Terminologies in Debt Market Ready Reference

Liquid Funds : Also known as Money Market Schemes, These funds provides easy liquidity and preservation of capital. These schemes invest in short-term instruments like Treasury Bills, inter-bank call money market, CPs Repos and CDs. These funds are meant for short-term cash management of corporate houses and are meant for an investment horizon of 1day to 3 months. These schemes rank low on risk-return matrix and are considered to be the safest amongst all categories of mutual fund Short Term Plans (STPs): Meant for investment horizon for three to six months. These funds primarily invest in short term papers like Certificate of Deposits (CDs) and Commercial Papers (CPs). Some portion of the corpus is also invested in corporate debentures. A Fixed Maturity Plan (FMP) is a close-ended scheme, and has an exit load, if redeemed, before the maturity period. Such schemes can have a maturity period of three months to three years. It selects an instrument, which corresponds with its maturity period. For instance, if the maturity of a scheme is one year, then the scheme will invest in instruments having one-year maturity. As the instrument will have a fixed interest rate payable on quarterly/half-yearly basis, the NAV will be on interest accrual basis. Debt Funds : Debt funds are funds that invest strictly in debt related securities. Unlike any other asset class like equity, debt securities are characterized by the following factors Known maturity period, Known coupon rate (or in common parlance known interest rate) & Known maturity value. By investing in debt instruments, these funds ensure low risk and provide stable income to the investors. Income/bond schemes invest in long- and mediumterm instruments like corporate bonds, debentures & fixed deposits. Government authorities, Pvt. Cos., Banks and FIs are some of the major issuers of debt papers. Examples of these instruments include Debentures issued by Corporates, State Govt. & Central Govt., FD, CP, T Bills & Debentures. Debt funds are further classified as : Income/bonds, liquid/money market and gilts schemes. MIPs : Invests maximum of their total corpus in debt instruments while they take minimum exposure in equities. It gets benefit of both equity and debt market. These scheme ranks slightly high on the risk-return matrix when compared with debt schemes. Gilt Funds : Invest their corpus in securities issued by Government, popularly known as Govt. of India debt papers. These Funds carry zero Default risk but have Interest Rate risk. These schemes are safer as they invest in papers backed by Government. G Secs / Gilt edged Securities : Securities / Sovereign papers issued by the Central / State & Quasi Governments. It is a promissory note, issued by the original holder, which contains a promise by the President of India / State Govt. to pay as per given schedule. The maturity period is medium- and long-term depending upon an investors goals. There are other plans, too, like monthly income plans (MIPs) wherein every month a fixed amount is invested of which approximately 20% is allocated to equity and the remaining to debt. SGL : Subsidiary General Ledger Account is the demat facility for G Sec offered by the RBI. In the case of SGL facility the securities remain in the computers of RBI by credit to the SGL account of the owner. Treasury Bills : Short-term instruments issued by the Treasury or RBI to mobilize short term funds for the Govt. They have a tenor like 14 to 364 days & sold at a discount & redeemed at par on auction basis by GOI. They have nil credit risk & negligible price risk. Money Market Instruments : Debt instruments having maturity less than 1 year at the time of issue. These are highly liquids and have negligible risk. The MMT are treasury bills, CD, CP & Repos. CD : These are transferable short term deposits issued by Banks & FIs. It has a maturity of 91 365 days & are issued at a discount & redeemed at par. They offer higher rate if interest than T Bills & Term deposits. CP : They are short-term unsecured promissory note issued by financially strong forms. It has a maturity of 90 180 days & are issued at a discount & redeemed at par. Repos : It is used as an abbreviation for repurchase agreement or ready forward & involves a simultaneous sale & repurchase agreement. They are very convenient, safe & earn a pre-determined return. Repos are very shortterm market instruments. It is nothing but a collateralized borrowing and lending. In reverse Repos securities are purchased in a temporary purchase with a promise to sell it back after a specified period at a pre-specified price. Repo for one party is Reverse Repo for the other party. The rate of interest paid by the RBI to borrow funds from commercial banks is call Repo Rate Call Money : Borrowing or lending for one day in the inter-bank market is known as call money. Entry into this segment of the market is restricted to notified participants which include scheduled commercial banks, primary dealers and satellite dealers, development financial institutions and mutual funds. CRR : A portion, decided by the RBI, of the depositors money that banks must keep in the form of cash. The purpose of CRR is to ensure that the banks are liquid at all times and is changed from time to time to regulate the availability of credit and the money supply in the economy. Basis Point : One hundredth of a percentage (i.e..01). As interest rates are generally sensitive in the second place after the decimal point, the measure has large importance for the debt market.

Terminologies in Debt Market Page 3

Coupon : The rate of interest paid on a security, generally a fixed percentage of the face value, is called the coupon. The origin of the term dates back to the time when bonds had coupons attached to them, which the investor had to detach and present to the issuer to receive the money. Asset backed security : Any security that offers to the investor as asset as collateral. The rate of return required for such types of bonds is less compared to bonds that offer no collateral. Auction : The process of issuing a security through a price-discovery mechanism through asking for bids. This is the process followed by the RBI for all type of issues of debt market paper by it. Currency Yield : The coupon rate divided by the price of the bond. This is a very inadequate measure of yield, as it does not take into the account the effect of the future cash flows and the application of discounting factors on them. Discount : The quantum by which a security is issued or traded below its par value is called Discount. Duration : Duration is a measure of Bonds price risk. It is a weighted average of all the cash-flows associated with a bond, weighed by the proportion of value due to the jth payment in the cash-flow stream, with sum of all js equalling one. Thus a bond with duration of 1.50 years means that a rise in its yield by one percent would result in a decline of its value by 1.50%. Floating Rate Note : It is an instrument that does not pay a fixed rate of interest on its face value. The interest paid on such instruments is dependent upon the value of a benchmark rate. The benchmark rate is mutually agreed upon by the issuer and the investor and has to specify some criteria. The interest paid is typically a mark-up on the benchmark so agreed. Interest Rate Swap : It is transaction in which a flow of coupon of one variety is exchanged for another of a different variety, but in the same currency. LIBOR : Stands for London Inter-Bank Offered Rate. This is very popular bench mark and is issued for USD, GBP, Euro, Swiss Franc, Canadian Dollar & Yen. MIBOR : Stands for Mumbai Inter-Bank Offered Rate, it is closely modeled on the LIBOR. Currently there are two calculating agents for the benchmark Reuters & the NSE. The NSE MIBOR benchmark is more popular of the two. Mark to Market : MTM is a very popular reporting and performance measurement tools for any investment In this technique the price at which the investment was made is compared with the price which the asset can realize if liquidated in the current market at that moment. The difference is either MTM gain or MTM loss depending upon the current worth vis--vis the original price. Liabilities can also be made subject to the same analysis as assets. Periodicity of the MTM depends upon the liquidity of the market in which the asset is a class. Risk Free Rate : An interest rate is given out by an investment that has a zero probability of default. Theoretically this rate can never exist in practice but sovereign debt is used as the nearest proxy. PLR : This is the acronym for Prime Lending Rate. This is the rate at which a bank in India lends to its prime customer. The bank usually follows as internal credit rating system and charges a spread over the PLR for nonprime customers. SLR : Statutory Liquidity Ratio is that part of their Net Demand and Time Liabilities that a bank is required by Law to be kept invested in approved securities, like sovereign issues, is known as SLR. The maintenance of SLR ensures a minimum liquidity in the banks assets. Yield to Maturity (YTM) : It is the rate of discount that equates the discounted value of all the future cash flows of a security with its current price. In a way, it is another way of stating the price of a security as other things remaining constant, the price is a direct function of the YTM. It is used primarily for its simplicity of nature and ease of calculation. Zero Coupon Bond : ZCB is one that pays no periodic interest are typically issued at a discount and redeemed at face value. The discount rate, apportioned over the life of the bond is the effective interest paid by the issuer to the investor. In India, the ZCB are virtually non-existent over one year & up to one year, the T-Bills issued are proxies for ZCB.

Tax Implication of Debt Schemes

Short Term Capital Gains Tax Long Term Capital Gains Tax Dividend income Dividend Distribution Tax
Liquid Fund Resident Individual/HUF Parttnership Firm/AOP/BOI Domestic Companies As per slab As per slab 30% 10% (20% with indexation) 10% (20% with indexation) 10% (20% with indexation) TAX FREE TAX FREE TAX FREE 28.33 28.33 28.33 Debt Fund 14.16 22.66 22.66 NIL NIL NIL STCG-30% LTCG - 20% (after indexation)

TDS

NRI

As per slab

10% (20% with indexation)

TAX FREE

28.33

14.16

FD vs FMP ( or Debt Schemes)

Interest income from FDs is added to the Investors income and is taxable at the applicable tax slab for that Investor, whereas, Dividend from FMPs is TAX FREE in the hands of the investor. But the Mutual Fund has to deduct a dividend distribution tax of 14.16% for an Individual & 22.66% in the case of Corporates. Whereas in FDs the TDS is deducted @ 33.99% for Corporates Due to Indexation benefit, FMPs end up in becoming more Tax efficient than a FD as indexation lowers tax liability. Long Term Capital Gain (Investment of more than 365 days) in FMP & Debt Funds enjoys Indexation benefit. FDs dont have this advantage. There are no hassles of TDS in FMP as compared to FDs.

Comparison between a 13 month FD & FMP

Parameters FD FMP Dividend Option FMP Without Indexation Parameters FMP With Indexation

Rate TDS DDT LTCG Net

9.30% 33.99%

9.50%

9.50%

9.50%

Inflation (Assuming)
22.66% 11.33%

8% 8% 1.50% 22.66% 0.34%

Single Indexation Taxable LTCG Tax

6.14%

7.74%

8.42%

9.16%

* DDT = Dividend Distribution Tax *** LTCG = Long Term Capital Gains

Double Indexation : For calculating capital gains, we reduce the cost from the sale value. For calculating long-term capital gains, such cost can be enhanced by the inflation multiple. For this purpose, CBDT (Central Board Of Direct Taxes) releases the index figures for each financial year. Such declared index is applicable for any transaction done during the entire year. The base year is 1981-82 for which the index is 100. Then on, considering the inflation figure for the year, CBDT has been releasing indices for each year. Such an index is known as the Cost Inflation Index (CII). Thus, Double indexation is a neat trick where you by holding the investment a little into the next financial year, an investor can use the facility of the CII for two years (holding an investment for a little more than one year & getting the benefit of the index multiple of two years). The CII usage boosts the cost beyond the sale price due to which the investor suffers a notional capital loss. Consequently, the entire maturity value is rendered tax-free. The net annualized return remains without any tax incidence whatsoever. This is called Double Indexation, Ladies and Gentlemen !