it introduced in India? It was introduced in India in 1990. It was aimed at providing high rated corporates with a borrowing option. So while they could borrow from a bank, now with the help of a Commercial Papers, they could also borrow from the open market. Since Commercial Paper is used to borrow directly from the market, the rate of interest is lesser as compared to the banks. THUS… A commercial paper is a lower cost alternative to borrowing from a bank. However not all organisations are in a position to issue Commercial Papers. Only reputed organisations whose papers have a good rating can borrow directly through Commercial Papers and save money. LETS TAKE AN EXAMPLE….. ABC Group are the owners of a large retail stores. They want to raise funds from the market to purchase merchandise. If they go to a bank for a loan, they would have to pay 10% interest on the loan. But from the open market they could perhaps get the loan at only 7%. Hence by resorting to an instrument like Commercial Papers, the organization gains 3%. Therefore By issuing Commercial Papers the organisation borrows directly from investors and by-passes the banks. As a result, it gets to borrow at a lower rate from the market as compared to what the banks would have charged. This process is also called Financial Disintermediation or in other words getting rid of the mediator. So who is eligible to issue Commercial Papers? Corporates Primary dealers Satellite Dealers All-India Financial Institutions (FIs) And who can invest in CPs? Individuals Banking companies Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs) etc. For what maturity periods are CPs issued…..? CPs can be issued for maturities between a minimum of 15 days and a maximum of up to one year from the date of issue. CP can be issued in denominations of Rs. 5 lakh or multiples thereof. Amount invested by single investor should not be less than Rs. 5 lakh (face value). Therefore it is used to fund the working capital or current requirements of organisations. However, one important point to note is that the borrowed amount can only be used to fulfill current requirements. It is not meant be used for purchase of fixed assets, such as a new plant. Commercial Papers is usually issued at a discount from face value and rarely range longer then 270 Days. It is mandatory for CPs to be credit rated by approved Credit Rating Agencies as may be specified by RBI from time to time. Treasury Bills What Treasury Bills are… Treasury Bills or T- Bills are exactly the same as CPs. Except that while CPs are issued by corporates, T- Bills are issued by the Government of India for financing its working capital needs. T-Bills issued by Reserve Bank of India are for 91 Days, 182 Days and 364 Days T-bills. T-Bills are Zero Coupon securities and are issued at discount and redeemed at face Value on Maturity. T-Bills are Secured.

Certificate of Deposits CDs or Certificates of Deposits are Financial Instruments. CERTIFICATES OF DEPOSIT What do CDs actually mean? Who issues them?? Who subscribes to them??? CERTIFICATES OF DEPOSIT Sunil wishes to borrow Rs. 40 Lakhs for his new business venture. He goes to his bank to ask for a loan. But though the bank agrees to provide a loan, it realizes that it has only Rs. 30 lacs at present. Now the bank does not wish to lose him to another bank. So the bank asks him to come back later to collect the loan amount. CERTIFICATES OF DEPOSIT So how does the bank provide the additional Rs.10 lakhs? CERTIFICATES OF DEPOSIT The bank has corporate relationships from whom they can borrow. In order to borrow, they issue ‘Certificates of Deposit’ to these corporate relationships. Obviously the rate of interest offered by the bank to the corporate institutions would be higher than regular fixed deposits. Thus money comes into the bank and is in turn offered to Sunil. CERTIFICATES OF DEPOSIT CDs, thus, become the financial instrument issued by banks at a higher interest rate than Fixed Deposits to entice corporates to park money with them in order to meet a lending need. A CD bears: a maturity date, generally range for 7 days to onr year. Financial Institution’s can issue CD’s for a period not less than one year and not exceeding 3 years from the date of issue. a specified interest rate, and can be issued for Rs.1 lakh and in multiple of Rs.1 Lakh thereafter. CERTIFICATES OF DEPOSIT To Sum Up CD’s are a negotiable money market instrument and issued in dematerialized form or as a promissory note against funds deposited at a bank. CD’s can be issued by scheduled commercial banks and financial institutions permitted by Reserve Bank of India. CD’s are rated by approved rating agencies. (Example- CARE, ICRA, CRISIL and FITCH)

CALL MONEY On a lazy Sunday night you and your family are relaxing on a couch watching your favorite TV show. Suddenly, someone rings your door bell. You open the door and it’s your long distance relatives who have made a surprise visit. While you can’t show your displeasure but you still welcome them and offer a cup of tea or coffee. However, your wife whispers to you that there is no milk at home and all the neighborhood shops would be closed. So, now you are left with no option but knock your neighbour\’s door to borrow some milk for your guests with an intention to return it next day once the shop reopens. At least your friendly neighbour becomes your savior and saves you from embarrassment….. Similarly, in the money market, call money serves as a savior to banks facing temporary cash crunch and lends them overnight money to avert the shortage situation… What  is  Call Money…? Call money relates to day-to-day funds requirements of banks. When one bank faces a temporary cash crunch, it borrows from another bank that has surplus cash for a period of one to fifteen days. Typically, banks borrow to bridge temporary shortfall in funds. This borrowing and lending is on unsecured basis. When money is lent for one day or on overnight basis it is known as “Call Money” and, if it exceeds one day to 14 days is referred to as “Notice Money” and “Term Money” refers to borrowing/lending of funds for fixed tenure for 15 days upto 1 year. WHO CAN PARTICIPATE …? The call money market is the most important segment in the Indian money market. In this market, only Schedule Commercial Banks, Co-operative Banks(other than Land Development Banks), Payments Banks, Small Finance Banks and Primary dealers (PDs) are allowed to both borrow and lend. WHY DOES BANK BORROW MONEY WHEN THEY LEND MONEY TO EVERYONE…? Banks have to maintain a mandatory minimum cash balance known as the cash reserve ratio (CRR). They also have to maintain sufficient liquidity for their day-to-day operations. Also, banks sometimes need to borrow funds to meet a sudden demand which may arise due to large cash withdrawals during festivals, long bank holidays and cash supply at ATMs etc. Any surplus / shortfall could be met through call money route. WHAT IS ITS IMPACT…? The interest paid on call money is called call rate. Eligible participants are free to decide on what the interest rates would be. This is very liquid money market and is the main indicator of the day to day interest rates. If the call money rates fall, this means there is a rise in the liquidity and vice versa. Also, the call money rates have implications on the monetary policy. If the call rates consistently trade at levels which are not in line with the RBI’s policy rates then RBI may conduct Open Market Operations (OMO) to infuse or suck liquidity from the market. Simply put, call money serves the purpose of meeting the short-term liquidity requirement of banks.