Government Securities Market in India & Duration Management-VRK100-09102009

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Government Securities Market in India

    Duration Management

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.

OWNERSHIP PATTERN OF GOVT. SECURITIES

            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.

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’.

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.  

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
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.

	Year	Cash Flow	Present value factor at 6%	Present value at 6% YTM	Proportion of bond's value	Proportion  x  time
	A	B	C	D = B x C	E = D / Total PV *	F = E x A
	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.

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.

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

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