Here is an essay on ‘Products Available to Treasury in the Financial Markets’ for class 11 and 12. Find paragraphs, long and short essays on ‘Products Available to Treasury in the Financial Markets’ especially written for school and banking students.
- Essay on the Products of Foreign Exchange Market
- Essay on Money Market Products
- Essay on the Products of Securities Market
- Essay on Domestic and Global Markets
Essay # 1. Products of Foreign Exchange Market:
Foreign exchange (forex) market is the most liquid market as free currencies (major currencies which are fully convertible, e.g. USD, EUR, GBP, JPY, CHF, etc.) can be readily bought and sold. Free currencies belong to those countries, whose markets are highly developed and where exchange controls are practically dispensed with.
Currencies which are not fully convertible, have limited demand and may not be traded actively, but they may also enjoy high liquidity, depending on the size and stage of development of domestic market. For instance, Indian Rupee (INR) is only partially convertible, but the market for USD/INR is fairly liquid, owing to large domestic market and high growth rate of the economy.
Foreign Exchange Market is also most transparent as most of the transactions take place ‘on-line’ across the time zones in electronic medium and the exchange rate movements are reflected on the screen from moment to moment, even when the trades take place in far-off markets, say in New York or Tokyo.
It is a virtual market, without physical boundaries, the only limitation for currency trades being domestic regulation or convertibility. The information dissemination is very fast through electronic media – most common being the screens of information vendors, such as Reuters and Bloomberg, who also provide dealing screens where the buy / sell transactions can take place.
There are also internet sites which provide trading platform. Several banks have their own sites where customers can deal in foreign exchange on-line. Worldwide networks of forex brokers also use telecommunications for instant transmission of information. In this sense, foreign exchange market may be called near perfect, with an efficient price discovery system. For most currencies, dealers in the forex market offer two-way quotes (for purchase and sale of currency), lending liquidity and transparency to the market. Narrower the buy-sell spread, more liquid is the currency market.
1. Spot Trades:
Currencies are mostly bought and sold in spot trades. The spot refers to settlement – payment and receipt of funds in respective currencies. Spot settlement takes place two working days from the trade date, i.e. on the third day. Currency may also be bought and sold, with settlement on the same day, i.e. today (TOD), or, on the next day, i.e. tomorrow (TOM).
All the exchange rates quoted on the screen, or in print, are for spot trade, unless otherwise mentioned. The TOD and TOM rates are generally quoted at a discount to the spot rate, i.e. the rate is less favourable to the buyer of the currency. In an integrated market, the premium or discount charged on the currency is really decided by overnight interest rate differentials of the currencies bought and sold.
2. Forward Rates:
While spot trade refers to current transaction, forwards refer to purchase or sale of a currency on a future date. The exchange rates for forward sale or forward purchase are quoted today; hence such transactions are referred to as forward contracts between the buyer and seller. Treasury may enter into forward contracts with customers (merchant business) or with banks (inter-bank market) as counterparties.
Customers, i.e. importers, exporters and others, who expect payments or receipts in foreign currency, cover their currency risk by entering into forward contracts with their respective banks. Treasury in-turn covers its customer exposure by taking reverse positions in the inter-bank market. Treasury may also enter into forward contracts, purely for the purpose of making profit out of price movements.
Forward exchange rates are not exchange rates forecast into the future; in other words, they do not reflect projected rate movements in the market. Forward exchange rates are arrived at on the basis of interest rate differentials of two currencies, added or deducted from spot exchange rate.
The difference between spot rate and forward rate, say, for GBP/USD therefore represents the difference in risk-free interest rates in the USA and UK. The interest rate differential is added to the spot rate for low-interest yielding currency (representing forward premium) and deducted from the spot rate for high-interest yielding currency (representing forward discount).
However, forward rates fully reflect interest rate differentials only in perfect markets, where the currencies are fully convertible and where the markets are highly liquid. Since Rupee is not yet fully convertible, the demand for forward contracts influences the forward exchange rates more than the interest rate differentials.
The spot and forward transactions are the primary products in foreign exchange market. A combination of spot and forward transactions or a combination of two forward transactions is called a swap. A swap transaction is also described as an exchange of cash flows. Buying USD (with Rupees) in the spot market and selling same amount of USD in forward market, or vice versa, constitutes a USD/INR swap. Similarly, simultaneous purchase and sale of currency on two forward dates (forward to forward) is also a swap.
The swap route is generally used for funding requirements, but there is also a profit opportunity from interest rate arbitrage. When we have USD funds, but we need Rupee funds to invest in a commercial paper for 3 months, we may enter into a USD/INR swap deal – to sell USD at spot rate (converting into Rupee funds) and buying back the USD 3 months forward (with Rupee funds on maturity of the CP). If the interest earned on CP is higher than the cost of USD funds, the swap results in a profit. The cost of USD funds consists of interest at market rate plus forward premium for the 3-month period.
However, interest arbitrage exists only when one of the currencies exchanged is not fully convertible. There is no interest arbitrage between free currencies, as the forward premium/discount is equal to the interest rate differentials, The swap is otherwise used to eliminate currency and interest rate mismatches.
The swap route is used extensively to convert cash flows arising from principal and interest payments of loans from one currency to another currency, with or without involving actual exchange of funds – such transactions are referred to as currency swaps, as distinct from short-term funding swaps, which are more common in treasury dealings.
Forwards and swaps, used widely in managing foreign currency liabilities, fall under the scope of derivatives.
4. Investment of Foreign Exchange Surpluses:
Treasury is also responsible for investment of foreign exchange surpluses of the bank.
The surpluses arise out of:
(a) profits from treasury operations
(b) profits from overseas branch operations
(c) Forex borrowings in overseas/domestic market and
(d) foreign currency and convertible Rupee deposits with branches (mainly from NRI depositors and exporters).
Such surpluses, net of bank’s lending in foreign currency to eligible borrowers, are left at the disposal of Treasury. The forex surpluses also include floating funds on account of customer transactions (e.g. balances in nostra accounts, or funds maintained in an EEFC account) and Rupee funds swapped in to foreign currency.
Banks are permitted to invest foreign exchange surpluses in global money markets/in short-term securities.
Following are the avenues available to the Treasury for investment of forex surpluses:
i. Inter-Bank Loans:
Normally not exceeding one-year term, but mostly in over-night deposits with domestic and global banks, subject to pre-approved credit lines to the respective banks.
ii. Short-Term Investments Banks:
Short-term Investments Banks are permitted to invest overseas in short-term instruments of high credit quality, such as Treasury Bills/Gilts issued by foreign governments, commercial paper and other debt instruments issued by multilateral institutions and companies with AAA credit rating, subject to appropriate policy for the investments, approved at board level.
iii. Nostro Accounts:
Where floating funds of the bank are parked, pending utilization/customer drawals. Nostra accounts are current accounts denominated in foreign currency, maintained by the banks with their correspondent banks in the home country of the currency (e.g. Japan for Yen, UK for Sterling, USA for Dollars etc.). Balances held in the Nostro accounts do not earn any interest.
However, many correspondent banks offer automatic investment facilities for funds held overnight, subject to a minimum balance in the account (say, USD 100,000). The correspondent banks invest the excess funds in money market on behalf of the account-holding bank, and pay in return interest at a rate normally linked to Fed rate for USD funds. Thus the Treasury is able to earn nominal interest on idle funds held in the Nostro accounts.
5. Loans and Advances:
Credit is a banking function and Treasury is not involved in credit appraisals and disbursements. However clearance from Treasury is sought as to the availability of foreign currency funds and cost of funds, prior to sanction of foreign currency advances. (In fact such clearance is increasingly becoming necessary in disbursement of large domestic advances also, in the context of liquidity management and transfer pricing).
Banks also extend working capital denominated in foreign currency, by means of FCNR loans, PCFC and discount of foreign currency bills to select customers. Treasury is more actively involved in short-term funding, as part of its cash flow management.
6. Rediscounting of Foreign Bills:
This is an inter-bank advance, where Treasury refinances the foreign currency bills purchased/negotiated by another bank. This is a Treasury product, as the bills are rediscounted with recourse to the bank (without credit risk of the client).
The bill-rediscounting is priced slightly higher than market placements, as:
(a) The advance covers a usance period – anywhere from 15 days to 360 days, and
(b) The counterparty would charge their customer commercial rate of interest for the underlying.
Though it is an inter-bank exposure, RBI has allowed banks to include rediscounting of bills in their credit portfolio.
In integrated treasury, foreign exchange fund management is not really different from domestic fund management, and, as we shall see, the products and markets overlap providing a wide variety of choices to the treasurer.
Essay # 2. Money Market Products:
Money Markets refer to raising and deploying short-term resources, with maturity of funds generally not exceeding one year.
The inter-bank market is sub-divided into call money, notice money and term money market.
i. Call Money:
Refers to overnight placements, i.e. funds borrowed by banks need to be repaid on the next working day. Call money rates indicate liquidity available in the inter-bank market. Overnight Mumbai Interbank Offered Rate (O/N MIBOR) is the indicative rate for call money, fixed daily in the morning, used widely as a benchmark rate for overnight interest rate swaps.
ii. Notice Money:
Refers to placement of funds beyond overnight for periods not exceeding 14 days.
iii. Term Money:
Market is for placement of funds with banks for periods in excess of 14 days, but not exceeding 1 year. Typically term money placements range from 1 month to 6 months, and placements for longer periods are not very common.
The call money market is purely an inter-bank market – non-bank players, such as financial institutions and mutual funds, were phased out of call money market w.e.f 6 August 2005. Only banks, primary dealers and cooperative banks (other than land development banks) can participate in the call money market.
Inter-bank markets are at the forefront of financial markets and are the first to signal any changes in money supply and the resultant liquidity in the system. On any particular day the call money transactions reflect the liquidity available in the system. Inter-bank market is considered to be a risk-free market, though in reality, the banks do carry counterparty risk.
However, for practical purposes, inter-bank market carries lowest risk, next only to sovereign risk; hence the interest rates prevailing in inter-bank market constitute ‘benchmark’ rates. The call money rate, as indicated by the overnight Mumbai Interbank Offered Rate (O/N MIBOR) is most widely accepted benchmark rate for floating rate debt paper, as also for overnight interest rate swaps (OIS).
Treasury invests surplus cash in money market, after meeting the cash Reserve Ratio (CRR) stipulated by RBI. Currently the CRR is 6% of bank’s demand and time liabilities. CRR is an important monetary policy instrument of RBI to influence liquidity in the market. The RBI does not pay interest on CRR balances held by banks. Bank treasuries typically deal in inter-bank markets, but treasury operations now extend to short-term investment paper issued by government, financial institutions and companies in public and private sectors.
Following are the securities mainly dealt with for placement of short-term funds:
1. Treasury Bills:
These are issued by Government of India through Reserve Bank for maturities of 91 -days, 182 days and 364-days, for pre-determined amounts. The interest is by way of discount, so the bills are priced below Rs.100 (e.g. T-bill of 91 days is priced at 99.26 yielding interest at 5.16% p.a., which is known as implicit yield).
The price of T-bills is determined through an auction process where banks and primary dealers are the main participants. The auction however is open to all players in the financial markets, including financial institutions, mutual funds, corporates, and other business entities, as also individuals.
T-bills are issued on fixed dates and for pre-fixed amounts. Currently, 91-day T-bill is issued weekly on each Wednesday, 182-day T-bill is issued fortnightly on Wednesday preceding non-reporting Friday, and 364-day T-bill is also issued fortnightly on Wednesday preceding reporting Friday.
For bank treasury, investment in T-bills is a convenient way of parking short-term surpluses in risk-free investment, yielding interest generally higher than the overnight call money rates. T-bills have a liquid secondary market and the T-bill yields constitute a valid benchmark rate for debt paper. FIMMDA (Fixed Income Money Market and Derivatives Association of India) and Reuters collaborate to publish benchmark T-bill yields for one week to one year based on residual maturity of T-bills in circulation.
The T-bill, like other government securities, is in electronic form and is to be held in a SGL account/constituent SGL account maintained by banks with Reserve Bank of India (though, depository participants are also now permitted to operate through SGL account to facilitate retail sales of government securities). Secondary market settlement of T-bills takes place through Clearing Corporation of India Ltd. (CCIL).
2. Commercial Paper (CP):
This is a short-term debt market paper issued by corporates, with a minimum maturity of 7 days and maximum maturity of 1 year. Corporates, primary dealers and financial institutions are eligible to issue commercial paper. The issue of CP is governed by guidelines issued by RBI and market practices prescribed by FIMMDA.
As per RBI guidelines, the principal requirements are:
(i) The issuing company should have minimum credit rating of P2
(ii) Net worth as per last balance sheet must not be below Rs. 4 cr. and
(iii) Any advances from bank must be under standard asset classification of the bank.
The issue of CP should be for a minimum amount of Rs 5 lacs. Banks are permitted to invest in CP only if it is in demat form; hence most of the CPs are issued in demat form. CP is to be issued through an IPA (issuing and paying authority) who must be a bank. It is common practice that banks earmark part of the available working capital limits of a corporate customer, as a measure of credit enhancement, so that the company would obtain required credit rating for issue of commercial paper. Reputed companies with a sound balance sheet may obtain higher credit rating on their own, without such credit support.
The CP carries relatively low credit risk, owing to its short-term nature and minimum credit rating requirement. The CP is issued in the form of a promissory note for discounted amount, i.e. price of CP is less than the face value, and the price is quoted for face value of Rs 100. The CP is a negotiable instrument and has a fairly active market. CP is issued in Demat form, hence the purchase and sale of CP is affected through the depository participant (DP) accounts of investors.
The issuers use CP as a substitute for working capital, as market rates of interest are lower than the PLR-related interest rates charged by banks on regular working capital facilities.
At the same time, banks tend to invest in CPs through the treasury, as:
(a) Credit risk is relatively low and limited to a short period
(b) Yield on CP is higher than inter-bank money market yield and
(c) CP being a tradable instrument, there is no liquidity risk.
Secondary market for CPs is fairly active and the indexed return on CP is used as a benchmark rate for short-term advances.
3. Certificates of Deposit (CD):
This is a debt instrument similar to commercial paper, but is issued by banks against deposit of funds. Unlike a deposit receipt, CD is a negotiable instrument and generally bears interest rates higher than regular deposits of the bank. It is also more expensive to the bank, as the CD attracts stamp duty, and is generally rated by an approved credit rating agency.
CD is meant primarily for high net worth individuals, the minimum amount of the deposit being Rs 1 lac and period of maturity may range between 15 days and 1 year. CDs are issued for Rs. 1 lac and multiples thereof, either in demat form, or as promissory notes. Since CD is negotiable, it is also an investment vehicle for corporates and banks. However, secondary market for CD market is not very active and banks find it attractive, only when liquidity conditions are tight.
Repo, in fact, is a securities transaction, but is used for lending and borrowing money market funds, for terms extending from 1 day to 1 year. Repo refers to sale of securities with a commitment to repurchase the same securities at a later date. Presently, only government securities are being dealt with under repo transactions. The bank in need of funds, and having surplus securities (in excess of its SLR requirement), can enter into a repo transaction with a counterparty who could be another bank, primary dealer, or financial institution.
Mutual funds and corporates are also now permitted to take part in the Repo market. The bank sells the securities to the counterparty, with an agreement to repurchase the same securities, say after 3 months, at a predetermined price. The bank thus gets cash, in exchange of securities, and pays back the cash after 3 months to repossess the securities. The difference in the sale price and repurchase price is akin to interest on the cash advance.
The repurchase price is adjusted to any income on the securities that may accrue to the counterparty during the holding period. The effective interest rate on repo transactions would be marginally less than corresponding money market rate, as the lending bank has securities in hand till the ‘loan’ is repaid. The entire transaction, however, appears as a sale and purchase of securities in the bank books.
The counterparty obviously has surplus cash which it uses for purchase of securities. The advantage to the counterparty bank is earning interest on secured lending, and at the same time holding securities which will help it to meet any shortfall in its SLR compliance. In fact, the value of securities is higher by a margin, about 5% to cover price risk, in case of a default. The margin is called ‘hair cut’, as the principal amount exchanged against the securities is lower than the market value of securities.
All repo settlements are routed through Clearing Corporation of India Ltd. (CCIL). Currently, government securities are actively traded in Repo. (Permitting corporate securities for Repo trade is under active consideration of RBI and SEBI.)
However, Repo in corporate securities has also been permitted by RBI w.e.f. December 2009. The market is yet to be activated. Detailed guidelines on Repo accounting have also been issued by RBI in March 2010.
Repo, as a tool of RBI under Liquidity Adjustment facility, and Repo in the form of CBLO (collateralized borrowing and lending scheme), are explained separately.
Repo under Liquidity Adjustment Facility:
Repo is used extensively by Reserve Bank of India as an instrument of monetary policy to control liquidity in the inter-bank market. In case of shortage of funds, banks and primary dealers can sell government securities to RBI with a commitment to repurchase the securities on a specified date, and avail of liquidity.
In case banks have surplus liquidity, i.e. funds in excess of demand in the money market, they can buy securities from RBI in exchange of cash deposit, with an agreement to resell the securities after a fixed period. The difference in purchase and sale prices (adjusted to the coupon accruing during the repo period, if any) constitutes the interest paid or received by the banks from RBI.
RBI, having gradually withdrawn various schemes of refinancing the banks, has since adopted Repo as the main instrument for liquidity management under Liquidity Adjustment Facility (LAF) for commercial banks. Infusion of liquidity is effected through lending to banks under a Repo transaction, and absorption of liquidity is done through accepting deposits from banks, what is now known as ‘Reverse Repo’ transaction. Banks may submit bids to RBI, either for Repo or for Reverse Repo, as per their requirement. The bids are either accepted or rejected in an auction conducted by RBI.
Repo and Reverse Repo rates thus become policy rates of RBI at which banks may borrow from or lend to RBI, respectively, based on their liquidity position. Under the annual policy review announced by the Governor of RBI in April 2010, RBI has fixed Repo and Reverse Repo rates at 5.25% and 3.75% respectively. (The rates are revised from time to time in response to liquidity conditions and perception of inflation).
It is the intention of RBI that the Repo rate would set the upper band and Reverse Repo rate would set the floor for money market, i.e. overnight inter-bank rates should normally move within the bandwidth of 150 bp, set by RBI. RBI generally conducts Repo auctions for overnight period, twice daily – but RBI has full discretion to change frequency of the auctions, period of Repo and to accept or reject banks’ bids for Repo/Reverse Repo, either in full or in part. In view of recent liquidity crisis in global markets, RBI has also conducted 3-month repo auctions to provide term money to banks.
5. Collateralised Borrowing and Lending Obligation (CBLO):
CBLO is a money market instrument launched by Clearing Corporation of India Ltd. (CCIL). CBLO is essentially a Repo instrument, which is used not only by banks and primary dealers, but also by all other players like financial institutions, insurance companies, mutual funds and corporates who cannot access call money market.
A borrower can deposit government securities with CCIL and borrow against such securities (sell securities) from others who have surplus liquidity, subject to repayment (repurchase of securities) after a fixed term ranging from 1 day to 1 year – the underlying securities are represented by the CBLO, which is effectively the Repo instrument. CCIL acts as an intermediary for the Repo trade, so that the lenders and borrowers do not have counterparty risk.
CBLO is actively traded in secondary market, hence the lender in case of need, readily sell and encash the CBLO without waiting till due date. The borrower can also prepay any time by purchasing the CBLO in the market. All settlements take place through CCIL.
6. Bill Rediscounting:
It provides another avenue for investment of money market funds. Treasury will discount bills of exchange of short-term nature (3 to 6 months) which are already discounted by other banks. The rediscounting is done at around money market rate and usually negotiated between the lending (rediscounting) bank and the borrowing (original discounting) bank.
The benefit to the lending bank is that their surplus funds are invested at term money rates and the credit risk is low as they have recourse to the discounting bank. The borrowing bank is able to infuse liquidity from out of existing assets and at the same time, improves its capital adequacy ratio as the bills are taken out of credit portfolio and added to the inter-bank liability.
Essay # 3. Products of Securities Market:
Investment Business is an important part of integrated treasury and is composed of buying and selling products available in Securities Market. Investment being a subject in itself, we would outline briefly the investment products available to bank treasuries and the subject is to be studied in detail by those who would like to specialise in investment business.
1. Government Securities:
Treasury invests primarily in Government Securities to comply with the reserve requirement of the bank, i.e. Statutory Liquidity Ratio (SLR), which is presently at 25% of bank’s demand and time liabilities (DTL). RBI, at its discretion, can increase or decrease the SLR, subject to a cap of 40%, in order to control money supply in the market – in fact the SLR has been gradually reduced over the last 10 years from a high of 36%. The Banking Regulation Act of 1949 was amended in 2007 to allow RBI to stipulate SLR below 25% which was earlier minimum SLR level stipulated under the Act.
To satisfy SLR requirement, banks can also invest in other approved securities, such as priority sector bonds issued by Small Industries Development Bank of India (SIDBI) and National Bank for Agricultural and Rural Development (NABARD). However, the number of eligible bonds for this purpose is being curtailed and banks, by and large, invest in government securities for the purpose of SLR. Banks can also hold cash or gold to fulfill SLR requirement.
Government Securities are issued by Public Debt Office of Reserve Bank of India on behalf of Government of India. State governments also issue State Development Bonds through RBI. Government Securities are sold through auctions conducted by RBI. The interest is paid on face value of the bonds (expressed as percentage; minimum value of bonds is Rs. 10000) at coupon rate, but the price of the bonds is determined in the auction conducted by RBI.
RBI arrives at a cut-off price based on the bids submitted by banks and primary dealers (constituting demand for the bonds) and the price may be higher or lower than the face value of Rs.100. Government securities are actively traded in secondary market; hence the price and yield of the bonds would be constantly changing depending on the demand for bonds (which in turn depends on the liquidity available in the system).
The yield on bonds is therefore different from coupon rate of interest. For instance, 10-year G-sec, maturing in January 2020 and carrying a coupon of 6.35% is currently priced at 90.60 giving a yield of 7.72%. The bond is at a discount, as risk free interest rate for 10-year period is higher than the coupon of the bond. The price of the bonds and the yield on bonds move in opposite direction.
The Government of India borrows from public by issue of securities, to finance its deficit – which is the difference between Government’s income and expenses. RBI is the issuing and paying agency for government securities. RBI also uses government securities as a policy instrument to control liquidity in the market in order to influence the interest rates. RBI may absorb liquidity by selling the securities in the market and may infuse liquidity by buying back the securities from the public. These are known as open market operations (OMO) of the central bank.
Banks invest in government securities not only for meeting with SLR requirement, but also to profit from price changes of the securities. Bank’s investments are classified in to Held till Maturity (HTM) – consisting of securities mainly for investment purpose, Available for Sale (AFS) and Held for Trading (HFT) which consist of tradable securities. Securities under HFT are actively traded and are marked-to- market (MTM) regularly for accounting purpose.
Banks and institutional investors actively buy and sell government securities in anticipation of price changes. The view on prices/interest rate is based on the rate of inflation, GDP growth and other economic indicators. The yields and prices of securities move in the opposite direction – prices fall when yields (interest rates) rise, and vice versa. Interest rates are also traded based on notional bond (G- sec) prices in futures market, but the interest rate futures market is yet to take-off after its reintroduction in 2009.
RBI also uses the G-sec market to develop debt markets. Since G-sec yields set benchmark rates for corporate bonds, RBI has issued bonds for various maturities ranging from 1 year to 30 years, so as to establish a market determined yield curve. RBI has also issued a variety of bonds, with step-up coupons or coupons linked to inflation index, or floating rate coupons. Current proposals include issue of STRIPS (Separate Trading of Registered Interest and Principal Securities), where the principal and interest are traded as separate zero-coupon securities.
2. Corporate Debt Paper:
Corporate debt paper refers to medium and long-term bonds and debentures issued by corporates and financial institutions, which are tradable. They are also referred to as non-SLR securities, to distinguish the corporate debt from government securities and other approved securities, which are eligible for meeting SLR requirement of banks. Tier-2 capital bonds issued by banks also fall under this category.
Treasuries find corporate debt paper as an attractive investment, as yields on bonds and debentures are higher than the yield on government securities. Now that most of the corporate debt paper is issued in demat form, there is fairly active secondary market and the bonds issued by top corporates are highly liquid. (Banks are allowed to invest only in demat securities.)
Yields on corporate debt differ from instrument to instrument, depending on the credit quality, that is, higher the credit risk, higher is the yield. Most of the debt issues have credit rating by one of the four credit rating agencies in the country. Global ratings are necessary if the debt paper is being issued in the international markets. Treasury can invest FCNR deposit funds and other foreign currency surpluses in global debt paper as per policy guidelines approved by the management.
3. Debentures and Bonds:
These are debt instruments, issued by corporate bodies, literally with a charge on specific assets. The literal meaning has been lost in practice and debentures and bonds may be issued with or without security. In practice, Company Law requires that debentures issued by companies are always secured (otherwise they will be subject to regulations pertaining to public deposits); hence debentures are generally secured by mortgage or with a floating charge or a lien on assets – although the latter security is more of a technical nature to give comfort to the investors.
In India, conventionally, debentures are debt instruments issued by corporates in private sector, while bonds are issued by institutions in public sector, which distinction really has no meaning in international market. Bonds, though issued by public sector companies, do not imply guarantee by the government, unless it is so mentioned specifically in the terms of the issue.
In domestic market, there are material differences in debentures and bonds. Debentures are governed by relevant provisions of Company Law and are transferable only by registration. Bonds on the other hand are negotiable instruments governed by law of contracts. However, currently almost all debt instruments are issued in demat form and sales/purchases or transfer of security takes place in the depository accounts, without regard to the nature of the instrument.
Debenture may be convertible or non-convertible. Convertible debentures may be converted in to equity as per terms of issue. There is no practical difference between non-convertible debentures (NCD) and bonds. As a matter of convenience, we use bond as common nomenclature for non-convertible corporate debt paper, with original maturity of 1 year and above. Where the debentures and bonds are convertible in to equity, they are so mentioned specifically.
Bonds may be issued with differing structures in order to enhance the marketability of the instruments as also to reduce the cost of issue. The variations include structured obligations, with put/call or convertibility options, zero coupon bonds, floating rate bonds, deep discount bonds and instruments with step up coupons.
Bonds are also issued with redemption in installments over a period (sometimes called period bonds) and also with a premium on redemption in addition to coupon rate of interest. Bonds which are not secured by mortgages, but secured by stocks or other collateral, are also referred to as collateralised obligations. Finally, there are also bonds with put call option and step up coupons, with the incentive of higher interest for non-redemption of the bonds in early stages.
The bond-holders have, like other creditors, prior legal claim over the equity and preference stockholders, on the assets of the company. The issuer appoints a Trustee, most commonly when the debentures and bonds are secured, who would act in fiduciary capacity to protect the interests of the debenture and bond-holders.
The Trustee, by virtue of the Trust Deed executed by the issuer, holds charge of the security and would be instrumental in initiating legal action for recovery of principal/interest in case of any default. The Trustees, as per SEBI guidelines, are to be vested with requisite powers for protecting the rights of the debenture and bond-holders, and sometimes have a right to appoint a nominee director on the board of the issuing company.
Issue of Prospectus for public offer of debentures and bonds is governed by relevant provisions of Companies’ Act, similar to the provision for offer of equity. SEBI (Securities Exchange Board of India) has also evolved a framework of detailed guidelines for protection of investors’ rights. However, most issues are placed privately with qualified institutional investors; hence attract only minimum regulation of SEBI.
4. Convertible Bonds:
These are a mix of debt and equity, where the bond-holders are given an option to convert the debt into equity on a fixed date or during a fixed period, and the conversion price is predetermined. If the issuer company’s stock price is higher than the prefixed conversion price, the investors would prefer to convert the debt into equity.
The benefit to the company is that there is no debt repayment and at the same time its equity base is strengthened. The coupon on convertible bond is generally lower than the coupon on non-convertible bond of similar credit standing. In case the bond is converted in to equity, the equity holdings of the existing shareholders get diluted.
Banks are permitted to invest in equities (shares of listed companies) subject to a limit on capital market exposure, set by RBI. Equities are traded on stock exchange and the stock prices are influenced by fundamentals (financial position) of the company has also various economic factors. In view of the risks involved in equity trading, bank treasuries are generally cautious in investing surplus funds in the stock market.
However, we must mention that Indian stock market is one of the oldest in Asia and the institutional structure is well developed, with SEBI as the Regulator. Bombay Stock Exchange and National Stock Exchange are the two leading stock exchanges, where the trading is done on an electronic platform (also called screen-based trading). The derivative products available in the market, viz. index futures, index options, stock futures and stock options have since become highly popular for risk management as well as for speculation.
Major investors in domestic market include foreign institutional investors, mutual funds, insurance companies and private fund managers, with a huge backdrop of retail market. Bank treasuries have not been leading investors in stock markets, as the stock prices are highly volatile, and banks prefer low risk investments. Nevertheless, equities continue to be an important part of the treasury portfolio.
Essay # 4. Domestic and Global Markets:
We have seen the products available in foreign exchange markets, money market and securities market. Not only these markets are overlapping (e.g. USD funds swapped into Rupees and invested in securities, or lent in the inter-bank market), but are also common to domestic and global markets.
The interaction takes place wherever funds can be swapped freely from one currency to another currency, or where funds can be transferred easily from one market to another market. Most such transfers are to-day done with few restrictions, as Rupee is fully convertible on current account and is partially convertible on capital account.
We may briefly recapitulate the points of interaction of domestic and global market, confining ourselves only to treasury related business:
i. FII Investments:
Foreign investments flow in to India by way of foreign direct investment (long term project related investments), and portfolio investments (investment in stock market and debt market for short term gains). Foreign institutional investors who include investment banks and hedge funds invest mainly in portfolio investments.
Private equity funds, corporate investors and other institutional investors with a long term view prefer direct investments in new projects/potentially profitable Indian companies. Owing to liberal policies of Government, last few years witnessed strong capital inflows by way of FDI as also FII – though the latter fluctuates with rise and fall of stock markets. Sectoral caps on foreign investment have been either removed or raised to 74% in several industries, except in some key industries like banking and aviation.
ii. ADR/GDR Issues by Indian Companies:
Indian companies mobilize foreign currency resources by issue of equity in global markets. The holders of ADR/GDR (foreign investors) have an option to sell their holdings in domestic markets, and receive proceeds in foreign currency.
iii. External Commercial Borrowings (ECB):
Indian companies can borrow in global markets, from banks (syndicated loans) or issue debt paper (floating rate notes, bonds etc.) within the guidelines issued by RBI, to fund their domestic/overseas projects. Under current regulations, Indian companies can borrow up to USD 500 mn up to minimum period of 5 years and USD 20 mn up to minimum period of 3 years without prior approval of RBI. The debt can be repaid from Rupee/foreign currency resources of the borrower.
iv. Foreign Currency Funds of Banks:
Banks can use their FCNR deposit funds for investment in overseas markets as well as for domestic lending in foreign currency. They are also permitted to borrow/invest in overseas markets within a ceiling (presently 50% of Unimpaired Tier-1 capital, minimum USD 10 million), subject to guidelines issued by RBI. Banks generally use this facility to extend short term loans (usually with 6-month rollover).
v. Special Facilities to Exporters:
Exporters are permitted to hold export earnings in foreign currency accounts, designated as EEFC accounts. Banks are allowed to extend pre-shipment and post-shipment finance to exporters in foreign currency (PCFC and PSFC, respectively) in four major currencies- Banks can borrow foreign currency for the specific purpose of financing export credit (including discount of export bills).
vi. Overseas Direct Investment (ODI):
RBI allows corporates to invest in joint ventures/subsidiary units overseas, from their Rupee resources subject to a cap based on their net worth (currently 4 times their net worth). This has allowed leading Indian business groups to expand globally by establishing companies near their markets or by acquiring other companies.
vii. Free Remittance Facility:
Individuals are now permitted to remit overseas freely, without RBI approval, up to USD 200000 a year, for any purpose (with a few exceptions like gambling and margin trading). They may choose to invest the funds in global debt, equity or simply spend the money for consumption purposes.
The impact of two way capital flows, as above, is felt in domestic interest rates as also in exchange rate. For instance, FII flows peaked in 2007, resulting in appreciation of Rupee and lower interest costs. In the latter half of 2008-09, owing to global recession and liquidity crisis, FII flows thinned out, stock markets crashed, Rupee depreciated sharply, crossing the historical low of 50.00 against USD, and credit became scarce, raising interest costs to corporates.
Government of India and RBI have, during second and third quarters of 2009, taken policy initiatives, again in line with the governments and central banks in developed countries, by providing stimulus to the economy and bringing down reserve ratios and policy rates, in a concerted effort.
As a result of close interaction between domestic and global markets, the scope of treasury has expanded and the financial markets have become interdependent. The 2008-09 crises in financial markets, which originated in US and Europe, but soon, got translated in to global recession, taught us that globalization is not an unmixed blessing and we need to continue to have minimum capital regulations in order to minimize systemic risks.