AUTHOR: Rama Krishna Vadlamudi vrk_100@yahoo.co.

in
MUMBAI
October 9th, 2009

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An Intro to Govt. Securities and Duration Management

Governments issue bonds to raise money for spending on infrastructure

projects or for their day-to-day expenditure. Likewise, companies also raise
money through bonds to meet their capital expenditure or working capital needs.
In the Indian Securities Market, the term ‘bonds’ is generally used for debt
instruments issued by the Central and State Governments and public sector
organizations; and the term ‘debentures’ is used for debt instruments issued by
the private corporate sector. However, the terms bonds, debentures, and debt
instruments are used by the general public inter-changeably.
 WHY DO GOVERNMENTS RAISE MONEY

Governments issue bonds to fund their day-to-day operations or to finance

specific projects. When investors buy a bond, they are loaning their money for a certain
period of time to the issuer; usually at a fixed rate of interest. In return, bond holders get
back the loan amount at maturity; plus interest payments at periodical intervals.

Government of India as well as State Governments raise money through

Government Securities (G-Secs). The income of governments comes in lumpsum
amounts whereas the expenditure is steady as a result there will be a gap between
revenue and expenditure. For example, income tax is paid at quarterly intervals by
corporates whereas governments incur expenses, like, salaries, etc., on a monthly basis.
To bridge the gap, governments raise money through G-Secs. There are a few
occasions when Governments receive big money through disinvestment of state-owned
enterprises or in a specific situation like auction of 3G spectrum to telecom companies
through which GOI expects to raise over Rs 25,000 crore. Over a period of several
decades, the governments’ deficit has gone up substantially. As on September 29,,
2009, the outstanding stock of Government of India securities is at Rs 17.42 lakh crore,
which means this much amount is owed by the Government of India to bondholders as
on September 29, 2009. This is excluding the outstanding amount of Treasury Bills (T-
Bills are raised for short term maturity of 364 days or less) at Rs 2.17 lakh crore as on
September 25, 2009.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 9th, 2009 Page 2 of 9

 OWNERSHIP PATTERN OF GOVT. SECURITIES

OWNERSHIP PATTERN OF G-Secs %

End Jun. 2009 End Mar. 2007

120.00

100.00

80.00
%

60.00

40.00

20.00

0.00
Insurance Others
Commerci Primary Provident
Companie incl. MFs, RBI TOTAL
al Banks Dealers Funds
s FIIs, FIs,
End Jun. 2009 39.29 23.07 12.28 11.06 7.89 6.41 100.00
End Mar. 2007 41.57 26.19 10.94 6.51 8.11 6.68 100.00

Date Source: RBI Graphics : By the author

As can be seen from the above graph, the major investors in G-Secs are banks,
life insurance companies, general insurance companies, pension funds and EPFO.
Banks are required to keep a minimum of 24 per cent as a statutory preemption in
government securities whereas life insurance companies are required to invest 50 per
cent of their total investment in G-Secs. Other investors include primary dealers, mutual
funds, foreign institutional investors, high networth individuals and others whose
holdings are very small. Reserve Bank of India is entrusted with the responsibility of
managing the public debt on behalf of Government of India. RBI is the Banker to the
Government of India. In India, debt market is dominated by G-Secs.

Interestingly, from the above graph it can be observed that while the share of
banks and insurance companies has gone down by 200 and 300 basis points
respectively between March 2007 and June 2009, the share of Reserve Bank of India
has gone up by 450 basis points. In fact, the share of RBI in ownership of G-Secs has
gone up from 4.78 per cent end-March 2008 to 11.06 per cent end-June 2009, a
spectacular rise of 6.3 percentage points in just 15 months! The inference is that RBI
has been actively buying back securities in the secondary market as part of their Open
Market Operations (OMO) and outright buyback of securities also from banks and others
with a view to boosting positive sentiment in the bond markets. This is interesting from a
macro perspective and has got large implications from economy’s point of view also.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 9th, 2009 Page 3 of 9

 SOME IMPORTANT & RELEVANT ACTS

The following are some of the acts which affect Government Securities.
Fiscal Responsbility and Budget Management (FRBM) Act, 2003: FRBM Act was
enacted by the Parliament in 2003 and came into force with effect from July 5, 2004. In
order to place fiscal discipline on a statutory basis Government has brought out the
Fiscal Responsibility Act, imposing rules on fiscal and revenue deficit. This Act has been
considerably diluted by Government of India between 2007-08 and 2009-10 and in the
process the fiscal discipline has suffered massive erosion in the last three years.
Securities Contracts (Regulation) Act, 1956: Transactions in securities are governed
by the Securities Contracts (Regulation) Act, 1956 as government securities are
"Securities" as defined in the Act. The definition of ‘Securities’ as per the Securities
Contracts Regulation Act (SCRA), 1956, includes instruments such as shares, bonds,
scrips, stocks or other marketable securities of similar nature in or of any incorporate
company or body corporate, government securities, derivatives of securities, units of
collective investment scheme, interest and rights in securities, security receipt or any
other instruments so declared by the Central Government.
Government Securities Act, 2006: G.S.Act, 2006 came into force on December 1,
2007. The new Act and Regulations would facilitate widening and deepening of the
Government securities market and its more effective regulation by the Reserve Bank in
various ways, such as:
1. Stripping or reconstitution of Government securities;

2. Legal recognition of beneficial ownership of the investors in Government

securities through the Constituents' Subsidiary General Ledger (CSGL);
3. Facility of pledge or hypothecation or lien of Government securities for availing of
loan; and

4. Extension of nomination facility to hold the securities or receive the amount

thereof in the event of death of the holder.
Definition of a Government Security: "Government security" means a security created
and issued by the Government for the purpose of raising a public loan or for any other
purpose as may be notified by the Government in the Official Gazette and having one of
the forms mentioned in Government Securities Act, 2006.
Forms of Government securities: A Government security may be issued in one of the
following forms, namely:-
1. a Government promissory note payable to or to the order of a certain persons; or
2. a bearer bond payable to bearer; or
3. a stock; or
4. a bond held in a ‘bond ledger account’.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 9th, 2009 Page 4 of 9

 CRITERIA FOR PICKING UP BONDS FOR A PORTFOLIO

Liquidity: In the market, some bonds of certain maturity are tradeable easily due to high
volume of transactions; whereas, some bonds offer little or no liquidity due to lack of
interest on the part of investors. As such, while choosing to have a portfolio of bonds, it
is better to look for liquidity of the particular bond in the market place.

Return from the bond: Another important criterion for the investor before investing in
bonds is the return it offers. Most bonds offer periodic interest payments, either half-
yearly or yearly, to investors.

Credit default: While Government bonds carry sovereign guarantee and as such their
credit default risk is zero, some corporate bonds entail some degree of credit default. As
such, investors need to know the credit rating of the bonds rated by a reputed rating
agency. Many financial institutions have their own credit rating models to assess the risk
of credit default using parametres, like, debt-equity ratio, interest coverage ratio, cash
flows, outlook on industry, return on equity and a few qualitative factors.

Taxability of bonds: Governments often come out with tax-free bonds which means the
interest income received from the issuer is free from income tax in the hands of the
investors. Last month, Government of India has announced an issue of Rs 40,000-crore
infrastructure bonds by India Infrastructure Finance Company Limited (IIFCL) as part of
two Economic Stimulus Packages announced in December 2008 & January 2009.

Investment horizon: Different investors have different needs and expectations from
their investments. One important factor for investors is the time they want to stay
invested. According to the time horizons, investors zero in on certain investments to
meet their time horizon and requirements.

HOLDING OF GOVT. SECURITIES BY BANKS

The statutory liquidity ratio (SLR) for banks has been reduced to the present 24 percent
from a high of 38.5%; while banks’ SLR now is around 33 per cent, signifying that they
are holding government securities far in excess over and above the SLR requirements,
estimated excess being to the tune of Rs 4.00 lakh crore (including Banks’ temporary
parking of funds in RBI’s Liquidity Adjustment Facillity-Reverse Repo) as at the end of
September 2009. Banks hold government securities not only on account of statutory
prescriptions and lowest risk weight for capital adequacy purposes but also as profitable
investment. However as credit demand picks up and credit portfolios of banks expand
aided with better credit culture and risk management practices, banks' resource
allocation to support government borrowings may progressively get impacted.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 9th, 2009 Page 5 of 9

 BOND IMMUNISATION STRAGEGY

As and when there is hardening of yields, the bond managers try to manage the
bond portfolio through reduction of the duration of the portfolio in order to minimise the
impact of rising yields. In a rising interest rate scenario, bond managers typically prune
their exposure to long-term bonds (that carry higher interest rate risk compared to short-
term bonds) and move into short-term instruments, like, money market instruments.

In the same way, whenever treasury managers are of of the view that interest
rate outlook is going to be soft, they increase the exposure to long-term bonds (which
show higher rise in their prices compared to a smaller rise in short-term bond prices) to
maximize their profits and reduce their investments in short-term paper. If the treasury
managers are able to time the market correctly by capturing the volatility in interest rate
movements, they are likely to make big profits for their treasuries. However, different
managers follow different strategies, like:
Conservative Strategy : This strategy tries to maintain an appropriate balance between
risk and return. In this, portfolio managers try to insulate the portfolio from the vagaries
of the market, which are caused by interest rate movements in the economy.
Active Strategy : The portfolio managers who try to actively churn their portfolios with a
view to maximising their returns depending on the volatility in bond prices come under
this Active Strategy. Here, they will try to take a view on the market directions and
predict the future course of interest rate movements. They will try to exploit the
mispricing, if any, of bonds in an aggressive manner.
Moderate Strategy : There are some portfolio managers who try to have a blend of both
the above strategies. Here, managers will keep a portion of the total portfolio in various
securities of different maturities. The remaining portion will be used for actively churning
the portfolio across different time periods and coupons depending on the macro
economic scenario, so that the total return from the portfolio remains at a higher level
though the latter portion may carry higher risk.
Interest Rate Risk: The biggest risk faced by G-Sec holders is interest rate risk. When
interest rates go up, G-Sec prices fall. But, an increase in interest rate allows the
bondholder to reinvest the cash flow at a higher rate.
Likewise, when interest rates come down, G-Sec prices increase. So,
bondholders can make good capital gains from bonds. But, they have to reinvest the
sale proceeds at a lower interest rate as interest rates have fallen.
Prices of different bonds change in variable degrees to interest rate movements.
The price change depends on several factors, like, maturity period, coupon rates, yields,
etc. The following rules are applicable to bond-price relationship:
1. Bond prices and yields move in opposite directions
2. Prices of long-term bonds are more sensitive to interest rate changes than prices
of short-term papers
3. Prices of low-coupon bonds are more sensitive to interest rate movements than
prices of high-coupon bonds

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 9th, 2009 Page 6 of 9

 4. An increase in yield causes a proportionately smaller price change than a
decrease in yield of the same magnitude
5. As maturity increases, interest rate risk increases but at a decreasing rate

Portfolio managers use Duration Management as a tool for immunising their bond
portfolio. Immunisation strategies enable banks/others in neutralising the effects of
interest rate changes from an overall portfolio perspective, thus reducing market risks.

DURATION MANAGEMENT

Duration can be defined mathematically as the weighted average life period of a

bond adjusted for the quantum and periodicity of the cash flows. It is a measurement of
how long, in years, it takes for the price of a bond to be repaid by its internal cash flows.
Thus, the duration of a bond is equal to the length of time that elapses before the
present value from the bond is received. It is an important measure for investors to
consider, as bonds with higher durations carry more risk and have higher price volatility
than bonds with lower durations.

Calculation of Duration with an example :

Let us calculate the duration of a bond with:
a face value Rs 100, coupon of 8.24% (interest paid annually), years to maturity
six, maturity value Rs 100, present market price of the bond Rs 111.02 and yield
to maturity of 6 per cent.

Cash
Year Present value Present value Proportion of Proportion
Flow
factor at 6% at 6% YTM bond's value x time

A B C D=BxC E = D / Total PV * F=ExA

1 8.24 0.9430 7.7700 0.0700 0.0700

2 8.24 0.8900 7.3340 0.0660 0.1320
3 8.24 0.8400 6.9220 0.0620 0.1870
4 8.24 0.7920 6.5260 0.0590 0.2350
5 8.24 0.7470 6.1550 0.0550 0.2770
6 108.24 0.7050 76.3090 0.6870 4.1240

TOTAL 111.0200 5.0250

* Total present value which is Rs 111.02 or bond’s current price

As can be seen from the column ‘F’ of the above table, Duration of this bond is 5.025
years, or 5 years & 3 months.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 9th, 2009 Page 7 of 9

Some properties of Duration:

1. For a zero coupon bond (ZCB), duration is equal to its term to maturity. They are
bonds issued at a discount to face value and the face value is paid at the end of
the maturity period. Zero coupon bonds do not carry any coupon.

2. For a Vanilla Bond, duration will always be less than its term to maturity

3. Duration is measured in terms of years and months

4. Bonds with high coupon rates and, in turn, high yields will tend to have lower
durations than bonds that pay low coupon rates or offer low yields

5. For a given coupon rate, a bond’s duration generally increases with maturity

6. Other things being equal, the duration of a coupon bond varies inversely with its
yield to maturity

Uses of Duration:

1. It indicates the sensitivity of a bond to the movements in interest rates

2. It is used as a measure of the interest rate risk. Higher the duration of a bond,
greater is the risk of that bond to interest rate movements.
3. It is a management tool for immunizing the bond portfolio against interest rate
risks. Mathcing durations of assets and liabilities helps in immunising a portfolio.

MODIFIED DURATION: Modified Duration is a modified version of Duration and

accounts for changes in interest rate changes. Modified duration is the ratio of duration
to the yield to maturity of a bond.

Mathematical formula: Modified Duration = D / (1 + y)

where, D = Duration,

y = the bond’s yield to maturity

Modified Duration is a mathematical link between bond price and interest rate change.
With this measure it is possible to obtain a fairly accurate measure of how much a
bond’s price will change relative to a given change in market interest rate. Modified
duration is the measure of percentage change in bond price given a change in yield.

Because the modified duration formula shows how a bond's duration changes in relation
to interest rate movements, the formula is appropriate for investors wishing to measure
the volatility of a particular bond. Modified Duration will always be lower than the
Duration.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 9th, 2009 Page 8 of 9

SUMMARY:
As mentioned above, the inter-related factors of duration, coupon rate, term to maturity
and price volatility are important for those investors employing duration-based
immunization strategies. These strategies aim to match the durations of assets and
liabilities within a portfolio for the purpose of minimizing the impact of interest rates on
the net worth. To create these strategies, portfolio managers use duration.

Understanding what duration is, how it is used and what factors affect it will help in
determining a bond's price volatility. Volatility is an important factor in determining the
strategy for capitalizing on interest rate movements. Furthermore, duration will also help
in determining how the portfolio can be protected from interest rate risk.

References:

1. Investment Analysis and Portfolio Management by Prasanna Chandra

2. RBI website

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 9th, 2009 Page 9 of 9