Detail study of Zero coupon Bonds

Project Report

On

Detail Study of Debt Market Instruments

Submitted to fulfillment partial requirement for Master of Business Administration (Batch 2009-2011)

Guide: Pro. Masuma Mehta (Academic coordinator)

Prepared by: Name : Girish Babu

Registration No. :10P35H0473 Specialisation. : Finance Submitted To Institute of Business Management & Research Near ASIA School, Drive-in Road, Ahmedabad-380054

Centre for Participatory and Online Programmes Bharathiar University, Coimbatore 641 046. Tamilnadu
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CERTIFICATE This is to certify that the project work entitled Detail Study of Debt Market in instruments submitted to Bharathiar University in partial the requirements for Administration the award of the Degree of fulfillment of Master of Business

in Financial Management is a record of the original work

done by Girish Babu under my Supervision and guidance and that this project work has not formed the basis for the award of any

Degree/Diploma/Associate ship/Fellowship or Similar title to any candidate of any University. Date: Signature of the Guide

Place: AhmedabadName and Designation Forwarded by IBMR Business School, Submitted for University Examination held

on______________________________

Internal Examiner

External Examiner

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DECLARATION
I hereby declare that this project work titled Detail Study of Debt Market in instruments is a record of Original work done by me under the guidance of Prof. Masuma Mehta and that this project work has not formed the basis for the award of any Degree/Diploma/Associateship/ Fellowship or similar title to any candidate of any University.

Date:

Signature of the candidate Name: Girish Babu Registration No.: 10P35H0473 Course with Specialization: MBA(finance)

Countersigned by Signature of the Guide (with seal)

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ACKNOWLEDGEMENT

We take this opportunity to express my deep sense of gratitude to all our friends and seniors who helped and guide me to complete this project successfully. I am highly grateful and indebted to our project guide Lect. Ms. Masuma for their excellent and expert guidance in helping us in completion of project report.

Girish Babu

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PREFACE

The successful completion of this project was a unique experience for us because by visiting many place and interacting various person, I achieved a better knowledge about this project. The experience which I gained by doing this project was essential at this turning point of my carrier this project is being submitted which content detailed analysis of the research under taken by me. The research provides an opportunity to the student to devote her skills knowledge and competencies required during the technical session.

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S.no. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Particulars Indian Financial Systam Introduction to Indian Debt Market Introduction to Zero Coupon bonds Types of Zero-Coupon Securities Strategic Considerations of Zero Coupon Securities Zero coupon bonds yield curve Advantages and Disadvantages Pros and cons of zero coupon bonds ZCB pricing and interest Issue of ZCB by NABARD Bibliography

Page No. 8-16 17-53 54-56 57-58 59 60-65 66-67 68-69 70-82 83-93 94

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INDIAN FINANCIAL SYSTEM

The economic development of a nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector. While performing their activities these units will be placed in a surplus/deficit/balanced budgetary situations. There are areas or people with surplus funds and there are those with a deficit. A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. A Financial System is a composition of various institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities. Financial System;

The word "system", in the term "financial system", implies a set of complex
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and closely connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. The financial system is concerned about money, credit and finance-the three terms are intimately related yet are somewhat different from each other. Indian financial system consists of financial market, financial instruments and financial

intermediation. These are briefly discussed below; FINANCIAL MARKETS A Financial Market can be defined as the market in which financial assets are created or transferred. As against a real transaction that involves exchange of money for real goods or services, a financial transaction involves creation or transfer of a financial asset. Financial Assets or Financial Instruments represents a claim to the payment of a sum of money sometime in the future and /or periodic payment in the form of interest or dividend. Money Market- The money market ifs a wholesale debt market for lowrisk, highly-liquid, short-term instrument. Funds are available in this market for periods ranging from a single day up to a year. This market is dominated mostly by government, banks and financial institutions. Capital Market - The capital market is designed to finance the long-term investments. The transactions taking place in this market will be for periods over a year.
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Forex Market - The Forex market deals with the multicurrency requirements, which are met by the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market. This is one of the most developed and integrated market across the globe. Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short, medium and long-term loans to corporate and individuals.

Constituents of a Financial System

FINANCIAL INTERMEDIATION Having designed the instrument, the issuer should then ensure that these financial assets reach the ultimate investor in order to garner the requisite amount. When the borrower of funds approaches the financial market to raise funds, mere issue of securities will not suffice. Adequate information
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of the issue, issuer and the security should be passed on to take place. There should be a proper channel within the financial system to ensure such transfer. To serve this purpose, Financial intermediariescame into existence. Financial intermediation in the organized sector is conducted by a widerange of institutions functioning under the overall surveillance of the Reserve Bank of India. In the initial stages, the role of the intermediary was mostly related to ensure transfer of funds from the lender to the borrower. This service was offered by banks, FIs, brokers, and dealers. However, as the financial system widened along with the developments taking place in the financial markets, the scope of its operations also widened. Some of the important intermediaries operating ink the financial markets include; investment bankers, underwriters, stock exchanges, registrars, depositories, custodians, portfolio managers, mutual funds, financial advertisers financial consultants, primary dealers, satellite dealers, self regulatory organizations, etc. Though the markets are different, there may be a few intermediaries offering their services in move than one market e.g. underwriter. However, the services offered by them vary from one market to another.

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Intermediary

Market

Role Secondary Market to

Stock Exchange

Capital Market securities Corporate Capital Market, Credit advisory Issue of

Investment Bankers Market

services, securities Subscribe Capital Market,

to portion

Underwriters Money Market

unsubscribed of securities

Issue securities to the Registrars, Depositories, Custodians Capital Market investors on behalf of the company and

handle share transfer activity

Primary

Dealers Money Market

Market

making

in

Satellite Dealers

government securities Ensure exchange ink

Forex Dealers

Forex Market currencies

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FINANCIAL INSTRUMENTS Money Market Instruments The money market can be defined as a market for short-term money and financial assets that are near substitutes for money. The term short-term means generally a period upto one year and near substitutes to money is used to denote any financial asset which can be quickly converted into money with minimum transaction cost.

1. Call /Notice-Money Market Call/Notice money is the money borrowed or lent on demand for a very short period. When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day, (irrespective of the number of intervening holidays) is "Call Money". When money is borrowed or lent for more than a day and up to 14 days, it is "Notice Money". No collateral security is required to cover these transactions. 2. Inter-Bank Term Money Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money market. The entry restrictions are the same as those for

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Call/Notice Money except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days. 3. Treasury Bills. Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder. The rate of discount and the corresponding issue price are determined at each auction. 4. Certificate of Deposits Certificates of Deposit (CDs) is a negotiable money market instrument nd issued in dematerialised form or as a Usane Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time. CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI. Banks have the freedom to issue CDs depending on their requirements. An FI may issue
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CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments viz., term money, term deposits, commercial papers and intercorporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet. 5. Commercial Paper CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the debt obligation is transformed into an instrument. CP is thus an unsecured promissory note privately placed with investors at a discount rate to face value determined by market forces. CP is freely negotiable by endorsement and delivery. A company shall be eligible to issue CP provided - (a) the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b) the working capital (fund-based) limit of the company from the banking system is not less than Rs.4 crore and (c) the borrowal account of the company is classified as a Standard Asset by the financing bank/s. The minimum maturity period of CP is 7 days. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies. Capital Market Instruments The capital market generally consists of the following long term period i.e., more than one year period, financial instruments; In the equity segment Equity shares, preference shares, convertible preference shares, non15 | P a g e

convertible preference shares etc and in the debt segment debentures, zero coupon bonds, deep discount bonds etc. Hybrid Instruments Hybrid instruments have both the features of equity and debenture. This kind of instruments is called as hybrid instruments. Examples are convertible debentures, warrants etc.

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INTRODUCTION TO INDIAN DEBT MARKET

Towards the eighteenth century, the borrowing needs of Indian Princely States were largely met by Indigenous bankers and financiers. The concept of borrowing from the public in India was pioneered by the East India Company to finance its campaigns in South India (the Anglo French wars) in the eighteenth century. The debt owed by the Government to the public, over time, came to be known as public debt. The endeavors of the Company to establish government banks towards the end of the 18th Century owed in no small measure to the need to raise term and short term financial accommodation from banks on more satisfactory terms than they were able to garner on their own. Public Debt, today, is raised to meet the Governments revenue deficits (the difference between the income of the government and money spent to run the government) or to finance public works (capital formation). Borrowing for financing railway construction and public works such irrigation canals was first undertaken in 1867. The First World War saw a rise in India's Public Debt as a result of India's contribution to the British exchequer towards the cost of the

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war. The provinces of British India were allowed to float loans for the first time in December, 1920 when local government borrowing rules were issued under section 30(a) of the Government of India Act, 1919. Only three provinces viz., Bombay, United Provinces and Punjab utilized this sanction before the introduction of provincial autonomy. Public Debt was managed by the Presidency Banks, the Comptroller and Auditor-General of India till 1913 and thereafter by the Controller of the Currency till 1935 when the Reserve Bank commenced operations.

Interest rates varied over time and after the uprising of 1857 gradually came down to about 5% and later to 4% in 1871. In 1894, the famous 3 1/2 % paper was created which continued to be in existence for almost 50 years. When the Reserve Bank of India took over the management of public debt from the Controller of the Currency in 1935, the total funded debt of the Central Government amounted to Rs 950 crores of which 54% amounted to sterling debt and 46% rupee debt and the debt of the Provinces amounted to Rs 18 crores.

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Broadly, the phases of public debt in India could be divided into the following phases.

Upto 1867: when public debt was driven largely by needs of financing campaigns.

1867- 1916: when public debt was raised for financing railways and canals and other such purposes.

1917-1940: when public debt increased substantially essentially out of the considerations of

1940-1946: when because of war time inflation, the effort was to mop up as much a spossible of the current war time incomes

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1947-1951: represented the interregnum following war and partition and the economy was unsettled. Government of India failed to achieve the estimates for borrwings for which credit had been taken in the annual budgets.

1951-1985: when borrowing was influenced by the five year plans.

1985-1991: when an attempt was made to align the interest rates on government securities with market interest rates in the wake of the recommendations of the Chakraborti Committee Report.

1991 to date: When comprehensive reforms of the Government Securities market were undertaken and an active debt management policy put in place. Ad Hoc Treasury bills were abolished; commenced the selling of securities through the auction process; new instruments were introduced such as zero coupon bonds, floating rate bonds and capital indexed bonds; the Securities Trading Corporation of India was established; a system of Primary Dealers in government securities was put in place; the spectrum of maturities was broadened; the system of Delivery versus payment was instituted; standard
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valuation norms were prescribed; and endeavors made to ensure transparency in operations through market process, the dissemination of information and efforts were made to give an impetus to the secondary market so as to broaden and deepen the market to make it more efficient.

In India and the world over, Government Bonds have, from time to time, have not only adopted innovative methods for rasing resources (legalised wagering contracts like the Prize Bonds issued in the 1940s and later 1950s in India) but have also been used for various innovative schemes such as finance for development; social engineering like the abolition of the Zamindari system; saving the environment; or even weaning people away from gold (the gold bonds issued in 1993).

Normally the sovereign is considered the best risk in the country and sovereign paper sets the benchmark for interest rates for the corresponding maturity of other issuing entities. Theoretically, others can borrow at a rate above what the Government pays depending on how their risk is perceived by the markets. Hence, a well developed Government Securities market helps in the efficient allocation of resources. A countrys debt market to a large extent depends on the
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depth of the Governments Bond Market. It in in this context that the recent initiatives to widen and deepen the Government Securities Market and to make it more efficient have been taken.

INTRODUCTION Traditionally, the capital markets in India are more synonymous with the equity markets both on account of the common investors preferences and the oft huge capital gains it offered no matter what the risks involved are. The investors preference for debt market, on the other hand, has been relatively a recent phenomenon an outcome of the shift in the economic policy, whereby the market forces have been accorded a greater leeway in influencing the resource allocation.

In a developing economy such as India, the role of the public sector and its financial requirements need no emphasis. Growing fiscal deficits and the policy stance of directed investment through statutory pre emption (the statutory liquidity ratio SLR - for banks), ensured a captive but passive market for the
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Government securities. Besides, participation of the Reserve Bank of India (RBI) as an investor in the Government borrowing programme (monetisation of deficits) led to a regime of financial repression. In an eventual administered interest rate regime, the asset liability mismatches pose no threat to the balance sheets of financial institutions. As a result, the banking system, which is the major holder of the Government securities portfolio, remained a dominant passive investor segment and the market remained dormant.

The Indian Bond Market has been traditionally dominated by the Government securities market. The reasons for this are

The high and persistent government deficit and the need to promote an

efficient government securities market to finance this deficit at an optimal cost,

A captive market for the government securities in the form of public sector

banks which are required to invest in government securities a certain per cent of deposit liabilities as per statutory requirement1,

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The predominance of bank lending in corporate financing and

Regulated interest rate environment that protected the banks balance

sheets on account of their exposure to the government securities.

While these factors ensured the existence of a big Government securities market, the market was passive with the captive investors buying and holding on to the government securities till they mature. The trading activity was conspicuous by its absence.

The scenario changed with the reforms process initiated in the early nineties. The gradual deregulation of interest rates and the Governments decision to borrow through auction mechanism and at market related rates.

DEBT MARKET

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Debt market as the name suggests is where debt instruments or bonds are traded. The most distinguishing feature of these instruments is that the return is fixed i.e. they are as close to being risk free as possible, if not totally risk free. The fixed return on the bond is known as the interest rate or the coupon rate. Thus, the buyer of a bond gives the seller a loan at a fixed rate, which is equal to the coupon rate. Debt Markets are therefore, markets for fixed income securities issued by:

Central and State Governments Municipal Corporations Entities like Financial Institutions, Banks, Public Sector Units, and Public

Ltd. companies.

The money market also deals in fixed income instruments. However, difference between money and bond markets is that the instruments in the bond markets have a larger time to maturity (more than one year). The money market on the other hand deals with instruments that have a lifetime of less than one year.

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Segments of Debt Markets

There are three main segments in the debt markets in India,

Government Securities, Public Sector Units (PSU) bonds and Corporate securities.

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The market for Government Securities comprises the Centre, State and StateSponsored securities. The PSU bonds are generally treated as surrogates of sovereign paper, sometimes due to explicit guarantee and often due to the comfort of public ownership. Some of the PSU bonds are tax free while most bonds, including government securities are not tax free. The Government Securities segment is the most dominant among these three segments. Many of the reforms in pre-1997 period were fundamental, like introduction of auction systems and PDs. The reform in the Government Securities market which began in 1992, with Reserve Bank playing a lead role, entered into a very active phase since April 1997, with particular emphasis on development of secondary and retail markets.

MARKET STRUCTURE

There is no single location or exchange where debt market participants interact for common business. Participants talk to each other, conclude deals, send confirmations etc. on the telephone, with clerical staff doing the running around for settling trades. In that sense, the wholesale debt market is a virtual market.

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In order to understand the entirety of the wholesale debt market we have looked at it through a framework based on its main elements. The market is best understood by understanding these elements and their mutual interaction. These elements are as follows:

Instruments - the instruments that are being traded in the debt market. Issuers - entity which issue these instruments. Investors - entities which invest in these instruments or trade in these

instruments. Interventionists or Regulators - the regulators and the regulations

governing the market.

It is necessary to understand microstructure of any market to identify processes, products and issues governing its structure and development. In this section a schematic presentation is attempted on the micro-structure of Indian corporate debt market so that the issues are placed in a proper perspective. Figure gives a birds eye view of the Indian debt market structure.

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The Structure of the Indian Debt Market

Participants

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As is well known, a large participant base would result in lower cost of borrowing for the Government. In fact, retailing of Government Securities is high on the agenda of further reforms.

Banks are the major investors in the Government Securities markets. Traditionally, banks are required to maintain a part of their net demand and time liabilities in the form of liquid assets of which Government Securities have always formed the predominant share. Despite lowering the Statutory Liquidity Ratio (SLR) to the minimum of 24 per cent, banks are holding a much larger share of Government Stock as a portfolio choice. Other major investors in Government Stock are financial institutions, insurance companies, mutual funds, corporate, individuals, non-resident Indians and overseas corporate bodies. Foreign institutional investors are permitted to invest in Treasury Bills and dated Government Securities in both primary and secondary markets.

Often, the same participants are present in the non-Government debt market also, either as issuers or investors. For example, banks are issuers in the debt market for their Tier-II capital. On the other hand, they are investors in PSU bonds and corporate securities. Foreign Institutional Investors are relatively
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more active in non-Government debt segment as compared to the Government debt segment.

Central Governments, raising money through bond issuances, to fund

budgetary deficits and other short and long term funding requirements.

Reserve Bank of India, as investment banker to the government, raises

funds for the government through bond and t-bill issues, and also participates in the market through open-market operations.

Primary Dealers, who are market intermediaries appointed by the Reserve

Bank of India who underwrite and make market in government securities, and have access to the call markets and repo markets for funds.

State Governments, municipalities and local bodies, which issue securities

in the debt markets to fund their developmental projects, as well as to finance their budgetary deficits.

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Public Sector Units are large issuers of debt securities, for raising funds to

meet the long term and working capital needs. These corporations are also investors in bonds issued in the debt markets.

Public Sector Financial Institutions regularly access debt markets with

bonds for funding their financing requirements and working capital needs. They also invest in bonds issued by other entities in the debt markets.

Banks are the largest investors in the debt markets, particularly the treasury

bond and bill markets. They have a statutory requirement to hold a certain percentage of their deposits (currently the mandatory requirement is 24% of deposits) in approved securities

Mutual Funds have emerged as another important player in the debt

markets, owing primarily to the growing number of bond funds that have mobilized significant amounts from the investors.

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Foreign Institutional Investors FIIs can invest in Government Securities

upto US $ 5 billion and in Corporate Debt up to US $ 15 billion.

Provident Funds are large investors in the bond markets, as the prudential

regulations governing the deployment of the funds they mobilise, mandate investments pre-dominantly in treasury and PSU bonds. They are, however, not very active traders in their portfolio, as they are not permitted to sell their holdings, unless they have a funding requirement that cannot be met through regular accruals and contributions.

Corporate treasuries issue short and long term paper to meet the financial

requirements of the corporate sector. They are also investors in debt securities issued in the debt market.

Charitable Institutions, Trusts and Societies are also large investors in the

debt markets. They are, however, governed by their rules and byelaws with respect to the kind of bonds they can buy and the manner in which they can trade on their debt portfolios.
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DEBT MARKET INSTRUMENTS

The instruments traded can be classified into the following segments based on the characteristics of the identity of the issuer of these securities

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Commercial Paper (CP): They are primarily issued by corporate entities. It is compulsory for the issuance of CPs that the company be assigned a rating of at least P1 by a recognized credit rating agency. An important point to be noted is that funds raised through CPs do not represent fresh borrowings but are substitutes to a part of the banking limits available to them.

Certificates of Deposit (CD): While banks are allowed to issue CDs with a maturity period of less than 1 year, financial institutions can issue CDs with a maturity of at least 1 year. The prime reason for an active market in CDs in India is that their issuance does not warrant reserve requirements for bank.

Treasury Bills (T-Bills): T-Bills are issued by the RBI at the behest of the Government of India and thus are actually a class of Government Securities. Presently T-Bills are issued in maturity periods of 91 days, 182 days and 364 days. Potential investors have to put in competitive bids. Non-competitive bids are also allowed in auctions (only from specified entities like State Governments and their undertakings, statutory bodies and individuals) wherein the bidder is allotted T-Bills at the weighted average cut off price.

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Long-term debt instruments: These instruments have a maturity period exceeding 1year. The main instruments are Government of India dated securities (GOISEC), State Government securities (state loans), Public Sector Undertaking bonds (PSU bonds) and corporate bonds/debenture. Majority of these instruments are coupon bearing i.e. interest payments are payable at pre specified dates.

Government of India dated securities (GOISECs): Issued by the RBI on behalf of the Central Government, they form a part of the borrowing program approved by Parliament in the Finance Bill each year (Union Budget). They have a maturity period ranging from 1 year to 30 years. GOISECs are issued through the auction route with the RBI pre specifying an approximate amount of dated securities that it intends to issue through the year. But unlike T-Bills, there is no pre set schedule for the auction dates. The RBI also issues products other than plain vanilla bonds at times, such as floating rate bonds, inflationlinked bonds and zero coupon bonds.

State Government Securities (state loans): Although these are issued by the State Governments, the RBI organizes the process of selling these securities.
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The entire process, 17 right from selling to auction allotment is akin to that for GOISECs. They also form a part of the SLR requirements and interest payment and other modalities are analogous to GOISECs. Although there is no Central Government guarantee on these loans, they are believed to be exceedingly secure. One important point is that the coupon rates on state oans are slightly higher than those of GOISECs, probably denoting their sub-sovereign status.

Public Sector Undertaking Bonds (PSU Bonds): These are long-term debt instruments issued generally through private placement. The Ministry of Finance has granted certain PSUs, the right to issue tax-free bonds. This was done to lower the interest cost for those PSUs who could not afford to pay market determined interest rates.

Bonds of Public Financial Institutions (PFIs): Financial Institutions are also allowed to issue bonds, through two ways - through public issues for retail investors and trusts and secondly through private placements to large institutional investors.

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Corporate debentures: These are long-term debt instruments issued by private companies and have maturities ranging from 1 to 10 years. Debentures are generally less liquid as compared to PSU bonds.

TERMS IN DEBT MARKET

An individual must be aware about the following terms associated with Government Securities:

Coupon: The 'Coupon' denotes the rate of interest payable on the security.

E.g. a security with a coupon of 7.40% would draw an interest of 7.40% on the face value.

Interest Payment Dates (IP dates): The dates on which the coupon

(interest) payments are made are called as the IP dates.

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Last Interest Payment Date (LIP Date): LIP date refers to the date on

which the interest was last paid.

Accrued Interest: Accrued interest is the interest charged at the coupon

rate from the Last Interest Payment to the date of settlement. Accrued Interest for a security depends upon its coupon rate and the number of days from its LIP date to the settlement date.

Day count convention: The market uses quite a few conventions for

calculation of the number of days that has elapsed between two dates. The ultimate aim of any convention is to calculate (days in a month)/(days in a year). The Fixed Income Instruments in India 18/90 conventions used are as below. We take the example of a bond with Face Value 100, coupon 12.50%, last coupon paid on 15th June, 2008 and traded for value 5th October, 2008.

A/360(Actual by 360) : In this method, the actual number of days elapsed

between the two dates is divided by 360, i.e. the year is assumed to have 360 days.
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A/365 (Actual by 365) : In this method, the actual number of days elapsed

between the two dates is divided by 365, i.e. the year is assumed to have 365 days.

A/A (Actual by Actual): In this method, the actual number of days elapsed

between the two dates is divided by the actual days in the year.

30/360-Day Count: A 30/360-day count says that all months consist of 30

days. i.e. the month of February as well as the month of March is assumed to have thirty days.

Yield: Yield is the effective rate of interest received on a security. It takes

into consideration the price of the security and hence differs as the price changes, since the coupon rate is paid on the face value and not the price of purchase. The concept can be best understood by the following example:

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 A security with a coupon of 7.40%: If purchased at Rs. 100 the yield will be 7.40% If purchased at Rs. 200 the yield becomes 3.70%. If purchased at Rs. 50 the yield becomes 14.80% Thus it is seen that higher the price lesser will be the yield and vice-versa. The yield will be equal to the coupon rate if and only if the security is purchased at the face value (Par).

Yield to Maturity (YTM): YTM implies the effective rate of interest

received if one holds the security till its maturity. This is a better parameter to see the effective rate of return as YTM also takes into consideration the time factor.

Holding Period Yield (HPY): HPY comes into the picture when an

investor does not hold the security till maturity. HPY denotes the effective Fixed Income Instruments in India 19/90 yield for the period from the date of purchase to the date of sale.
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Clean Price: Clean Price denotes the actual price of the security as

determined by the market.

Dirty Price: Dirty Price is the price that is obtained when the accrued

interest is added to the Clean Price.

Shut Period: The government security pays interest twice a year. This

interest is paid on the IP dates. One working day prior to the IP date, the security is not traded in the market. This period is referred to as the 'Shut Period'.

Face Value: The Face Value of the securities in a transaction is the number

of Government Security multiplied by Rs.100 (face Value of each Government Security). Say, a transaction of 5000 Government Security will imply a face value of Rs. 5,00,000 (i.e. 5000 * 100)

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"Cum-Interest" and "Ex-Interest: Cum-interest means the price of security

is inclusive of the interest accrued for the interim period between last interest payment date and purchase date. Security with ex-interest means the accrued interest has to be paid separately

Trade Value: The Trade Value is the number of Government Security

multiplied by the price of each security.

Primary and Satellite Dealers: Primary Dealers can be referred to as

Merchant Bankers to Government of India, comprising the first tier of the government securities market. They were formed during the year 1994-96 to strengthen the market infrastructure. PDs are expected to absorb government securities in primary markets, to provide two-way quotes in the secondary market and help develop the retail market. The capital adequacy requirements of PDs take into account both credit risk and market risk. They are required to maintain a minimum capital of 15 per cent of aggregate risk weighted assets, including market risk capital (arrived at using the Value at Risk method). ALM discipline has been extended to PDs. RBI is also vested with the responsibility of on-site supervision of PDs. PDs have now been brought under the purview of
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the Board for Financial Supervision. The satellite dealer system was introduced in 1996 to act as a second tier to the Primary Dealers in developing the market particularly the retail segment. The system which was in operation for more than six years was discontinued because it did not yield the desired results.

SIZE OF DEBT MARKET

Worldwide debt markets are three to four times larger than equity markets. However, the debt market in India is very small in comparison to the equity market. This is because the domestic debt market has been deregulated and liberalized only recently and is at a relatively nascent stage of development. The debt market in India is comprised of two main segments, the Government securities market and the corporate securities market. Government securities form the major part of the debt market-accounting for about 90-95% in terms of outstanding issues, market capitalization and trading value. In the last few years there has been significant growth in the Government securities market. The aggregate trading volumes of Government securities in the secondary market have grown significantly from 1998-99 to 2008-09.

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Turnover in the Government Securities Market (Face Value) GOI TURNOVER

summary of average maturity and cut-off yields in primary market borrowings of the government.

In terms of size, the Indian debt market is the third largest in Asia after Japan and Korea. It, however, fairs poorly when compared to other economies like the US and the Euro area. The Indian debt market also lags behind in terms of the size of the corporate debt market. The share of corporate debt in the total debt issued had in fact declined.
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Bonds Issued by Public Sector Undertakings - (Rupees crore)

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REGULATORS The Securities Contracts Regulation Act (SCRA) defines the regulatory role of various regulators in the securities market. Accordingly, with its powers to regulate the money and Government securities market, the RBI regulates the money market segment of the debt products (CPs, CDs) and the Government securities market. The non Government bond market is regulated by the SEBI. The SEBI also regulates the stock exchanges and hence the regulatory overlap in regulating transactions in Government securities on stock exchanges have to be dealt with by both the regulators (RBI and SEBI) through mutual cooperation. In any case, High Level Co-ordination Committee on Financial and Capital Markets (HLCCFCM), constituted in 1999 with the Governor of the RBI as Chairman, and the Chiefs of the securities market and insurance regulators, and the Secretary of the Finance Ministry as the members, is addressing regulatory gaps and overlaps.

FACTORS AFFECTING MARKET

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Internal Factors Interest rate movement in the system RBI economic policies Demand for money Government borrowings to tide over its fiscal deficit Supply of money Inflation rate Credit quality of the issuer.

External Factors World Economy & its impact Foreign Exchange Fed rate cut Crude Oil prices Economic Indicators

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BENEFITS OF INVESTING IN A DEBT MARKET

Safety: The Zero Default Risk is the greatest attraction for investments in

Government Securities. It enjoys the greatest amount of security possible, as the Government of India issues it. Hence they are also known as Gilt-Edged Securities or 'Gilts'.

Fixed Income: During the term of the security there is likely to be

fluctuations in the Government Security prices and thus there exists a price risk associated with investment in Government Security. However, the return on the holding of investment is fixed if the security is held till maturity and the effective yield at the time of purchase is known and certain. In other words the investment becomes a fixed income investment if the buyer holds the security till maturity.

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Convenience: Government Securities do not attract deduction of tax at

source (TDS) and hence the investor having a non-taxable gross income need not file a return only to obtain a TDS refund.

Simplicity: To buy and sell Government Securities all an individual has to

do is call his / her Broker and place an order. If an individual does not trade in the Equity markets, he / she has to open a demat account and then can commence trading through any broker.

Liquidity: Government Security when actively traded on exchanges will be

highly liquid, since a national trading platform is available to the investors.

Diversification Government Securities are available with a tenor of a few

months up to 30 years. An investor then has a wide time horizon, thus providing greater diversification opportunities. DEVELOPMENTS IN MARKET INFRASTRUCTURE Securities Settlement System: Settlement of government securities and funds is being done on a gross trade-by-trade Delivery vs. Payments (DvP) basis in the
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books of Reserve Bank, since 1995. A Special Funds Facility from Reserve Bank for securities settlement has also been in operation since October 2000 for breaking gridlock situations arising in the course of DvP settlement. With the introduction of Clearing Corporation of India Ltd (CCIL) in February 2002, which acts as clearing house and a central counterparty, the problem of gridlock of settlements has been reduced. To enable Constituent Subsidiary General Ledger (CSGL) account holders to avail of the benefits of dematerialised holding through their bankers, detailed guidelines have been issued to ensure that entities providing custodial services for their constituents employ appropriate accounting practices and safekeeping procedures. Negotiated Dealing System: A Negotiated Dealing System (NDS) (Phase I) has been operationalised effective from February 15, 2002. In Phase I, the NDS provides on line electronic bidding facility in primary auctions, daily LAF auctions, screen based electronic dealing and reporting of transactions in money market instruments, facilitates secondary market transactions in Government securities and dissemination of information on trades with minimal time lag. In addition, the NDS enables "paperless" settlement of transactions in government securities with electronic connectivity to CCIL and the DVP settlement system at the Public Debt Office through electronic SGL transfer form.

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Clearing Corporation of India Limited: The Clearing Corporation of India Limited (CCIL) commenced its operations in clearing and settlement of transactions in Government securities (including repos) with effect from February 15, 2002. Acting as a central counterparty through innovation, the CCIL provides guaranteed settlement and has in place risk management systems to limit settlement risk and operates a settlement guarantee fund backed by lines of credit from commercial banks. All repo transactions have to be necessarily put through the CCIL, while all outright transactions up to Rs.200 million have to be settled through CCIL (Transactions involving larger amounts are settled directly in RBI). Transparency and Data Dissemination : To enable both institutional and retail investors to plan their investments better and also to providing further transparency and stability in the Government securities market, an indicative calendar for issuance of dated securities has been introduced in 2002. To improve the information flow to the market Reserve Bank announces auction results on the day of auction itself and all transactions settled through SGL accounts are released on the same day by way of press releases/on RBI website. Statistical information relating to both primary and secondary market for Government securities is disseminated at regular interval to ensure transparency of debt management operations as well as of secondary market activity. This is done through either press releases or Banks publications viz., (e.g., RBI
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monthly Bulletin, Weekly Statistical Supplement, Handbook of Statistics on Indian Economy, Report on Currency and Finance and Annual Report).

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INTRODUCTION ZERO COUPON BONDS

A bond which pays no coupons, is sold at a deep discount to its face value, and matures at its face value. A zero-coupon bond has the important advantage of being free of reinvestment risk, though the downside is that there is no opportunity to enjoy the effects of a rise in market interest rates. Also, such bonds tend to be very sensitive to changes in interest rates, since there are no coupon payments to reduce the impact of interest rate changes. In addition, markets for zero-coupon bonds are relatively illiquid. Under U.S. tax law, the imputed interest on a zero-coupon bond is taxable as it accrues, even though there is no cash flow. Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus the imputed interest, which is discussed below. The maturity dates on zero coupon bonds are usually longterm many dont mature for ten, fifteen, or more years. These long-term maturity dates allow an investor to plan for a long-range goal, such as paying for a childs college education. With the deep discount, an investor can put up a

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small amount of money that can grow over many years. Investors can purchase different kinds of zero coupon bonds in the secondary markets that have been issued from a variety of sources, including the U.S. Treasury, corporations, and state and local government entities. Because zero coupon bonds pay no interest until maturity, their prices fluctuate more than other types of bonds in the secondary market. In addition, although no payments are made on zero coupon bonds until they mature, investors may still have to pay federal, state, and local income tax on the imputed or "phantom" interest that accrues each year. Some investors avoid paying tax on the imputed interest by buying municipal zero coupon bonds (if they live in the state where the bond was issued or purchasing the few corporate zero coupon bonds that have tax-exempt status A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity. It does not make periodic interest payments, or have socalled "coupons," hence the term zero-coupon bond. When the bond reaches maturity, its investor receives its par (or face) value. Examples of zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds,[1] and any type of coupon bond that has been stripped of its coupons.

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In contrast, an investor who has a regular bond receives income from coupon payments, which are usually made semi-annually. The investor also receives the principal or face value of the investment when the bond matures. Some zero coupon bonds are inflation indexed, so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power rather than a set amount of money, but the majority of zero coupon bonds pay a set amount of money known as the face value of the bond. Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond markets. Short-term zero coupon bonds generally have maturities of less than one year and are called bills. The U.S. Treasury bill market is the most active and liquid debt market in the world. Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity, the principal/face value is repaid to the holders. No interest (coupon) is paid to the holders and hence, there are no cash inflows in zero coupon bonds. The difference between issue price (discounted price) and redeemable price (face value) itself acts as interest to holders. The issue price of Zero Coupon Bonds is inversely related to their maturity period, i.e. longer the maturity period lesser would be the issue price and vice-versa. These types of bonds are also known as Deep Discount Bonds.
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Types of Zero-Coupon Securities

There are as many kinds of zero-coupon securities as there are bonds, plus a number of interesting variations. Corporate zeros: These are corporate bonds, done zero-style. Because you are buying into the credit risk of the corporation, corporate zeros are the most risky kind of zero coupon. These are even riskier than a corporate coupon bond (or registered bond), because if the issuing company defaults on the zero, the holder receives no interest at all. Strips: Strips are zeros that are backed by government securities and offered by brokerage houses. Brokerages are proliferating their own proprietary brands of strips under a dizzying array of acronyms: TIGRs, CATS, and other species. Each has different features but works in a similar way. The brokerage buys either U.S. government or municipal securities and holds them in escrow. It then separates--strips--the principal from the interest and markets zero certificates based on one or the other. One example is the Salomon Brothers CATS (Certificate of Accrual on Treasury Securities), a zero in which the face value is based on the accrued value of the underlying Treasury securities.

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STRIPS: The Treasury also offers STRIPS--which stand for "separate trading of registered interest and principal of securities"--based on Treasury bonds. Some of the venerable U.S. savings bonds are actually forms of zeros as well. Municipal zeros: Municipal and state governments also issue zeros in the form of zero-coupon municipal bonds, which frequently have lower returns but are generally tax-free on the federal level. Zero-coupon convertibles: Finally, zero-coupon convertible bonds can be changed from zeros to other kinds of securities. Companies may issue zerocoupon bonds that may be converted into shares of common stock in the company. Convertible municipal zeros can change from zero coupon to regular interest-paying bonds at some time before maturity.

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Strategic Considerations of Zero Coupon Securities

Zero coupon bonds share many of the characteristics of other types of bonds, with one important exception. Since they do not feature regular interest payments, they are not an income investment, as other bonds are, but should be considered an appreciation investment. It is important to remember, however, that unlike the growth in value of a stock portfolio or mutual fund, the appreciating value of a zero is really a representation of accrued compound interest, and is taxed as such--not as capital gains, which are taxed at lower rates. There are, however, a variety of tax-free government zeros available. Zeros are also suitable in an IRA or other taxdeferred or tax-free plan since they make no distinction between capital gains and ordinary income for tax purposes. Since zeros are debt instruments, the risk involved depends largely on the credit strength of the issuer. Zeros backed by government securities like U.S. Treasury bonds have very low credit risk, while corporate zeros can be much riskier. If the issuer does default, you may be out quite a bit, because you have not received any interest payments. Also, as with other bonds, the real values of zeros depend on how the returns compare with prevailing interest rates--a factor

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that makes zeros quite volatile on the secondary market. As a result, most investors hold zeros to maturity.

ZERO COUPON BOND AND YIELD CURVE

The zero coupon yield curve is one of the most fundamental tool in finance and is essential in the pricing of various fixed income securities. Unfortunately, zero coupon rates are not observable in the market for a range of maturities. Therefore, an estimation methodology is required to derive the zero coupon yield curves from observable data. There are many methodologies and each can provide surprisingly different results. Nevertheless, each seeks to provide an estimation that fit the data well while maintaining an easily interpretable form.

Basic concepts of zero coupon bonds

The Law of One Price The law of one price states that two securities with identical cash flows and risk should sell for the same price. Hence it is possible for a security to be priced

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identically to a combination of other securities by way of a replicating portfolio on the securitys cash flows. Zero Coupon Rates A zero coupon rate is an interest rate or bond yield that corresponds to a single cash payment at a single point of time in the future. Also commonly known as spot rates, it is the compounded return from investing in a zero coupon bond with t time to maturity. By the law of one price, a coupon bond is identical to a replicating portfolio of zero coupon bonds. Thus, pricing the coupon bond is equivalent to summing its cash flows and discounting each cash flow with the corresponding zero coupon rates at the specific time of coupon dissemination. Yield to Maturity The yield to maturity (YTM) is a single rate that represents the internal rate of return of a bonds stream of cash flows. In other words, it can be seen as the average of a portfolio of zero coupon rates weighted by the timing of the corresponding cash flows with an assumption that all intermediate cash flows are reinvested. In simple mathematics, the relationship between YTM and zero coupon rates is defined as follows: The Coupon Effect

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Since YTM is seen as a time weighted average of cash flow returns, it follows that coupon levels will have an impact on the resulting yield. Thus two bonds with differing coupons but same maturities will have different YTM. This is called the coupon effect. Because of the coupon effect, using YTM to price a bond can only be done for the specific bond to which it was derived from. Zero coupon rates though, can be used to price any single cash flow asit is not affected by the coupon effect. Par Yield Par yield is an YTM rate that a bond would have if priced at approximately its par, i.e. a bonds YTM must equal to its coupon rate. This means in curve terms, samples of bonds are used to estimate the hypothetical par yields at the given tenure followed by usage of estimation methodologies to obtain a good fit to all the observed YTMs. It is the theoretical rate for the various YTMs of existing bonds that have the same maturity to provide par valuation. Like YTMs, par yields a time weighted average of zero coupon rates with reinvestment assumption but its representation is for the sample at the specific tenure rather than a single bond. Yield Curve Construction

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As mentioned, zero coupon rates are often not observable in the market hence estimation methodology is required to derive the zero coupon curves from observable data. On the other hand, the availability of market data such as YTM and YTM derived prices means par yield curves may be modeled and constructed directly. Recall that the par yield is an aggregation of observed YTMs for a given tenure. For example, a sample of seven year tenure AAA bonds traded and issued at par for the day may be used to derive the AAA par yield curves rate at seven year tenure point. Therefore, critical to the construction of zero coupon yield curves are par yield curves. After the par yield curve is constructed, using bootstrapping techniques, zero coupon yield curves are extracted from the constant maturity par yield curves. 4.1 Par Yield Curve Two important issues are addressed; curve tenure point selection and data sample of observable rates. Prior to constructing the par yield curve, constant tenure points are set. Classification of tenure points would be above the mean of the preceding adjacent tenure point to the mean of the next adjacent tenure point. For example, if the set tenure points are 5, 7 and 10 years, seven year tenure point is defined as time to maturity of above 6 to 8.5 years i.e. 6 < tenure(7) < 8.5.Raw data are then sourced for manipulation. Brokers live quotes
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End of day indicative quotes Daily trades BWMs mark to market rates Interest rate swaps Bankers weekly par yield curve contribution
Included for short te rm tenure point

KLIBOR rates Indicative deposit rates or deposit rate fixings Overnight policy rates Included for short term tenure points Repo rates Bankers acceptance rate Bills

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Bands

The raw data are aggregated based on a ranged period into a segmented sample pool for each class. For example, a cumulation of one week data prior from today for the AAA par yield curve. Inmost cases, due to the Malaysian bond markets illiquidity, a ranged period is necessary in order to obtain enough samples. The data samples are then filtered. Several filtration methods are done. One of which involves omitting traded data samples which transacted at off market levels. These may include pass through, position parking, cross trading and odd lot transactions. Once data samples are segmented to their relevant classes and tenure points, the corresponding yield points are derived using an averaging function on all the filtered samples.

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Advantages and Disadvantages of Zero coupon bonds Advantages

Zero coupon bonds have some really attractive features to them. One is that you buy zero coupon bonds at a deep discount. This means that you pay much less than the bond's par value, the amount it is worth at maturity. As the bond matures, the interest is accrued and the bond increases in value. Because the interest isn't paid out yearly, the bonds can be issued at a deep discount Zero coupon bonds also offer investors predictability for the long-term. Zero coupons are volatile investments but they still provide a predictable return for investors who want a lump sum of money paid by a specific date. One last advantage of zero coupon bonds is that they also benefit whoever issues them. Because they don't pay periodic interest, they allow corporations, municipalities, and the government to continue using the loan amount without having to pay back interest.

Disadvantages
Zero coupon bonds also have a few drawbacks. The first big drawback is that they are extremely volatile investments. Interest rates changes can swing the price of the bond in either direction. This means that if you want to sell it before

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it matures, you aren't guaranteed to make a profit. However, if you hold it until maturity, you won't have to worry about this. As with stocks, long-term investing in zero coupon bonds is the best way to go. Another major drawbacks is that you still have to pay income taxes on the bonds while they are maturing. With regular interest-yielding bonds, you would have to pay income taxes on the amount of interest you earned. Well, with zero coupon bonds, you have to pay taxes each year on the amount of interest you would have earned. One way to get around this is to invest in tax-free zeros, such as municipal zeroes. Or you can find a qualified tax-deferred retirement plan and put the zero coupon bonds in there. One final drawback to investing in zeroes is that they are callable. What this means is that the issuer can say that they want to repay the bonds before maturity at a certain percentage rate. This really makes your taxes complicated because if the IRS thinks you made more than you should have, you would have to pay a capital gains tax as well. Zero coupon bonds offer investors one more way to invest in bonds and they do have advantages. For those who understand them, they provide an excellent way of investing for the long-term. Just because they are bonds, that doesn't mean they don't carry their own risks. We encourage you to weigh the risks and rewards before investing.

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Pros and cons of Zero coupon bonds

Pros One of the big advantages of zero coupon bonds is that they have higher interest rates than other corporate bonds. In order to attract investors to this type of long-term proposition, companies have to be willing to pay higher interest rates. This means that if you are alright with not receiving regular interest payments, you can actually make more money in the long run with zero coupon bonds. This type of investment is also great for investors who have long-term specific objectives in mind. This type of bond gives you the assurance that you will know exactly how much it will be worth at a specific date in the future. Therefore, if you are trying to save for a specific objective, this can be a nice investment. For example, if you are trying to save money for a child's college tuition and you do not feel comfortable putting that money into the stock market or a mutual fund, a zero-coupon bond will allow you to know exactly how much to expect. This makes it possible for you to know that you will have enough for your child's tuition in the future. Cons One of the biggest problems with investing in zero coupon bonds is that you have to pay taxes on phantom interest. This means that you will need to pay
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income taxes on interest that you are not actually receiving. Even though you are not physically receiving any interest payments from the bond issuer, according to the federal government, you are still earning this money. This means that you have to pay income taxes on that interest in the year in which it was earned. While this will be nice when the bond matures and you do not have to pay any taxes on the money, it can be a hassle leading up to that point. Many people do not want to have to come up with money from another source in order to pay taxes on the interest from this type of bond. Another problem with zero coupon bonds is that they have a higher default risk than traditional bonds. The reason behind this is that companies do not have to make regular interest payments to the investors. They just keep all of the money and do with it as they please. If they do not make the proper arrangements to pay off the debt in the future, they could go into default. In some cases, these bonds can be called by the companies that issued them. This means that they will pay back the amount that you invested with the interest that you have earned but it will not last for the entire term

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Zero Coupon Bond Pricing

When bonds are issued, they are usually sold at their par value, which is also referred to as their face value. For most corporate bond issues, this par value is Rs.1,000, while some of the government bonds can have a par value of Rs.10,000. This is the principal amount of a bond and it is returned to the investors when the bond matures. However, during the term of a bond, market forces make the value of the bond change. At any time, the bond could be selling at a value higher than its par, lower than its par or at its par value. Why Do Bond Prices Change The main reason behind this change in bond value is change in interest rates. Interest rates in the economy are dynamic and they are constantly adjusted by the Federal Reserve in response to changing economic situation. When the economy is not doing well, the Fed can lower interest rates to encourage lending and to give a boost to economic activity. But when there are serious inflationary expectations in the economy, the Fed can lower interest rates to cool things down. Such decisions can have a significant impact on the bond market, and prices of bonds always respond to changes in interest rates. Inverse Relationship with Interest Rates: Bond prices have an inverse relationship with interest rates. When interest rates in the economy go up (all
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other things being equal), bond prices go down, and vice versa. It is easy to understand why this happens. Lets say you have invested in a plain vanilla bond at a par value of Rs.1,000 and a coupon rate of 5%. When interest rates in the economy go up, future bond issues will have to pay a higher coupon rate, lets say 6%. In such a scenario, an investor will be willing to buy your bond from you only if you sell it at a value lower than its par such that the buyer is compensated for the lower interest payments. The opposite of this happens when interest rates go down. Now future bonds will be issued at a lower interest rate and buyers will be willing to pay you more as your bond offers higher interest earnings. This will increase the price of the bond in the market. Impact of Creditworthiness: Another reason that can have a huge effect on bond prices is a change in the creditworthiness of the issuer. For example, if a company is facing financial difficulties that can adversely impact its ability to repay its obligations, credit rating agencies can decide to lower its credit rating. When that happens, markets will react by lowering the prices of bonds issued by the company as there is now a much greater risk of default associated with those bonds. The same thing can happen to countries and it is not uncommon to see the prices of bonds issued by a national government change drastically in response to bad economic data.
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It should be noted that the bond market does not always wait for a credit rating agency to lower the rating of the issuer before lowering the price of its bonds. Large market participants are well aware of the risks that an issuer faces and expectations of default are always factored in bond prices. Premium and Discount When a bond is selling at a value higher than its par, it is said to be selling at a premium. On the other hand, when the price of a bond falls below its par, it is said to be selling at a discount. When listing bond prices, the prices are mentioned in terms of percentage of premium or discount, irrespective of what the par value of the bond is. When a bond is selling at par value, its price is listed as 100. When it is selling at a 10% discount, its price is listed at 90. Similarly, lets say when its selling at a 5% premium, its price is listed as 105. This kind of quoting convention allows bonds to be compared directly and easily. Finding the true price of the bond is easy. The price of a bond listed as 105 and having a par value of Rs.1,000 can be calculated as 105% of Rs.1,000, which comes to Rs.1050. Understanding Present Value of Future Payments Bonds assure a stream of future payments to the investor. For a plain vanilla bond, you receive regular interest payments from the bond issuer until the bond matures, and at maturity, you receive the par value of the bond. Therefore, the
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price that you should be willing to pay for a bond is the value that you can attach to these future payments. However, valuing future payments is not very simple. This is where you have to understand one of the most fundamental concepts of finance time value of money. Think about two straightforward scenarios, one where you get $1,000 immediately and one where you get $1,000 one year later. Any smart investor will prefer the first scenario. Why? Because if you receive the money today, you can invest it somewhere and earn interest on it. If you could get 5% interest on your investment, one year from now, you would have Rs.1,050 in the first scenario, while in the second scenario, you would just have Rs.1,000. In other words, any future payments are not worth the same amount that they would be if the payment was made today. To determine the present value of a future payment, you would have to discount it. The farther you go in future, the more this discounting would be. The present value of a Rs.1,000 payment one year from now should be the amount that if you had today and invested in the market would yield Rs.1,000 one year later. This amount would always be lower than the future payment. In the previous example, it is clear that the rate of discounting a future payment should be the interest that you can realistically earn on your investment. This interest is known as the required rate of interest or the required yield. If you had Rs.1,000 today, it would be worth Rs.1,050 one year from now if the required
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rate of interest is 5%. This is equivalent to saying that the present value of a payment of Rs.1,050 one year from now is Rs.1,000. The present value of any payment can be calculated using this formula: PV = F/ (1+r)^n Here: PV is present value F is future payment r is required rate of return n is the number of periods after which the payment would be made Applying this formula in the previous example, we can easily calculate the present value of a Rs.1,000 payment one year from: PV = Rs.1,000 / (1+.05) ^ 1 = Rs.953.38
Calculating Bond Prices

The price of a bond is equal to the present value of all its future interest payments and the repayment of par value at maturity. We can use the formula for present value of future payments to determine the value of a bond. But keep in mind that as coupon payments come at different points in time, the discounting factor for each of them will be different, with payments coming later having a heavier discount. The price of a bond can be represented as the following formula: Price = [I / (1+r)] + [I / (1+r)^2] + + [I / (1+r)^n] + [Par Value / (1+r)^n]
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Here:

I is the interest or coupon payment paid at the end of every period r n is is the the number of required periods after rate which the of bond will return mature

This series of periodic payments in a plain vanilla bond is referred to as an ordinary annuity. This formula assumes that the first coupon payment will be made one period from the present time and the end of every subsequent period, the next coupon payments will be made. Note that period here could be anything, but typically bonds pay coupon semi annually or annually, so one period will be 6 months or 12 months long. Also note that the last coupon payment and the par value of the bond are paid together. It is clear from the formula that the payments that come farther in the future have a lower present value. Another thing evident from the formula is the inverse relationship between bond prices and interest rates. As interest rates go up in the economy, the required rate of return (r) also goes up. This increases the discounting factors in the formula and the price of the bond will be lower. The bond pricing formula given above can be simplified as: Price = I x [1- [1 / (1+r)^n ] ] / r + [Par Value / (1+r)^n]
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When you use this formula, you wouldnt have to calculate the present value of each coupon payment separately, and the price can be determined simply by plugging in the value of these variables. The same formula can be used irrespective of the nature of the bond. Here is an illustration of how this formula can be applied when determining the price for different kinds of bonds. Pricing a Plain Vanilla Bond Lets consider a plain vanilla bond with a par value of Rs.5,000, maturity period of 5 years, and a coupon rate of 5%, paid semi-annually. Lets assume that the required rate of return is 10%. Here are the values of different variables that well need in the formula. n = 10 (Coupon payments are made with a periodicity of 6 months. There are 10 such periods in 5 years) I = Rs.5,000 * 2.5% = $125 (Although coupon rate is 5%, this is the annual interest rate. For semi annual payments, coupon rate will be half of the annual rate) r = 5% (For a 10% annual required rate of return, the semi-annual required rate will be 5%) Par Value = Rs.5,000
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Plugging these values in the bond price formula: Price = Rs.125 x [1- [1 / (1+.05)^10 ] ] / .05 + [Rs.5,000 / (1+.05)^10] = Rs.4,034. 7 You can see this value in light of our previous discussion on bonds selling for a premium or a discount. In this case, the required rate of return is significantly higher than the coupon paid by the bond. That is why the bond is selling at a heavy discount, as otherwise investors will have no reason to purchase this bond. Now, lets see what happens when the coupon rate of the bond is 15%. The coupon payment in this case (I) will be Rs.5,000 * 7.5% = Rs.375. All the other variable for the formula remain the same. This will result in the bond being priced as: Price = Rs.375 x [1- [1 / (1+.05)^10 ] ] / .05 + [Rs.5,000 / (1+.05)^10] = Rs.5,965.2. The bond is offering a higher coupon rate than the interest rate investors can earn in the market, which is why the bond is now selling at a premium.

Pricing a Zero Coupon Bond

A zero coupon bond does not make any interest payments throughout the life of the bond. There is only a single cash flow, at the time of maturity of the bond,
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when the par value of the bond is returned to the investors. Pricing such a bond is much simpler. Lets consider a zero coupon bond with a par value of Rs.5,000 and a maturity period of 5 years. Lets assume that the required rate of return is 10%. Plugging these values in the bond pricing formula: Price = [Rs.5,000 / (1+.05)^10] = Rs.3069.5 Compare this price with the price of the plain vanilla bond that we calculated in the last example. You can see that as there are no coupon payments made by the bond issuer, investors need a much larger incentive, in the form of a bigger discount, to purchase the bond. Of course, in case of zero coupon bonds, there is no question of the bond selling at a premium, or even at par. No investor would be ready to pay Rs.5,000 (or more) today, just to get Rs.5,000 back a few years from now. You would have noticed that we assumed a periodicity of 6 months in the formula despite the fact that a zero coupon bond pays no interest. This is done so that these bonds can be easily compared with other bonds that pay coupon on a semi-annual basis. Dirty and Clean Bond Prices So far, the bond pricing that weve discussed misses out on one crucial point accrued interest. In the formula that we used to find out bond prices, we did not take into account the fact that the price of a bond will change as coupon
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payment date comes closer. We simply assumed that the next coupon payment is exactly one period away. At any given date between two coupon payments, the price of a bond should include the interest that has been accrued so far since the last coupon payment. This is the interest that the bond investor has already earned by holding the bond, but it has not bee paid to him yet. You can also think of this change in price between two coupon payments in terms of time value of money. Lets say a bond paid coupon on June 31 and the next payment is scheduled for Dec 31. As the next payment and all future cash flows come closer, their time value should increase, which means that the price of the bond should increase. However, this has not been accommodated in the formula so far. Bond prices that include accrued interest are known as dirty bond prices while those excluding accrued interest are referred to as clean bond prices or flat prices. Typically, quoted prices of bonds are flat prices. The reason behind this is that a clean price allows investors to evaluate the quality of the bond on the basis of issuer risk, interest rates etc. It also enables easier comparison between two bonds, without complicated assessment of when the last coupon was paid and how much interest has been accrued.

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The dirty price of a bond moves in a saw tooth pattern throughout the life of the bond (assuming interest rates and issuer risk do not change in that period). The price of the bond keeps increasing from the date of coupon payment as more and more interest gets accrued. On the subsequent coupon payment, the price falls to its minimum level again and starts rising in the same manner from the next day onwards. Calculating Accrued Interest As you would have guessed, to be able to calculate the accrued interest, we need to first determine the exact number of days that have passed since the last coupon payment. Different day counting conventions are used for different bonds. In an actual / actual day-count convention, you need to count the exact number of days that have passed so far since the last coupon payment and evaluate interest assuming that it accrues on every day. This convention is used for treasury securities. Consider a situation where the last coupon payment on a treasury bond was made on July 1 and the next payment is scheduled for January 1. To price the bond on September 1, well have to count the exact number of days between July 1 and September 1. Accrued interest in this case will be calculated for 62 days, which is the number of days that have passed since the last payment.
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In a 30 / 360 convention, it is assumed that each month of the year has 30 days and that there are 360 days in a year. This somewhat simplifies the calculation for the number of days, as you dont have to think about which month has 30 days, which has 31, if it is a leap year, and so on. This convention is typically used for corporate bonds and municipal bonds. If in our previous example, the bond was issued by a company, the accrued interest would have been calculated on 60 days instead of 62 days. But in this case, the daily accrual of interest will be calculated assuming that there are only 360 days in the year, i.e. interest will be divided into 360 periods. Accrued interest can be calculated using the following formula: Accrued interest = I x [d/D] Here: I = Coupon payment d = Number of days since last payment D = Total number of days between payments Lets consider a corporate bond, where the last coupon payment was made on July 1, the next payment is due on January 1, and we are calculating accrued interest on October 1. The coupon rate is 10%, paid semi-annually, and the par value of the bond is $5,000.

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I = Rs.5,000 x (10% / 2) = $250 d = 90 days (as all months are assumed to have 30 days and exactly 3 months have passed since last coupon payment) D = 180 days (coupon payments are semi-annual, so periodicity is 6 months, with each month assumed to have 30 days) Accrued Interest = Rs.250 x [90 / 180] = $125 This accrued interest should be added to the clean price of the bond (as calculated from the bond pricing formula) to arrive at the true value of the bond. This is the price that youll have to pay if you want to buy the bond from the secondary market.

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NABARDs Zero coupon Bonds

The zero coupon bond or Bhavishya Nirman bond of National Bank for Agriculture and Rural Development (Nabard) has mobilised Rs 3,000 crore in January 2009 against the targeted Rs 2,600 crore. There were very few similar long-term instruments in the market which give equal yields of 8.62 per cent to both institutional and retail investors. There was a daily inflow of Rs 10-15 crore in the kitty and they get another Rs 1,000 crore in March 2009. What BNB offers?

BNB is a zero-coupon bond with a lock-in period of 10 years. There is no call or put option i.e. investors cannot prematurely liquidate their investments in BNB through NABARD. However, to provide liquidity to investors, the bonds will be listed and traded on the Bombay Stock Exchange. Hence, investors will have the option to sell their holdings at market prices before maturity.

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The current issue price of each bond is Rs 8,250 and the face value is Rs 20,000. Investors should note that the face value of the bond is actually the maturity value and not the buying price, as is the case with other investment avenues. For investors, this means that they will be issued the bond at Rs 8,250 and after 10 years they will receive Rs 20,000 for each bond they own. The difference of Rs 11,750 is effectively the return on their investments.

These bonds can be held in both physical as well as in dematerialised (demat) form. However, investors who wish to trade in these bonds once they are listed at the exchange, should compulsorily have them in demat form. Remember that on the stock exchange, depending on the prevailing interest rate, these bonds could trade at a premium or discount.

Tax implications

In terms of tax implication, the maturity proceeds from these bonds attract no tax deduction at source. Instead, the said income i.e. difference between face value and issue price, will be treated as capital gains and capital gains tax will be payable by the investor.

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How much return do they offer?

As per NABARD, the current issue of BNB offers a post-tax yield of 12.82 per cent. But before investors get excited about this they need to check if the return of 12.82 per cent works out as projected; sadly it doesn't.

The advertised return is only the simple annualised return, which is not the conventional way to calculate returns i.e. it is nothing more than a clever marketing strategy to attract investors. The conventional parameter is compounded annualised growth rate (CAGR), which for the BNB is not very impressive. Moreover, the CAGR of 9.26 per cent, projected by NABARD, does not give the exact picture to investors. Let us understand this with the help of an example.

NABARD's projected CAGR

Issue price Rs. 8,250 Face value Rs. 20,000

CAGR 9.26 %

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Here, the CAGR has been calculated before accounting for capital gains tax, which means the 9.26 per cent CAGR is the pre-tax return. In our view, it is important to calculate post-tax return for a more accurate picture. Below we have calculated the exact post-tax CAGR return if the BNB is held till maturity period (i.e. for 10 years).

Personal fn's projected scenario

Issue price (a) Rs. 8,250 Face value (b) Rs. 20,000 Return (b-a) Rs. 11,750 Capital gains tax @11.33% Rs. 1,331 Post-tax return Rs. 18,669

CAGR 8.51 %

(We have taken a 10 per cent capital gains tax plus surcharge (10 per cent) and education cess (3 per cent), as opposed to the 20 per cent capital gains tax with indexation benefit.)

As can be seen in the table, after accounting for capital gains tax, the returns
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that investors will receive after 10 years will be Rs 18,669 and not Rs 20,000. Consequently the rate of return will be 8.51 per cent CAGR and not 9.26 per cent CAGR as represented by NABARD.

What should investors do?

The most prominent feature of BNB is that they offer assured returns and are suitable for investors with a low risk appetite. Given the bond has a lock-in period of 10 years; investors will be locking in the yields for an unduly long period of time.

So, if you have no need for liquidity and have a very low risk appetite, then you may want to consider investing in this bond. But, do not put in all your money. Alternative avenues like Fixed Maturity Plans, though not as safe, but not high risk either, could offer you better tax-adjusted returns from time to time (for instance in March 2008, if liquidity does dry out like has been happening for a couple of years now, you could lock in your money at very attractive yields).

However, if you have appetite for volatile returns then consider Monthly Income Plans (MIP) from mutual funds. These plans could, over a period of time, generate double-digit returns. The downside -- since neither the return nor
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the capital is assured, you stand a chance to lose money. In our view, a wellmanaged MIP could however deliver attractive risk-adjusted returns.

I. GENERAL INFORMATION

i. A 10 Year Zero Coupon Bond of National Bank for Agriculture and Rural Development (NABARD) here in after referred to as Bhavishya Nirman Bond is being issued by way of private placement as long term investment under Sections 2 (47)& 2(48) of Income Tax Act, 1961.

ii. The bonds will be made available for investment as unsecured bonds during the Financial Years 2006-07, 2007-08 and 2008-09 unless NABARD decides otherwise.

iii. The present issue is made under Section 19 (a) of NABARD Act, 1981 as approved by the Board of Directors of NABARD.

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iv. The bonds will be listed at BSE.

v. The proceeds of the issue will be utilized by NABARD for its business activities in terms of NABARD Act, 1981.

vi. The bonds are governed by NABARD (Issue and Management of Bonds) Regulations, 1987 (as amended up to date), for the time being in force.

vii. Rating AAA by CRISIL and CARE

Terms of Bhavisaya Nirman Bonds

1. Face Value Each Bond was Face value of Rs. 20,000/2. Issue Price Issue Price was declared by NABARD on its website by time to time. 3. Tenure of Bond The Bonds was issued of 10 years tenure from the deemed date of allotment. 4. Minimum investment Minimum investment in Bhavisaya Nirman bond was five bonds. 5. Tax Liability No tax at source in terms of 194 A(3) of the Income Tax Act 1961.6.v 6. Deemed date of allotment
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The Deemed date of allotment of bonds was the first day of month succeeding the month in which the application money for investment is received by NABARD. 7. Right to update/revise/close the bond issue The instructions and other detail contained in the application from was updated from time to time any investment made was governed by the terms and conditions applicable on the date of realization of application money NABARD Had reserves the right to close/revise the terms and conditions at its scale discretion without assigning any reason. III General Terms 1. Terms of Payment paid The full amount of issue price of the bonds applied should be paid as per rate prevailing on the date of payment. 2. Interest on application money Successful application will be paid interest on their application money @ 5.00% p.a. from the date of realization of application money into the NABARD account up to the end of the month in which the application money for investment is received and will be sent to the investor by way of warrant along with the bond certificate/Demat advice

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3. Investment Holing and Market Lot Investment in bonds may be hold either in Physical From or in DEMAT From for trading, the market was be of five bonds. Depository Arrangement Investors will have the option to hold the security in dematerialised form and deal with the same as per the provisions of Depositories Act, 1996 (as amended from time to time). Procedure for opting for DEMAT facility a. Investors should have/open a Beneficiary Account with any Depository Participant of NSDL or CDSL. b. Responsibility for correctness of investors age and other details given in the Application Form vis--vis those with the investors Depository Participant would rest with the investors. Investors should ensure that the names of the sole/all the applicants and the order in which they appear in the application form should be same a Registered with the investors Depository Participant. c. For opting for bonds in dematerialized form, the Beneficiary Account number and Depository Participants ID shall be specified in the relevant columns of the Application Form. d. If incomplete/incorrect Beneficiary Account details are given in the application form or where the investor does not opt for the option to receive
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the bonds in dematerialized form, the bonds will be issued in the form of physical certificates. e. The bonds allotted to investors opting for dematerialized form, would be directly credited to the Beneficiary Account as given in the application form after verification. Allotment advice/refund order (if any) would be sent directly to the applicant by the Registrars to the Issue but the confirmation of the credit of the bonds to the investors Depository Account will be provided to the investor by the investors Depository Participant. f. Investors may please note that the bonds in DEMAT form can be traded only on the Stock Exchanges having electronic connectivity with NSDL or CDSL.

Despatch of Bond Certificates and Refund Orders NABARD shall ensure despatch of refund orders and bond certificates by Registered Post/Speed Post only. Despatch of bond certificates shall be completed within 60 days from the deemed date of allotment. NABARD shall not be liable for delay in receipt of the bond certificate or its loss in transit. viii. Despatch of Interest Warrant Interest warrants will be despatched alongwith the bond certificates. The interest warrant pertaining to the bonds
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in demat form will be sent by Registered Post if the amount exceeds Rs.1000/-. ix. Rejection of applications NABARD reserves the rights to accept or reject any application in whole or in part and in either case without assigning any reason therefor. In the event the bonds applied for are not allotted in full/part, the excess application money, without interest, in respect of any application will be refunded. Any application for bonds, which is not complete in all respects, may be rejected. x. Mode of Refunds In case of rejection of applications or non-allotment of the bonds, refunds will be made by Account Payee cheque or by pay order drawn on any bank payable at centres as per the details furnished in the application form.

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Bibliography
News Papers Websites Zero Coupon Bond offer Documents Articles NABARD BNB Report www.Moneycontrol.com www.scribd.com www.nabard.org

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