Bonds

Bonds refer to debt instruments bearing interest on maturity.
In simple terms, organizations may borrow funds by issuing debt securities named bonds, having a fixed maturity period (more than one year) and pay a specified rate of interest (coupon rate) on the principal amount to the holders.
Bonds have a maturity period of more than one year which differentiates it from other debt securities like commercial papers, treasury bills and other money market instruments.

More technically, bonds are negotiable certificates that represent the indebtedness of the issuer to the holder. The negotiable element refers to the fact that the ownership of a bond can be transferred from one party to another in the secondary market.
Terminology
Types of Bonds
Investing in Bonds
Many people invest in bonds with an objective of earning certain amount of interest on their deposits and/or to save tax. Bonds are considered to be a less risky investment option and are generally preferred by risk-averse investors. Though investors should not get overtly confident of investing in bonds as bond prices are also subject to market risk. For example, bond prices have a negative correlation with interest rates due to which any increase in interest rates can lead to a fall in bond prices and vice-versa. Thus, it is recommended that investors should consider the risk-return factor (i.e. the expected return for the given level of risk) before investing.

Investments Eligible for Deductions

1. Holders of certain bonds are eligible to claim deduction from their taxable income. A list of such deposits is mentioned hereunder:
2. Interest on Government Securities, National Savings Certificate (issues VI, VII and VIII), Development Bonds, Development Bonds and 7 year National Rural Development Bonds
3. Interest on Post Office Term Deposits, Recurring Deposits Accounts and National Savings Schemes (as referred to in National Savings Scheme Rules, 1992)
4. Dividends received from a co-operative society
5. Income from investments in UTI (up to assessment year 1999-2000)
6. Interest on deposits with a banking company or a co-operative bank
7. Interest on deposits with a co-operative society made by a member of the society
8. Interest on deposits with housing boards
9. Interest from deposits made under A.E. (C, D.) Act & C.D.S. (I.T.P.) Act.
10. Interest on notified debentures of any co-operative society, any institution or any public sector company.
11. Interest on deposits with a financial corporation which is engaged in providing long-term finance for industrial development in India and which is eligible for deduction under Section 36(l)(viii) [up to assessment year 1999-2000, the corporation is approved by Central Government].
12. Interest on deposits with a public company formed and registered in India with the main object of carrying on the business of providing long-term finance for construction or purchase of houses in India for residential purposes and which is eligible for deduction under Section 36(l)(viii) [up to assessment year 1999-2000, the company is approved by the Central Government under Section 36(l)(viii)].
13. Interest on deposits with Industrial Development Bank of India.
14. Interest on deposits under National Deposit Scheme. Income in respect of units of mutual fund specified under Section 10(23D) [up to assess. year 1999-00].
15. Interest on deposits under Post Office (Monthly Income Account) Rules.

Abbreviations
YTM - Yield to maturity
NPV - Net present value
SPV - special purpose vehicle
FRN - Floating Rate Notes

Participants in the money markets

The major players in the money market are:

• banks
• corporates
• brokers
• central authorities 

Banks

Banks and other financial intermediaries provide the means by which funds are transferred from one entity to another.

Banks are involved in the money market through their dealing rooms. These rooms are staffed by dealers who trade in the various money market instruments by quoting prices to each other, to investors, and to corporations. However, prices are usually quoted to other banks through money brokers.
Banks deal with
1. Corporates
2. Other banks
3. Investors

Bank limits
Transactions in the money markets between banks and financial intermediaries are usually carried out through interbank market, without backing of any specific security. This is known as full faith and credit. Trust and confidence are vital in these transactions.
Banks have some limits according to which it borrow, lend, buy or sell. These limits are determined by :

• balance sheet 
• solvency
• liquidity
• profitability
• sovereign risk 

Balance sheet are v.important for insuring security and credit of any corporation but especially banks when they deal with Central banks.
Solvency - Solvency measures the amount of borrowed capital used by the business relative the amount of owner’s equity capital invested in the business. In other words, solvency measures provide an indication of the business’ ability to repay all indebtedness if all of the assets were sold. Solvency measures also provide an indication of the business’ ability to withstand risks by providing information about the farm’s ability to continue operating after a major financial adversity.
A firm with insufficient assets to meet liabilities is termed insolvent.

Liquidity measures the ability of the farm business to meet financial obligations as they come due, without disrupting the normal, ongoing operations of the business. Liquidity can be analyzed both structurally and operationally. Structural liquidity refers to the balance sheet (assets and liabilities) and operational liquidity refers to cash flow measures.

Two recommended measures of liquidity are the current ratio and working capital. The current ratio measures the relationship between total current farm assets and total current farm liabilities and is a relative measure rather than an absolute dollar measure. The higher the ratio, the more liquid the farm is considered to be.
Working capital is a measure of the amount of funds available to purchase inputs and inventory items after the sale of current farm assets and payment of all current farm liabilities. Working capital is expressed in absolute dollars; therefore, determining adequate working capital is related to the size of the farm operation.

Solvency vs liquidity 
Unlike liquidity, solvency is concerned with long-term as well as short-term assets and liabilities. Solvency measures evaluate what would happen if all assets were sold and converted into cash and all liabilities were paid. The most straightforward measure of solvency is owner equity, using the market value of assets and including deferred taxes in the liabilities. As with working capital, adequacy of equity depends on business size, making comparisons difficult without using ratios.
Three widely used financial ratios to measure solvency are the debt-to-asset ratio, the equity-to-asset ratio and the debt-to-equity ratio. These three solvency ratios provide equivalent information, so the best choice is strictly a matter of personal preference.
The debt-to-asset ratio expresses total farm liabilities as a proportion of total farm assets. The higher the ratio, the greater the risk exposure of the farm.
The equity-to-asset ratio expresses the proportion of total assets financed by the owner’s equity.
The debt-to-equity ratio reflects the capital structure of the farm and the extent to which farm debt capital is being combined with farm equity capital. It is a measure of the degree to which a farmer is leveraging his equity.

 Profitability measures the extent to which a business generates a profit from the factors of production: labor, management and capital. Profitability analysis focuses on the relationship between revenues and expenses and on the level of profits relative to the size of investment in the business. See more on profitability.

Sovereign risk Some firms carry risks beyond their intrinsic credit risk, due to where they are based. If the firm lies in an unstable political and economic environment, this can affect its ability to meet liabilities.

Bank & Market Rates

Banks 'take a view' on the market. This is the bank's perception of market rate movements, taking current and possible future circumstances into account. The bank's dealers then act according to this view. Banks also need to balance their books and may find themselves with a deficit or surplus like any other corporation. They then need to manage these exposures in the money markets.

Banks' borrowing and lending practices follow a pattern. In a normal interest rate environment, banks usually borrow short and lend long. This means that they try to borrow whatever money they require over a short time span and lend it over a longer time period. In this way, they are often able to gain maximum advantage from existing market conditions by borrowing at lower interest rates than those at which they lend.


Corporates

Corporations (commercials) are involved in the money market, usually through their banks, either to lend or borrow money. As we have said, corporations may find that they have a temporary shortfall and the money market not only provides a way to cover this, but also an opportunity to profit from a surplus.

The money market also provides corporations with access to funds when required. When a corporation wants to borrow or lend money to banks, the corporation – usually through the corporate treasury or finance department – contacts dealers in various banks and strikes the best deal available.


Corporate Dealings with Banks

A corporation will deal with a bank's dealing room, lending department or corporate relations department, depending on the size of the firm and the size of the transactions. Remember, money market dealers work in a wholesale market.

There is also an increasing use of bank to customer dealing systems to automate customer transactions, thereby making the process more efficient and freeing up the time of the dealer.

Borrowing from banks is not the only way corporations may raise money to clear a deficit in the short-term. They can take advantage of various money market instruments, such as commercial paper. The means by which corporations borrow, varies from country to country.

Brokers 
Brokering functions
Most brokering functions occur when buying , selling, lending, borrowing of funds occur between 2 parties.
Central Banks

The central authority is a government created agency. In most countries, the central authority is known as the central bank.

Notable exceptions to the use of the title of central bank are:
UK - the Bank of England
US - the Federal Reserve (the 'Fed')
India - Reserve Bank of India ( RBI )


The primary objective of the central authority is to help create stable financial conditions in the country. To achieve this, the central authority is a participant on the domestic money market where its major impact is felt by commercial banks. It may also participate in the international money market. In the case of member states of the euro area, this responsibility is assigned to the European Central Bank (ECB).

Typical  Central bank 
Central bank is responsible for the monetary policy of the country. Its primary responsibility it is the stability of the currency and money supply. It has following funtions:
1. Supervision of the banking system

2. Advising the government on monetary policy

3. Issue of banknotes

4. Acting as banker to other banks

5. Acting as banker to government

6. Raising money for the government

7. Controlling the nation’s currency reserves

8. Acting as “ lender of last resort”

9. Liaising with international bodies

Central bank Activity 
Central Banks & the Exchange Rate

The central authority can also influence the exchange rate of the domestic currency on the FX market by intervening openly in the buying and selling of that currency. The central authority will seek to have the real value of its currency reflected accurately in the FX market. If it thinks this is not the case, it will intervene in the market if it feels this intervention will be effective in achieving the desired result.

This can be achieved by intervening directly in the FX markets or by adjusting the domestic interest rate to make investing in the currency look more or less attractive.

Instruments in the money markets

Money market instruments are generally characterized by a high degree of safety of principal and are most commonly issued in units of $1 million or more. Maturities range from one day to one year; the most common are three months or less. Active secondary markets for most of the instruments allow them to be sold prior to maturity. Unlike organized securities or commodities exchanges, the money market has no specific
location. Available from financial institutions, money markets give the smaller investor the opportunity to get in on treasury securities. The institution buys a variety of treasury securities with the money you invest. The rate of return changes daily, and services such as check writing may be offered.

The range of products enables user to spread their exposures before differing:

• maturity
• currencies
• credit risks
• structures

The major participants in the money market are commercial banks, governments, corporations, government-sponsored enterprises, money market mutual funds; futures market exchanges, brokers and dealers. Some of the money market instruments are:

a. Treasury Bills(T-bills)
Treasury bills (T-bills) are short-term notes with maturity period less than 1 year. In US, they come in three different lengths to maturity:90, 180, and 360 days. The two shorter types are auctioned on a weekly basis, while the annual types are auctioned monthly. T-bills can be purchased directly through the auctions or indirectly through the secondary market. Purchasers of T-bills at auction can enter a competitive bid (although this method entails a risk that the bills may not be made available at the bid price) or a noncompetitive bid. T-bills for noncompetitive bids are supplied at the average price of all successful competitive bids.


These are issued by the Reserve Bank usually a period of 91 days. The Reserve Bank uses these bills to take money out of the market. This will reduce a banks ability to lend to its clients leading to a contraction of the money supply. The bill consists of an obligation to pay the bearer the face value of the bill upon a given date. A bank buying such a bill will not pay face value for it but would instead buy it at a discount. The bill is tradable so
the purchaser does not have to hold it until the due date. If interest rates decrease during the term of the bill, the holder can sell the bill at a profit before the due date.

b. Bankers Acceptance(BA)
"A banker's acceptance begins life as a written demand for the bank to pay a given sum at a future date," Brealey and Myers noted. "The bank then agrees to this demand by writing 'accepted' on it. Once accepted, the draft becomes the bank's IOU and is a negotiable security. This security can then be bought or sold at a discount slightly greater than the discount on Treasury bills of the same maturity." Bankers' acceptances are generally used to finance foreign trade, although they also arise when companies purchase goods on credit or need to finance inventory. The maturity of acceptances ranges from one to six months.

Although BA’s, as they are known, have their origin in trade bills issued by merchants, today they are an important money market instrument. A banker’s acceptance is simply a bill of exchange drawn by a person and accepted by a bank. The person drawing the bill must have a good credit rating otherwise the
BA will not be tradable. The drawer promises to make payment of the face value upon a given future date. The most common term for these instruments is 90 days. They can very from 30 days to180 days. The BA has the advantage of locking the borrower in to a fixed rate over the term of the bill. This can be important if a rise in short-term rates is expected.

c. CERTIFICATES OF DEPOSIT. Certificates of deposit (CDs) are certificates issued by a federally chartered bank against deposited funds that earn a specified return for a definite period of time. They are one of several types of interest-bearing "time deposits" offered by banks. An individual or company lends the bank a certain amount of money for a fixed period of time, and in exchange the bank agrees to repay the money with specified interest at the end of the time period. The certificate constitutes the bank's agreement to repay the loan. The maturity rates on CDs range from 30 days to six months or longer, and the amount of the face value can vary greatly as well. There is usually a penalty for early withdrawal of funds, but some types of CDs can be sold to another investor if the original purchaser needs access to the money before the maturity date.

Large denomination (jumbo) CDs of $100,000 or more are generally negotiable and pay higher interest than smaller denominations. However, such certificates are insured by the FDIC only up to $100,000. There are also eurodollar CDs, which are negotiable certificates issued against U.S. dollar obligations in a foreign branch of a domestic bank. Brokerage firms have a nationwide pool of bank CDs and receive a fee for selling them. Since brokers deal in large sums, brokered CDs generally pay higher interest rates and offer greater liquidity than CDs purchased directly from a bank.

 d. Negotiable Certificates of Deposit (NCD)
NCD’s are like fixed deposits except they are bearer documents. They offer a market related rate of interest and are completely liquid because they can be negotiated during the term of the deposit. Most NCD’s have a term of less than one year. They usually offer a rate of return slightly higher than banker’s acceptances which makes them extremely popular instruments.

e. Deposits

• Call deposits - are transactions that the depositor has the right to call at any time, depending on the notice period agreed at the time the deal was transacted(normally 1 - 7 days)

• Fixed deposit ( term or time deposit ) Under this scheme money is deposited for a fixed period of time so it is also called Fixed Deposit. Investor can withdraw the money only after the time period. Premature withdrawals are also allowed by paying a penalty. Interest is calculated on monthly, quarterly or yearly depends on the bank and scheme. Many banks offers loan or overdraft facility as an added features with fixed deposits. Term deposits is a safe investment and it is therefore a very good option for conservative, low-risk investors.
• Overnight lending - are usually midday to midday, where an averaged overnight rate of interest is used. The rate in euro area is called Eonia(Euro overnight indexed average rate). It represents the effective overnight reference rate for euro and is calculated by the weighted of all overnight unsecured euro lending transactions undertaken in the internet bank. In the US, federal fund rate is the interest rate at which the banks lend to each other  on overnight basis.

f. REPURCHASE AGREEMENTS (Repo or buyback) and Reverse Repo

These also known as repos or buybacks—are Treasury securities that are purchased from a dealer with the agreement that they will be sold back at a future date for a higher price. These agreements are the most liquid of all money market investments, ranging from 24 hours to several months. In fact, they are very similar to bank deposit accounts, and many corporations arrange for their banks to transfer excess cash to such funds automatically. 

A repo agreement is the sale of a security with a commitment to repurchase the same security as a specified price and on specified date while a reverse repo is purchase of security with a commitment to sell at predetermined price and date. A repo transaction for party would mean reverse repo for the second party. In liew of the loan, the borrower pays a contracted rate to the lender, which is called the repo rate. As against the call money market where the lending is totally unsecured, the lending in the repo is backed by a simultaneous transfer of securities. The main players in this market are all institutional players like banks, primary dealers like PNB Gilts Limited, financial institutions, mutual funds, insurance companies etc. allowed to operate a SGL with the Reserve Bank of India.
Further RBI also operates daily repo/ reverse repo auctions to provide a benchmark rates in the markets as well as managing in the liquidity in the system. RBI sucks or injects liquidity in the banking system by daily repo/ reverse operations.

g. Tax-Exempt Bonds
Often referred to as municipal bonds, tax-exempt bonds represent state and local government debt. A City, town, or a village and also states, territories, and housing authorities, port authorities, and local government agencies may issue these bonds. Interest earned is exempt from income taxes and from state and local income taxes if bonds issued are from your state or city. Interest rates are determined by the general level of
interest rates and by the credit rating of the issuer. The seller of these bonds has tables showing you what the taxexempt yields of these bonds are equivalent to in taxable yield for your tax bracket. As little as $1,000 may be invested in these bonds, available from a broker or a financial institution.
Type 3 investments include corporate bonds and corporate stocks. Higher investment risk and lower purchasing power risk are represented by these investment alternatives.



i. COMMERCIAL PAPER(CP).
Commercial paper refers to unsecured short-term promissory notes issued by financial and nonfinancial corporations. Commercial paper has maturities of up to 270 days (the maximum allowed without SEC registration requirement). Dollar volume for commercial paper exceeds the amount of any money market instrument other than T-bills. It is typically issued by large, credit-worthy corporations with unused lines of bank credit and therefore carries low default risk.

Standard and Poor's and Moody's provide ratings regarding the quality of commercial paper. The highest ratings are A1 and P1, respectively. A2 and P2 paper is considered high quality, but usually indicates that the issuing corporation is smaller or more debt burdened than A1 and P1 companies. Issuers earning the lowest ratings find few willing investors.

Unlike some other types of money-market instruments, in which banks act as intermediaries between buyers and sellers, commercial paper is issued directly by well-established companies, as well as by financial institutions. "By cutting out the intermediary, major companies are able to borrow at rates that may be 1 to 1 ½ percent below the prime rate charged by banks," according to Brealey and Myers. Banks may act as agents in the transaction, but they assume no principal position and are in no way obligated with respect to repayment of the commercial paper. Companies may also sell commercial paper through dealers who charge a fee and arrange for the transfer of the funds from the lender to the borrower.

Importance of Money

Trading involves the exchange of goods and services for payment by money. Those wanting to purchase goods/services require money, while those selling expect to receive money.

The business world has developed to the stage where money is not only a medium of exchange, but it is also a commodity. Therefore, money itself is bought and sold.

The evolution and development of the money markets is closely linked to the business world’s requirement of this scarce commodity – money.

Money supply and Demand

Money may be in surplus -- due to large financial profits, completion of lucrative contact, unexpectedly high return on some investment.
Money may be in deficit -- heavy financial loss, insufficient yield in short-term from long term project, buying abroad and falling to cover adverse currency fluctuation.

Transactions
Transactions may be 
1. Lending 
2. Borrowing
3. Selling
4. Buying 

Money markets

Definition of the Money Market
The money market is the market where the buying, selling, lending, and borrowing of short-term funds occur.

It is not a physical market; instead, all participants are linked by a sophisticated network of telephones and computers.

The short-term nature of the money market is its major distinguishing feature. Transactions in the money market are for one year or less. This contrasts with the capital market where transactions are long-term in nature, that is, greater than one year.
 
Main Players : 
Mainly it is  
1. International Money markets where transaction involves currency other than domestic currency.
2. Interbank markets, where transactions are actually carried out between banks.

In case of India, it is Reserve bank of India (RBI), Discount and Finance House of India (DFHI), mutual funds, banks, corporate investor, non-banking finance companies (NBFCs), state governments, provident funds, Primary dealers. Securities Trading Corporation of India (STCI), public sector undertaking (PSUs), non-resident Indians and overseas corporate bodies. 

Characteristics of Money markets 
Money markets are 
1. global - It doesnt have central trading floor. Instead they form global OTC market, connected by sophisticated networks and telephone lines, that operate on 24 hour basis.
2. Wholesale - These transactions have corporations, banks, brokers, dealers and central authorities.
3. Short term - It has short maturity and hence its instruments are called cash instruments.

Functions of the Money Market: 

A money market is generally expected to perform three broad functions:

1. Provide a balancing mechanism to even out the demand for and supply of short term funds
2. Provide a focal point for central bank intervention for influencing liquidity and general level of interest rates in the economy.
3. Provide reasonable access to suppliers and users of short term funds to fulfill their borrowings and investment requirements at an efficient market clearing price.

Besides the above functions, a well functioning money market facilitates the development of a market for longer term securities. The interest rates for extremely short term use of money serve as a benchmark for longer term financial instruments.
 
Benefits of an Efficient Money Market:  

An efficient money market benefits a number of players. It provides a stable source of funds to banks in addition to deposits allowing alternative financing structures and competition. It allows banks to manage risks arising from interest rate fluctuations and to manage the maturity structure of their assets and liabilities.

A developed inter-bank market provides the basis for growth and liquidity in the money including the secondary market for commercial paper and treasury bills.

An efficient money market encourages the development of non-bank intermediaries thus increasing the competition for funds. Savers get a wide array of savings instruments to choose from and invest their savings.

A liquid money market provides an effective source of long term finance to borrowers. Large borrowers can lower the cost of raising funds and manage short term funding or surplus efficiently.

A liquid and vibrant money market is necessary for the development of a capital market, foreign exchange market, and market in derivative instruments. The money market supports the long term debt market by increasing the liquidity of securities. The existence of an efficient money market is a precondition for the development of a government securities market and a forward foreign exchange market.

Trading in forwards, swaps, and futures is also supported by a liquid money market as the certainty of prompt cash settlement is essential for such transactions. The government can achieve better pricing on its debt as it provides access to a wide range of buyers. It facilitates the government market borrowing.

Monetary control through indirect methods (repos and open market operations) is more effective if the money market is liquid. In such a market response to the central bank’s policy actions are both faster and less subject to distortion.
 
The Indian Money Market: 
The average turnover of the money market in India is over Rs 40,000 crore daily. This is more than 3 per cent of the total money supply in the Indian economy and 6 percent of the total funds that commercial banks have let out to the system. This implies that 2 per cent of the annual GDP of India gets traded in the money market in just one day. Even though the money market is many times larger than the capital market, it is not even a fraction of the daily trading in developed markets.