What is Debt Market? Importance, Functions, Advantages, Disadvantages, Features, Issues

What is Debt Market?

The Debt Market is the market where fixed income securities of various types and features are issued and traded. Debt Markets are, therefore, markets for fixed income securities issued by Central and State Governments, Municipal Corporations, Govt. bodies and commercial entities like Financial Institutions, Banks, Public Sector Units, Public Ltd.

Table of Contents

1 What is Debt Market?
2 Indian Debt Market
3 Importance of Debt Market
4 Functions of Debt Market
5 Advantages of Debt Market
6 Disadvantages of Debt Market
7 Features of Debt Market
8 Issues Concerned with Indian Debt Market

Companies and also structured finance instruments. The debt market is one of the largest segments of Indian financial markets.

Indian Debt Market

In India, the Government debt market is well developed in terms of instruments, size, participants and regulatory framework. Both the Government of India and State Governments raise funds from this market through the issue of various debt instruments.

By and large, these instruments are issued under the auctions. Investors prefer to invest in Government debt instruments because there is no credit risk at all. The corporate debt market in India consists of debt instruments issued by banks and financial institutions, public sector undertakings, local bodies and private companies.

Such bonds are issued with varied terms and conditions such as bonds with a fixed coupon, floating-rate bonds, bonds with put and call options and zero-coupon bonds etc. As compared to the Government debt market, the corporate debt market in India is not developed. Only the primary market for corporate debt instruments is active.

The principal feature of the debt market is that it sustains the economy. In no country can the government meet its expenditure and all governments need debt. To raise funds, the government asks the central bank of the country to auction bonds from time to time.

These bonds range in time from 3 to 30 years and most carry a fixed interest rate. Not only national governments but in many countries state, territorial and local governments are also allowed to raise finances by a bond issue.

The nature of debt and equity is the opposite. If the equity market rises then usually the returns from the debt market falls. When the equity market falls investment seeks a safe haven, i.e. steady gains, and debt prices rise. In this sense, the competitor of the debt market is precious metals such as bullion which are also safe-havens.

The debt market performs reflecting the mood of the country’s economy. If the economy is performing poorly, then investors in the bond of that government want to sell it off quickly leading to its plunge. This is the way in which the debt market acts as a barometer for economic health.

Importance of Debt Market

The debt market of a country performs some important functions and helps in the process of economic development of the country. We know that the debt market is the market for medium-term and long-term financial assets. It deals in securities having a maturity period of 1 year and above.

It supplies funds for financing fixed capital requirements of firms as well as long-term requirements of the government for funds. By its activities, the debt market of a country makes a considerable contribution towards the process of its economic development. This will be clear if we mention the major functions of the debt market of an economy.

The important functions of the debt market may be summarized as follows: Trade and industry of a country require funds or liquidity for their expansion. The debt market provides medium-term and long-term funds for the development of trade and industry. It thus acts as a provider of liquidity.

For economic development, small savings of the country should be mobilized first. The debt market mobilizes small savings scattered over the country through its various institutions. It thus collects much-needed funds required for the economic development of a country.

Mere mobilization of savings is not enough. The mobilized savings are to be properly invested. The debt market arranges proper investment of the funds collected from the savers. It thus makes an efficient allocation of resources.

The debt market protects the interests of both the savers and the investors. It thus helps increase the propensity to save of the savers and propensity to invest of the investors. The debt market helps in selling the securities of government enterprises and autonomous bodies.

It thus provides the much-needed funds to the government and the autonomous bodies who are important agents in the process of economic development of a country.

On the one hand, the debt market opens new opportunities for investment and thus keeps the savings of the economy mobile. On the other hand, it encourages savings, raises the rate of savings and thus helps in the economic development of the country.

In the debt market, some special purpose development financial institutions provide financial help to some targeted sectors. Some of them provide financial help to small and cottage industries. They thus help in the process of economic development of a country.

Credit rating agencies of the debt market provide superior, low-cost information to the investors about their investment. These agencies ensure optimal uses of investible funds. By providing investment information, credit rating agencies increase the propensity to invest of the investors and thus help in the economic development of a country.

Functions of Debt Market

Some financial institutions of the debt market provide managerial and technical know-how to industrial organizations. This service is also of great help for the expansion of the industrial sector of an economy. Other key functions of debt markets can be summarized as follows:

Mobilize long-term savings to finance long-term investments.
Provide capital in the form of debt to entrepreneurs.
Encourage broader ownership of productive assets.
Provide liquidity with a mechanism enabling the investor to sell financial assets.
Lower the costs of transactions and information.
Improve the efficiency of capital allocation through a competitive pricing mechanism.
Enable quick valuation of financial instruments both equity and debt.
Enable wider participation by enhancing the width of the market by encouraging participation through networking institutions and associating individuals.
Provide operational efficiency through: simplified transaction procedures: lowering settlement timings; and Lowering transaction costs.
Develop integration among: real and financial sectors; equity and debt instruments; long-term and short-term funds; long-term and short-term interest costs; private and government sectors; and o Domestic and external funds.
Direct the flow of funds into efficient channels through investment, disinvestment, and reinvestment.

Thus, we can say that without a developed debt market, the economic development of a country is not possible. The process of economic development might be slow or may even be halted if the debt market is underdeveloped and unorganized.

Advantages of Debt Market

These are the advantages of debt market given below:

The biggest advantage of investing in Indian debt markets is its assured returns.
The returns that the market offer is almost risk-free (though there is always certain amount of risks, however the trend says that return is almost assured).
Government securities are safest avenues. There are certain amounts of risks in the corporate, FI and PSU debt instruments. However, investors can take help from the credit rating agencies which rate those debt instruments. The interest in the instruments may vary depending upon the ratings.
Another advantage of investing in India debt market is its high liquidity.
Banks offer easy loans to the investors against government securities.
Greater safety and lower volatility as compared to other financial instruments.
Higher leverage available in case of borrowings against government securities.
Greater diversification opportunities, adequate trading opportunities with continuing volatility expected in interest rates.
It speeds up the economy by making it possible for banks to offer mortgages to consumers.

Disadvantages of Debt Market

These are the disadvantages of debt market explained below:

As the returns here are risk free, those are not as high as the equities market at the same time. So, at one hand you are getting assured returns, but on the other hand, you are getting less return at the same time.
Retail participation is also very less here, though increased recently. There are also some issues of liquidity and price discovery as the retail debt market is not yet quite well developed.
Debt securities usually have much smaller price changes than stocks or commodities. Traders in debt securities must take larger positions to achieve the same level of profits.
The debt trading markets are dominated by hedge funds and the trading desks of large financial institutions. These traders have access to information and capital that is difficult or impossible for the individual trader to obtain. By the time the small trader gets the news that these large players are trading on, it may be too late to profit from the news.
Traders in corporate debt securities trade high-yield or junk bonds to earn the higher interest rates these bonds pay. The trader can also achieve capital gains if the issuing corporation gets an upgrade in its credit rating. The downside of high yield bonds is a bankruptcy and total loss of the principal invested.

Features of Debt Market

The bond/ Debt market is of central importance to economic activity. The bond market is vital for economic activity because it is the market where interest rates are determined. Interest rates are important on a personal level because they guide our decisions to save and to finance major purchases (such as houses, cars, and appliances, to give a few examples).

From a macroeconomic standpoint, interest rates have an impact on consumer spending and on business investment. The features of debt markets can be summarized as follows:

Classified into Segments

There are three main segments in the debt markets in India, viz.

Government Securities
Public Sector Units (PSU) bonds
Corporate securities

The market for Government Securities comprises the Centre, State and State-sponsored securities. In the recent past, local bodies such as municipalities have also begun to tap the debt markets for funds. Some of the PSU bonds are tax-free, while most bonds including government securities are not tax-free.

Corporate bond markets comprise commercial paper and bonds. These bonds typically are structured to suit the requirements of investors and the issuing corporation and include a variety of tailor-made features with respect to interest payments and redemption.

Nomenclature of Markets

The debt market often goes by other names, based on the types of debt instruments that are traded. In the event of the debt market dealing mainly with municipal and corporate bonds, the debt market may be known as a bond market.

If mortgages and notes are the main focus of trading, the debt market may be known as a credit market. When fixed rates are connected with the debt instruments, the market may be known as a fixed income market.

Changing Structure

In the majority of the countries, the debt market is more popular and many times bigger than other financial markets including the equity market. However, in India, the opposite was true for a very long time, because of the existence of a passive internal debt management policy, where only the government borrowed from a captive group of investors like banks.

The Indian debt market, in the pre-liberalization era, was characterized by controls on pricing of assets, segmentation of markets and barriers to entry, low levels of liquidity, the limited number of players, near lack of transparency and high transaction costs.

Changes in Post Liberalization Era

The debt market in India has traditionally been a wholesale market with participation restricted to a few institutional players – mainly banks. Indian securities and bonds markets have witnessed far-reaching reforms in the post-liberalization era in terms of market design, technological developments, settlement practices and introduction of new instruments

Today, we have integrated trading, clearing and payment platforms, which enable seamless settlement of transactions. The markets have achieved tremendous stability and as a result, have attracted huge investment.

Diversified Participants

The investors in the debt markets concentrate on banks, financial institutions, mutual funds, provident funds, insurance companies and corporations. Many of these participants are also issuers of debt instruments.

Fixed Return

The most distinguishing feature of debt instruments of the Indian debt market is that the return is fixed, i.e., returns are almost risk-free. This fixed return on the bond is often termed as the ‘coupon rate’ or the ‘interest rate’.

Larger Volume

The Indian debt market, in terms of volume, is larger than the equity market. The Indian debt market measured by the estimated value of bonds outstanding is next only to Japanese and Korean bond markets in Asia.

Variety of Debt Instruments

A variety of debt instruments have been introduced into the Indian capital market in recent years. They are called new innovative instruments. These new instruments may again be divided into two categories: instruments issued by corporate and instruments issued by financial intermediaries.

In the first category, we have participating debentures, convertible debentures with options, fully convertible debentures, warrants and so on. In the second category, we may mention floating rate bonds, zero-coupon bonds, regular income bonds, retirement bonds, growth bonds, index bonds, deep discount bonds and so on.

Stringent Regulation

The regulatory jurisdiction over the corporate debt has been assigned to the Indian securities market regulator SEBI under SEBI Act, 1992. For Government debt securities, RBI has the jurisdiction to provide the guidelines to run the debt market.

To avoid the confusion of multiple regulations, a notification issued by the Government on March 2, 2000, clearly defined the areas of responsibility between RBI and SEBI. The issue of corporate debts is also under the regulation of SEBI. The issuance of debt instruments by the government is regulated by the Government Securities Act 2006.

The issuance of corporate securities is regulated by the SEBI Guidelines for disclosure and Investor protection. The Government Securities Act, 2006 was enacted by the Parliament in August 2006. The RBI made Government Securities Regulation, 2007 to carry out the purpose of the Government Securities Act, 2006. The Act and the Regulations are applicable to Government securities created and issued by the Central and the State governments.

Type of Transactions

There are two types of transactions in the debt market. Firstly there are direct transactions between wholesale market participants. These account for approximately 25% of the wholesale market volumes. Secondly, there are broker intermediated transactions i.e. where brokers undertake dealings for banks, institutions or other entities.

Dematerialization of Debt Securities

The government abolished stamp duty on debt securities to boost the dematerialization of debt securities and enhance levels of trading in corporate debt securities. Both the NSDL and the CDSL were permitted to admit debt instruments to the depository.

The debt instruments include debentures, bonds, commercial papers, and certificates of deposit, irrespective of whether these instruments are listed, unlisted or privately placed. With dematerialization, it has become possible for banks to sell securities in smaller lots to corporate clients, provident funds, trusts, and others.

The cost of holding securities in Demat form is negligible as most of the banks are depository participants (DPs) of NSDL.

Wholesale Debt Market

The National Stock Exchange of India Ltd set up a separate segment for trading in debt securities known as the Wholesale Debt Market segment of the exchange. Prior to the commencement of trading in the WDM segment of the NSE, the only trading mechanism available in the debt market was the telephone.

The NSE provided, for the first time in the country, an online, automated, screen-based system known as NEAT (National Exchange for Automated Trading) across a wide range of debt instruments. In the WDM trading system, there are two markets:

Continuous Market
Negotiated Market. In the continuous market, the buyer and seller do not know each other and they put their orders. If the orders match, it results in a trade which is settled directly between the participants. In the negotiated market, no counter-party exposure limit needs to be involved as the participants are familiar with each other.
This system is an order-driven system which matches the best buy and sells orders on a price time priority and simultaneously protects the identity of the buyer and the seller.

Retail Debt Market

It involves participation by individual investors, Small trusts and other legal entities in addition to the wholesale investor classes.

Issues Concerned with Indian Debt Market

The corporate debt market in India is yet to be fully developed. Despite various reforms in the corporate debt market, still, there are certain issues that need to be addressed and changes will have to be made in the existing policy framework. These issues are discussed below:

Lack of Liquidity in respect of many Debt Instruments in the Secondary Market

The secondary market for corporate debt instruments is illiquid. In the absence of an active secondary market, investors have difficulties to sale debt instruments in the secondary market. The concepts of Primary Dealers need to be introduced in respect of the corporate debt segment to create a secondary market in respect of a large number of corporate debt securities which are not listed on stock exchanges.

Increasing the Number of Participants

Increasing the number of players in the market will result in participants being available on both sides of the market and will also boost volumes. Various institutional investors need to be encouraged to participate in the secondary market.

FIIs also will have to be encouraged to invest in corporate debt securities. The Pension funds, provident funds and charitable funds, etc., need to be encouraged to participate in the market. For this, suitable tax benefits can be offered to the investors.

Need for Change in Attitude of Retail Investors

There is a need to encourage the participation of retail investors in the corporate debt market. Retail investors do not trade in the corporate debt securities in the secondary market. The normal tendency is to invest in and hold corporate debt securities till maturity.

This attitude needs to be changed. The retail investors will have to be encouraged to trade in corporate debt securities in the secondary market. The primary dealers can play a significant role in this regard. They have to offer two-way quotes in respect of a large number of debt securities.

Need for Innovative Instruments

There is no point in offering only plain Vanilla debt securities. In order to encourage savings from small investors and attract investment from institutional investors, there is a need to bring innovations in the issue of debt instruments.

The debt securities having features such as monthly interest payment, deep discount bonds, bonds with put and call options and floating rate bonds etc., are likely to be subscribed by both institutions as well as retail investors. Therefore more variety of debt instruments needs to be offered to the retail and institutional investors.

Greater Disclosure in Respect of Privately Placed Debt Instruments

A larger portion of the corporate debt securities is privately placed. In view of this, various issues relating to the private placements need to be addressed. In this context, it is essential to ensure greater transparency, adequate disclosures, minimum credit rating and proper accounting standards.

This will enhance the confidence of investors in the debentures issued by private corporate entities. Credit rating agencies will require taking utmost care while the rating of debt instruments that are privately placed.

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