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Do we really understand government securities? You can now, with its distinguishing features

Flummoxed was the correct reaction when I heard from my son that thousands of pages of research papers have been written in USA over government securities. But, when Mr. Viral V. Acharya, Deputy Governor, RBI in his speech at annual dinner of FIMMDA, Mumbai stated that current bond future contracts, introduced only in 2014

“Flummoxed” was the correct reaction when I heard from my son that thousands of pages of research papers have been written in USA over government securities. But, when Mr. Viral V. Acharya, Deputy Governor, RBI in his speech at annual dinner of FIMMDA, Mumbai stated that current bond future contracts, introduced only in 2014, has not shown reasonable activity, I was wondering whether do we really understand the distinguishing features of government securities and if not, why not transcribe them from RBI’s web site updated till October 2017 with a simpleton’s touch? For easy reference, questions and answers approach was adopted.

Graceful features of government securities (updated till October 17, 2017, by RBI)

  • A Government security is a tradable instrument issued by the Central Government or the State Governments. It acknowledges the Government’s debt obligation. Such securities are short term (usually called treasury bills, with original maturities of less than one year) or long term (usually called Government bonds or dated securities with original maturity of one year or more).
  • I would like to quote apart from above, others which are risk-free gilt-edged instruments, state government issued State Development Loans, NSCs (we all know what are these), oil bonds, Food Corporation Certificates, power bonds etc., also for easy recognition. Some of them are not fully tradable.

Why should I invest in government securities?

  • To avoid risk in holding, getting regular income in the form of coupons(interest), having wide range of periods, 91 days to 30 years (Wow! Never heard of anywhere!), easy salability in secondary market, and in the latest form of holding like dematerialized form.
  • At the click of my computer, I can sell it if it is in D Matt form. Naturally, banks, insurance companies, big investors, Provident funds and Reginal Rural Banks are some of the prominent buyers

How are government securities issued?

  • RBI conducts auctions for government securities on an electronic platform called NDS- Auction platform.
  • Entities like commercial banks, scheduled urban development banks, primary dealers (list available in RBI website), insurance companies and provident funds are some of the As common sense indicates, they maintain funds account and securities account with RBI. Those who maintain Gilt accounts with commercial banks can also purchase through them.
  • RBI in consultation with the Government of India issues half-yearly auction calendar with full details of exact particulars of the securities, viz., name, amount, type of issue and procedure of auction. This information is available through RBI website. Advertisements in English/Hindi are issued through newspapers after issue.

What are the different types of auctions used for issue of securities?

Yield Based Auction: A yield-based auction is generally conducted when a new Government security is issued. Investors bid in yield terms up to two decimal places (for example, 8.19 per cent, 8.20 per cent, etc.). Bids are arranged in ascending order and the cut-off yield is arrived at the yield corresponding to the notified amount of the auction.

  • The cut-off yield is taken as the coupon rate for the security. Successful bidders are those who have bid at or below the cut-off yield. Bids which are higher than the cut-off yield are
  • An illustrative example of the yield-based auction is given below:
  • Yield-based auction of a new security, we may say. The other details are:
  • Maturity date: September 8, 2018

Coupon: It is determined in the auction (8.22% was received in the illustration given by RBI. One can refer RBI website for information.)

Auction date: September 5, 2018: Auction settlement date: September 8, 2018 (6 and 7th September 2018 are holidays): Notified Amount: Re. 100 Crores (Please do not get surprised. Big entities will participate in this auction)

Price Based Auction: A price- based auction is conducted when Government of India re-issues securities issued earlier. Bidders quote in terms of price per Rs. 100 of face value of the security (e.g., Rs. 102.00, Rs. 101.00, Rs. 100.00, Rs. 99.00, etc., per Rs. 100/-). Bids are arranged in descending order and the successful bidders are those who have bid at or above the cut-off price. Bids which are below the cut-off price are rejected. An illustrative example of price- based auction is given below:

Price based auction of an existing security 8.24% GS 2018

  • Maturity Date: April 22, 2018
  • Coupon: 8.24%
  • Auction date: September 5, 2008
  • Auction settlement date: September 8, 2008*
  • Notified Amount: Rs. 1000 crore

* September 6 and 7 being holidays, settlement is done on September 8, 2008 under T+1 cycle.

(For authenticity purposes, exact examples are quoted from RBI web site. Superbly explained, these examples are a pleasure to read and understand)

Both competitive bidding and non- competitive bidding processes do exist. For obvious reasons, competitive process may not interest an avid reader like yourself but details of non- competitive bidding process are given below.

Non-Competitive Bidding: With a view to providing retail investors, who may lack skill and knowledge to participate in the auction directly, an opportunity to participate in the auction process, the scheme of non-competitive bidding in dated securities was introduced in January 2002. Non-competitive bidding is open to individuals, HUFs, RRBs, co-operative banks, firms, companies, corporate bodies, institutions, provident funds, and trusts. Under the scheme, eligible investors apply for a certain amount of securities in an auction without mentioning a specific price / yield. Such bidders are allotted securities at the weighted average price / yield of the auction.

What are the Open Market Operations (OMOs)?

OMOs are the market operations conducted by the Reserve Bank of India by way of sale/ purchase of Government securities to/ from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis. When the RBI feels there is excess liquidity in the market, it resorts to sale of securities thereby sucking out the rupee liquidity. Similarly, when the liquidity conditions are tight, the RBI will buy securities from the market, thereby releasing liquidity into the market.

One needs to understand OMOs since these operations are quite often quoted by experts to explain expansion or contraction of money in the system.

How and in what form can Government Securities be held?

The Public Debt Office (PDO) of the Reserve Bank of India, Mumbai acts as the registry and central depository for the Government securities. Government securities may be held by investors either as physical stock or in dematerialized form. From May 20, 2002, it is mandatory for all the RBI regulated entities to hold and transact in Government securities only in dematerialized (SGL).

This information is no brainer since we, as individual investors use only Dematerialized form only for our transactions.

How does the trading in Government securities take place?

There is an active secondary market in Government securities. The securities can be bought / sold in the secondary market either (i) Over the Counter (OTC) or (ii) through the Negotiated Dealing System (NDS) or (iii) the Negotiated Dealing System-Order Matching (NDS-OM).

Facilities are also available for trading in Government securities on stock exchanges (NSE, BSE) which cater to the needs of retail investors.

Who are the major players in the Government Securities market?

Major players in the Government securities market include commercial banks and primary dealers besides institutional investors like insurance companies. These institutions are obligated by legal requirements to keep some of their investments in government securities market.

Primary Dealers play an important role as market makers in Government securities’ market. Other participants include co-operative banks, regional rural banks, mutual funds, provident and pension funds.

Foreign Institutional Investors (FIIs) are allowed to participate in the Government securities market within the quantitative limits prescribed from time to time. Corporates also buy/ sell the government securities to manage their overall portfolio risk. Recent changes in budget 2018 are expected to bring more investors from abroad to invest here. Also, bonds market may expand, as per market reports or government’s expectations.

How are the dealing transactions recorded by the dealing desk?

For any transaction initiated, deal slip with details of nature of deal, name of counter-party, direct deal or through the use of a broker, details of security, amount, price, and details of contract date and settlement date is to be maintained. For obvious reasons, the present computerized system takes care of these requirements.

For internal control purposes and to avoid frauds, use of back office to verify serial numbering of deal slips, and other details to confirm successful completion of the deal is an expected step. Once the deal is concluded, the deal slip should be immediately passed on to the back office (it should be separate and distinct from the front office) for recording and processing. Timely receipt of confirmation from a counter-party would also be monitored by the back office.

The need for counter party confirmation of deals matched on NDS-OM will not arise, as NDS-OM is an anonymous automated order matching system. However, in case of trades finalized in the OTC market and reported on NDS, confirmations have to be submitted by the counter parties in the system i.e., NDS.

Having been a back-office manager in a leading bank, I do appreciate that back office plays an equally effective role in ensuring smooth functioning of these operations.

What are the important considerations while undertaking security transactions?

Institutional buyers may be aware of the nature of the securities to be purchased and for what reasons. Mostly, it may be to meet statutory requirements. For shorter duration securities in the range of 5-10 years, it may be advisable to buy securities which are liquid, those who trade in large volumes and details of these securities are available in the following web site:

CCIL (http://www.ccilindia.com/OMMWCG.aspx).

In terms of transparency and easy availability, NDS-OM is the safest place since it is alive and an anonymous platform where trades are disseminated as they are struck and also counter parties to any trade is not revealed. Use of a bank or authorized trader with NSE or BSE is also advisable. But frequent frauds taking place around the country have already raised alarming bells in the market.

How to ensure correct pricing – Since investors like UCBs have very small requirements, they may get a quote/price, which is worse than the price for standard market lots. To be sure of prices, only liquid securities may be chosen for purchase. A safer and simpler way to buy is under the primary auctions conducted by RBI through the non-competitive route. Since there are bond auctions about twice every month, purchases can be considered to coincide with the auctions.

Why does the price of Government security change?

I would like quote the following reasons for the change in price:

  • Simple, demand and supply of security. Sudden change in RBI directives to banks or other corporates on higher holding of securities may influence higher purchases.
  • Changes in interest rates, expected level of inflation, hotly contested during the budget talks, liquidity in the market and also mostly, developments in international bond markets with special emphasis on U S Treasuries do matter.
  • As I have already drawn the attention of readers through the speeches of important senior officers of RBI, hints of cash reserve ratio, and open market operations also play an effective role in deciding the price. Computerized age has totally transformed the situation and extra caution needs to be taken to increase the profits.

How does one get information about the price of a Government security?

The return on a security is a combination of two elements (i) coupon income – that is, interest earned on the security and (ii) the gain / loss on the security due to price changes and reinvestment gains or losses.

  • Information on traded prices of securities is available on the RBI website http://www.rbi.org.inunder the path Home → Financial Markets Watch → Government securities market → This will show a table containing the details of the latest trades undertaken in the market along with the prices.
  • Additionally, trade information can also be seen on CCIL website
  • http://www.ccilindia.com/OMHome.aspx.

How are the Government securities transactions reported?

Transactions undertaken between market participants in the OTC/telephone market are expected to be reported on the NDS platform within 15 minutes after the deal is put through over telephone.

All OTC trades are required to be mandatorily reported on the secondary market module of the NDS for settlement. NDS-OM helps participants to place order on the system and the order could be a bid for offer of sale or purchase of securities.

NDS-OM system has separate screen for Central government, state government and treasury bill trading. Moreover, there is also a screen for odd lots or smaller lots of Re. 5 Cr or less.

How is the yield of a bond calculated?

An investor who purchases a bond can expect to receive a return from one or more of the following sources:

  • The coupon interest payments made by the issuer;
  • Any capital gain (or capital loss) when the bond is sold; and
  • Income from reinvestment of the interest payments that is interest-on-interest.

My observations

Interest payments are treated current income and capital gain or capital loss are treated differently. Proper treatment of income is important in tax return since the details are also submitted to tax authorities.

The three yield measures commonly used by investors to measure the potential return from investing in a bond are coupon yield, current yield and yield to maturity. Ample examples have been in RBI website explaining the calculation of the yield measures.

What are the day count conventions used in calculating bond yields?

Day count convention refers to the method used for arriving at the holding period (number of days) of a bond to calculate the accrued interest. This is uniformly required so that every one of the bond owner is served the same treatment of calculation of bond interest. After all, as a bond holder, I am worried about the same for my income/investment purposes.

For example, the conventions followed in Indian market are given as under:

Bond market: The day count convention followed is 30/360, which means that irrespective of the actual number of days in a month, the number of days in a month is taken as 30 and the number of days in a year is taken as 360 though our common sense calls a year as 365 days.

Money market: The day count convention followed is actual/365 which means that the actual number of days in a month is taken for number of days(numerator) whereas the number of days in a year is taken as 365 days. Hence, in the case of Treasury bills, which are essentially money market instruments, money market convention is followed. Since mostly institutions hold treasure bills, this information is important.

Nowadays, computers are extensively used from reference stage till sale of securities and hence, even the calculation of interest is invariably done by computers. It is highly unlikely any default occurs at any stage.

Conclusion

The main purpose of this article is to create interest in government securities with information such as nature of government securities, the ways of issuing them, various types of auctions related to these securities, and other relevant information which may be of interest to a reader. This will motivate the general public to invest in government securities which rank among the safest instruments of investment. Even the Finance Minister in his recent budget for the year 2017-2018 expressed his desire for more use of government bonds by the investors in India. Compared to US Bond market, we are at infant stage though our systems and procedure of their management is on a par with the best in the world.

Reference

RBI Website

https://www.rbi.org.in/scripts/FAQView.aspx?Id=79#26

It also contains the list of banks primary dealers and other standalone primary dealers. Investing public can contact them for guidance and purchase of securities.

About the author : Subramanian Natarajan C.P.A. (USA), M.Sc., CAIIB took voluntary retirement in 2000 from Punjab National Bank after handling various facets of banking like deposit mobilization, foreign exchange, auditing and borrower accounts. After living in USA for 12 years during which period he worked in international auditing firms specializing in international tax, auditing, IFRS etc. He can be reached at subcpa@gmail.com. Tel: 7503562701, 9015613229. He currently lives in Delhi. His name appears as tax consultant in web site of American embassy, New Delhi.

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