This article has been written by Aditi Agarwal pursuing the Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
This article has been published by Oishika Banerji.
When the Indian financial markets underwent reforms in the 90s, a need was felt to change the way in which government spending was financed. Phasing out the earlier system of automatic deficit monetization that allowed the government to cover its excess expenditure by getting more money printed through the Central Bank, the government started using public borrowings as a means of funding its excess capital expenditure. This led to the development of a systematic procedure that allowed the government to auction its debt instruments such as government bonds to raise money. This article will shed light on the system in place for issuing government bonds through auction.
What are government bonds?
Government bonds are financial instruments that are issued by the Central or the State Government from time to time in order to finance the projects and activities undertaken by them. Also known as dated government securities (in case the bonds are issued by Central government) or State Development Loans (in case bonds are issued by the State Governments), they represent the long term debt-obligation of the government, the bond issuer, towards its lenders, also known as the bondholders or investors, from whom the funds are borrowed. A Government bond is issued for a defined period of time, not less than a year, for a variable or fixed rate of interest that is payable to the bondholder at regular intervals until the expiry of the term. Once the term expires or the bond matures, the investors are paid back the principal amount invested by them into the bonds. Regulated by the Reserve Bank of India (RBI), Government bonds are regarded as one of the safest forms of investments since they are backed by a Sovereign guarantee.
Rules and regulations
The legal framework for issuance and management of Government securities by RBI is provided under the Government Securities Act, 2006. As per Section 2(f) of the Act, “Government security means a security created and issued by the Government for the purpose of raising a public loan” which as per Section 3 of the Act includes government bonds.
Types of government bonds
Following are the various types of government bonds issued in an auction –
- Bonds issued by Central Government
- Fixed-Rate Bonds – These bonds assume a fixed rate of interest that is payable to the investor till the time of bond maturity. Most Government bonds fall under this category.
- Floating Rate Bonds (FRB) – These bonds have a variable rate of interest. The change in interest takes place at pre-announced intervals, for example, every six months or every year. So if an FRB has a pre-announced interval of, for instance, one year, then it would mean that the interest rate on the bond would be reset every year till the maturity of the bond. Another category of FRBs assumes a base rate and a fixed spread. The fixed spread is decided by the way of auction and remains the same through the bond tenure.
- Capital Indexed Bonds (CIB)- These bonds have their principal amount connected to the inflation index to protect the investors from the brunt of inflation.
- Inflation-Indexed Bonds – Taking one step further from CIB, these bonds have both their principal as well as interest rates linked to the inflation index. This ensures that not only the principal amount but also the regular returns received by the investors are safeguarded against inflation.
- Bonds with Call or Put Options – These bonds give the issuer the option to call or buy back the bonds or the investor the option to sell the bonds (put option) to the issuer before bond maturity. However, the option can only be exercised once the bonds have completed a tenure of 5 years from the date of issuance.
- Sovereign Gold Bonds (SGB) – These bonds allow the investors to invest in gold without incurring the burden of holding gold in a physical form. The prices of these bonds are linked to the prices of gold in the market.
- Zero-Coupon Bonds – These bonds do not offer any interest to the investors. Rather, the profits of the investors arise from the difference between the issuance price (discounted) and the redemption value (face value) of the bond.
- Bonds issued by State Government
Bonds issued by the State Government are known as State Development Loans (SDLs). They are issued through standard auctions similar to the ones conducted by the Central Government for the issuance of government-dated securities. Interest on these bonds is paid out every six months and the repayment of the principal amount is done upon the bond maturity.
Government bond auction
One of the popular ways of issuing government bonds is by way of auction. Before the launch of auctions in 1992, it was upon the government to fix the interest rates as per their choice, however, after the introduction of auctions, it is the market that decides the interest rates for the government bonds. The government “announces auction dates and bond sales ahead of time, and discloses the number of securities it intends to sell.” There are two types of auctions that can be conducted by the Government. One is a Yield Based Auction and the other is a price-based auction.
- Yield Based Auction
A Yield Based Auction is usually conducted when new bonds are issued by the government. In a Yield Based Auction, the investors bid as per the percentage return they expect from the bond. These bids may go up to two decimal places (say 7.50 percent, 8.30 percent etc.). The RBI then arranges these bids in ascending order, fixing the cut-off yield (the rate at which bids are accepted) in accordance with the notified amount (the amount to be raised through the auction). Thereafter, the coupon or interest rate for the bond will be fixed at the cut-off yield arrived at in the auction. All bidders who have placed their bids at or below the cut-off yields will be qualified to purchase the bond.
- Price Based Auction
A Price Based Auction is usually conducted when the government plans to reissue an existing government bond. In a Price Based Auction, the investors bid “in terms of price per ₹100 of the face value of the security (say, ₹102.00, ₹101.00, ₹100.00, ₹99.00, etc.).” In contrast to the yield auction, the bids in a Price Based Auction are arranged by the RBI in a “descending order of the price offered”. Once the cut-off price (the minimum price to be accepted for the bond) is determined, the coupon rate is calculated based on the cut-off price. The investors who have placed” their bid at or above the cut-off price will be qualified to purchase the bond.
Once the successful bidders emerge (those who have cleared the cut-off), RBI can choose to allot the bonds on either a Multiple Price basis or a Uniform Price basis.
- Multiple Price Auction
Under Multiple Price Auction, all successful bidders have to pay for the quantity purchased in accordance with their respective bids.
- Uniform Price Auction
Under Uniform Price Auction, the rate at which the quantity is purchased remains the same for all the successful bidders regardless of the bid quoted by them. In other words, bonds are allotted to all successful bidders at the same rate i.e. the cut-off rate.
In July 2021, the Central Bank declared that it will be using Uniform Price Auction for bonds with a tenure of 2, 5, 10, 14 years and floating-rate bonds. In contrast, the bonds having a tenure of 30-40 years will continue to be allocated on multiple price basis. As per Bloomberg, RBI has changed its methodology to persuade banks to bid at “slightly lower yields”, following a series of “partially failed auctions”.
When it comes to participation in the auction, there are two categories under which the investors, depending upon their eligibility, may place their bids. The first category is Competitive Bidding and the other category is Non-Competitive Bidding.
- Competitive Bidding
In Competitive Bidding, the investors are “well-informed institutional investors such as banks, financial institutions, Primary Dealers, mutual funds, and insurance companies.” The bidding takes place in multiples of Rs. 10,000, with the minimum bidding amount being Rs. 10,000. Under Competitive Bidding, the investor is allowed to place multiple bids at diverse prices or yield levels.
- Non-Competitive Bidding
Until 2001, retail investors had no way of bidding in auctions. Subsequently, to encourage wider participation, the government allowed for Non-Competitive Bidding. Non-Competitive Bidding does not demand that the investor quote the price or the yield while bidding which gives the investors, who may not have the expertise to bid competitively in auctions, a fair chance to secure bond allotments. “The allotment under the non-competitive segment will be at the weighted average yield or price of all allotments to competitive bidders”, who in contrast will be allotted bonds in accordance to the Multiple or Uniform Price Auction, as is determined by RBI.
As per the earlier scheme, “individuals, HUFs, firms, companies, corporate bodies, institutions, provident funds, trusts and any other entity prescribed by RBI” could participate via Non-Competitive Bidding, given that they – “did not have a current account (CA) or Subsidiary General Ledger (SGL) account with the RBI and submitted the bid indirectly through Aggregator/ Facilitator”.In other words, to participate in the auction, eligible investors had to necessarily participate via a Scheduled Bank or Primary Dealer or Specified Stock Exchange or any other entity approved by RBI. Furthermore, the investors could only place a single bid in multiples of Rs.10,000, with the minimum amount being Rs.10,000 and the maximum being “Rs.1 crore (face value) of securities per auction”. In 2021 the RBI, under its monetary policy, announced a new scheme called ‘RBI Retail Direct scheme’ which changed some of these provisions. Under the new scheme, the retail investors no longer need to apply through Aggregator/ Facilitator and can directly participate in the bond auction as long as they maintain a ‘Retail Direct Gilt Account’ (RDG Account)’ with the RBI. Furthermore, under the new scheme, the bid amount for the single bid has been increased to Rs. 2 Crores per bond per auction for the investor. The new scheme has therefore increased the scope of participation in the auctions by easing the participation process (with the removal of intermediaries) and increasing the cap on the bidding amount.
How are government bond auctions conducted?
The RBI, in consultation with the Government of India, publicizes the date on which auction of government bonds would be conducted a week prior via a press notification. In addition, it also announces whether the issue would be for a fresh loan or an existing bond would be reissued. It also notifies the type of auction i.e. whether the bids are to be placed in the terms of price or yield. The competitive bidders place their bids depending on the same. The non-competitive bidders on the other hand need not quote the price or yield in their bids. RBI also calls for underwriting bids to be submitted a day before the auction. “The sealed bids (placed physically as well as electronically) are opened at an appointed time”, based on which the cut-off price or yield is announced by the RBI. It is also based on the bids on which the underwriting fee of the Primary Dealers is decided. If the demand is high, then the fees are low and vice-versa. Once the cut-off is announced, RBI allots the bonds to all successful bidders in full or in part. A typical auction result includes “the cut-off price yield, number and amount of competitive and non-competitive bids received, weighted average price yield, partial allotment details of competitive and non-competitive bids, devolvement on Primary Dealers or RBI if any, and amount of underwriting accepted from primary dealers.”
A popular way of debt financing for the government is through the issuance of government bonds. For investors, Government Bonds are considered one of the safest forms of investments since they are backed by a Sovereign guarantee. These bonds are issued by way of auction, the details of which are disclosed by the government well in advance. A bond auction may be conducted on a price basis or yield basis depending on the method RBI feels suitable. Furthermore, RBI can also dictate whether the bonds would be allotted on a uniform price basis or multiple price bases. When it comes to participating in bond auctions, it is also open to the investors to either go via the route of competitive bidding or non-competitive bidding, depending on the criteria they fall in. Once the bid is submitted, RBI announces the cut-off, based on which the bonds are allotted to successful bidders.
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