Valuation of Debt Securities in India

Debt funds and Valuation Debt funds like any other asset are driven by the same basic tenet. A fair valuation is one that has to take into account market realities at prices that are market driven. A debt fund at any given point in time holds different debt instruments. Thus the NAV, which reflects the value of all the underlying assets in the portfolio, to be fair and correct should take into account the market price of each of the instruments that comprise the portfolio. This process where each asset is valued at current market prices is called "Marking to Market". Marking to market has become very essential as it indicates the financial health of a portfolio. To a large extent this procedure indicates the amount of risk the fund carries. Essentially any portfolio can either have liquid or illiquid securities. While valuing liquid securities is a no-brainer as the prices can be taken from the exchanges, valuation does assume great significance when it comes to valuing illiquid securities. The problem of valuation gets compounded when it comes to valuing debt securities in India. The absence of a broad based market resulted that trades were concentrated around a few securities. A Debt fund at any given point of time can hold three different types of assets. • Government securities • Corporate debentures with a residual maturity of more than 6 months • Money market instruments and corporate debentures with a residual maturity of less than 6 months Different categories of assets are marked to market in different ways depending mainly on the liquidity of the asset. As a thumb rule, higher the credit, higher the liquidity. Consequently the most liquid among debt instruments are the securities issued by the Government as the risk is sovereign. Bond Valuation The value of a bond can be defined as the present value of the future cash flows discounted at an appropriate rate. The cash flows expected from the bond are made up of a) Coupon payments and b) Redemption of Principal. Bond Price= C/(1+i) + C/(1+I)2 + C/(1+I)3+ …..+ C/(1+I)n +M/(1+I)n Where C = Coupon Payments M = Redemption Amount N = Number of Coupon Payments i = Discounting rate or the yield of the bond. Yield or the Discounting Rate The price of the bond depends significantly on the rate which is used to discount the future cash flows. To get a uniform pricing for various debt instruments a matrix known as the CRISIL Bond Valuer maintained and developed by CRISIL and approved by SEBI is used for bond valuation. Valuing Government Securities Government securities are marked to market on a daily basis. Since the G Sec market in our country is the most liquid segment of our debt markets, it is possible to get a price of G-Secs on any given day. Hence the G-sec portion of the portfolio is marked to market on a daily basis at the last traded price. Earlier fund houses used differing sources ranging from NSE to the RBI's SGL. However circa March 2002 it is mandatory for all fund houses to use prices provided by CRISIL. CRISIL uses the Spread over Benchmark concept while valuing non traded government securities. Any event like an interest rate change triggers the rise or fall of government securities. But the impact is not similar across all G-Secs. The impact depends on a host of factors chiefly duration, coupon rate and the liquidity level of the security. Benchmarks are set up for different tenor buckets e.g. securities with 1-2 years outstanding maturity, 2-3 years 3-4 years and so on. For each of these tenor buckets benchmarks are identified based on the turnover, frequency of trading in the secondary market. These prices are provided by CRISIL on a daily basis. Valuing Corporate Securities Debt securities like bonds, debentures are valued differently depending on whether they are traded or non- traded and additionally depending on the value of the traded securities. The valuation for the traded securities of traded value in excess of Rs 5 crores is done based on the YTM. The YTM is calculated on the last traded price and is maintained till the next CRISIL matrix. Thinly traded securities and non-traded securities valued at more Rs 5 crores and with a residual maturity of more than 182 days are valued using the Crisil Bond Valuer. The Crisil Bond Valuer uses a benchmark YTM built using GOI Sec as the base for each duration bucket. There are 7 duration buckets starting from 0.5 to > 6 years. CRISIL provides a matrix of yields across various duration buckets (the most row in the table below) and rating categories (the leftmost column) on a weekly basis. Here is how it works. When deciding the price of a corporate debenture the key is to determine the yield of the debenture. CRISIL arrives at this table after taking into account various macro and micro economic factors and the repaying capacity. Once the yield is known the price computation is easily accomplished.

23/10/2002 Average 0.5-1 1.0-2.0 2.0-3.0 3.0-4.0 4.0-5.0 5.0-6.0 >6.0 Gilt 6.46% 5.85% 6.01% 6.17% 6.31% 6.54% 7.05% 7.28% AAA 7.21% 0.75% 0.87% 0.83% 0.80% 0.78% 0.59% 0.64% AA+ 7.58% 1.11% 1.16% 1.08% 1.05% 1.14% 1.11% 1.19% AA 7.95% 1.45% 1.43% 1.40% 1.40% 1.63% 1.54% 1.62% AA- 8.47% 1.95% 1.89% 1.86% 1.89% 2.15% 2.10% 2.26% A+ 9.15% 2.60% 2.62% 2.62% 2.65% 2.84% 2.73% 2.78% A 9.73% 3.00% 3.18% 3.22% 3.30% 3.52% 3.39% 3.33% A- 10.66% 3.70% 4.16% 4.31% 4.28% 4.41% 4.31% 4.28% BBB+ 11.59% 4.47% 5.03% 5.22% 5.25% 5.38% 5.28% 5.28%

If you buy a bond at face value, its rate of return, or yield, is just the coupon rate. However, after they're first issued, bonds rarely sell for exactly face value. The yield differs from the coupon. While the coupon rate is the stated interest rate offered by the debenture and is always calculated on the principal value, the yield is often the return that one would get considering the future interest flows and the prevailing interest rate scenario. To give an example using the above matrix say a corporate debenture issued by a Corporate rated AA+ with a residual duration of 2.5 years would be calculated as under. The yield of this will be the benchmark yield plus the markup depending on the bucket the debenture falls into. Therefore yield used for valuation would be 6.17(benchmark)+1.08(spread) =7.25%. All corporate debentures that fall in a particular slot within the matrix are valued at rates specified by CRISIL matrix. Additionally the fund house is at a liberty to add a discretionary discount/premium upto +100/-50 bps for rated paper with duration upto 2 yrs and upto +75/-25 bps for rated paper with duration over 2 yrs. In case of an unrated paper the fund house needs to assign an internal credit rating which is then used for valuation. In this case the yield would be marked up by adding 50 basis points for securities having a duration upto two years and by 25 basis points for securities of duration higher than two years. Valuing Money Market instruments Money market instruments and corporate debentures with residual maturity of less than 6 months are valued by amortization. The difference between the face value and the cost is amortised over the life of the instrument. SEBI has provided that all money market instruments and corporate debentures maturing within 6 months have to be valued on a cost plus accrual basis instead of marking to market. So the next time you decide to invest in a fund you know what to look out for. Valuation therefore is a critical element of the entire funds management business. It takes time and hence funds have cut-off times so that all transactions for the day can be accounted for the days NAV. Any transaction that gets missed out implies that the resulting NAV is not the accurate NAV. It is for this reason that AMFI along with SEBI has started getting stricter on adherence to cut-off times.