Investment in Fixed Income or Debt

It is pretty normal (& fair) for investors to chase returns irrespective of the type of investment category, be it Equity, Real Estate, Gold or Debt / Bonds.  While there are hidden risks in each of the categories, the risks associated with Debt fund, though simpler, is not widely understood. As a result, investors are time and again bitten by the risks associated with the Debt related investments. This post aims to give an elaborate background of the basics of a Debt investments, ending with a few Do’s and Don’t.

What is a Debt Investment ?

The first point to understand when investing in any debt related investment is > it simply equates to giving money on a loan! A loan has following characteristics :

1. The borrower may delay the payment of interest on the due date or may not even pay the interest – CREDIT RISK
2. The borrower may delay the repayment of the loan or may not return it fully or at all. You may not be able to recover the money as your loan may not have a security hypotheciated in your favour or partially hypotheciated – CREDIT RISK
3. If the loan is given for a fixed duration, say for 5 years, you may not get your money back during this period of 5 years other than for the regular EMI payments. Hence your money will be illiquid for this period of time – LIQUIDITY RISK
4. If you have an option to sell this loan investment to some-one else, you may not always find some one who would be interested to buy this investment loan from you and hence you may be again be stuck – LIQUIDITY RISK;
5. Lastly, if you are able to find some one who is ready to buy the loan investment from you, you may be offered money which may be lower or higher than your invested amount. Wondering why ? Following could impact the value of your Loan investment – MARKET / INTEREST RATE RISKS
   • If the borrower has now become more riskier as his business profile may have changed or he would have taken excessive amount of loans – the new investor may want to pay lesser for the same loan;
   • You may have given the loan at say 10% interest when the underlying RBI interest was 7%, i.e. 3 % higher than the RBI interest. But now the RBI interest rate would have increased from 7% to 9%. The new investor will be not be ready to buy the investment at the same original price which gets him 10% as RBI’s rate itself is 2% higher than earlier. He would now be interested to buy only if you sell your loan investment to him at a lower value so that he can make 12% return, i.e.3% higher than RBI rate of interest. If you need to exit, you will have to sell your investment at a lower value.

What is above for a loan, is exactly applicable in case of any investment where you loan out your money. These include your Fixed Deposits, PPF, PF, Government Bonds, Corporate Bonds or even your Indian Rupee note. Suprised how come Rupee note comes here ? Take out any note from your wallet and read what it says “I PROMISE TO PAY THE BEARER THE SUM OF XXXX RUPEES” The underlying borrower may enjoy different levels of credibility, but the broad concept remains the same > IT IS A LOAN.

Debt Funds

For this para, we will move our focus more towards loans taken by the Government or Corporates. When such loans are taken from wider public, they are commonly called as ‘Bonds’. Essence remains the same, the Company is borrowing money and is agreeing to pay the investor a specific % of interest (coupon or yield) on a set frequency and the repayment of initial principal on a specific date (maturity date).Unfortunately, a vast majority of these bonds are out of reach of retail investors owing to following key reasons :

• The ticket size of a bond tends to be in multiples of Rs. 10 lakh (1 mn INR).
• Even if an investor has this size of capital to invest, the bonds can not be purchased easily as they are not actively traded like stocks. To get hold of such bonds, one needs to get hold of specialist brokers who have a network of investors to buy / sell such bonds;
• You need to invest a significant amount of money to spread the risk of one single borrower going bust. Imagine if one bond is of INR 10 lakhs, you would need atleast INR 1 crore to hold 10 bonds in your portfolio of different Companies!

It is here where Debt funds come handy. The pool of money which they get from millions of investors get them the required muscle power to :

1. Identify good credible companies who would repay their obligations on time. This must not be under estimated – a significant amount of research & paperwork is required to identify and tie in the borrowers to pay back with varying levels of security being taken.
2. Being able to diversify the portfolio with many borrowing Companies such that any one Company’s default would not significantly impact the portfolio.
3. Providing an option to the investors to encash their holdings in the fund. This is a key and one of the most difficult task as not all Bonds are easily saleable in the markets, even if they are good investments.

What is not working Now – LOCKDOWN ?

My long winded background was key to help bring the point home > what is going wrong at this moment with Debt Funds. I won’t specifically call out Credit Risk Funds, but all funds if they have following attributes :

1. All fund managers have extreme pressures (rightly or wrongly) to deliver better than market returns on their schemes and this is no different for a debt fund. Remember RULE #1 *A high risk borrower pays higher interest rate*. If I keep all things constant, a debt fund manager will have to loan out funds to riskier Companies in order to get a higher rate of interest (commonly called as ‘Yield’);
2. A healthy amount of risk shouldn’t matter much as long as majority of the invested Companies are healthy and continue to pay their obligations;
3. The fund manager tries to mitigate the risk of borrowers turning bad by diversifying across multiple Companies and aiming NOT to have excessive investment in any single borrower. Hence, in an ideal scenario they may have long list of borrowers in their fund with less than 2-3% invested in a single Company. The more riskier a borrower is, less allocation of money is given. The only exceptions being Government / PSU or Bank bonds.
4. To take care of ongoing redemptions – a health amount of liquid money is kept to make repayments to people who need to encash their chips. However, beyond a point, having excessive cash drags the returns. As a result, the fund manager may use his experience to limit it to a %, usually within 5% of the portfolio.

A perfect storm

Now lets see what happens when this scenario happens all in one go:

1. A lot of investors want to encash their investments – much more than the cash maintained by the fund manager.
2. There is already a cash crunch in the economy owing to a lock down or any other economic scenario. Hence even if the fund manager approaches the Borrowing Companies whom he has lent out funds, he won’t get early repayments. Let alone, many borrowers wouldn’t even pay the interest obligations on time citing ‘moratorium’ – fair enough !
3. Fund manager tries to sell the bond securities in the market, but no one is ready to buy many of the Bonds at this moment as every one is being excessively risk averse. Or some one may buy, but at a significantly reduced price which does not merit selling the loan.
4. The scheme may not be holding a lot of extremely high quality bonds (Government / PSU) as they don’t fetch higher returns – remember Rule #1 – High Risk gets High Returns. At times of scare, every one only wants quality bonds. This makes a double whammy for the fund manager. He ends up selling most of the good bonds to give the repayment back to the investors who are exiting. The more he sells the good quality (and hence more readily saleable, i.e. liquid) bonds, the more riskier his existing investment pool becomes as it will end up increasing the % investment in not so good quality bonds higher. Consequently, the resultant fund becomes increasingly more illiquid and riskier for the investors who do not want to exit.
5. The manager may take short term loan funding from a bank to pay redemptions, but the scale of redemptions are higher than what he can borrow.

Finally a tipping off point comes when the fund manager decides not to let this irrational selling continue. He then takes a decision to shut down the fund so that the true value of the securities is obtained by slowly selling them in the market or as and when the scheduled repayments happen and subsequently repaying it to the investors. Yes, the investor’s biggest advantage is lost at this point, i.e. liquidity, but this is the only best course of action to avoid selling of the investments at distress value.

Lessons for Us

Instead of highlighting what a fund manager should have done – something which I find as not so fruitful thing to do, I would rather like to focus on things which are more in an Investor’s control. Caveat Emptor – let the buyer be aware and do a full checkup before entrusting the funds.

A few Do’s and Don’ts

1. DO look into the portfolio of underlying Companies in a bond fund to confirm if they sound safe to you. Though, it does not mean that if you haven’t heard a name it becomes riskier.
2. DO look into the underlying maturity of the entire portfolio. Remember point 5 in the first paragraph. Align your investment objective with the maturity profile of the investment schemes. Technically it is called as ‘Average Duration‘ and ‘Modified Duration‘;
3. DO Monitor the scheme portfolio regularly. I know that this can be a challenge for a normal investor.  But it is key to do this as the funds may end up getting carried away and enter into not so great securities. It could also be the case that while addressing to redemption pressures, the fund is now having only poor quality investments remaining. These are red alerts !
4. DO NOT only follow the returns and enter into an investment. More categorically **DO NOT FOLLOW THE STAR RATINGS** of the rating websites. A key point to understand is > most of the ratings only are driven based upon previous track record of returns. The Rule 1 comes handier > High Risk – High Returns.
5. Most Importantly > Equity has a notional loss > Debt can have a permanent loss. Contrary to the common belief, I find Debt investments more riskier than Equities. It is ironical that this category of investment is called ‘Fixed Income’ but there is nothing fixed in it. Hence, if you do not understand it well, you may rather invest in a Nationalised Bank’s Fixed Deposit, PPF or get hold of an advisor to find a right product for you in this category.

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