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Be wary of a Curate’s Egg

The association between interest rate offered by a bond and its credit rating is a nebulous area for lay investors. The writer has a word of caution for them
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Nilanjan Dey   |   Published 13.09.21, 12:09 AM

Cry havoc! And let slip the dogs of war!

The debt market embraces intrigues that would shame dark plots captured in Shakespearean tragedies, especially for lay investors. For most of them, the association between coupons offered by bonds and credit ratings still remains a nebulous area. Few care to delve deep enough to unearth the latent significance of ratings, good or bad.

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The immediate trigger for this Monday’s cautionary tale is an NCD issue which I have lately come across. The debenture in question has promised nearly 10 per cent, a rate that helps it beat most of the usual fixed-income alternatives, at least the ones that are currently available in the market.

It is not clear how such a high rate would be serviced for the entire tenure by the issuer, a financial services company with weighty antecedents. The simple fact that stands out is this: the cost of fund for the issuer would be quite steep. And that, of course, brings home all too familiar images of defaults and downgrades.

Issuances that offer particularly stiff rates typically command poor credit ratings. A section of the investing fraternity, nevertheless, seems to ignore this very significant relationship. Clearly, many of those who invest in the debt market are motivated purely by superior yield — never mind the fact that other debt options with similar tenure (being more creditworthy) are comparatively better for their portfolios. Better, because these are safer and more stable.

At this stage, I must put on record that most credible debt structures are typically yielding in single digits. The latter are well below the 10 per cent or so promised by the particular NCD that I referred to earlier. My point is that many of these bonds are potentially quite risky, and investors must choose cautiously. A portfolio consisting of, say, AAA-rated paper (the highest rating) would yield low; however, it would be a lot more reliable and secure than portfolios marked by lower average ratings.

I must also remind investors that there have been many instances of default in the recent past. The history of the Indian debt market is replete with major mishaps — in short, corporate houses that have not paid interest and repaid principal — and large sections of investors have been miffed because of delayed payments. Debt, therefore, is a classical “curate’s egg”: low-yielding in some parts and risky in some others.

Let me, at this stage, dwell a bit on returns delivered by the debt market, primarily by mutual funds that create entire portfolios with debt instruments. How much do you think a medium-duration debt fund offers an investor who stays committed to it for a year or so? Well, if you go by the last 12-months’ record, an average of 6.5 per cent (perhaps just a tad higher) is what you probably secured at the most from this category of funds. And, yes, that number barely covers inflation. Some of those that have under-performed have truly disappointed.

Change tack

So, this may be just the time for you to change tack and adapt to a bit of risk. The latter would mean shedding some of your debt holdings (the absolutely low-yielding, slow-moving sort should probably be the first to go) and switching them to equity. You would assert, of course, that equity is by far a riskier asset class. Yes, there are no two arguments about it.

Allow me to suggest that a serious look at your risk-profile is probably in order. A 100 per cent debt-driven portfolio with an average 5-6 per cent return would not serve you well at all —certainly not if you happen to be in the highest income tax bracket. The effects of low returns and high tax are enough to cause nightmares even for the most intrepid investor.

Now, assuming that changes in your asset allocation are indeed justified, here is what I would like to propose:

  • Move from debt to equity in a graded manner, perhaps in small doses of, say, 5 per cent every quarter. You may wish to do this over a stretch of time (again, a matter of personal discretion) such as over two years.
  • Draw a line beyond which you would not go. Imagine that the line stops at 50 per cent. Therefore, in the best of times, half of your portfolio would be dedicated to equity, and the other half to debt. That just might be a fair deal.
  • This would obviously mean that risk would increase significantly. Thus, be prepared for a marked decline in valuation. Such a development can be prompted by various macro factors and sundry adverse conditions.
  • Systematic transfer plans are quite common these days. This is a tool that is often used judiciously by mutual fund investors. Organised, premeditated transfers from debt to equity are often a prudent exercise. This may be considered actively as well.

Choice is everything

The debt market presents a wide fare; prudent choices, however, hold the key. There is no need to select an income fund with a poor credit profile, just as there is no reason for you to pick up a debt security that rating agencies have castigated. A smart investor needs to keep an eye on all developing credit implications.

Investors might well expect less from debt over the immediate term. This means that other forms of assets would gain significance. Striking a clear balance between safety and risk is the biggest challenge in today’s perilous world. An investor who can do this successfully across market cycles is indeed a rare bird — good tidings would await him at every turn.

The writer is director, Wishlist Capital Advisors



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