Disasters In Debt — Learning About Safety And Returns In Investments
Investors and their advisors have again learnt a few lessons the hard way. Or maybe not. Definitely, the result of wrong investments in their portfolios have manifested. Whether the lessons have been learnt remains to be seen.
The myth that fixed income investments are “safe” since they are specifying a “return” on their label, i.e. an interest coupon, has been busted. The episodes of debt mutual funds losing value has been a phenomenon which has started to repeat with a high frequency. Investors who thought debt mutual funds would be “risk free” have learnt that they can have not only duration risk, but also credit risk. This has manifested in liquid funds as well. Liquid funds have effectively become illiquid. So liquidity risk also exists now in these funds.
The same lessons should be learnt by investors investing in NCDs and Corporate Fixed Deposits. However, even today, most investors would choose an NCD or a Corporate Fixed Deposit or a Debt Mutual Fund which shows are slightly higher interest coupon, even 50 bps (0.5%), rather than enquire why is it higher and what is the credit quality of such a company. Is the extra 50 or 200 bps (0.5% to 2%) enough to compensate for the extra credit risk one is taking?
In fact, can credit risk be at all compensated by higher coupon rates?
Higher coupon rates compensation for higher credit risk only makes sense in a fully diversified portfolio of a large number of such securities from different issuers from several different sectors. This is actually a junk bond fund managed by experts who know what is happening in each of those companies and sectors. The large diversified portfolio of high coupon paper could, in principle, compensate for the extra risk, depending on how much higher the coupon rate is in relation to the chances of defaults in the portfolio. This is driven by large diversification, as in a life insurance operation.
For an individual investor none of the higher risk paper makes sense because they will not be able to diversify sufficiently. For an individual investor the best course of action is to invest in government securities, T-bills, G-Secs etc. Today, it is possible to do so via the stock exchanges which allow retail investors to buy these government securities. Or, invest solely in gilt mutual funds which invest 100% in government securities only.
Since the mutual fund managers did not perform their duty of investing in the appropriate quality paper and diversifying sufficiently, the onus is now on the investor themselves to go through the holdings of the mutual funds to determine whether the quality is being met. And this would have to be done month-on-month by each investor. However, if that expertise and time existed with each investor then they don’t need a fund manager at all.
The lesson to be learnt is that a company with a weak balance sheet is neither a good debt investment, nor a good equity investment. Further, what is a good debt investment is an even better equity investment assuming that the stock price is not overvalued. Since a strong balance sheet will provide a strong margin of safety on the downside for the debt paper, but the upside on the debt paper is limited by the coupon. While in an equity investment in the same company, while the downside in the short term is not provided, in the long-term the margin of safety is similar if the price paid is below the intrinsic value of the company. But the upside in an equity investment is unlimited.
For us the core lesson has always been that whether you invest in debt or equity, the underlying business and the balance sheet are providing the margin of safety. The fundamental analysis in both cases has to be of a similar nature. The only extra analysis in case of equity is the estimation of a conservative intrinsic value and comparing whether the market price is significantly lower than that before investing.
Hence, the analytical expertise and efforts are nearly identical, with equity requiring extra expertise in valuation techniques. However, the risk being identical for both equity and debt, the returns in equity are far superior if done right.
Similarly, the risks in debt can be far higher compared to what is generally believed or perceived if NOT done right.
Hopefully, investors and their advisors will learn from the recent events and go deeper into real economic sources of safety and returns rather than focusing on contractual nature of the securities.
Dr. Vikas V Gupta, CEO and Chief Investment Strategist, OmniScience Capital
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