How do oil bonds work? (courtesy-- wiki answers)

The govt. of India (GOI) issues special oil bonds to govt. owned oil marketing companies to compensate for the losses they incur due to the administered pricing regime. What exactly are these oil bonds and how exactly do they compensate the oil marketing companies?
I will work out the answer to this question by using the financial statements of Indian Oil Corp. (IOC) for 2007-08.

IOC makes a loss selling petroleum products due to govt. restrictions on pricing (i.e. due to the administered pricing regime). The govt. of India compensates this loss by issuing special oil bonds.

IOC shows these bonds as income on its P&L (the IOC P&L for 2007 - 2008 shows an income of Rs.13,943 CR this way), thus converting the loss into a profit.

IOC also shows these bonds as investment on its balance sheet (Schedule G of IOC balance sheet for 2007 - 2008 shows investment worth Rs. 14,308 in these GOI special bonds). This means that without paying a penny for these bonds, IOC has invested in these GOI bonds! If you think about it, the real investment is the losses IOC incurred to oblige the GOI.

Now, if IOC just sits on these bonds, it will get a cash flow (around 7% - 8%) from GOI by way of interest payment on these bonds. Also upon maturity, the GOI will have to redeem these bonds from IOC (maturity periods are anywhere from 2009 to 2026 as per Schedule G). i.e. upon maturity the GOI has to cough up cash compensation for the losses IOC has incurred in 2007 - 2008!

Instead, what IOC does is, it sells these bonds in the secondary bond market to mutual funds, insurance companies and other such financial institutions (http://www.thehindubusinessline.com/2008/05/02/stories/2008050250780600.htm). Thus, the bonds are converted into hard cash (Schedule G says IOC made Rs. 6,503 Cr this way in 2007- 2008). This is how IOC gets hard cash to compensate for its losses immediately. (Of course, upon maturity the GOI has to still pay cash to whoever holds these bonds at that time).

The interesting part is this: GOI has issues bonds without actually borrowing from anybody. Does this run counter to the very definition of a bond? Not really.

The GOI has issued bonds to IOC without directly borrowing any money from IOC. The borrowing is indirect - IOC made a loss to oblige the GOI and that is akin to the GOI borrowing from IOC and hence the GOI issues these bonds to IOC. This is the crux of the matter.

Bottom line is, the oil bond is a GOI bond and hence is a govt. debt which has to be repaid some day. Interestingly, this debt stays off-budget and does not reflect in the revenue or fiscal deficit of the GOI (http://www.business-standard.com/common/news_article.php?leftnm=10&bKeyFlag=BO&autono=323750)!