MONEY & BANKING

MODULE 4
GOVERNMENT SECURITY
A Government security is a tradable instrument issued by the Central Government
or the State Governments. It acknowledges the Government’s debt
obligation. Such securities are short term (usually called treasury bills, with
original maturities of less than one year) or long term (usually called Government
bonds or dated securities with original maturity of one year or more).
In India, the Central Government issues both, treasury bills and bonds or dated
securities while the State Governments issue only bonds or dated securities,
which are called the State Development Loans (SDLs). Government securities carry
practically no risk of default and, hence, are called risk-free gilt-edged
instruments. Government of India also issues savings instruments (Savings
Bonds, National Saving Certificates (NSCs), etc.) or special securities (oil bonds,
Food Corporation of India bonds, fertiliser bonds, power bonds, etc.). They are,
usually not fully tradable and are, therefore, not eligible to be SLR securities.
TREASURY BILLS (T-bills)
Treasury bills or T-bills, which are money market instruments, are short term debt
instruments issued by the Government of India and are presently issued in three
tenors, namely, 91 days, 182 days and 364 days. Treasury bills are zero coupon
securities and pay no interest. They are issued at a discount and redeemed at the
face value at maturity.
CASH MANAGEMENT BILLS (CMBs)
Government of India, in consultation with the Reserve Bank of India, has issued a
new short-term instrument, known as Cash Management Bills (CMBs), to meet the
temporary mismatches in the cash flow of the Government. The CMBs have the
generic character of T-bills but are issued for maturities less than 91 days. Like
T-bills, they are also issued at a discount and redeemed at face value at maturity.
The tenure, notified amount and date of issue of the CMBs depends upon the
temporary cash requirement of the Government.
DATED GOVERNMENT SECURITIES
Dated Government securities are long term securities and carry a fixed or
floating coupon (interest rate) which is paid on the face value, payable at fixed time
periods (usually half-yearly). The tenor of dated securities can be up to 30 years.
SPECIAL SECURITIES
In addition to Treasury Bills and dated securities issued by the Government of India
under the market borrowing programme, the Government of India also issues, from
time to time, special securities to entities like Oil Marketing Companies, Fertilizer
Companies, the Food Corporation of India, etc. as compensation to these companies
in lieu of cash subsidies. These securities are usually long dated securities
carrying coupon with a spread of about 20-25 basis points over the yield of the dated

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securities of comparable maturity. These securities are, however, not eligible SLR
securities but are eligible as collateral for market repo transactions. The
beneficiary oil marketing companies may divest these securities in the secondary
market to banks, insurance companies / Primary Dealers, etc., for raising cash.
STATE DEVELOPMENT LOANS (SDLs)
State Governments also raise loans from the market. SDLs are dated securities
issued through an auction similar to the auctions conducted for dated securities
issued by the Central Government. Interest is serviced at half-yearly intervals and
the principal is repaid on the maturity date. Like dated securities issued by the
Central Government, SDLs issued by the State Governments qualify for SLR. They
are also eligible as collaterals for borrowing through market repo.
BENEFITS OF GOVERNMENT SECURITIES
Holding of cash in excess of the day-to-day needs of a bank does not give any
return to it. Investment in gold has attendant problems in regard to appraising its
purity, valuation, safe custody, etc. Investing in Government securities has the
following advantages:
 Besides providing a return in the form of coupons (interest), Government
securities offer the maximum safety as they carry the Sovereign’s commitment
for payment of interest and repayment of principal.
 Government securities are available in a wide range of maturities from 91 days
to as long as 30 years to suit the duration of a bank's liabilities.
 Government securities can be sold easily in the secondary market to meet cash
requirements.
 Government securities can also be used as collateral to borrow funds in the repo
market.
 Government security prices are readily available due to a liquid and active
secondary market and a transparent price dissemination mechanism.
 Besides banks, insurance companies and other large investors, smaller
investors like Co-operative banks, Regional Rural Banks, Provident Funds are
also required to hold Government securities.

PRIMARY DEALER
A primary dealer is a firm that buys Government securities directly from a market,
with the intention of reselling to others, thus acting as a market maker of
Government securities. PDs are permitted to borrow, lend and trade in the money
market including call money market, CBLO of CCIL and participate in Repos.

PREVIOUS YEARS’ QUESTIONS (PRELIMS)

1. Consider the following statements (2018)
1. The Reserve Bank of India manages and services Government of India
Securities but not any State Government Securities.
2. Treasury bills are issued by the Government of India and there are no treasury
bills issued by the State Governments.
3. Treasury bills offer are issued at a discount from the par value.
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 Which of the statements given above is/are correct?
(a) 1 and 2 only (b) 3 only (c) 2 and 3 only (d) 1, 2 and 3
2. Consider the following: (2001)
1. Market borrowing
2. Treasury bills
3. Special securities issued to RBI
Which of these is/are component(s) of internal debt?
(a) 1 only (b) 1 and 2 (c) 2 only (d) 1, 2 and 3
3. Gilt-edged market means (2000)
(a) bullion market
(b) market of Government securities
(c) market of guns
(d) market of pure metals

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prelims-in-110-hours.html

ECOFFAIRS
MONEY & BANKING
1. BOND PRICE & BOND YIELDS
A bond is an instrument to borrow money. A bond could be floated/issued by a
country’s Government or by a company to raise funds. Since Government bonds
(referred to as G-secs in India, Treasury in the US, and Gilts in the UK) come with the
sovereign’s guarantee, they are considered one of the safest investments. As a
result, they also give the lowest returns on investment (or yield). Investments in
corporate bonds tend to be riskier because the chances of failure are higher.
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WHAT ARE BONDS YIELDS?
Simply put, the yield of a bond is the effective rate of return that it earns. But the
rate of return is not fixed — it changes with the price of the bond. But to understand
that, one must first understand how bonds are structured. Every bond has a face
value and a coupon payment. There is also the price of the bond, which may or
may not be equal to the face value of the bond.
Suppose the face value of a 10-year G-sec is Rs 100, and its coupon payment is Rs
5. Buyers of this bond will give the Government Rs 100 (the face value); in return,
the Government will pay them Rs 5 (the coupon payment) every year for the next 10
years, and will pay back their Rs 100 at the end of the tenure. In this case, the
bond’s yield, or effective rate of interest, is 5%. The yield is the investor’s reward for
parting with Rs 100 today, but for staying without it for 10 years.
WHY AND HOW DO YIELDS GO UP AND DOWN?
Imagine a situation in which there is just one bond, and two buyers (or people willing
to lend to the Government). In such a scenario, the selling price of the bond may go
from Rs 100 to Rs 105 or Rs 110 because of competitive bidding by the two
buyers. Importantly, even if the bond is sold at Rs 110, the coupon payment of Rs 5
will not change. Thus, as the price of the bond increases from Rs 100 to Rs 110,
the yield falls to 4.5%.
Similarly, if the interest rate in the broader economy is different from the initial
coupon payment promised by a bond, market forces quickly ensure that the yield
aligns itself with the economy’s interest rate. In that sense, G-sec yields are in
close sync with the prevailing interest rate in an economy. With reference to the
above example, if the prevailing interest rate is 4% and the Government announces
a bond with a yield of 5% (that is, a face value of Rs 100 and a coupon of Rs 5) then
a lot of people will rush to buy such a bond to earn a higher interest rate. This
increased demand will start pushing up bond prices, even as the yields fall. This will
carry on until the time the bond price reaches Rs 125 — at that point, a Rs-5 coupon
payment would be equivalent to a yield of 4%, the same as in the rest of the
economy.
This process of bringing yields in line with the prevailing interest rate in the
economy works in the reverse manner when interest rates are higher than the
initially promised yields.
The price of a bond and its yield-to-maturity are negatively correlated to each
other. When the yield-to-maturity is higher than the coupon rate, the price of a
bond is less than the face value and vice-versa. Usually bonds are issued at
coupon rates close to the prevailing interest rate, so that they can be sold close
to their face values.
However as time passes, bonds frequently trade at prices that are different from
their face values. While two parties can agree on a price and execute a trade, a vast
majority of bonds are sold either through a public sale or through an exchange
platform and the price of the bond is thus determined by the market, and as a result,
may vary every minute.
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The price of a bond issued by a party is directly linked to the credit rating of that
party, since there is always a default risk associated with a bond, which means that
the borrower might not be able to pay the full or partial amount of the loan taken. So,
bonds with low ratings, called junk bonds, are sold at lower prices and those with
higher ratings, called investment-grade bonds, are sold at higher prices.

MARK-TO-MARKET (MTM) LOSS

Mark-to-market can be defined as an accounting tool used to record the value of
an asset with respect to its current market price.
 MTM is an accounting concept used for valuing bonds in a treasury portfolio
 A bank has three baskets to keep the bonds - Held to Maturity (HTM), Available
for Sale (AFS) and Held for Trading (HFT)
 The MTM exercise has to be done for the last two baskets
 A bank has to value its bonds at existing market price, and not the price at which
the bonds were acquired
 So, if a bond was acquired at `97 and the value of it now has fallen to `95, the
bank will have to record a loss of `2 in the trading account to reflect the fair value
of the bonds
 The MTM losses are nominal losses and become actual only when the bank sell
the bonds in the market and crystalise the losses