Corporate Bond

Summer Internship Report Exploring opportunities in Resource Mobilization from

Domestic Markets by the means of Convertible Bonds for PFCLSubmitted by:

Preeti gupta(200709 Batch)POWER FINANCE CORPORATION LTD.,

URJANIDHI, 1, Barakhamba Lane, Cannaught Place, NEW DELHI 110001

Under the guidance of

Mr. Milind M. Dafade

Manager (Finance)

Power Finance Corporation Ltd.

Jagan Institute Of Management StudiesNew Delhi

Table of ContentsSummer Project Certificate......4Acknowledgement..5Executive Summary...61) Indian Power Sector: ....7

1.1 Introduction..7

1.2 Privatization...13

1.3 Highlights of Performance....14

1.4 Demand side Management: Recommendations..16

1.5 Supply side Management: Recommendations172) Power Finance Corporation: Overview.183) Resource Mobilization Unit29

3.1 Rupee Resources (Domestic).29

3.2 Foreign Currency Resources (International)..30

3.3 The 3 Main Decisions Taken by RMU.....31

3.4 Instruments Used By PFC to Raise Funds in Domestic Market...........344) Indian Debt Market.37

5.1 Overview.37

5.2 Market Micro Structure....41

5) Capital Market: Fixed Income Market.............46

4.1 Introduction....46

4.2 Classification of Bond Market......47

4.3 Bonds Market Instruments...49

4.4 Factors Influencing Bond Market....51

6) Corporate Bond.......52

6.1 Convertibles and Exchangeables..52

6.2 Adjustment Events.....56

6.3 Why Invest in Convertible Bonds: Investors perspective.607) Some General Underlying Legal Issues in Convertible...61

7.1 SEBI Guidelines.....62

7.2 Guidelines for Preferential Issues.................................67

7.3 Guidelines for the OCTEI Issues..69

7.4 Guideline for Bonus Issues70

7.5 Some SEBI Circulars for Amendment of Guidelines.727.6 Private Placement of Securities79

7.7 The Indian Stamp Act...828) General Procedure Followed While Issuing Convertible Debenture.....849) Methodology.88

9.1 Essentials in case PFC goes for convertible debentures issue....88

9.2 Assumptions.......89

9.3 Analysis...909.4 Recommendations .9210) References...93Summer Project CertificateAcknowledgementThis project would have been difficult to complete without the invaluable contributions from some important persons. Let us take this opportunity to thank them.

First of all, we would like to thank Power Finance Corporation Ltd for giving us such challenging projects to work upon. We hope this challenge has brought the best out of us.

We are indebted to our project guide Mr. Milind M. Dafade, Sr. Manager (Finance), Resource Mobilization Unit, for the direction and purpose he gave to this project through his invaluable insights, which constantly inspired us to think beyond the obvious. His encouragement and co-operation helped us instill a great degree of self-confidence to deliver a good work. We are also thankful to Mrs. Parminder Chopra (DGM) and Ms. Tabassum for taking constructive interest in our project and providing us valuable support at many points of time.

We are also thankful to all the employees of Power Finance Corporation who provided us with an environment conducive for learning during the last two months.

We hope we can build upon the experience and knowledge that we have gained here and make a valuable contribution towards this industry in the coming future.Preeti GuptaExecutive SummaryAs Indian economy has been growing at a rapid and impressive pace averaging over 8.5% and Electricity is one of the most vital infrastructure inputs for economic development of a country; the country needs a commensurate growth in the Power Sector also. So, even Power Finance Corporation (PFC) has to live up to its impeccable image of being a leading Power Sector Financial Institution in the country. PFC is committed to act as a catalyst for reforming Indias Power Sector to mobilize various types of resources at competitive rates and further lend the funds to enable availability of required quality power at minimum cost to consumers. Herein lays the justification of the project undertaken.

Our project attempts at analyzing various present and prospective sources of finance that can be used by PFC to maximize rate of return through efficient borrowing & lending and introduction of innovative financial instruments for the power sector. With the blurring of geographical boundaries after globalization, taking advantage of the global markets for mobilizing resources at a cheaper rate has become a necessity to sustain and grow. Hence, exploring the possibilities of mobilizing resources through innovative routes becomes a natural extension for any Power Financing Corporation.

The following project aims at working out the possibility of issuing Convertible Bonds and MIBOR-linked Bonds in the Domestic market as a means of resource mobilization. As PFC is a Public Sector Undertaking, issuing Convertible Bonds will although lead to dilution of Governments stake in the undertaking but it can turn out to be a good a source of finance bringing in hordes of funds, the benefits of both Debt & Equity and at the same time can help in containing the Debt-Equity Ratio of the corporation within the financial covenants specified by the corporations lenders. At the same time, resorting to another option of issuing MIBOR-linked Bonds can further expand the horizon of sources of finance for the corporation. It can help the corporation in enjoying the advantage of market-linked interest rates and avoiding a fixed rate of interest which has to be paid irrespective of the market conditions prevailing in the economy.

Our project has thrown open two new ways of mobilizing funds in the Domestic market which if implemented can definitely reduce the cost of borrowings for the corporation and can facilitate in achievement of the Corporations long term goal of catapulting the sustainable development of Indian Power Sector.

Indian Power Sector

Introduction to the Power Sector in India

Electricity is one of the most vital infrastructure inputs for economic development of a country. The demand of electricity in India is enormous and is growing steadily. The vast Indian electricity market, today offers one of the highest growth opportunities for private developers.

Since independence, the Indian electricity sector has grown many folds in size and capacity. The generating capacity has increased from a meager 1362 MW in 1947 to more than 91000 MW by 2003, a gain of more than 60 times in capacity addition. India's per capita energy consumption is projected to grow from 6.2 million Btu in 1980 to 18.2 million Btu in 2010 -- a rise of almost 300 percent. Although, India's energy consumption per unit of output is still rising, but it is expected to level off and to decline in the future. India consumes two-thirds more energy per dollar of gross domestic product (GDP) as the world average. India consumes only about 18 percent of the energy per person as the world average. Nearly 64.4 per cent of India's electricity is produced in thermal facilities using coal or petroleum products. 25 per cent electricity is generated by hydroelectric facilities.In its quest for increasing availability of electricity, the country has adopted a blend of thermal, hydro and nuclear sources. Out of these, coal based thermal power plants and in some regions, hydro power plants have been the mainstay of electricity generation. Of late, emphasis is also being laid on non-conventional energy sources i.e. solar, wind and tidal.

India is one of the main manufacturers and users of energy. Globally, India is presently positioned as the eleventh largest manufacturer of energy, representing roughly 2.4% of the overall energy output per annum. It is also the worlds sixth largest energy user, comprising about 3.3% of the overall global energy expenditure per year. In spite of its extensive yearly energy output, Indian Power Sector is a regular importer of energy, because of the huge disparity between oil production and utilization.

Indias power market is growing faster than most of the other countries. With an installed generation capacity of 141.5 GW, generation of more than 600 billion kWh, and a transmission & distribution network of more than 6.3 million circuit Kms, India has today emerged as the fifth largest power market in the world compared to its previous position of eighth in the last decade.

Usually energy, especially electricity, has a major contribution in speeding up the economic development of the country. The existing production of per capita electricity in India is around 600 kWh per annum. Ever since 1990s, Indias gross domestic product (GDP) has been increasing very rapidly and it is estimated that it will maintain the pace in the next couple of decades. The rise in GDP should be followed by an increase in the expenditure of key energy other than electricity.The gross electricity production capability of Indian Power Sector is placed at around 141.5 GW. A key portion of this generated electricity i.e. 64.4 per cent is thermal energy. Though, this is still not sufficient.

Installed Generation Capacities

Total installed capacity is 141,500 MW

Electricity generation mix is heavily dependent on thermal at around 64.4% with hydro contributing to 25%

The following graph shows a near doubling of per capita consumption of electricity from about 350 units in 1998 to over 600 units in 2005.

Structural and regulatory reform conducive to PSPIn the past, the power sector growth has not kept pace with the economic expansion and this has resulted in India experiencing a 13 per cent shortage in peak capacity and 8 per cent in energy terms, on an overall basis. Driven by the requirement to enhance the budgetary allocations to social sectors to meet the emerging requirements of sustainable growth, the Government has envisaged a manifold increase in the role of the private sector in the financing and operations of the power sector. Significant structural and regulatory reforms have paved the way for increased private sector participation in all aspects of the sector. Many of the legal and regulatory requirements to enable this are in place, while the operational provisions are in different stages of implementation in different states.Opportunities of growth in the Indian power sector

The Government of Indias blueprint for the power sector envisages a capacity addition of 100,000 MW between 2002 & 2012, and a required associated investment for the transmission and distribution network. A similar substantial capital investment is required to develop the national grid, for renovation and modernization of inefficient and ageing generation plants and network, for electrification of rural areas, and to improve adequacy, reliability and the quality of power supply.

Growth Blue-print of Ministry of Power:

An investment requirement of US$ 90 billion in generation of which US$ 19 billion is expected from the private sector

An investment requirement of US$ 90 billion in transmission and distribution of which nearly US$ 15 billion is needed for the National Grid

An investment of US$ 6 billion for the National Grid is expected to come from the private sector, the rest from the Central sector

The rest of the investment in transmission and distribution will be financed through a mix of the state and the private sector

Implies at least US$ 25 billion of investments from the private sector. The large capital and knowledge requirements cannot be met by the Government alone. Further, given the magnitude of actual and opportunity loss, these investments and efforts must be brought in at the earliest. A partnership and private & foreign investment is necessary to meet the rapidly growing demand and to achieve global standards in operating efficiency and quality of supply.

In Generation, the development of the power market and deregulation of supply to large consumers, presents options for the sale of power to distribution utilities and to contestable consumers.

In Transmission, competitive bidding guidelines are being finalised, and the Central Transmission Utility has identified specific elements of interstate transmission systems. The JV or BOT model may be adopted in the intra-state transmission segment as well.

In Distribution, privatisation continues to remain on the agenda of states (e.g. Uttar Pradesh), though the actual timing of initiation of any privatisation process remains uncertain. The Act envisages the possibility of more than one distribution licensee in an area. Some applications for such licenses have been made to the relevant SERCs, and the guidelines for issue of such licenses (including minimum service obligations) are expected to evolve.

Power trading has been recognized as a separate activity, and a number of private firms have obtained trading licenses. The trading volumes have increased manifold over the last few years, and are expected to increase further as the national grid is strengthened and inter-regional flows increase. The trading business offers opportunities as a stand-alone business, as well as a strategic adjunct to investments in other segments.

The investment required is not restricted to financial capital. The electricity sector incurs a commercial loss of about Rs 20,000 crores (nearly US$ 4 billion) per annum; a significant part of which is attributed to inefficient operation. To plug this, the power sector, and specifically, the distribution companies must re-engineer their business processes, invest in modern IT systems for billing, MIS, tracking, energy audit etc., train their operating staff to improve their management, commercial and technical skills, and undertake other such performance improvement measures. All of this provides significant business opportunities to various service providers.

Ultra Mega Power Projects by Government of India

Reorganizing the fact that economies of scale leading to cheaper power could be secured through large size power projects and for introducing the efficient super critical technology in a big way, a unique initiative has been launched for development of Ultra Mega Power Projects (UMPPs) under tariff based international competitive bidding route. 9 sites for development of 4000 MW project each have been identified so far.

Government of India (GoI) has launched Ultra Mega Power Projects initiatives to step up power generation capacity at rapid speed

Seven projects of capacity 4000 MW each identified to be allocated to the developers on tariff based competitive bidding

Each Project to cost around USD 3 bn

Tariff determined in this manner to be accepted by the regulator under the Electricity Act

GoI to acquire land, secure environment clearance, arrange water linkage and secure Captive Coal Mine (for pit head plants) before handing over the projects

Payment Security Mechanism in terms of Letter of Credit, Escrow Arrangement and Third Party Sale

Transmission: Policy Initiatives Guidelines for encouraging competition in development of transmission projects

Policy was issued on 13th April, 2006.

Promote competitive procurement of transmission services.

Encourage private investment in transmission lines.

Facilitate transparency and fairness in procurement processes.

Facilitate reduction of information asymmetries for various bidders.

Protect consumer interests by facilitating competitive conditions in procurement of transmission services of electricity.

Enhance standardization and reduce ambiguity and hence time for materialization of projects.

Ensure compliance with standards, norms and codes for transmission lines while allowing flexibility in operation to the transmission service providers.

High Voltage Transmission Capacity:CapacityMVACircuit KM

765/800 KV1,500439

400 KV6,1707,390

220 KV7,8634,927

HVDC3,0005,872

Distribution In principle approval accorded for 90 projects with an outlay for Rs.1588 crore to strengthen the distribution system in urban areas

More than Rs.2030 crore utilized under APDRP for strengthening & up gradation of electricity distribution network.

Incentive for cash loss reduction has been disbursed to Kerala, Punjab and West Bengal.

Andhra Pradesh, Goa, Himachal Pradesh, Punjab, Gujarat, Meghalaya, Chattisgarh and West Bengal have reported profits during 2005-06. Jharkhand, Madhya Pradesh, Haryana, Rajasthan, Uttaranchal, Karnataka, Kerala and Assam have reported reduction in losses during 2005-06.

Andhra Pradesh, Goa and Tamil Nadu have AT&C losses below 20% during 2005-06. Punjab and 2 DISCOMs of Gujarat (Madhya & Uttar) have AT&C losses below 25% during 2005-06.

Action plan prepared for franchising in urban areas to reduce AT&C losses and improve efficiency in distribution. Maharashtra, Rajasthan and Madhya Pradesh have invited tenders for franchisee in urban areas. The first urban franchisee has been awarded by Maharashtra in Bhiwandi town.

5304 engineers of State distribution utilities were trained under Distribution Reforms capacity building programme.

Started the Advanced Certificate Programme in Distribution Management in collaboration with IGNOU, about 1212 have registered so far.

Privatization

Many countries facing high electricity demand growth favor privatizing their electric power sectors and opening their markets to foreign firms. This approach can free up large amounts of public capital, which can be used instead for social programs. In addition, private ownership allows managerial accountability, market efficiency, and better customer service while reducing government deficits and international debt. The reasons for electric utility privatization are numerous and vary from country to country.

Some of the more evident reasons include the following:

Raising revenues for the state through asset sales

Acquiring investment capital

Improving managerial performance

Moving toward market-determined prices

Technology transfer

Reducing the frequency of power shortages

Reducing the cost of electricity to consumers through efficiency gain

Taking advantage of creating national and regional power grids, and

Re-thinking whether electric power generation in today's economy constitutes a natural monopoly.

Privatization of formerly state-owned electric power assets in developing countries has opened up enormous investment opportunities. For foreign investors, investment in overseas electricity assets offers opportunities to achieve potentially higher returns and, in many cases, helps to realize greater growth opportunities than are available at home.

In 1991, the Government began to encourage private sector participation in the power industry. Since this date, a total capacity of approximately 7,400 MW from 37 private power plants has been commissioned. As of March 31, 2006 an additional capacity of around 4,500 MW from 12 projects is reported to be under construction. Orissa was the first state in the country to privatize the state's electricity distribution. This was followed by the privatization of Delhi Vidyut Board. Various other states including Uttar Pradesh, Haryana, Karnataka, Andhra Pradesh, Madhya Pradesh, Delhi and Rajasthan have restructured their boards into separate entities for generation, transmission and distribution. Some states are also attempting to corporatize the former SEB entities.

Reliance Energy Limited and Tata Power Limited dominate the private sector.

Tata Power, with a generation capacity of 2278 MW. Tata Power recently bagged 4000 MW UMPP contract.

Reliance Energy has a 933 MW of generation capacity.

GMR Infrastructure Limited with a combined generation capacity of 420 MW and an additional 389 MW plant to be commissioned in the near future is another serious private sector participant.

Private investment in Power sector

Post Electricity Act 2003, private sector interest has revived.

100% FDI allowed in generation, transmission & distribution, 100% FDI also allowed in power trading (License given to British Gas).

Inter Institutional Group (IIG) and Green Channel constituted to facilitate financial closure of Independent Power Projects (IPPs).

11 IPPs of more than 4000 MW capacity have achieved financial closure.

Another 3 IPPs have been agreed in principle by FIs for financial closure.

Another 8 IPPs of about 9500 MW capacity are under active consideration.

Highlights of performance of Power sector in 2007

(i) Capacity Addition:

9050 MW (5093 MW)

(ii) Placement of Award (generation projects):9354MW (9701 MW)

(iii) Growth in Power Generation:

6.9% (7.2%)

(iv) Plant Load Factor:

76.7% (75.77%)

(v) Villages Electrified:

39,383 villages

(vi) Ultra Mega Power Projects:

LOI issued in case

of Sasan and Mundra

(vii) Important policies notified:

- Tariff Policy

- Rural Electrification Policy

- Policy for development of Merchant Plants

- Guidelines for encouraging competition in development of Transmission projects.

Note: Figures in brackets pertain to year 2006Highlights of the XIth Five Year Plan

Capacity Addition Projections (as on 28 Feb. 2008)

Figures in MW

Total Installed Capacity:Sector MW%age

State Sector 74,453.7652.5

Central Sector 47,520.9934.0

Private Sector 19,525.0913.5

Total 1,41,499.84

Fuel MW%age

Total Thermal 91,145.84 64.6

Coal75,252.3853.3

Gas14,691.7110.5

Oil1,201.750.9

Hydro (Renewable) 35,378.7624.7

Nuclear 4,120.002.9

RES** (MNRE) 10,855.247.7

Total 1,41,499.84

Power Situation: (April 2007-February 2008) (Provisional)DemandMetSurplus/ Deficit

Energy671,915 MU608,053 MU-9.5 %

Demand side ManagementRecommendations

Encourage Non-conventional energy usage, Raising energy efficiency awareness Turning the Computer Monitors off when not in useThere is a need to boost: Energy audits reports by energy managers consumption of >1MVA Commercial buildings to use only energy efficient lighting and equipment. Energy efficient equipment manufacturing incentives. TOD tariff Buildings with natural ventilation and lighting Passive Houses Penalty for power factor Evaluate the major facilities for interruptible load opportunities.Supply side Management

RecommendationsThere is a need to boost:

Upgrading existing Supply Load Aggregation On-Site Generation Use of Captive Power Plants Peak Power development through Hydro Encourage capacity addition through various fuels Distributed Generation Setting up Big size High efficiency plants Setting up Merchant Power Plants-

Power Finance CorporationBackground

PFC was established in July 1986 as a Development Public Financial Institution (PFI) under Section 4A of the Companies Act, 1956. It is dedicated to the Power Sector. It is a wholly owned by Government of India. A Nav-Ratna public Sector Undertaking. It has highest safety ratings from domestic and international credit rating agencies and also ISO 9001-2000 Certification for the Project Appraisal System.

PFC provides financial assistance to all types of power projects like Generation, R&M, Transmission, Distribution, system improvement, etc. PFC encourages optimal growth and balance development of all segments of power sector through assigning priorities for financing different categories of projects. The state sector utilities are the main beneficiary of PFCs financial assistance. PFC has also been funding private sector projects for last 5-6 years.

Mission

PFC's mission is to excel as a pivotal developmental financial institution in the power sector committed to the integrated development of the power and associated sectors by channeling the resources and providing financial, technological and managerial services for ensuring the development of economic, reliable and efficient systems and institutions.

Received awards from Hon'ble President, Hon'ble Vice President & Hon'ble Prime Minister for being in the top ten Public Sector Undertakings of Government of India

Credit Ratings

Placed at Sovereign Rating by International Rating Agencies - Moodysand Standard & Poorsfor long term foreign currency debt.

Placed at thehighest safety ratings by accredited rating agencies in India - CRISILand ICRA

Domestic borrowings include term loans and bonds; External borrowings take the form of Syndicated Loans, Fixed & Floating Notes.

Consistently rated Excellent by the Government of India (GOI) for overall performance against the targets set inMemorandum of Understanding (MoU) between GOI and PFC.

Performance Highlights*Consistently rated Excellent for its overall performance against the targets set in Memorandum of Understanding (MoU) by the Government of India (GoI) since 1993-94.

*Nav-Ratna Public Sector Undertaking.*Ranked among the top 10 PSUs for the last four years.

*Employee profit stands at Rs.3.9 crores per head.

A Development Financial Institution - has consistently maintained profitability in its operations provides finances for projects/ schemes, has expertise in reform linked studies/consultancy.

PFC has an authorized capital of Rs.20000 Million and paid-up capital of Rs.11477.70 Million (presently the entire equity is in owned by Government of India). PFC in its present role has the following main objectives: -

To rise the resources from international and domestic sources at the competitive rates and terms and conditions and on-ward lend these funds on optimum basis to the power projects in India.

To act as catalyst to bring institutional, managerial, operational and financial improvement in the functioning of the state power utilities

To assist state power sector in carrying out reforms and to support the state power sector during transitional period of reforms

Range of Services

Fund Based

Rupee Term Loan

Foreign Currency Term Loan

Buyers Line of Credit

Working Capital Loan

Loan to Equipment manufacturers

Debt Restructuring/ Refinancing

Take out Financing

Bridge Loan

Bill Discounting

Lease Financing

Non-Fund Based Guarantees

Exchange Risk Management

Consultancy Services

Clients of PFC:

State Electricity Boards

State Power Utilities

State Electricity/Power Departments

Other State Departments (like irrigation Department) engaged in the development of power projects

Central Power Utilities

Joint Sector Power Utilities

Co-operative Societies

Municipal Bodies

Private Sector Power Utilities

Institutional Development

Institutional Development of Power UtilitiesFormulation and Implementation of Operational and Financial Action Plan (OFAP) for its borrowers - to achieve qualitative improvement in the functioning of the State Power

Utilities in managerial, technical and financial areas through: - Participative approach in formulation of OFAPs - prepared in consultation and agreement with the Utility and State Government concerned.

Organizing seminars, workshops and training for Power Sector personnel - in India and abroad.

Studies and Consultancy Services

Reforms & Restructuring InitiativesPFC has been actively persuading State Govts. to initiate reform and restructuring of their power sector in order to make them commercially viable. In this regard following initiatives have been taken:-

PFC is providing financial assistance to reform-minded States under relaxed lending criteria/exposure limit norms

PFC has decided to provide technical/financial assistance to State Govts. / Power Utilities for structural reforms of the State Power Sector.

Reform Group constituted in PFC to advice and assists the State Govt. /Power Utilities to formulate suitable restructuring programmes.

Major Projects Funded by PFC:

Name of the Project Capacity (MW)Cost (Crs)Amount Funded by PFC (Crs)

Malwa TPS2x500 40542730

Yamuna Nagar TPS2x300 24001920

Tenughat Extn. Stage II3x210 23661892

Khaperkheda TPS Extn.1x50021911753

Kameng HEP4x15024851740

Birsinghpur TPS1x5001950

Mejia Extn. Unit 2x2502801456

Sagardighi TPS PH12x30027541925

Chandrapura Extn. Unit 7&82x25020531435

Panipat TPS Stage V2x25017851428

Parichha TPS Units 3&42x21017551404

Revival of PP& LNG work of Dhabol Power Co. 2150100381400

Tehri Dam HEP Stage14x25080002560

Nathpa Jhakri HEP6x25083281438

Financial Position

Financial Highlights for the year 2007-08(Audited) Profit After Tax Rs. 1,206.76 Crores

Sanctions Rs. 69,498 Crores

Disbursements Rs. 16,211 Crores

Net Interest Margin 3.75 %

Resource Mobilization Rs. 52,421 Crores

Net Worth Rs. 8824 Crores

Realization 99%

Resources as on 31 March, 2008

Recent Initiatives:

Exploring possibilities of faster capacity addition through Special Purpose Vehicles.

Made a foray into renewable energy sector.

Extended tenor of loans up to 20 years for Hydro and 15 years for other schemes.

Policy for short term financial assistance for import of coal introduced

Expense limit increased for reforming GENCOS.

Short-term loan extended to TRANSCOS against receivable from DISCOMS.

Aims to capture a share of 20-25% of the total investment to be made in the Power Sector during the Xth and XIth Plan period.

Accomplishments:

First Developmental Financial Institution to introduce Operational and Financial Action Plans to improve efficiency in the State Power Sector.

Long term financial resources to the power sector from multilateral agencies channeled through PFC.

Tapped international financial markets to raise ECBs, setting benchmark rates for Indian corporates.

Complementing the efforts of Govt. of India, for its sponsored programmes Accelerated Generation & Supply Programme and Accelerated Power Development & Reform Programme.

Introduced new tailor-made products and services like debt re-financing, interest restructuring, funding to equipment manufacturers, short term loans, buyers' line of credit and loans for asset acquisition.

Future Plans:

Aims to capture a share of 20-25% of the total investment to be made in the Power Sector during the 10th and 11th Plan period.

To consolidate and expand present business.

To introduce new financial initiatives such as Universal Banking Services, Insurance, Equity Participation and Merchant Banking.

To spread into allied sectors.

To make a foray into global markets.

Diversification in terms of forward or backward integration in the power sector (financing for fuel tie ups and laying down of gas pipelines).

SWOT Analysis:

Strengths

Govt. of India undertaking.

Good quality management

Well established, Long standing relations in the power industry

Implementing agency for Mops schemes including AG &SP and APDRP

Highest credit rating (due to government ownership)

Weaknesses

Poor asset quality with most of the lending to SEBs, whose loan repayment capabilities in the long run is doubtful.

Concentration risk attributed to lending in single sector.

Opportunities

Power sector presents significant investment opportunities.

Sector expertise for consultancy and providing investment gateways for domestic and external financial agencies.

New business opportunities to cover the entire range of activities in the Power sector.

Threats

PFC has significant exposures entities which are loss making, financially weak and are defaulting to most of their creditors. Delinquencies by these entities to PFC could impair the currently sound Balance Sheet of PFC.

Under the Tenth Five-year Plan, REC has been allowed to disburse funds through AG & SP. Since this scheme gave a price advantage to PFC, its competitive edge is diluted.

With increasing exposure to SEBs, their weak balance sheet may affect PFCs creditworthiness.

Currently, borrowers of PFC are unable to attract other sources of funding. If the reform programme is successful, and these entities become creditworthy, PFCs ability to lend against quality assets would be weakened.

Resource Mobilization UnitResource Mobilization Unit (RMU) is responsible for raising fund resources both in domestic for further disbursement as financial assistance to its customers. RMU also undertakes various activities like appointment for various agencies like RTA, Trustees, IPA, Collecting and Paying Banker for coordinating the resource mobilizing process. It is also responsible for listing for various debt instruments on NSE.

The main objective of the RM department is to mobilize resources/raise funds at the minimum cost and the easiest terms and conditions keeping in mind the requirements, objectives and the financial position of the company.

The fund requirement for carrying out disbursement varies from year to year. In 2000-2001, the disbursement was amounting to Rs. 3230 crores. In the year 2005-2006 PFC achieved a disbursement level of as high as 9870crores, a three-fold increase. Thus, in order to keep pace with the increasing level of disbursement needs, the RMU has to keep itself occupied and vigilant to tap the markets for smooth operations of the company.

The company segments the market into two:

Domestic (under the RM dept.)

International

Rupee resources (Domestic)

In terms of domestic resources, a significant proportion of our Rupee funds are raised through privately placed bond issues in the domestic market and term loans. We have a diverse investor base of banks, financial institutions, mutual funds, insurance companies, provident fund trusts, gratuity fund trusts and superannuation trusts. The bonds we issue are unsecured, redeemable, non-convertible, non-cumulative and taxable and are listed on the wholesale debt market segment of the NSE. Our bonds are rated LAAA by ICRA and AAA by CRISIL, the highest safety domestic ratings. In fiscal 1988, the Ministry of Finance authorized public sector issuers that were infrastructure oriented to issue tax-exempt bonds. We were historically given a large share of this annual allocation and a large portion of our funds were raised through tax exempt bonds. From fiscal 2001 onwards, it became part of the governments overall policy to reduce funding support to companies that had become financially independent and that could raise resources at competitive rates on their own. After this time, our direct support from the GoI for raising debt reduced.

The following table gives details of our Rupee funds as on March 31 in FY 2007-08:

Foreign currency resources (International)

Multilateral, Bilateral and Export Credit Agencies

We began accessing foreign currency loans from multilateral, bilateral and export credit agencies in fiscal 1991 when we obtained funds from the French government, which were guaranteed by the GoI. Subsequently, we obtained a complementary financing loan from the Asian Development Bank in fiscal 1991, which was denominated in US Dollars and Japanese Yen. Traditionally, our major foreign currency borrowings have been from multilateral institutions such as the World Bank and the ADB. These funds were routed through GoI, where the foreign exchange risk was borne by GoI. These sources enabled us to raise long term funds at competitive costs, which supplemented the funds available from commercial sources. Presently, we are borrowing directly from these agencies, and the foreign exchange risk is borne by us. We have a US$ 50 million line of credit facility with the ADB that has 20 year tenure. This line of credit facility is guaranteed by the GoI. We also have foreign currency loans from two other external credit agencies namely KfW and Export Development Canada (EDC).

Commercial borrowings in foreign currency

We first accessed commercial foreign currency borrowings that were not guaranteed by the GoI in January 1997 with the establishment of a syndicated loan facility. Since then, we have borrowed funds in the international commercial markets in the form of syndicated loans as well as fixed and floating rate note/bonds issues. This has enabled us to diversify our investor base.

The 3 main decisions taken by Resource Mobilization department are:

1. When to raise Funds and for what tenure.

2. Instruments to be used for raising these funds.

3. Pricing of the debt raised.

1. When to raise funds

The RM Unit has to decide when it will be most conducive to raise funds for the company so as to ensure there is:

a. Timely availability of funds.

b. Lowest Cost at which funds can be raised.

c. Least pressure for obligations.

The amount of funds to be raised is normally decided by the Treasury Management Unit. The RM Unit prepares a Liquidity Statement to find out the time for raising funds when there is least pressure for obligations for the company. Liquidity Statement shows the funds inflows and outflows of the company. The following factors are taken into consideration while preparing it:

Amount of Disbursement that has to be made.

Interest Payments.

Repayment of loan taken by the company.

Taxes, Dividends, etc.

Funding Sources:

PFC generally fund their assets, comprising loans to the power sector, with borrowings of various maturities in the international and domestic markets. Their market borrowings include bonds, short term loans, medium term loans, long term loans, and commercial papers.

2. Instruments to be used for raising funds:

Debt instruments are obligations undertaken by the issuer of the instrument as regards certain future cash flows representing interest and principal, which the issuer would pay to the legal owner of the instrument. Debt instruments are of various types. They are:

a. Money Market Instruments: The term money market refers to the market for short-term requirements and deployment of funds. Money market instruments are those instruments, which have a maturity period of less than one year. The most active part of the money market is the market for overnight and term money between banks and institution (called call money) and the market for repo transactions. The main traded instruments are commercial papers (CPs), certificate of deposits (CDs) and treasury bills (T-Bills). All of these are discounted instruments i.e. they are issued at a discount to their maturity value and the difference between the issuing price and the maturity/face value is the implicit interest. These are also completely unsecured instruments. One of the most important features of money market instruments is their high liquidity and tradability. A key reason for this is that these instruments are transferred by endorsement and delivery and there is no stamp duty or any other fee levied when the instrument changes hands. Also there is no tax deducted at source from the interest component.

b. Long term Debt Instruments: These are the instruments having a maturity exceeding one year. The main instruments are Government of India securities (GOISEC), State Government securities (state loans), Public Sector bonds (PSU bonds), corporate debentures, etc.

Most of these are coupon bearing instruments i.e. interest payments (called coupon) are payable at pre specified dates called coupon dates. At any given point of time, any such instrument has a certain amount of accrued with it i.e. interest which has accrued (but is not yet due) calculated at the coupon rate from the date of the last coupon payment. E.g. if 30 days have elapsed from the last coupon payment of a 14% coupon debenture with a face value of Rs.100, the accrued interest will be

100*0.14*30/365 =1.15

Whenever coupon-bearing securities are traded, by convention, they are traded at a base price with the accrued interest separate. In other words, the total price would be equal to the summation of the base price and the accrued interest.

3. Pricing of the Issue: The unit has to keep a number of factors into consideration to decide upon the price of the instruments and loan facilities it wish to avail.

The factors considered by the company normally are:

Liquidity Position of the company

Present Benchmark Rates

Primary / Secondary Market Conditions

Timing of issue or raising

Quantum of funds to be raised

Liquidity in the debt market

Other Economic and market considerationsTypes of Instruments used for raising funds by PFC in the Domestic Market

I. Bonds - Bonds are a form of indebtedness that is sold in set increments. In return for loaning the debtor the money, the lender gets a piece of paper that stipulates how much was lent, the agreed-upon interest rate, how often interest will be paid, and the term of the loan.Features of bonds

1. Nominal, principal or face amount: The amount over which the issuer pays interest, and which has to be repaid at the end.

2. Issue price: The price at which investors buy the bonds when they are first issued, typically Rs.1 million (specifically for PFC). The net proceeds that the issuer receives are calculated as the issue price, less issuance fees, times the nominal amount.

3. Maturity date: The date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or maturity of a bond.

i. short term (bills): maturities up to one year;

ii. medium term (notes): maturities between one and ten years;

iii. Long term (bonds): maturities greater than ten years.

4. Coupon: The interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as MIBOR or LIBOR, or it can be even more exotic.

5. Optionality: A bond may contain an embedded option; that is, it grants option like features to the buyer or issuer:

i. Callability: Some bonds give the issuer the right to repay the bond before the maturity date on the call dates. These bonds are referred to as callable bonds.

ii. Puttability: Some bonds give the bond holder the right to force the issuer to repay the bond before the maturity date on the put dates.

6. Liquidity: A bond is a highly liquid instrument which is freely tradable in the market. A large number of investor categories such as bank treasuries, mutual funds, insurance companies and funds like pension fund and provident funds prefer this instrument because of its assured returns and suitable maturities for each investor category.

Procedure followed by PFC for issue of bonds:1. Board approval.

2. Borrowing limit of the corporation as laid down as u/s 293 (1) (d) of the Companies Act, 1956.

3. Determining nature of bonds to be issued.

4. Credit rating.

5. Appointment of registrar and transfer agent.

6. Appointment of trustees.

7. Debt/Equity ratio.

8. AL&RM position of the corporation.

9. Collection banker.

10. Interest rate determination.

11. Shelf Information memorandum.

12. Merchant banker.

13. One to one deal with banks, institutions, body corporates etc.

14. Receipt of application money and application forms.

15. Allotment of bonds.

16. Conversion of application money into bonds.

17. Issuance of letter of allotment/ bonds in Dematerialized form.

18. Remittance of interest on application money along with excess application money if any.

19. Issuance of letter of allotment in physical form.

20. Payment of stamp duty.

21. Listing with NSE.

22. Execution of documents with the trustees.

23. Appointment of printers.

24. Appointment of payee bankers.

II. Commercial Paper

Commercial paper is a money market security issued by large banks and corporations. It is generally not used to finance long-term investments but rather to manage working capital. It is commonly bought by money funds (the issuing amounts are often too high for individual investors), and is generally regarded as a very safe investment. As a relatively low risk option, commercial paper returns are not large.

The stamp duty on Commercial paper is between 5 to 7 basis points which is very less in comparison to bonds. It is a short term instrument, highly liquid resulting in free tradability among the market participants. It is mainly preferred by mutual funds and it proves to be an efficient instrument in raising money in emergency situation. III. Loans

A bank loan to a company, with a fixed maturity and often featuring amortization of principal. If this loan is in the form of a line of credit, the funds are drawn down shortly after the agreement is signed. Otherwise, the borrower usually uses the funds from the loan soon after they become available.

A fixed-rate term loan offers an unchanging interest rate for the life of the loan, making it easy to budget, with the same predictable payments over the life of the loan.Secure, fixed interest for the life of the loan borrowed what you need with a predictable monthly payment. Fixed-rate loans offer an unchanging interest rate for the life the loan, making it easy to budget with the same, predictable payments over the entire term.

i. Simplify budgeting with predictable payments

ii. Lock in interest rates with fixed interest over the life of the loan

iii. Stabilize your business finances

Short-term

Short-term loans can have maturations of as little as 90-120 days or as long as one to three years, depending on the purpose of the loan. In general, banks require very specific repayment plans for their short-term loans. For instance, if you took out a loan to even out your cash flow until your customers paid you, the lender would expect you to repay the loan as soon as you receive your money. In the case of short-term loans for inventory purposes, you would pay off your debt when you sell your inventory. Before a lender will grant a short-term loan, it will review your cash-flow history and payment track record. Most short-term loans are unsecured, meaning they do not require collateral. Rather, the bank relies on your personal credit history and credit score for approval.

Medium-term

Medium term loans have maturity of less than three years; these loans are generally repaid in monthly installments (sometimes with balloon payments) from a business's cash flow. There repayment is often tied directly to the useful life of the asset being financed.

Long Term

Long term loans are commonly set for more than three years. Most are between three and 10 years, and some run for as long as 20 years. Long-term loans are collateralized by a business's assets and typically require quarterly or monthly payments derived from profits or cash flow. These loans usually carry wording that limits the amount of additional financial commitments the business may take on (including other debts but also dividends or principals' salaries), and they sometimes require that a certain amount of profit be set-aside to repay the loan. The Indian Debt Market

The Debt Markets play a very critical role in any modern economy. And more so in the case of developing countries like India which need to employ a large amount of capital and resources for achieving the desired degree of industrial and financial growth. The Indian Debt Markets are today one of the largest in Asia and includes securities issued by the Government (Central & State Governments), public sector undertakings, other government bodies, financial institutions, banks and Corporates.There is no single location or exchange where debt market participants interact for common business. Participants talk to each other, conclude deals, send confirmations, etc on the telephone, with clerical staff doing the running around for settling trades. In that sense the wholesale debt market is a virtual market. The daily transaction volume of all the traded instruments would be about Rs.5 bn per day excluding call money and repos.

The debt market is much more popular than the equity markets in most parts of the world. In India the reverse has been true. This has been due to the dominance of the government securities in the debt market and that too, a market where government was borrowing at pre-announced coupon rates from basically a captive group of investors, such as banks. Thus there existed a passive internal debt management policy. This, coupled with automatic monetization of fiscal deficit prevented a deep and vibrant government securities market.

The debt market in India comprises broadly two segments, viz., Government Securities Market and Corporate Debt Market. The latter is further classified as Market for PSU Bonds and Private Sector Bonds.

The market for government securities is the oldest and has the most outstanding securities, trading volume and number of participants. Over the years, there have been new products introduced by the RBI like zero coupon bonds, floating rate bonds, inflation indexed bonds, etc. The trading platforms for government securities are the Negotiated Dealing System and the Wholesale Debt Market (WDM) segment of National Stock Exchange (NSE) and Bombay Stock Exchange (BSE).

The PSU bonds were generally treated as surrogates of sovereign paper, sometimes due to explicit guarantee of government, and often due to the comfort of government ownership. The perception and reality are two different aspects. The listed PSU bonds are traded on the Wholesale Debt Market of NSE.

The corporate bond market, in the sense of private corporate sector raising debt through public issuance in capital market, is only an insignificant part of the Indian Debt Market. A large part of the issuance in the non-Government debt market is currently on private placement basis. Tables 1, 2 and 3 provide details of amount raised by financial institutions and non-financial institutions by way of public issue and private placement. Private placement accounts for little over one third of the debt issuance. Unofficial estimates indicate that about 90 per cent of the private corporate sector debt has been raised through private placement in the recent past. The amount raised through private placement has been continuously rising for the past five years which increased by more than 300 per cent over the five year period. The growth rate in the public issue processes is only about 80 per cent over the period, increasing from Rs. 20896 crore to Rs. 36466 crore. The listed corporate bonds also trade on the Wholesale Debt Segment of NSE. But the percentage of the bonds trading on the exchange is small. The secondary market for corporate bonds till now has been over the counter market. With the recent guidelines issued by SEBI the scenario is expected to change.

The development of a corporate bond market in India has lagged behind in comparison with other financial market segments owing to many structural factors. While primary issuances have been significant, most of these were accounted for by public sector financial institutions and were issued on a private placement basis to institutional investors. The secondary market, therefore, has not developed commensurately and market liquidity has been an issue. The Government had constituted a High Level Committee on Corporate Bonds and Securitization (Patil Committee) to identify the factors inhibiting the development of an active corporate debt market in India and recommend necessary policy actions. The Committee made a number of recommendations relating to rationalizing the primary issuance procedure, facilitating exchange trading, increasing the disclosure and transparency standards and strengthening the clearing and settlement mechanism in secondary market. The recommendations have been accepted in principle by the Government, the Reserve Bank and SEBI and are under various stages of implementation. The two stock exchanges, namely, the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), as well as the industry body FIMMDA have since operationalized respective trade reporting platforms. While all the exchange trades in corporate bonds get captured by concerned exchanges reporting platform, OTC transactions can be reported on any of these platforms. The aggregated trade information across the platforms is being disseminated by FIMMDA on its website. BSE and NSE have also started order driven trading platforms in July 2007. In practice, however, trading still continues to be largely OTC. SEBI has also implemented measures to streamline the activity in corporate bond markets by reducing the shut period in line with that of G-sec, reducing the size of standard lots to Rs. one lakh and standardizing the day count convention. Further, to streamline the process of interest and redemption payments, Electronic Clearing Services (ECS), Real Time Gross Settlements (RTGS) or National Electronic Funds Transfer (NEFT) are required to be used by the issuers. Further progress is anticipated in regard to rationalizing the primary issuance procedures, which is a critical step for moving away from the pre-dominance of private placements. To reduce the settlement risk and enhance efficiency, the Patil Committee has also proposed setting up of a robust clearing mechanism. The settlement was proposed to be initially on delivery versus payment (DvP) I basis (i.e., trade by trade basis) to address the counterparty settlement risk and gradually migrate to DvP III (net settlement of funds as well as securities) to impart enhanced settlement efficiency. (The DvP modules can be broadly classified into three broad categories, viz., DvP I, DvP II and DvP III. Under DvP I, the funds leg as well as the securities leg is settled simultaneously on a contract-by-contract basis. Under DvP II, while the securities leg is settled on a contract-by-contract basis, the funds leg is settled for the net amount. Under DvP III, both the funds and the securities legs are settled for the net amounts.)

Igniting the Dormant Corporate Debt Market (CDM)

The relatively young private bond segment in India presently stands at US$100bn and is predicted to grow to US$ 575bn by 2016. The primary market for corporate debt paper issuance is dominated mainly by domestic non-banking finance companies (NBFCs). For other corporate borrowers, bank finance has traditionally been the favored funding source.

Significant developments in the CDM space since the 1990s include abolition of controlling function by government and the controller of capital issues (CCI) on the interest rates that Corporates had to pay whenever they raised capital through debentures. Reserve Bank of India (RBI) also gradually annulled all the conditions in regard to the level of interest rates that the banks could charge on their loans to corporate clients. Over time, the role of the development financial institutions, which were the major source for funding long term corporate projects, also declined.

In 2004, SEBI mandated secondary market trading through an automated order matching screen-based trading system. However, this, did not find favor with the institutional participants, thus leaving the OTC deals still the preferred way of dealing in corporate bonds for operational and liquidity concerns. The government has accepted the recommendations of the report submitted by the High Level Committee on Corporate Bonds and Securitization (RH Patil Committee) and have re-iterated that necessary steps would be taken to create a single, unified, exchange-traded market for corporate bonds. The leading exchanges, Bombay Stock Exchange (BSE) and National Stock Exchange (NSE), as well as the industry body Fixed Income, Money Market and Derivatives Association (FIMMDA) have already commenced services of the trade reporting platforms for deals done in the CDM segment.

On the whole though, the CDM hasn't picked up in India. One can sense that this market was left on its own, hence it has become more lethargic, inefficient and less vibrant. The reform process in the CDM faces multiple challenges. Attracting the retail investors is not going to be an easy task given the current state of CDM microstructure. There is not a single trade reported in the Retail Debt Market Segment (RDM) of the NSE in the second half of year 2007. There is a disincentive for a retail investor to invest/trade in corporate bonds as the total cost of trade (including stamp duty, brokerage, and cost of settlement) impacts the returns to the investor. The same money can be deployed in debt schemes of mutual funds without hassle and worry about costs. Efforts should be directed towards educating the retail investors about the pricing of bond and peculiar bond market concepts like yield to maturity etc, in the same way as was done when derivatives were first introduced in India. This will help them to better understand and embrace the debt market.

From the issuer's point of view, reaching retail investors adds to the cost of distribution, plus there is a continuous cost of servicing the retail bond holders and the time to market is longer. Hence Corporates prefer private placement as it is much cheaper and quicker. Also, private placement of bonds bypasses the already loosely tied regulations and gives Corporates one more reason not to buy public bonds.

There is an urgent need to introduce market makers as this will improve the liquidity and bring in more variety of investors with different risk profiles. Another way forward could be to allow the banks to distribute the debt products to the retail investors for a fee-based income.

The way forward is to establish screen-based trading and a well defined and structured clearing and settlement mechanism. The procedure for issuance of bonds in the primary market needs to be rationalized in order to widen the investor base and move away from the dominance of private placement deals. There is also a need to re-examine the stamp duty structure for consistent application across the country.

Market Micro Structure

It is necessary to understand microstructure of any market to identify processes, products and issues governing its structure and development. In this section a schematic presentation is attempted on the micro-structure of Indian corporate debt market so that the issues are placed in a proper perspective. Figure 1 gives a birds eye view of the Indian debt market structure.

The microstructure of the Indian Debt Market can be explained under two broad sub sections:

a) Primary Corporate Debt Market

1) Market structure consists of issuers, instruments, processes, investors, rating agencies and regulatory environment.

i) Issuers

Indian Debt Market has almost all possible variety of issuers as is the case in many developed markets. It has large private sector corporate, public sector undertakings (union as well as state), financial institutions, banks and medium and small companies: Thus the spectrum appears to be complete. Above figure delineates details on various classes of issuers. Two main classes include private sector corporates and banks.

ii) Instruments

Figure provides names of some of the more popular instruments that have been issued. Till recently Indian debt market was predominantly dominated by plain vanilla bonds. Over a period of time, many other instruments have been issued. They include partly convertible debentures (PCDs), fully convertible debentures (FCDs), deep discount bonds (DDBs), zero coupon bonds (ZCBs), bonds with warrants, floating rate notes (FRNs) / bonds and secured premium notes (SPNs).

The coupon rates mostly depend on tenure and credit rating. However, these may not be strictly correlated in all cases. The maturities of bonds generally vary in between one year to ten years. However, the median could be around four to five years. The maturity period by and large depends on outlook on interest rates. In expectation of falling interest rates environment, corporate, it is observed, mostly go to shorter term instruments while the opposite is true in case of possible hike in interest rates. For the past few years interest rates have been falling and short end issues are on the rise. This is one of the reasons that many corporate are reluctant to go for public issue route and listing of their securities.

iii) Processes

There are several processes that are in vogue in India as well as in other markets. The more popular ones are public issue and private placement routes. Both these have their own pros and cons. In a mature and developed market where large number of institutional investor /sophisticated investors is available and a highly developed mutual fund industry is in operation, the private placement route may be acceptable to issuers, investors and regulators. In a less developed market / small market it is a catch 22 position. Private placement is not suitable because this market do not have adequate number of informed investors and the public issue route may create regulatory arbitrage, higher compliance costs resulting sometimes in migration of markets. In India private placement route is highly popular owing to various reasons.

iv) IntermediariesTwo classes of intermediaries required for the proper development of debt market are broker and investment banker/ merchant banker. Most of the brokers as well as merchant bankers in India are inadequately capitalized and their professional knowledge also needs further improvement. In some markets, it is observed that there are dedicated Debt Managers who facilitate subscription or sometimes subscribe to the issue and later on even facilitate trading in bonds. India needs a dedicated Bond Manager concept.

v) Investors

For the development of Corporate Debt Market / Fixed Income Securities Market, it is necessary and sufficient to have a large as well as diverse number of sophisticated / institutional investors. Figure lists some of the classes of investors that have been investing in the debt market. Institutional Investors in India are few in number and the variety also is limited. We have only 37 mutual funds, hardly five insurance companies till recently and there are no pension funds. Banks and financial institutions, by and large, do not take active interest in Corporate Debt Market. Investors with diverse expectations are a precondition for the development of corporate debt market. Diversity could be in terms of maturity needs as well as expectations on interest rates. The most important structural weakness in India is lack of large and diverse institutional investors.

India has large number of retail investors; however, their expectations are quite contrary to market principles - risk and return. Most investors think and perceive that investments in bonds should provide them guarantee, repayment of principal and regular payment of coupons. Any delay/default causes worries in their minds. And sometimes these investors complain to regulators or to the government for non receipt of coupons or non-repayment of principal. This type of behavior implies lack of understanding of the principles of the capital market on the part of the investors.

vi) Rating agencies

India has a well developed Credit Rating Agency system and rating agencies are well experienced and regarded. By and large, their ratings do carry confidence in the market.

2) Some of the Structural Weaknesses identified in the Primary Market are:

(i) Lack of large and diverse investors

(ii) Lack of dedicated intermediaries (Bond Manager)

(iii) Heavy tilt towards private placement

b) Secondary Corporate Debt Market

1) Appropriate micro-structure of secondary market is vital for trading, clearing and settlement. The present infrastructure has its own merits and demerits. Some of the micro structure features are discussed below:

i) Trading PlatformCorporate debt instruments are traded either as bilateral agreements between two counterparties or on a stock exchange through brokers. Worldwide, the majority of transactions in corporate bonds is conducted in the over-the-counter (OTC) market by bilateral agreements. In India corporate bonds are traded, mostly, on WDM segment of NSE.

The National Stock Exchange (NSE) introduced a transparent screen- based trading system in the whole sale debt market, including government securities in June 1994. The wholesale debt market (WDM) segment of NSE has been providing a platform for trading / reporting of a wide range of debt securities.

The WDM trading system, known as NEAT (National Exchange for Automated Trading), is a fully automated screen based trading system, which enables members across the country to trade simultaneously with enormous ease and efficiency. The trading system is an order driven system, which matches best buy and sell orders on a price/time priority.

Trading system provides two market sub-types:

Continuous Automated Market:

In continuous market, the buyer and seller do not know each other and they put their best buy/ sell orders, which are stored in order book with price/time priority. If orders match, it results into a trade. The trades in WDM segment are settled directly between the participants, who take an exposure to the settlement risk attached to any unknown counter-party. In the NEAT-WDM system, all participants can set up their counter-party exposure limits against all probable counter-parties. This enables the trading member/participant to reduce/minimize the counter-party risk associated with the counter-party to trade. A trade does not take place if both the buy/sell participants do not invoke the counter-party exposure limit in the trading system.

Negotiated Market:

In the negotiated market, the trades are normally decided by the seller and the buyer, and reported to the exchange through the broker. Thus, deals negotiated or structured outside the exchange are disclosed to the market through NEAT-WDM system. In negotiated market, as buyers and sellers know each other and have agreed to trade, no counter-party exposure limit needs to be invoked.ii) Clearing and Settlement Mechanism:Primary responsibility of settling trades concluded in the WDM segment rests directly with the participants and the exchange monitors the settlement. Mostly these trades are settled in Mumbai. Trades are settled gross, i.e. on trade for trade basis directly between the constituents / participants to the trade and not through any clearing house mechanism. Thus, each transaction is settled individually and netting of transactions is not allowed. Settlement is on a rolling basis, i.e. there is no account period settlement. Each order has a unique settlement date specified upfront at the time of order entry and used as a matching parameter. It is mandatory for trades to be settled on the predefined settlement date. The Exchange currently allows settlement periods ranging from same day (T+0) settlement to a maximum of two business days from the date of trade (T+2).

iii) Instruments traded on WDM:

The WDM provides trading facilities for a variety of debt instruments including government securities, Treasury Bills and bonds issued by Public Sector Undertakings (PSU)/ corporate/ banks like Floating Rate Bonds, Zero Coupon Bonds, Commercial Paper, Certificate of Deposit, corporate debentures, State Government loans, SLR and Non-SLR bonds issued by financial institutions, units of mutual Funds and securitized debt by banks, financial institutions, corporate bodies, trusts and others.

From Table 4, a highly skewed pattern can be observed in trading of debt instruments. In 1994-95 government securities used to account for less than 50 per cent of the total trades reported, in 2002-03 the same went up to about 94 percent which is more than double. All other segments account for a little over 6%.

iv) Investors in WDM:Large investors and a high average trade value characterize this segment. Till recently, the market was purely an informal market with most of the trades directly negotiated and struck between various participants. The commencement of this segment by NSE has brought about transparency and efficiency to the debt market, along with effective monitoring and surveillance to the market.

v) Regulatory Environment:

The listed corporate debt is under the regulations of SEBI. SEBI is involved whenever there is any entity raising money from Indian individual investors through public issues/ private placement. It regulates the manner in which such moneys are raised and tries to ensure a fair play for the retail investor. It forces the issuer to make the retail investor aware of the risks inherent in the investment. SEBI has in fact laid down guidelines known as Disclosure and Investor Protection (DIP) Guidelines, 2000 guidelines to maintain transparency in the market and make it efficient.

Some of the Structural Weaknesses identified in Secondary Market

(i) Absence of Clearing Corporation and CCPS.

(ii) Dedicated trading platform.

(iii) Exclusive, well capitalized and professional intermediaries.(iv) Lack of reliable and up to date information.Capital Markets: Fixed Income MarketIntroductionCapital Markets comprise of the Equities Market and the Debt Markets. Worldwide equity market attracts a lot of attention. Debt is considered boring. But it is surprising to know that in any country in the world, the debt market is several times bigger than the equity market. So much bigger, that most of the market is beyond the reach of ordinary investors. Institutional investors are the major players in the market. These institutions buy bonds worth tens of millions and not thousands. Debt Markets are markets for the issuance, trading and settlement in fixed income securities of various types and features. Fixed income securities can be issued by almost any legal entity like Central and State Governments, Public Bodies, Statutory corporations, Banks and Institutions and corporate bodies.

Fixed income securities

Fixed Income securities are one of the most innovative and dynamic instruments evolved in the financial system ever since the inception of money. Based as they are on the concept of interest and time-value of money, Fixed Income securities personify the essence of innovation and transformation, which have fueled the explosive growth of the financial markets over the past few centuries.

Fixed Income securities offer one of the most attractive investment opportunities with regard to safety of investments, adequate liquidity, and flexibility in structuring a portfolio, easier monitoring, long term reliability and decent returns. They are an essential component of any portfolio of financial and real assets, whether in form of pure interest bearing bonds, innovative and varied type of debt instruments or asset-backed mortgages and securitised instruments.

Market SegmentIssuerInstruments

Government SecuritiesCentral GovernmentZero Coupon Bonds, Coupon Bearing Bonds, Treasury Bills, STRIPS

State GovernmentsCoupon Bearing Bonds.

Public Sector BondsGovernment Agencies / Statutory BodiesGovt. Guaranteed Bonds, Debentures

Public Sector UnitsPSU Bonds, Debentures, Commercial Paper

Private Sector BondsCorporatesDebentures, Bonds, Commercial Paper, Floating Rate Bonds, Zero Coupon Bonds, Inter-Corporate Deposits

BanksCertificates of Deposits, Debentures, Bonds

Financial InstitutionsCertificates of Deposits, Bonds

Fixed Income Markets The Fixed Income securities market was the earliest of all the securities markets in the world and has been the forerunner in the emergence of the financial markets as the engine of economic growth across the globe. The Fixed Income Securities Market, also known as the Debt Market or Bond Market, is easily the largest of all the financial markets in the world today. The Debt Markets have a very prominent role to play in the efficient functioning of the world financial system and in catalyzing the economic growth of nations across the globe.

Classification of Bond Markets

Bond markets can be categorized into different classes based on the nature of the market, nature of the issuer, and nature of issuance. They can be classified as primary bond market and secondary bond markets based on the nature of the market; government and corporate bond market based on the nature of the issuer; and domestic, foreign, and Eurobond market based on the nature of bond issuance.

Primary and Secondary Bond Markets

Bonds are first issued in a primary bond market. In this marketplace, a borrower issues or sells bonds to the investor or buyer. As the name suggests, it is a first-sale market, where the issuer places his bonds with the investor for the first time. Until 1970s, only primary bond markets existed and bonds were issued in the form of plain vanilla products. Investors used to purchase bonds and hold them until maturity. The predictable nature of the future cash flows associated with bonds made them more attractive. Investors enjoyed the risk-free returns.

A secondary market for bonds came into existence in the late 1970s. Since then, investors started taking advantage of price differences. Unlike primary market, secondary market is a re-sale market, where the buying and selling of already existing bonds take place. There is no fresh issue of bonds; instead, the already existing bonds are exchanged among investors.

Bond dealers and banks are the major participants in a bond market. They act as intermediaries, by buying bonds from issuers and selling the same to investors in a primary bond market. Bond dealers also maintain active secondary bond markets. Bond trading is largely done over-the-counter, where bond dealers bid for bonds that investors are willing to sell and offer them to investors willing to buy. Secondary bond markets are equipped with highly sophisticated networked counters.

Bond markets can be segregated into government bond markets and corporate bond markets based on the issuers of bonds.Government Bond Markets

According to many studies, governments are the largest issuer of bonds worldwide. Government bonds, also known as 'sovereign debts', play an important role in enhancing the liquidity of a bond market. These are the backbones of healthy domestic debt markets.

From a macroeconomic perspective, government bonds enhance stability in an economy by acting as one of the sources for funding budget deficit. Market-oriented funding of budget deficit reduces debt-service costs. A government bond market also facilitates the implementation of monetary policy. Development of a deep and liquid government bond market helps in ironing out the friction caused by financial shocks. Such a market, coupled with sound debt management, can help governments reduce exposure to currency, interest rate and other financial risks

Corporate Bond Markets

Private and public corporations issue corporate bonds in order to fund their business purposes, ranging from building facilities to purchasing equipment for expansion. Investors generally go for corporate bonds due to their advantages of attractive yields, marketability, dependable income, safety and diversity. Moreover, credit ratings of the corporate bonds enhance the safety factor associated with them. Investors in this market include individuals, and large financial institutions e.g., pension funds, endowments, mutual funds, insurance companies and banks.

Corporate bonds serve as a readily available source of financing for companies hunting for long-term funds. These reduce companies' over dependence on banks for short-term borrowing and instead facilitate long-term financial planning. In order to issue corporate bonds, companies approach investment bankers with their proposal to issue bonds, who in turn send recommendations to exchanges after a due diligence analysis.

Domestic Bond Markets

Bonds in domestic/local markets are issued by a domestic borrower usually in the local currency. There has been a rapid growth in the local bond markets over the past few years. This growth is the immediate upshot of the financial crises. The blows dealt by the financial crises made countries realize the need for an efficient domestic debt market that could act as a substitute for external sources of funding. These markets could shield against the on-and-off nature of international capital markets during the crises period. It could also help in creating a wider list of home-grown instruments to overcome inherent currency and maturity mismatches. Countries are poised to develop a strong domestic bond market to reduce dependence on international markets. To what extent the domestic bond market can prove to be a substitute of international sources of funding in crisis still remains a point to ponder.

Domestic bond markets were full of lacunae, such as, restricted demand for fixed income products, limited supply of quality bond issuances, and last but not the least, inefficient market infrastructure. These loopholes were overlooked till the Asian crisis, but as an aftermath, many governments are making consistent and determined efforts to plug them. Nevertheless, there have been differences in the rate of growth and factors driving the growth in different countries. Financing expansionary fiscal policies, the need for re-capitalizing the banking system and a lack of bank credit have been the major drivers to the growth of domestic bond markets in the Asian region. Whereas, the increased participation of domestic institutional investors and corporate sector's refinancing needs have been the main drivers to bond market growth in the Latin American region. In the EU region, the harmonization of regulations for the accession to the EU, has been the primary driver for growth.

Foreign Bond Markets

Foreign bonds are issued by a foreign borrower in a local market in the local currency. Foreign bonds have interesting nomenclatures indicating the local markets where they are issued. Bonds issued in US dollar by a borrower located outside US are called Yankee bonds, bonds issued in sterling by a borrower residing outside UK are known as Bulldog bonds. Similarly, bonds issued in yen by a borrower residing outside Japan are called Samurai bonds.

Ninety years ago, international bond markets were confined to foreign bonds. Erstwhile international bond markets were not very different from today's markets in terms of types of issuers and subscribers, and underwriting and syndication practices. In the post-World War I era the US economy witnessed a tremendous growth and so did its currency. The US foreign bond market, also called the Yankee bond market, continued dominating the world's capital markets. It grew more rapidly after World War II. The Yankee bond market remained the most dominant and largest foreign bond market for many years. But of late, it is being overtaken by CHF (Swiss franc) foreign bond markets. Table 1 gives the history of foreign bond markets in major countries.

Eurobond Markets

Loans arranged through a syndicate of banks of international repute and placed in the countries not corresponding to the currency of issue are called Eurobonds. The history of Eurobonds dates back to the early 1960s, when Eurodollar bonds (USD bonds issued outside US) dominated the Eurobond market. The first Eurobond was issued in 1957. Presently, Eurobonds are denominated in almost all the major currencies. Today, the Eurobond markets are well developed and more sophisticated than they were at their inception.

Bond Market Instruments: A wide variety of bonds are available in the marketplace. Issuers can issue bonds according to the specifications of an investor, such bonds are not publicly traded and are privately placed. The most popular instruments of bond markets are:

Straight bonds: These are the fixed income bonds with specific interest payments on specified dates over a specified period of years. Straight bonds are also known as debentures. These are the basic fixed income bonds, where the owner receives a predetermined interest amount from the issuer at regular intervals, either annually or semi-annually. The issuer doesn't have an option to redeem the loan prior to maturity. The issuer has to redeem the bond at its face value, also known as par value at a predetermined date. Perpetual bonds: These bonds have no maturity date. A steady stream of interest on these bonds is paid forever and these cannot be redeemed.

Callable bonds: The issuer has an option to call back or buy back all or a part of their bonds under specified conditions before the maturity date. Corporations and municipal corporations issue these bonds in order to capitalize on the fall in interest rates. When the issuer calls back his bonds, then the owner is obligated to sell them back to the issuer at a price specified when they were issued, which usually exceeds the market price. The difference between current market price and the call price is the call premium.

Zero-coupon bonds: These are the straight bonds with no periodic interest payments. These bonds are issued at less than par value and redeemed at par value. They serve to eliminate investment risk to the investor. The investor does not receive any interest payments on these bonds. Hence the investor bears no reinvestment risk till the maturity of the bond. Greater certainty of the returns is the major attraction to the investors of these bonds.

Strips: A Separately Registered Interest and Principal of Securities is an innovation to zero-coupon bonds. This is issued by the borrowers and deposited with a trustee, who in turn, divides the bond into separate individual payment components that allow the components to be registered and traded as separate securities. Then the trustee directs the appropriate amount of interest or maturity payments to investors.

Floating rate notes: These notes are issued by banks and building societies. FRNs are similar in structure to the straight bonds except for their interest calculations. Coupon rates of FRNs are linked to the London Interbank Offered Rate (LIBOR). The coupon rates are reset at regular specified intervals, normally 3 months, 6 months, or one year. Investors benefit from lower pricing of bank loans and larger maturities of straight bonds.

Convertible bonds: Convertible bond, as the name suggests, can be converted to or exchanged for another security at the bondholder's option under specified conditions. Convertible bonds are generally exchanged for an issuer's common shares. Issuers can have an advantage of lower funding costs and possibility of non-repayment of the principal amount.

Junk bonds: Junk bonds are high-yield bonds issued by companies and are considered highly speculative because of high risk of default. The credit rating for these bonds are either 'speculative' grade or below 'investment' grade. Although these bonds have higher default risks than others, the returns associated with these are relatively higher than those of other bonds. Hence the risk of default is more than compensated by high yields. Catastrophe bonds: These are insurance linked debt instruments used to raise money in case of a catastrophe. The catastrophe could be an earthquake or hurricane of sufficient magnitude and within a particular region. Usually, insurance or a reinsurance company is the issuer of a catastrophe bond. The special condition linked with such a bond is that, if the issuer suffers a loss from a catastrophe, then the investor is obligated to either defer or completely forgo the principal and/or interest payable by the issuer.

Factors Influencing Bond Markets

The fluctuations in bond markets are caused by several economic factors, the most significant factor being a change in interest rates. Interest rates have an inverse relation with the bond price: as interest rates rise, the bond price falls and vice versa. Changes in interest rates could be due to changes in demand and supply of credit, fiscal and monetary policies, exchange rates, market psychology and inflation expectations.

Inflation is considered to be yet another major factor affecting bond markets. Bond investors always have an aversion towards inflation. They fear inflation, as it lowers the value of bonds by reducing the future purchasing power of fixed interest payments they receive. Hence, any economic development that is likely to result in inflation causes panic in the bond markets.

International bond markets are exposed to exchange-rate risk. Cash flows associated with foreign bonds are dependent on the exchange rate at the time the payments are received. Hence, fluctuations in the exchange rates cause changes in the value of bonds.

Policy actions can also impact bond markets significantly. A conscious policy move or increase in the forex reserves makes the bond markets more volatile. Liquidity created by such policy actions drives investors to trade more frequently and actively. In an uncertain interest rate scenario, created by conflicting signals from different policy makers, bond investors tend to become increasingly risk-averse.

Corporate Bond

A debt security issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. In some cases, the company's physical assets may be used as collateral for bonds.

Corporate bonds are issued by private and public corporations. Companies issue corporate bonds to raise money for a variety of purposes, such as building a new plant, purchasing equipment, or growing the business. When one buys a corporate bond, one lends money to the "issuer," the company that issued the bond. In exchange, the company promises to return the money, also known as "principal," on a specified maturity date. Until that date, the company usually pays you a stated rate of interest, generally semiannually. While a corporate bond gives an IOU from the company, it does not have an ownership interest in the issuing company, unlike when one purchases the company's equity stock.

Corporate bonds are considered higher risk than government bonds. As a result, interest rates are almost always higher, even for top-flight credit quality companies.

Corporate bonds are issued in blocks of $1,000 in par value, and almost all have a standard coupon payment structure. Corporate bonds may also have call provisions to allow for early prepayment if prevailing rates change.

Corporate bonds, i.e. debt financing, are a major source of capital for many businesses along with equity and bank loans/lines of credit. Generally speaking, a company needs to have some consistent earnings potential to be able to offer debt securities to the public at a favorable coupon rate. The higher a company's perceived credit quality, the easier it becomes to issue debt at low rates and issue higher amounts of debt.Convertibles and exchangeables

Convertible bonds are corporate bonds with an embedded equity option and often with embedded (issuer) calls and/or (holder) puts. Convertibles have characteristics of both bonds and equities (or equity derivatives if held on a hedged basis), i.e. they are hybrids.

A convertible bond is a bond which can be converted into shares of the bond issuing company at the option of the bondholder. The bonds can be converted into equity at a pre-specified ratio, the conversion ratio; or alternatively, at a pre-specified price, the conversion price, which is at a premium to the underlying equity spot price at issuance.

An exchangeable bond differs only in that the bond is exchangeable for shares in a company other than the issuing company. Invariably the issuer is committed to pay