Liberalisation, Capital Markets and Innovation
The Indian financial system was reshaped during the 1990s by a series of market‑oriented reforms that removed many earlier controls and opened the economy to new players. Interest‑rate deregulation, freedom to price equity issues, entry of private and foreign institutional investors, liberalisation of the banking sector to private participation, and permission for Indian firms to access foreign capital markets directly all contributed to a fundamentally different operating environment. These changes expanded choice for firms and investors and intensified competition across the corporate and financial sectors.
The capital market emerged as a particularly important avenue for meeting the long‑term financing needs of both private and public enterprises. By enabling firms to raise equity and long‑term debt from a broad investor base, it complemented traditional bank finance and helped channel savings into productive investment.
At the same time, the scale of corporate and institutional funding requirements, together with a more discerning investor base, heightened competition among issuers for investor funds. Investors became more selective and sophisticated in their preferences, so issuers needed to offer instruments that matched diverse risk–return profiles. This pushed financial innovation to the fore: firms and intermediaries began designing novel securities and structures to attract capital. Known broadly as financial engineering, these innovations have substantially altered corporate finance and financial markets by creating more tailored ways to transfer risk and mobilise resources.
Defining New Financial Instruments
A new financial instrument is one that introduces novel features into the contractual terms compared with existing securities. In practice, very few instruments are wholly original; most are traditional securities modified with additional clauses or rights to improve their marketability. The basic building blocks remain familiar—equity shares, preference shares and debentures (fully convertible, partly convertible and non‑convertible)—but the addition of features such as detachable warrants, special conversion rights or altered payment priorities can transform a conventional instrument into something new.
For example, attaching a warrant to the non‑convertible portion of a debenture creates a hybrid security that combines debt characteristics with an equity option, thereby changing its appeal to investors. Such adjustments do not reinvent finance so much as repurpose existing instruments to meet specific issuer needs or investor preferences.
Drivers of Financial Innovation in India
Financial innovation has largely been driven by a combination of changing investor preferences, shifting cost structures and the need for issuers to remain competitive. Financial products cannot remain static: they must be continually re‑engineered and tailored to meet evolving customer needs, because repeated offerings of the same instruments fail to stimulate the investment environment.
A fall in prevailing interest rates altered return expectations and prompted corporates to devise new structures that could offer attractive risk‑return profiles despite a low‑rate backdrop. At the same time, many investors have grown averse to long‑dated commitments and prefer instruments with flexible maturities and embedded features such as put and call rights, which permit early redemption by holders or issuers.
The traditional reliance on banks and other financial institutions for funding has given way to greater use of the capital market. To access this market successfully, companies have been compelled to make even debt securities more appealing through better terms or innovative structuring. Confidence in the equity market was also dented by a series of scandals, leading investors to stay away; this increased the demand for novel, attractive products that could restore investor interest.
In the post‑reform era a wide range of innovative instruments were introduced in India’s capital markets, the bulk of them being debt instruments. These new issues were not only thoughtfully structured but were also effectively marketed at the retail level, helping deepen and diversify the investor base.
Innovative Debt Instruments in India
Floating rate bonds (FRBs) are debt securities whose interest payments are linked to a benchmark or anchor rate rather than fixed for the life of the bond. This structure was developed primarily to protect investors and issuers from the effects of falling or volatile interest rates: as the benchmark moves, the coupon adjusts, reducing the risk that either party will be unduly disadvantaged by changing market conditions.
In India, the State Bank of India was the first to offer floating rate bonds to retail investors, linking coupons to the bank’s term deposit rate as the anchor. Other common anchors include treasury bill yields and interbank reference rates; in recent years the NSE MIBOR has often been used. Because the anchor reflects prevailing money-market conditions, linking the coupon to it makes the bond’s yield responsive to broader economic indicators.
To make FRBs attractive, issuers typically add a fixed mark-up over the anchor rate. For example, in some IDBI issues the coupon equalled the 364‑day treasury bill rate plus a fixed 2 percent. That mark-up gives investors compensation above the benchmark while preserving the bond’s floating character.
Floating rate bonds are designed so neither borrower nor lender is fully exposed to interest-rate swings. When market rates rise, investors benefit from higher coupons; when rates fall, borrowers benefit because their cost of borrowing declines. Issuers may also include caps and floors: a cap limits the maximum interest the issuer must pay, while a floor guarantees a minimum return to the investor. These features strike a balance between protecting issuers from excessive payments and ensuring investors a minimum yield.
Despite the predominance of fixed-rate government securities, the government itself issued two FRBs in November–December 2001, with maturities of five and eight years and a total size of around Rs 75,000 crore. Such issues were intended to help banks and other major holders manage asset‑liability mismatches and regulatory risk weights. FRBs act as useful diversification tools in debt management: they capture term premium when appropriate and reduce refinancing risk by tying coupons to short-term benchmarks.
However, FRBs are not without drawbacks. They remain susceptible to interest-rate risk in the sense that changing benchmarks alter cash flows, and their effectiveness depends on an active secondary debt market so investors can trade positions and price risk. In a falling-rate environment FRBs can be particularly attractive, but their overall usefulness hinges on market liquidity and transparent benchmark-setting.
Zero-coupon bonds, as the name implies, make no periodic interest (coupon) payments and are issued at a substantial discount to their face value; the investor’s return accrues and is realised when the bond redeems at maturity. Because issuers avoid near‑term interest outflows, these bonds help contain funding costs when interest rates are volatile. For investors, the absence of periodic coupons reduces reinvestment risk and suits those who can hold the security until maturity.
Issuers sometimes structure these instruments with conversion options: at maturity the bond may convert into equity—avoiding any cash outflow for the company—or convert into a regular interest‑bearing bond after a specified period, depending on the firm’s capital needs. Indian firms such as Mahindra & Mahindra and HB Leasing & Finance were among the early adopters of this instrument in the domestic market.
Zero-coupon bonds are particularly attractive for companies undertaking long‑gestation projects because they impose no immediate interest commitments; the deferred repayment can be aligned with project cash flows. For investors seeking safe, predictable returns and prepared to hold the bond to maturity, these securities can be appropriate additions to a portfolio. Finally, an active secondary debt market is important for liquidity and for making such bonds broadly appealing to investors.
Deep Discount Bonds (DDBs) are long‑term zero‑coupon instruments issued at a substantial discount to their face value, typically with maturities of 15 years or more. The Industrial Development Bank of India (IDBI) pioneered their introduction in 1992. Because they pay no periodic interest but promise a large payoff at maturity, these bonds have often been marketed with the appeal of high long‑term capital appreciation — for example, the promise that an investor could become a “lakhpati” over a 25‑year horizon.
Many DDBs include embedded call and put options that permit early redemption by either the issuer or the investor at pre‑specified prices and dates. For issuers, this structure reduces the burden of interim cash‑flows and makes such funds suitable for financing infrastructure and other projects with long gestation periods; for investors, optionality and the deep discount provide both yield enhancement and flexibility.
Several variations of zero‑interest and deep‑discount instruments have appeared in the market. In a Zero Interest Secured Premium Convertible Bond, the investor may convert the bond into equity at a substantial discount — commonly 30% off the average market price after one year. If the conversion price so determined is lower than the bond’s face value, the issuer will make good the difference. Some issues also offer conversion into multiple shares at maturity (for example, two equity shares) and may carry detachable warrants.
Zero Interest Fully Convertible Debentures (FCDs) carry no periodic interest but are structured to convert into equity after a specified notification period; the conversion is automatic and compulsory. If a company undertakes a rights issue before the FCDs are converted and equity is allotted, holders of FCDs are to be offered securities as determined by the company to protect their position prior to conversion.
The Revolving Underwriting Finance Facility (RUFF) is a short-term financing instrument issued as a 91-day debenture with two defining features: an underwriter (typically a bank or financial institution) who commits to purchase any unsold portion, and a built‑in rollover mechanism that allows the instrument to be kept in the market for up to five years. After each 91‑day period the debentures are redeemed and re‑auctioned; this periodic reissuance — or rollover — is what gives the facility its “revolving” character.
If market conditions tighten and there are insufficient bidders at auction, the underwriter steps in and buys the lot at a pre‑agreed rate, providing a backstop that enhances the issue’s marketability. The coupon is set with reference to the treasury bill rate, plus a premium that reflects demand and supply for the 91‑day paper; the overall yield is generally constrained so it does not exceed the prime lending rate (PLR). RUFFs are also evaluated by credit rating agencies, which helps investors assess credit risk.
RUFFs benefit all parties involved: issuers obtain long‑term funding by repeatedly rolling over short‑term paper, underwriters earn a regular fee for their commitment and liquidity provision, and investors gain access to a relatively liquid, short‑dated debt instrument supported by an underwriting guarantee.
Auction Rated Debentures (ARDs) are secured, non‑convertible instruments whose yields are set by the market through competitive bidding. They are redeemable after 90 days but can be issued for longer tenors; the ARD structure blends features of commercial paper (short‑term, market‑determined yield) with those of debentures (security and redeemability).
ANZ Grindlays developed this instrument for Ashok Leyland Finance (ALF). In ALF’s case the issue had a three‑year horizon but carried a zero coupon: it was sold at a discount rather than paying periodic interest. The company repurchased the papers after three months and then reissued them through fresh, privately placed auctions; interest (effective yield) was negotiated at quarterly auctions throughout the three‑year period. Using this mechanism ALF mobilised about Rs 30 crore. Although ARDs are technically short‑term instruments, their periodic repurchase and reissue allowed ALF to secure long‑term finance.
Secured Premium Notes (SPNs) are debt instruments that are redeemable after a company-notified period, typically four to seven years. They carry a lock-in period during which no interest is paid. Each SPN comes with detachable warrants that give the holder the right to apply for—and, if the SPN is fully paid, to be allotted—equity shares. Any conversion or exercise of that right must take place within the time limit specified by the issuing company.
After the lock-in period the SPN holder may choose to sell the note back to the company at par value; if this option is exercised, no interest or premium is payable on redemption. If the holder instead retains the SPN, the company will repay the principal together with any additional interest or premium on redemption, typically in instalments and according to terms decided by the company. By deferring interest payments in the early years, SPNs help firms reduce immediate debt-servicing costs. Early issuers of SPNs in India included TISCO and Bombay Dyeing.
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NCDs with Detachable Warrants
A Non-convertible Debenture (NCD) with detachable equity warrants is a debt instrument that also gives the holder a separate right to buy company shares. Each warrant specifies a pre-determined exercise price and a limited period during which the holder may convert the warrant into equity. The warrants are issued only after full payment for the underlying debenture has been made; being “detachable” means the warrant can be severed from the debenture and dealt with independently of the debt instrument. Typically there is a lock-in or minimum holding period, and after that the warrant holder must exercise the option within the prescribed window. If the warrant is not exercised within that period, the company may treat the unclaimed share entitlement as lapsed and is free to sell or otherwise dispose of the unapplied shares at its discretion.
Early Indian companies that issued NCDs with detachable warrants include Escorts, Bombay Dyeing and Indian Rayon. These structures were used to combine fixed-income financing with a potential equity upside for investors, while allowing the company flexibility in managing its equity base.
Secured Partly-Convertible Debentures with Detachable Warrants
This secured, zero-interest instrument comprises two distinct parts. Part A is a partly convertible debenture that converts into equity shares at a fixed price determined on the date of allotment. Part B is non-convertible and is redeemable at par after a specified period from the date of allotment; attached to Part B is a detachable, separately tradable warrant that gives the warrant holder the option to acquire one equity share per warrant at an exercise price set by the company.
Fully Convertible Debentures with Optional Interest
Fully Convertible Debentures (FCDs) with Interest (Optional)
Fully convertible debentures of this type carry no interest for an initial, specified short period. After that period, holders may choose to convert their debentures into equity shares; this option—often described as conversion at a “premium” for which no additional cash is payable—must be exercised by indicating it in the application form. Where conversion happens in stages, interest becomes payable at a predetermined rate from the date of one conversion up to the subsequent (second or final) conversion. Instead of paying that interest in cash, the company issues equity shares in lieu of the interest amount.
Domestic Convertible Bonds and Warrants
Domestic convertible bonds are hybrid securities that combine debt and an equity option: the bond carries a right to convert into shares, and the embedded equity component can be separated and traded independently. Because investors have the option to convert debt into equity, issuers can typically borrow at lower interest rates than on plain vanilla debt.
In the 2008–09 budget, the Finance Minister proposed domestic convertible bonds as a means to deepen the corporate bond market. Implementing them, however, would have required changes across multiple regulatory frameworks, so the Securities and Exchange Board of India (SEBI) suggested an alternative instrument — non-convertible debentures with detachable warrants. This structure lets companies raise relatively low-cost debt while giving investors the ability to detach the warrant (the equity-linked part) and trade it separately.
Differential Voting Rights Shares
Differential shares are a class of equity that carry unequal rights—most commonly differing voting power and dividend entitlements. They can be structured to give investors higher dividends with reduced or no voting rights, or to vary both voting and dividend rates across share classes. The idea, which originated in Canada, was incorporated into Indian company law by the Companies (Second Amendment) Act, 2000, which permits companies to issue shares with differential rights “as to voting or dividend or otherwise.”
Under current Indian rules, listed companies may issue differential voting-rights shares, including non‑voting shares, up to 25 per cent of total paid-up equity capital, provided the company has declared distributable profits in each of the preceding three years. A company cannot convert its ordinary equity into differential voting shares, nor vice‑versa. Differential shares sit between ordinary equity and preference shares: preference shareholders receive a fixed or preferential dividend but generally lack voting rights, while ordinary equity shareholders have proportional voting rights but no assured return.
The issue of differential shares must be authorized by the company’s articles of association and approved by shareholders in a general meeting; listed companies must also secure approval by postal ballot. The notice to shareholders proposing such an issue must include an explanatory statement that clearly sets out the differences in rights, the scale or proportion in which voting rights will differ, and the predetermined entitlements on rights or bonus issues for each class of shares.
Certain companies are barred from issuing differential shares. Ineligibility includes firms convicted under the Securities and Exchange Board of India Act, 1992, the Securities Contracts (Regulation) Act, 1956, or the Foreign Exchange Management Act, 1999, as well as companies that have defaulted in filing annual returns in the preceding three years, failed to repay deposits or interest, failed to redeem debentures or pay dividends when due, or have not addressed investor grievances. The law also provides that if a company fails to pay dividends on differential shares for three consecutive years, those shares are liable to be converted into ordinary equity; during a period of non-payment investors may be deprived of dividend returns and, where applicable, of voting rights.
For investors, differential shares can be attractive where voting power is of little concern and higher immediate returns are preferred. For promoters and issuers, they offer a way to raise capital without proportionately diluting control, serve as a defensive tool against takeovers, and can improve cash management and capital structure flexibility—features that are particularly useful for new or closely held firms. However, experience abroad shows several limitations: these instruments tend to favour issuers over investors, can concentrate control, and often suffer from lower liquidity in the market. To address these shortcomings, both regulators and issuers need to consider measures that enhance transparency and secondary‑market liquidity for differential shares.
Securitization in India: Structure and Regulation
Securitization, widely used in developed markets such as the US and the UK, began in the United States in the 1960s with the pooling of residential mortgages and has since expanded to cover a broad range of financial assets, including corporate receivables and various types of loans. At its core, securitization is a method by which a company raises funds by converting illiquid receivables into tradable securities and selling them to investors. The receivables are typically sold at a discount, and that discount effectively represents the yield to investors.
In simple terms, securitization packages a pool of underlying assets and transforms them into securities—commonly called pass-through certificates (PTCs) or asset-backed securities (ABSs). When housing loans are securitized the instruments produced are known as mortgage-backed securities (MBSs); bond receivables give rise to collateralized bond obligations (CBOs); and industrial loan receivables become collateralized loan obligations (CLOs). The precise label depends on the nature of the underlying assets.
The securitization process begins with the selection of assets based on their credit quality and then obtaining a credit rating from a specialized agency. The asset pool is transferred to a separate legal entity—typically a special purpose vehicle (SPV)—which acts as the legal owner and trustee of the assets. Housing the assets in an SPV protects investor interests if the originator becomes insolvent. The SPV issues the asset-backed securities and a servicer—either the original seller or a third party—collects principal and interest from the underlying assets and passes payments on to investors according to the agreed terms.
Asset-backed securities come in several structural forms. A pass-through security conveys a pro rata share of the underlying pool to investors, so principal and interest flows closely mirror the cash flows of the assets; in India, PTCs are the most commonly issued form. An asset-backed bond is a debt obligation in which the payment schedule to investors differs from the underlying asset cash flows and the assets remain on the issuer’s balance sheet. Pay-through securities resemble asset-backed bonds but are structured so the assets are removed from the issuer’s balance sheet. A real estate mortgage investment conduit (REMIC) channels principal and interest into one or more regular classes of securities and a residual class, and assets are transferred into the REMIC in a tax-neutral manner.
These securities are negotiable and can be listed on exchanges such as the NSE, enabling trading in the secondary market. From the issuer’s perspective the process is often described as asset securitization because it converts receivables into marketable assets; from the investor’s viewpoint, once listed and traded, the instrument functions as a debt product, which is why the term “debt securitization” is also used.
The principal drivers of securitization are access to new, lower-cost funding sources and the ability to move assets off the balance sheet. For issuers this can improve funding flexibility and risk management; for investors it offers higher-yielding instruments that diversify portfolio exposures. Compared with traditional trade-finance mechanisms, securitization generally supports medium- to long-term financing and creates rated securities with potential secondary-market liquidity. Bills discounting, by contrast, is a short-term facility and involves more paperwork, while factoring—where a factor buys receivables at a discount—has evolved primarily as a trade-financing tool and typically lacks the formal credit ratings and secondary-market structures associated with securitization.
The first securitization in India’s auto-financing market was undertaken between Citibank and ICICI in 1990–91. For more than a decade after its introduction, securitization activity remained limited: only a handful of corporates and some state electricity boards attempted it. From the turn of the century, however, volumes picked up markedly as banks and financial institutions sought new ways to manage balance-sheet risk and raise funds.
A major impetus came from ICICI’s large-scale transactions. In 2001 ICICI offloaded loan assets worth Rs 77,000 crore to raise funds ahead of its merger with ICICI Bank, significantly energizing the market. In the first quarter of 2002–03, ICICI Bank securitized corporate loans of about Rs 22,250 crore and housing loans to meet statutory liquidity requirements after the merger. The market received further legal clarity with the promulgation of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Ordinance, 2002, which formally recognised securitization as a lawful activity and strengthened the framework for asset reconstruction and recovery.
Other notable transactions signalled growing acceptance across sectors. In February 2000, HUDCO securitized assets from its infrastructure portfolio reported at around Rs 21,500 crore, and municipal corporations across India raised more than Rs 600 crore through securitization or structured obligations. The prevailing practice among banks has been to issue pass-through certificates (PTCs) to convert illiquid loans into marketable securities, thereby realising upfront cash for more efficient asset–liability management and to help maintain capital adequacy ratios.
The rising popularity of securitization is reflected in rating agency activity. CRISIL, for example, rated 14 securitized transactions worth about Rs 363 crore in April–June 2002–03, compared with only two transactions worth Rs 52.7 crore in the same quarter a year earlier; ICRA also reported increased ratings activity in 2002–03. Historically, securitization was more prevalent in auto finance than in housing because of higher yields in vehicle loans, but issuers have since broadened the range of underlying assets and deal structures.
Issuers have been innovating to meet investor preferences. Citibank securitized a personal loan portfolio of around Rs 2,284.1 crore and launched an on‑tap programme called Citi SPOT, a master set of terms under which multiple securitization issuances can be made in a year. ICICI introduced “securitized notes,” a structure akin to PTCs but offering greater flexibility in shaping underlying cash flows to suit investor needs. Increasingly, deals are tailor-made for investors in terms of structure, tenor and coupon.
Institutional demand has also supported the market. Domestic mutual funds invested heavily in asset-backed securities (ABS), seeking trading profits and higher returns as opportunities in other fixed-income products narrowed. One landmark transaction came in October 2004, when ICICI Bank monetised about 12 per cent of its retail auto loan portfolio through a Rs 2,823.5 crore securitization—the largest of its kind in India at that time. The issue comprised senior tranches Al, A2 and A3 and a residual P strip, with average tenors of roughly 7, 18 and 27 months for the senior strips; ICICI acted as sole originator, structurer and arranger for the private placement.
By 2006 private-sector banks such as ICICI Bank and HDFC Bank were routinely securitizing retail loans for sale to foreign banks and public-sector banks. These sales provided immediate liquidity, freed up capital for reinvestment, expanded the asset base and lowered operating costs. Importantly, securitization allowed banks to grow their business volumes without proportionately increasing regulatory capital, making it an attractive tool for balance-sheet management.
The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Ordinance, promulgated on 24 June 2000, created a legal framework to help banks and financial institutions manage and recover stressed assets. By recognising securitization and providing for the formation of asset reconstruction companies (ARCs), the ordinance enables lenders to convert loans into tradable securities and to transfer non-performing assets to specialised firms for rehabilitation or recovery. It also gives statutory recognition to hypothecation — the creation of a security interest over movable assets without transferring title — thereby strengthening lenders’ remedies and helping to cleanse balance sheets.
To catalyse a market for securitised debt, the government promoted a dedicated vehicle, Asset Reconstruction Company India Ltd. (ARCIL). The ownership was structured to combine public and private financial sector participation: the government holds 49 per cent, ICICI holds 24.5 per cent, and the remaining shares are held by other financial institutions.
Despite a recent uptick in activity, the securitization market in India remains small and constrained by a range of structural, legal and institutional barriers. Growth has been stunted by a near-absence of a liquid secondary market, which removes a clear exit route for investors and makes trading in securitized instruments difficult. Most paper is placed privately rather than listed, which limits marketability and broader investor participation.
Legal and regulatory uncertainty further discourages issuance. There is no clear, uniform guidance on reporting requirements, accounting treatment for securitization, or the detailed process to be followed by originators. A formal regulatory framework for special purpose vehicles (SPVs) is lacking, and there are no comprehensive laws governing how different entities engaged in securitization should recognise income. Even after the introduction of the ordinance on Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest, originators face ambiguity about the appropriate authority to which they must report before launching an issue.
Tax and state-level duties raise the cost of securitization. Stamp duty varies across states and can make the transfer of industrial loan portfolios particularly expensive; this is significant because public sector banks hold relatively large shares of industrial, rather than retail, loans. Certain provisions of the income-tax law also act as disincentives to securitization.
The investor base remains narrow — largely confined to mutual funds, private and foreign banks — with limited participation from public sector banks, provident funds, trusts and foreign institutional investors. This concentration, together with the private-placement nature of most securitizations, restricts scale. Compounding these problems, the Securities Contract Regulation Act (SCRA) does not include securitized debt within its definition of “securities” and does not formally recognise SPVs that issue pass-through certificates; this exclusion impedes listing, trading, transparency and price discovery.
To accelerate growth, the market needs policy and institutional reforms: broadened investor participation, standardised procedures and accounting norms, tax changes, and an active secondary market underpinned by transparent disclosure and a formal regulatory framework. In recognition of these needs, the Reserve Bank has constituted a working group to recommend ways to widen the investor base, improve asset quality, create liquidity for trading securitized assets, and address related issues.
In February 2006 the Reserve Bank issued draft guidelines on asset securitization aimed at protecting investor interests and promoting market stability. A central feature of these guidelines is the introduction of a liquidity facility to help SPVs manage temporary cash shortfalls that arise from timing mismatches between receipts on the underlying assets and payments due to investors. The guidelines stipulate that such a facility should be drawn only when there is a sufficient level of non‑defaulting assets to cover the drawings, and that it should be used solely to meet short-term mismatches in receivables. The facility is explicitly not to be used as credit enhancement, to cover SPV losses or pool losses, as a permanent revolving source of funding, to finance recurring securitization expenses, to acquire additional assets for the SPV, to pay the final scheduled repayment to investors, or to cover breaches of warranties.
The draft also clarifies the treatment of securities issued by SPVs: these would be treated as non‑SLR instruments, and investors’ effective counterparty is the pool of underlying assets rather than the issuing SPV. Consequently, exposures to any individual or group borrower, industry or geographic area must be reckoned where obligors in the pool constitute 5 per cent or more of receivables or Rs 5 crore, whichever is lower. Profit from securitization should be amortised over the life of the securitised asset, preventing banks from using securitization to inflate near‑term results. Finally, banks that provide credit enhancement must bring in the required capital; credit enhancement—such as cash collateral—serves only to improve the credit rating of the securitised assets and cannot substitute for adequate capital support.
Collateralized Debt Obligations: Structure, Uses and Risks
A Collateralized Debt Obligation (CDO) is a form of securitization that repackages corporate debt—such as corporate loans, corporate bonds and asset-backed securities—into marketable instruments. CDOs typically include collateralized bond obligations, collateralized loan obligations and credit‑linked notes, all grouped within the same financial structure. Financial institutions use CDOs to manage balance‑sheet exposures and to generate fee and interest income by converting illiquid loan portfolios into tradable securities.
One important motivation for banks to issue CDOs has been regulatory capital treatment. Under the Basel Accord of 1988, banks in many countries are required to hold risk‑based capital equivalent to 8 per cent of certain lending exposures. Because margins on commercial lending are often thin, these capital charges can make holding loans relatively unattractive. By securitizing loans into CDOs, banks can trim their balance sheets, free up regulatory capital and raise fresh funds from the underlying assets.
CDOs are structured in hierarchical layers called tranches, created by pooling underlying assets with similar seniority and maturity. Each tranche has a different claim on cash flows and therefore a different risk–return profile: senior tranches receive payments first and are rated higher, while junior tranches offer higher yields but absorb losses first. Credit rating agencies assign ratings to the tranches before they are marketed, enabling investors to choose exposure according to their risk appetite.
Despite offering higher yields, CDOs carry significant default and structural risk. Off‑balance‑sheet financing instruments suffered reputational damage after the Enron scandal; some CDOs had direct exposure to Enron and experienced defaults, which contributed to broader market distrust. Nonetheless, CDOs have been used by banks across the United States, Europe and Japan as a tool for risk transfer and funding diversification.
In India the product has been introduced more recently and has taken time to gain acceptance. ICICI Bank’s first planned CDO in March 2002 was withdrawn because of unfavourable market conditions and the absence of clear regulatory guidance. The bank revised the structure and in February 2004 launched a shorter‑maturity issue of about two years; a 7,100 crore offering was successfully taken up by institutional investors. Through that transaction ICICI sold loans to 15 borrowers across 11 industries to raise new assets and better manage sectoral exposure. As investor awareness grows and a clearer regulatory framework develops, CDOs are likely to become a more widely used instrument by Indian banks and financial institutions.
Inverse Floating-Rate Bonds in India
Inverse float bonds are a recent addition to the Indian capital market. These instruments carry a floating coupon that moves inversely to short-term interest rates: when short-term rates fall, the bond’s coupon rises, and when short-term rates rise, the coupon falls. The floating reference rate is typically a money-market benchmark such as MIBOR (Mumbai Inter‑Bank Offered Rate) or a similar short-term rate. The actual coupon is calculated by subtracting the floating rate from a fixed benchmark. For example, if the benchmark is 12% and the six‑month MIBOR is 6%, the coupon payable would be 6% (12% − 6%).
Inverse floaters appeal to investors seeking higher returns in a low-interest environment, because their coupons increase as market rates decline. That same feature, however, makes them sensitive to interest-rate volatility: if rates move against expectations, investors can suffer poor returns. For this reason both investors and issuers typically manage interest-rate risk through hedging. Issuers may actually benefit when market rates rise, since a higher floating rate reduces the coupon they must pay even as overall market rates increase.
The instrument was first introduced in the US market in 1990. In India, inverse float bonds appeared in August 2002 when members of the Aditya Birla Group—Grasim and Hindalco—issued such securities. The Cholamandalam Investment and Finance Company Limited (CIFCL) was the first non‑banking finance company to raise funds through inverse floaters.
Perpetual Bonds and Capital Treatment
Perpetual bonds are debt instruments with no fixed maturity date: investors receive regular interest payments indefinitely. These instruments can be offered to retail investors, and market-making arrangements are often used to ensure liquidity. One of the oldest examples still in existence are the British government bonds issued in 1814 to finance the Napoleonic wars.
In the event of liquidation, holders of perpetual bonds are ranked near the bottom of the payment hierarchy: they are paid after all depositors and other creditors but before equity shareholders. Because they are permanent in nature, perpetual bonds are treated as part of a bank’s capital base and qualify as Tier I capital (that is, equity and free reserves). A closely related hybrid instrument is the perpetual preference share, which shares the same perpetual characteristic and subordinated claim.
Municipal Bond Market in India
Municipal bonds are debt securities issued by a city’s municipal corporation to raise funds for infrastructure and other capital projects. Indian municipalities face a large financing gap—estimated at around ₹28,500 crore for basic projects—and their overall fiscal health is weak. To date, only larger urban local bodies have been able to access the bond market; collectively they have issued about ₹21,500 crore. These issues have had limited appeal because of a very low annual cumulative ceiling on municipal bond issuance, the fact that tax-free status has been granted only selectively, and the occasional need to make bonds saleable through government guarantees.
Ahmedabad Municipal Corporation was the first urban local body to tap this route; in February 1996 it became the first to receive a general-obligation rating and to raise funds without a state government guarantee. The Bangalore Mahanagara Palike followed suit in December 1997, issuing municipal bonds with a seven-year maturity and a 13 per cent coupon. Despite these early experiments, municipal borrowing remained constrained and fragmented.
In June 2006 the Central Government approved a new model to deepen the municipal bond market. Under the proposal, bonds would carry an 8 per cent coupon and enjoy tax-free status. All urban local bodies in a state would pool their borrowing through a State Pooled Finance Entity (SPFE), which would enter the market on a regular basis and on-lend to individual municipalities. Pooling spreads risk across a wider set of activities than any single urban local body could and improves marketability by obtaining credit ratings for the pooled issues. To eliminate default risk during temporary holding periods, funds raised by the SPFE would be parked in AAA-rated papers until they were disbursed to projects. The Centre also proposed providing seed capital—₹400 crore—to the SPFEs to limit its contingent exposure.
The Indian municipal bond market remains tiny, accounting for only about 0.1 per cent of the corporate bond market, compared with roughly 12 per cent in the United States. Several factors constrain its growth: investors’ preference for shorter maturities, regulatory limits on where institutions can place funds, and the relative scarcity of tax-exempt municipal paper attractive to long-term investors such as insurance companies and banks.
By contrast, the US municipal bond market is large and liquid: investors hold roughly $1.7 trillion of municipal bonds, predominantly long-tenor and tax-free, and daily trading runs to about $11 billion, with households and mutual funds as the main buyers. To provide a clearer regulatory framework for municipal borrowing in India, the Securities and Exchange Board of India issued regulations in July 2015 governing the public issue, listing and trading of municipal debt securities.
Eligibility for Municipal Bond Issuance
A municipality may issue debt securities to the public under these regulations only if it meets a set of specific eligibility conditions.
First, whether the municipality proposes to issue securities directly or through a corporate municipal entity, it must have the constitutional authority to raise funds. Second, the municipality’s accounts for at least the three immediately preceding financial years must be prepared in accordance with the National Municipal Accounts Manual or with a similar municipal accounts manual officially adopted by the respective state government.
Third, the municipality must have recorded surplus income in its Income and Expenditure Statement in at least one of the three immediately preceding financial years, or meet any other financial criteria that the Board may specify from time to time. Where the issuer is a corporate municipal entity, that entity must not have had a negative net worth in any of the three immediately preceding financial years.
Fourth, the municipality must not have defaulted on repayment of debt securities or on loans from banks or financial institutions during the last 365 days. If the issuer is a corporate municipal entity, the accounting and non-default requirements described above (accounts and the 365-day non-default period) must be met by the municipality that is being financed by that corporate entity.
Fifth, there must be no order or direction in force from the Board that restrains, prohibits, or debars the corporate municipal entity or its directors. Finally, neither the corporate municipal entity nor its promoters, group companies, or directors shall be named in the Reserve Bank of India’s list of willful defaulters, nor shall they have defaulted on the payment of interest or repayment of principal in respect of any debt instruments previously issued to the public.
Requirements for Public Issues of Revenue Bonds
Public issues of debt securities are restricted to revenue bonds: an issuer wishing to raise funds from the public through debt must issue only revenue bonds. Such an issuer may proceed with a public offer only if it satisfies a set of prescribed conditions.
First, the issuer must apply to one or more recognized stock exchanges for listing of the bonds and, where more than one application is made, must designate one exchange as the designated stock exchange. If any of the chosen exchanges operates nationwide trading terminals, the issuer must select one of those as the designated exchange. For subsequent public offers the issuer may choose a different designated exchange, subject to these requirements. In addition to filing the application(s), the issuer must obtain in-principle approval for listing on each exchange where an application has been made.
The bonds must carry a credit rating from at least one credit rating agency registered with the Board, and that rating must be disclosed in the offer document. The revenue bonds proposed for issue must have a minimum investment-grade rating; if ratings are obtained from multiple agencies, all ratings—including any that were not accepted—must be disclosed in the offer document.
The issuer must arrange for the bonds to be issued in dematerialized form by entering into an arrangement with a depository registered with the Board in accordance with the Depositories Act, 1996 and the regulations made under it. The minimum tenure of revenue bonds is three years (or such other period as specified by the Board), and the maximum tenure is thirty years (or such other period as specified by the Board).
The issuer is required to appoint one or more merchant bankers registered with the Board, with at least one designated as the lead merchant banker. It must also create a separate escrow account into which the earmarked revenue for servicing the bonds will be deposited. That earmarked revenue in the escrow account must be monitored by a monitoring agency—typically a public financial institution or a scheduled commercial bank.
Where the issuer is a corporate municipal entity, the monitoring role is to be fulfilled by a debenture trustee registered with the Board, in accordance with the Securities and Exchange Board of India (Debenture Trustees) Regulations, 1993 and the Companies Act, 2013.
The offer document must present true, fair and material disclosures that enable subscribers of revenue bonds to make an informed investment decision.
When the issuer is a municipality, the issuer together with the lead merchant banker must ensure that the offer document includes the disclosures required by these regulations, a clear statement on compliance with Regulation 12, and any additional disclosures the Board may specify. Where the issuer is a corporate municipal entity, the issuer and the lead merchant banker must likewise include all disclosures required under the Companies Act, 2013 and the Companies (Prospectus and Allotment of Securities) Rules, 2014, as well as the disclosures mandated by these regulations, confirmation of compliance with Regulation 12, and any further disclosures the Board may require.
An issuer may not make a public issue of revenue bonds unless a draft offer document is filed with the designated stock exchange through the lead merchant banker. Where an issuer uses a shelf prospectus, no more than four public issues may be launched from that single shelf prospectus in a financial year.
Once filed, the draft offer document must be published on the designated stock exchange’s website to invite public comments for seven working days from the filing date. The draft may also be displayed on the websites of the issuer, the merchant bankers and the stock exchanges where the bonds are proposed to be listed, to improve accessibility.
The lead merchant banker is responsible for ensuring the draft includes the names and contact details (postal and email addresses, telephone and fax numbers) of the lead merchant banker’s compliance officer and of the issuer’s relevant officers, including the project officer where applicable. The lead merchant banker must also ensure that all comments received during the public consultation are duly considered and addressed. If the issuer is a corporate municipal entity, the lead merchant banker must ensure those comments are satisfactorily dealt with before the final offer document is filed with the Registrar of Companies.
Before filing draft offer documents with the Board, the issuer must obtain either a Viability Certificate or a Detailed Project Appraisal Report (DPR) from a scheduled commercial bank or a public financial institution. This document must state that the project is financially viable on the basis of the estimates and assumptions available at that time.
Copies of both the draft and the final offer documents must be forwarded to the Board for its records at the same time they are filed with the designated stock exchange. An issuer that files a shelf prospectus must also file an information memorandum with the recognized stock exchanges and the Board, and—if the issuer is a corporate municipal entity—with the Registrar of Companies. For corporate municipal entities, the information memorandum must contain the disclosures required under the Companies Act, 2013 and applicable rules, and must include a summary term sheet, any material updates (including rating revisions and the rating rationale), and the specified financial ratios.
Prior to the opening of the public issue, the lead merchant banker must furnish a due diligence certificate to the Board in the form specified in Schedule II of the regulations. For corporate municipal entities, this due diligence certificate must be provided to the Board before the final offer document is filed with the Registrar of Companies. Where a debenture trustee has been appointed under the relevant provision, that trustee must likewise submit the prescribed due diligence certificate to the Board before the public issue opens.
All funds raised through a public issue of debt securities must be applied solely to the projects set out in the offer document. Proceeds must be clearly earmarked for a defined project or a set of projects for which the necessary approvals from the concerned authorities have already been obtained.
The issuer must maintain a bank account into which the issue proceeds are deposited immediately after the issue closes; these funds may be used only for the specified project(s). Where the issuer is a corporate municipal entity, the proceeds, net of issue expenses, must be used exclusively for onward lending to the municipalities disclosed in the offer document. Such corporate municipal entities must also maintain a sufficient interest margin on onward lending to cover their operating expenses and other obligations.
To ensure proper project delivery and use of funds, the issuer shall set up a separate project implementation cell and appoint a project officer — not below the rank of deputy commissioner — to monitor project progress and to ensure that raised funds are applied only to the intended projects. If the issuer is a corporate municipal entity, this requirement will be fulfilled by the municipality receiving the financing.
For each project, the issuer must contribute at least twenty per cent of the project cost from internal resources or grants. In the case of a corporate municipal entity, the financed municipality must itself contribute no less than twenty per cent of the project cost from its internal resources or grants. The issuer must also disclose a detailed implementation schedule in the offer document, presented in tabular form, and must use the raised funds in accordance with that schedule.
A public issue of revenue bonds may be underwritten by an underwriter registered with the Board; where underwriting is arranged, full details of the underwriting arrangements must be disclosed in the offer document.
Listing Requirements for Debt Securities
Any issuer proposing a public offer of debt securities must apply for listing on one or more recognised stock exchanges. In the specific case of a corporate municipal entity, the listing application must be made in accordance with subsection (1) of Section 40 of the Companies Act, 2013.
Debt securities issued on a private placement basis may also be listed on a recognised stock exchange, provided the issuer meets certain conditions. The issuer may issue either general obligation bonds or revenue bonds. If the issuer is a municipality, its accounts must have been prepared in accordance with the National Municipal Accounts Manual, or a similar municipal accounts manual adopted by the relevant state government, for at least the three immediately preceding financial years. There must be no order of restraint, prohibition or debarment in force by the Board (i.e., SEBI) against the corporate municipal entity or its directors. A corporate municipal entity must have issued the debt securities in compliance with the Companies Act, 2013, particularly Section 42 and the rules thereunder, and with other applicable laws. The issuer must not solicit or collect funds except by way of private placement. The minimum subscription per investor must be at least ₹25 lakh, or such higher amount as the Board may specify from time to time. A credit rating for the debt securities must have been obtained from at least one credit rating agency registered with the Board. The securities proposed for listing must be in dematerialised form, and the issuer must make all disclosures required under the applicable regulations.
Safeguards for Debt Securities
For both public issues and private placements of debt securities, issuers must meet a set of minimum safeguards designed to protect investors and ensure sound asset backing.
An issuer proposing to raise debt must at all times maintain an asset cover sufficient to discharge the principal amount—effectively a one-to-one cover—so that the principal can be repaid in full. Issuers may offer investors an option to buy back debt securities, but any buy‑back price cannot be less than the face value of the securities; where such an option is provided, the offer document must clearly disclose this fact.
The offer document and any abridged prospectus or advertisement associated with a public issue must be truthful and complete. Material facts must not be omitted in a way that would render other statements misleading, and no false or misleading statements may be published in connection with the issue.
Where debentures are to be secured, security must be created by charging the issuer’s properties, assets or receivables to a value adequate for repayment of principal and interest. If unsecured debentures are nevertheless intended for listing on a stock exchange, they must either carry a guarantee from a state or the central government, or be supported by a structured payment mechanism under which the issuer deposits amounts for debt servicing into a designated bank account at least ten working days before the payment due date. The aggregate value of secured debentures issued cannot exceed the market value of the immovable property, other assets, or receivables upon which the charge is created.
The issuer must state in the offer document that the charged assets are free from encumbrances; where those assets already secure other debt, the issuer must have obtained the earlier creditor’s permission or consent to create a second or pari passu charge. Finally, issue proceeds may not be used until the security creation documents have been duly executed.
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A trust deed to secure the issue of debentures must be executed by the issuer in favour of the independent trustee or debenture trustee, as applicable, within three months of the closure of the issue.
The deed should include the clauses prescribed in Schedule‑IV of the Securities and Exchange Board of India (Debenture Trustees) Regulations, 1993. In the case of a private placement by a corporate municipal entity, the trust deed must also contain the additional clauses prescribed under Section 71 of the Companies Act, 2013 and the Companies (Share Capital and Debentures) Rules, 2014.
The trust deed must not contain any provision that has the effect of: (a) limiting or extinguishing the obligations and liabilities of the debenture trustees or the issuer in relation to the rights or interests of investors; (b) limiting, restricting or waiving the provisions of the Act, these regulations, or any circulars or guidelines issued by the Board; or (c) indemnifying the debenture trustees or the issuer for loss or damage caused by their negligence, commission or omission.
The issuer must redeem debt securities in accordance with the terms set out in the offer document. If the issuer is a corporate municipal entity and wishes to roll over the debt securities, it may do so only after passing a special resolution and giving at least twenty-one days’ notice to the holders of those securities.
Where the issuer is a municipality, the decision to roll over must be communicated both to the holders and to the stock exchanges where the securities are listed immediately after the decision. If municipal holders do not give their consent to the proposed roll‑over within the notice period, the municipality must redeem the debt securities of those non‑consenting holders.
The roll‑over notice must explain the rationale for the roll‑over and disclose the relevant credit rating. A corporate municipal entity must, before sending the notice to holders, file a copy of the notice and the proposed resolution with the stock exchanges where the securities are listed so that they can disseminate it on their websites.
Roll‑over is permitted only if certain conditions are met. It must be approved by a special resolution passed by the holders through a postal ballot with the consent of not less than 75% by value of the holders; this 75% consent requirement does not apply to a municipality. In the case of a municipality, holders must be granted a seven‑day period to provide their consent. At least one credit rating must be obtained from a credit rating agency within six months before the redemption date, and that rating must be disclosed in the notice. A fresh trust deed must be executed at the time of the roll‑over unless the existing trust deed specifically permits continuation. Adequate security must be created or maintained for the debt securities proposed to be rolled over.
Finally, the issuer is required to redeem the debt securities of any holder who does not give positive consent to the roll‑over.
Debenture Redemption Reserve
For the purpose of redeeming debentures issued by a corporate municipal entity, the issuer must create a debenture redemption reserve in accordance with the provisions of the Companies Act, 2013 and the rules made thereunder.
If the issuer has defaulted in payment of interest on debt securities, in the redemption of those securities, or in creating any security required under the terms of the issue, then any distribution of dividends by the issuer will require the prior approval of the debenture trustees.
Listing and Trading Requirements for Debt Securities
All issuers that make public offers of debt securities, or seek listing of debt securities issued on a private placement basis, must comply with the listing conditions prescribed by the Board, including ongoing disclosure obligations and the specific requirements set out in Schedule‑V to these regulations. If the issuer is a corporate municipal entity, at least one‑third of its board must consist of independent directors as defined in Section 149 of the Companies Act, 2013.
Credit ratings assigned to debt issues must be subject to periodic review by the registered credit rating agency, and any change in rating must be promptly disclosed by the issuer to the stock exchange(s) where the securities are listed. Where a rating is downgraded by two or more notches below the rating given at the time of issue, the issuer is required to explain the reasons for the downgrade and to present to all bondholders any steps it intends to take to restore the rating. Stock exchanges will determine the manner in which rating changes are disseminated, and issuers must follow those directions.
Issuers, appointed debenture trustees, and the stock exchanges are responsible for making all information and reports relating to debt securities — including compliance reports filed by issuers and trustees — available to investors and the public, primarily by publishing them on their respective websites. Information on rating changes and other material developments must likewise be placed on the websites of the issuer, the debenture trustee (if any), and the stock exchanges.
Debt securities that are listed on recognized stock exchanges must be traded and cleared/settled through recognized clearing corporations, subject to any conditions specified by the Board. The trading lot for privately placed debt securities shall be Rs. 1,00,000, unless the Board specifies a different amount. Trades executed over‑the‑counter must be reported to a recognized stock exchange with a nationwide trading terminal or to any other platform that the Board may specify. Key issue details — such as issuer and instrument information, ratings and rating migrations, coupon, buy‑back and redemption particulars — must be reported to a common database maintained with depositories or to any other platform as directed by the Board.
Policy Measures for Market Deepening
These new instruments hold substantial market potential, but realizing that potential will require coordinated action. Issuers and government agencies must expand investor education and disclosure so retail and institutional investors understand risks and returns. Where existing laws or regulations hinder issuance or trading, targeted legal amendments and clearer regulatory guidance will be necessary to provide certainty and protection. Finally, getting these securities listed on the NSE will help create secondary‑market trading, improving liquidity and deepening the Indian financial markets.
Innovations in Debt and Equity Instruments
A new financial instrument can be any security that introduces novel features in its contractual terms compared with existing instruments. Since the economic reforms, the Indian capital market has witnessed a surge of such innovations, most of them in the debt space. These new debt products have been carefully structured and many have also found acceptance at the retail level.
Floating-rate bonds pay interest that is linked to a benchmark or anchor rate rather than a fixed coupon; they were introduced mainly to protect investors when market interest rates fall. By contrast, inverse float bonds are a more recent innovation whose coupons move inversely to short-term interest rates, so the interest rises when short-term rates fall and vice versa.
Zero-interest bonds, or zero-coupon bonds, make no periodic interest payments and are issued at a substantial discount to face value. When the maturity is very long—typically 15 years or more—such instruments are often called deep-discount bonds. Investors earn their return through the difference between the purchase price and the redemption amount.
Several short-term and hybrid structures have been developed to meet market liquidity and underwriting needs. A revolving underwriting finance facility is a 91‑day debenture that is rolled over on maturity and backed by an underwriter who agrees to buy any unsubscribed portion. An auction-rated debenture is a secured, redeemable (after about 90 days), non-convertible instrument whose interest is determined by market bids and is placed privately.
Manufacturers of capital often combine debt with equity options through detachable warrants. Secured premium notes with detachable warrants are redeemable after a specified period (commonly four to seven years) and typically have a lock-in period during which no interest is paid; the attached warrants give holders the right to apply for equity shares provided the note has been fully paid. A non-convertible debenture with detachable equity warrants gives the holder an option to buy a predetermined number of company shares at a specified price within a set time. A more complex variation—secured zero-interest, partly convertible debentures with detachable and separately tradable warrants—has two parts: Part A is convertible into equity shares at a pre-set price (fixed at allotment), while Part B is non-convertible, redeemed at par after a defined period, and carries detachable, separately tradable warrants.
On the equity side, differential shares are a category of ordinary shares that separate dividend rates from voting rights: they can be structured to carry high dividends with limited or no voting rights, or to have differing combinations of voting power and dividend entitlement.
Securitization is a technique whereby a company converts receivables into marketable securities and sells them—typically at a discount—to investors who provide immediate cash. Collateralized debt obligations (CDOs) extend this idea to pools of corporate obligations such as loans, bonds and asset-backed securities; CDOs are structured into tranches and commonly include collateralized bond obligations, collateralized loan obligations and credit‑linked notes arising from the same underlying portfolio.
Finally, perpetual bonds are debt instruments without a fixed maturity date, paying interest indefinitely, while municipal bonds are debt securities issued by city municipal corporations to finance infrastructure and public-works projects.