Public Sector Undertakings (PSU) Bonds - October 18th, 2010

PSU are medium and long term obligations issued by public sector companies in which the
government share holding is generally greater than 51%. some PSU Bonds carry tax exemptions.
the minimum maturity is 5 years for taxable bonds and 7 years for tax-free bonds. PSU bonds are
generally not guaranteed by the government and are in the form of promissory notes transferable
by endorsement and delivery.

Debt Investment Strategies An Aid for Debt Portfolio Management:
let us have a look at some debt investment strategies adopted by the debt portfolio managers.

Buy and Hold:
historically, in India, UTI and many of the other mutual funds tended to invest in high yielding
debt securities that gave adequate returns on the overall portfolio. the returns are considered
sufficient to reward the investors. Therefore, the funds would just encash the coupons and hold
the bonds until maturity. these fund managers will tend to avoid bond with call provisions, to
counter the prepayment risk.
it has to be understood the strategy holds good as long as the general interest rate level are stable.
if yields rise, the price of bonds will fall. hence, while the fund may generate sufficient current
income according to original target, it will incur a capital loss on its portfolio as and when
revalued to current market price. another risk on the portfolio, particularly if its maturities are
long, is the risk of default by the issuer.

Duration Management:
if Buy and Hold is like Passive Fund Management, Duration Management is like Active Fund
Management. this strategy involves altering the average duration of bonds in a portfolio
depending upon the fund managers expectations regarding the direction of interest rates. if bond
yields are expected to fall, the fund manager would buy the bonds with longer duration and sell
bonds with shorter duration, until the funds average duration becomes longer than the markets
average duration. based as the strategy is on interest rate anticipations, it is akin to the Market
Timing Strategy for equity investments.

Credit Selection:
some debt managers look to investing in a bond in anticipation of changes on ots credit rating. an
upgrade of a bonds credit rating would lend to increase in its price, thereby leading to a superior
return. the fund would need to analyze the bonds credit quality so as to implement this strategy.
usually, debt funds will specify the proportion of assets they will hold in instruments of different
credit quality/ratings, and hold these proportions. active credit selection strategy would imply
frequent trading of bonds in anticipation of changes in ratings. while being an active risk
management strategy, it does not take away the interest rate, prepayment or credit risks that are
faced by any debt fund.

Prepayment Prediction:
As noted earlier some bonds allow the issuers the option to call for redemption before maturity. a
fund which holds bonds with this provision is exposed to the risk of high yielding bonds being
called back before maturity when interest rates decline. the fund manager would therefore strive
to hold bonds with low prepayment risk relative to yield spread. or try to predict the course of the
interest rates and decide what the prepayment is likely to be, and then increase or decrease his
exposure. in any case, the risks faced by such fund managers are the same as any other. what
matters at the end is the yield performance obtained by the fund manager.

Interest Rates and Debt Portfolio Management:
no matter which investment stragtegy is followed by a debt fund manager, debt securities are
always exposed to interest rate risk, as their price is directly dependent on them. while they may
yield fixed rates of returns, their market values are dependent on interest rate movements, which
in turn affect the performance of fund portfolio of which they are a part. hence, it is essential to
understand the factors that affect the interest rates. while this is an intricate subject in itself, we
have summarized below some key elements that have a bearing on interest rate movements:

Inflation: simply put, inflation is the percentage by which prices of goods and services in the
economy increase over a period of time. this increase may be on account of factors arising within
the country change in production levels, mechanisms for distribution of goods, etc, and/or on
account of changes in the countrys external balance of payments position. in india , inflation is
generally measured by the Wholesale Price Index although t he Consumer Price Index is also
tracked. when the inflation rate rises, money becomes dearer, leading to an increase in the
general level of interest rates.

Exchange Rate: a key factor in determining exchange rates between any two currencies is their
relative purchasing power. Over a period, the relative purchasing power between two currencies
may change based on the performance of the respective economies. the consequent change in
exchange rates can affect interest rate levels in the country.

Policies of the Central Bank: the central bank is the apex authority for regulation of the monetary
system in a country. in India, this role is played by the Reserve Bank. the RBIs policies have a
strong bearing on interest rate levels in the economy. if the RBI wishes to curb excess liquidity in
a monetary system, it could impose a higher liquidity ratio on banks and institutions.

This would restrict credit leading to an increase in interest rates. Similarly, and increase in RBIs
bank rate has the effect of increasing interest rate levels. RBI may also undertake open
operations in Treasury Bills and Government securities with the intention of restricting / relaxing
liquidity, thereby impacting the interest rates.

Use of Derivatives for Debt Portfolio Management:
as explained above, a debt portfolio is always exposed to the interest rate risk. hence, derivatives
contracts can be used to reduce or alter the risk profile of the portfolios containing debt
instruments. interest rate derivatives contracts can be exchange traded or privately traded (on the
OTC market). thus, a portfolio manager can sell interest rate futures or buy interest rate put
options, usually on an exchange, to protect the value of his debt portfolio. he can also buy or sell
forward contracts or swaps bilaterally with other market players on OTC market.


in india, interest rate swaps and forward rate agreements were introduced in 1999, though the
market for these contracts has not yet fully developed. in 2004, the National Stock Exchange has
introduced futures on Interest Rates. interest rate options are not yet available for trading on
exchange.


PSU Bonds Market
PSU bonds are medium and long term obligations issued by public sector undertakings.
PSU bonds issue is a phenomenon of the late 1980s when the Central Government stopped /
reduced funding to PSUs through the general budget. PSUs float bonds in the primary market to
raise funds. PSUs borrow funds from the market for their regular working capital or capital
expenditure requirement by issuing bonds. The market for PSU bonds has grown substantially
over the past decade. All PSU bonds have a built in redemption and some of them are embedded
with put or call options. Many of these are issued by infrastructure related companies such as
railways and power companies, and their sizes vary widely from Rs 10-1000 crore. PSU bonds
have maturities ranging between five and ten years. They are issued in denominations of Rs
1,000 each
The majority of PSU bonds are privately placed with banks or large investors. In privately placed
issues, rating is not mandatory while public issues are mandatorily rated by one or more of the
four rating agencies in India. Historically, default rates of PSU bonds are negligible and PSUs
are perceived as quasi-sovereign bodies. Usually, bonds issued by state owned PSUs carry
interest payment and principal payment guarantee by the respective state government. Such
guarantees are issued mainly to facilitate the fund raising programs for various long gestation
infrastructure projects.
PSUs are permitted to issue two types of bonds: tax free and taxable bonds. Tax free bonds are
bonds for which the amount of interest is exempted from the investors income. PSUs issue tax
free bonds or bonds with certain exemptions under the Income Tax Act with prior approval from
the government through the Central Board of Direct Taxes (CBDT) for raising funds for such
projects. PSUs which have raised funds through the issue of tax free bonds are central PSUs such
as MTNL and NTPC, and state PSUs such as State Electricity Boards (SEBs) and State Financial
Corporations (SFCs). The bonds issued by the State Financial Corporations are SLR eligible for
cooperative banks and non-banking finance companies (NBFCs). Interest on these bonds is
calculated on Actual / 365 days basis. Tax deduction at source is applicable. In the pre-reform
period, that is, before 1991, the maximum interest rate on taxable bonds was stipulated at 14 per
cent and maximum interest rate on tax free bonds was fixed at 10 per cent. The ceiling of banks
investment in PSU bonds was 1.5 per cent of incremental deposits. With effect from August
1991, the ceiling on interest rate on PSU bonds was removed and subsequently some of the PSUs
floated bonds at an interest ate of 17-18 percent. Later, ceiling on tax free bonds was raised to
10.5 percent. The ceiling of banks investments in PSU bonds was also removed which enabled
banks to invest freely in them.
Provident Funds were initially allowed to invest 15 per cent of their incremental deposit in PSU
bonds. Later, this limit was increased to 30 percent.
The revised guidelines for the issue of PSU bonds were issued in October 1993. The guidelines
indicate that the minimum maturity of tax free bonds should be seven years whereas PSUs will
have the freedom to fix the maturities of taxable bonds. The public issues shall be subject to
guidelines issued by SEBI.
PSUs are allowed to issue floating rate bonds, deep discount bonds, and variety of other bonds.
All new issues have to be listed on a stock exchange.
Investors in PSU bonds include banks, insurance companies, non-banking finance companies,
provident funds, mutual funds, financial institutions and individuals
.
Survey reveals a declining trend in the amount raised through the issue of tax free bonds. Since
1991-92, taxable bonds have become popular as the ceiling on interest rate of taxable bonds was
removed. PSU bonds which traditionally were floated in the public issue market were privately
placed in the 1990s. The PSUs preferred the private placement route for the issue of bonds. They
did not tap the primary market for four consecutive years that is, from 1998-99 to 2001-02. The
PSUs continued to tap the private placement market for their capital requirements.