From debt mutual funds lending to non-prime rate corporates to banks coming up with additional tier 1 bonds, fixed income instruments are taking on higher risks to ensure a higher rate of returns. It is better for investors to stick to AAA oriented investments and stay safe.
Returns from fixed income investments are expected to trend lower as interest rates have softened considerably over the last couple of years. While debt mutual fund (MF) investors have enjoyed almost double-digit returns for the last few years, going forward, this is expected to moderate, as the pace of rate softening slows down. Needless to say, fixed deposit returns have gone down for a while now. Investors used to high debt returns are left wondering what the alternatives are. While a few have increased their allocation to equity with a hope to push their returns up, many have tried to squeeze more from their investments, by unknowingly compromising on the quality of their investments. They are unwilling to accept a lower return on debt, despite the fact that finally, we are seeing a positive real return on the back of falling inflation. Some bond investors, however, have now turned adventurous in their pursuit of higher returns.
Plain old Debt MFs
Good quality is passe, the themes debt MFs are investing in now are ‘managed credits’ with ‘controlled exposure’. The fund manager is doing the job banks used to do till now —lend to non-prime rate corporates, where the ratings are lower, resulting in higher yields. The portion that is left unsaid here is ‘higher risk’. Events over the last year or so have been well-documented as to how mutual funds go to great extents to comfort their investors, in the face of rating downgrades. Add to this a dollop of high fund management costs, almost non-existent liquidity and valuations that’s not entirely kosher. Certainly not something investors exactly bargained for. If interest rates move in cycles, credit is a vicious cycle. This segment has suddenly ballooned to more than Rs 1 lakh crore from virtually nothing about six to seven years back.
High yield debentures
HNI investors find mutual funds too mass market. So, they now lend directly to corporates! The favourites here are real estate developers from large to mid to small. There’s a borrower for every wallet size. Beware the turbulence the real estate industry faces, from cost escalation to delay in sanctions and interest costs ballooning. We have not even spoken about stagnant demand or the effects of demonetisation. The impact of RERA will cast its shadow over time. Of course, all are not bad apples, but one needs to be choosy.
Additional Tier 1 (AT 1) bonds
This is the latest and the one with a twist. Issued by banks to shore up their capital base, these are bonds which are usually perpetual by tenor, albeit with exit option for the issuer at the end of 10 years, in most cases. These are now being marketed to HNIs with the pitch that the rates these bonds offer are higher than their corresponding FDs. Indian investors’ implicit faith in the banking system has ensured that these pitches are an easy sell. Investors need to clearly understand that these bonds have a clause wherein the coupon can be frozen if the capital adequacy hits a certain prescribed level. At a particular level, usual called ‘point of non-viability’, these bonds can be converted into the bank’s equity.
Therein lies the risk. Not all banks carry risk, however, given the dynamics, some of these entities could be beyond even the RBI or the government. Remember, here we are talking about ‘mature’ investors who understand the product and not lay investors in a bank’s FD. Hence, HNIs need to understand the instrument before buying these bonds. Even the best of the breed of banks do not have AAA owing to quasi equity risk. Gone are the days when debt investments could be easily differentiated. These days, there are many more varieties to choose from, some of them where risks are not directly evident. A careful analysis before committing will ensure debt investments do what they are supposed to—provide safety with moderate returns. It pays to stay safe with AAA oriented investments, to tide through any tough times.
The author, Ramesh G is principal, Investment Advisory, Entrust Family Office Investment Advisors