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Investment Insights

IDFC Mutual Fund

Dear Nephew,
 
Thank you for the box of chocolates you sent me. I’m regularly walking and doing my morning exercise and practicing restraint as far as chocolates go. I know you’ll say that I’m currently in great health, but good habits will ensure that this continues.
 
I’ve been reading the news lately when it struck me that I must write to you. I remember the concerns you and your clients went through during the financial crisis of 2008 with the sudden rise in borrowing costs and companies showing high stress on their ability to repay money they had borrowed. I recall how my friends rushed in to exit their FMPs even at the cost of high exit loads. It was hilarious seeing the blood rush from their faces whenever they held up the newspaper. The reason I brought this up is because even though today doesn’t feel like those times of stress, I see some signs around me that suggest that you must exercise caution with respect to whom you lend money to in your business. In the news and from my friends running businesses and corporations, I hear that there has been a substantial slow down in business activity. I read a news piece where Crisil had stated that annual default rate in corporate India has touched a 10 year high and is much higher than the stressful year of 2008-09. Now that is alarming! Being a keen follower of financial and economic news it seems to me that given the global and local conditions our RBI will not be able to display the policy aggression it showed in 2008-09. All these conditions suggest that it is far more prudent to take on interest rate risk which means relying that interest rates may not rise anymore given economic conditions rather than taking on credit risk while lending which means relying on heavily indebted borrowers to keep their promises
 
Let me tell you what you should watch out for when you lend to a business. These are a few principles that have helped me make prudent investment decisions in my life. Watch out for companies that show weak financials because this impacts their ability to service their borrowings.
 
1. Watch their debt/ EBDITA ratio: It will tell you which companies can repay comfortably from their business operations and which companies are likely to show stress. Companies that have taken on debt that is greater than 5 times their yearly operating earnings (EBDITA), I would consider them as posing high risk in their ability to honor their commitments to their borrowers.
 
2. Also watch for Debt/Equity ratios of companies since companies showing a high ratio are susceptible to stumble when the business cycle turns adverse. I look at companies where this ratio stands greater than 1.25 and have serious questions on their ability to weather adverse economic conditions. Always remember Ben Graham’s definition of investment being an operation which on thorough analysis promises safety of principal and an adequate return; note his emphasis on thorough analysis, note his emphasis on safety of principal and note his emphasis on adequate return not high return. All investment that don’t subscribe to this tenet must be described as speculative he says.
 
3. Watch out for companies that belong to promoters or groups that are financially weak.
 
My experience over many business cycles shows that though a standalone business may show strength, a weak parentage is likely to deteriorate their credit standing in the future. This seems to be a corporate version of the phrase “It runs in the family”. So watch out for parents when you lend; don’t look at the children alone.
 
4. Watch out for companies having direct or indirect exposure to real estate.
 
Real estate and people who have lent money against real estate remain exposed to volatile prices and uncertainty of demand. In case the real estate market experiences a meaningful decline, companies exposed to this sector will experience stress on servicing debt.
 
I see around me people taking on credit related risk without making an attempt to understand the workings of the companies to which they lend. I suggest you be extremely cautious of taking on such risks and if you do, make sure you’re adequately paid to take on risk. Most investors take on a Heads I win a little, Tails I lose a lot stance in such matters. If you ever encounter someone offering you a higher return for funds borrowed, chances are he’s taking higher business risk or his business doesn’t have the market standing to command funds cheap. This is the time to take on interest rate risk. I would rather rely on interest rates moving down rather than relying on the kindness of my borrowers in case adversity strikes.
 
You may say that all these things may not occur and you may not be wrong on that one. However as you know, in finance as in life if something hasn’t occurred so far, it doesn’t mean that it will never occur as the events of 2008 have made amply clear. As a man of finance you must display prudent investment habits; it’s far more profitable to side step risk than try to jump over it. I may never fall on ill health, but I must continue my exercise regime to protect against it.
 
Best wishes,
 
Your Uncle

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Suyash Choudhary

There are largely two sets of risks, loosely speaking, that investors can assume in order to beat ‘fixed deposit’ return: duration risk and credit risk. Both are legitimate means to aim for ‘excess return’, with excess return defined here as return over and above the risk free proxy that most investors practically use, that is,  fixed deposit rates. The operative word here is ‘practically’, since in practice most savers don’t associate fixed deposits with credit risk. Again, both duration and credit risks come with their own set of attendant downsides (which is why they are called risks after all). Thus the former subjects investments to daily volatility as interest rates tend to change dynamically. Whereas the latter is mostly of the nature of ‘binary’ risk; it strikes or it doesn’t. Actually in a more evolved market where credit risk was better traded, the risk wouldn’t be that binary since market prices would reflect the change in assessment for the risk. However, that is not the state of development of our market yet.

 

The decision whether to assume credit or duration risk, or what combination of the two, has to take into account one’s larger macro view as well. This is because the macro-environment creates either tailwinds or headwinds to each type of risk. The chart below tracks our quarterly nominal GDP growth over the last 10 years or so. Nominal GDP essentially captures output at current prices and to that extent can be considered a proxy for what an average economic agent realizes for goods / services sold. Hence, growth in nominal GDP in turn is a proxy for how the revenue realization of an average economic agent is growing. Thus when nominal GDP is growing robustly, either because price or volume or both are growing, the revenue realization of an average economic entity is also growing well. And vice-versa.

 

 

If the logic presented above rings true, then the implications for credit and duration risks from the state of nominal GDP are quite apparent. A phase of strong nominal GDP growth should correlate with reducing credit risk as companies’ ability to service debt improves with improving top line growth, all other things remaining constant. This phase should also correlate with rising duration risk as typically phases of strong nominal growth also coincide with closing output gaps and rising infaltion pressures. Indeed, the strong nominal growth may many times be attributable to already strong price growth which obviously doesn’t bode well for long term bonds. This was exactly the phase post the financial crisis of 2008-09. Credit spreads were wide reflecting the fear premium from the 2008 crash. Policy makers both locally and globally had unleased very strong, and in some cases unprecedented, stimuli which soon started to show in a strong return of nominal GDP growth (as is apparent in the chart above). Thus not only was the entry point lucrative but with the return of nominal GDP growth, debt servicing capabiltiies were only expected to improve going forward. It is no coincidence then that this phase heralded the new category of ‘credit opportunities’ products in our market. In line with the logic above, this phase should have also resulted in passive duration risk (long bonds) underperforming. Indeed, this was the case as well. Investors would have done well to be overweight credit risk in that phase while curtailing duration risk to a minimal; unless it was via well managed active duration funds.

 

The current phase is exactly the opposite. Nominal GDP growth has been steadily falling for the past few years and the fall has turned rather spectacular lately. Whereas, interest costs for most of the so-called ‘credit’ companies have not fallen. Hence, all other things remaining constant, the ability to service debt has on the margin started to erode in a rather noticeable fashion. Not just that, the prognosis for the future is not particularly bright. There is no prospect of a large size policy stimulus either locally or globally. Locally, the government is on a fiscal consolidation path whereas the RBI wants to offer a threshold level of ‘real’ positive rates over inflation and hence is unlikely to cut rates aggressively in a hurry. Even if it does, the transmission to lower rated credits is likely to be much slower; whereas the fall in revenue realisations is already underway. Globally, the developed markets have pushed policy easing almost as far as it can go; so that the incremental benefit of additional easing on world nominal growht is highly questionable. Indeed, the largest central banker seems now on the cusp of reducing some of its stimulus. There may be room in the developing world but that is also perceived to be constrained given the need to manage external vulnerabiltiies. Finally, China is now well and truly contributing to intensification of global deflationary pressures which cannot augur well for growth of global nominal GDP. Thus on top of already exporting its excess capacity arguably built over a multi decade industrialisation cycle turning, China has also now starting offering it at an even cheaper price point via the recent depreciation of the yuan. Also unlike the phase starting 2009, one cannot even argue that credit risk is getting attractively priced. The ballooning of the credit opportunities funds’ industry over the past few years has ensured a continued robust demand for credit assets and hence has kept driving spreads lower. Thus not only have macro tailwinds turned into headwinds, but the price point at entry is also not particulary exciting. Almost as an exact converse, and for most of the reasons mentioned above, duration risk is looking quite attractive.

 

Summary and Conclusions:

 

1. Credit risk and duration risk are both legitimate means to earn ‘excess’ returns over fixed deposits
 
2. The relative choice (of how much of each to take) has to take into account the macro environment which either creates a tailwind or a headwind to each type of risk
 
3. The period starting 2009 provided a compulsive tailwind to credit risk with a massive spike in nominal GDP, with the added benefit of a very attractive starting price point
 
4. The current environment is exactly the reverse where macro-environment now poses a headwind and pricing has steadily become less lucrative
 
5. In our view investors should rebalance towards duration risk and not get swayed by the apparent lack of volatility in credit risk products. The lack of volatility is partly owing to the binary nature of the risk and partly also because our markets don’t trade credit on a continuous basis.
 

The above is not intended to throw all credit risk in a bad light. Obviously there will be ‘value chains’ in the space that have not been subject to as sharp a revenue realisation haircut as the nominal GDP slowdown suggests. There will still be others who have responded aggressively to this slowdown so as to keep debt servicing capabilities intact. The intent here is only to give a macro-economic context to investors’ overall choice of whether to go overweight credit or duration risk. And the conclusion strongly is that the macro-economic logic is unabmigously in favor of duration risk at this juncture.

 
Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency and should not be treated as endorsement of the views or as an investment advice. The information/recommendation provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. This update has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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Suyash Choudhary

The RBI kept all rates on hold as was generally expected. In our view, the assessment was on the margin more dovish and more focused on the medium term than the impression conveyed by the June policy.
 
True the central bank is worried about the recent firming up in inflation at both a core and headline level, as well as the recent rise in near term household inflation expectations. Importantly, however, the RBI also talks of several factors that could have a ‘significant mitigating influence’. These include the sharp fall in crude oil prices since June and the likelihood of this to persist in view of global supply glut, increase in planting of pulses and oilseeds and prospects of rainfall in August and September according to some forecasters, effects of government’s current pro-active supply management to contain shocks to food prices, and its decision to keep increases in minimum support prices (MSP) moderate. Thus the assessment on inflation is quite balanced with the central bank looking at both the aspects of concerns as well as factors that may potentially offset these concerns. This is as should be for a data dependant, inflation targeting central banker. Also importantly, the RBI chose not to dwell at all on the IMD’s continuing forecast of 12% rain deficiency. All in all, the RBI’s net assessment on evolving inflation was reflected in it making the following 2 changes:
 
1. Reduce its inflation projection for January – March 2016 by 0.2%
 
2. Changed its assessment of risks to the 6% January 2016 inflation target from ‘upside’ to ‘broadly balanced’
 
On growth, the RBI assesses the outlook to be improving gradually. This seems largely predicated on some emerging signs on urban consumption and the possibility that a stronger than earlier anticipated monsoon can lift rural consumption. Weaker commodity prices could also impart a favorable real income effect and hence boost consumption. On the other hand, the continued downturn in global growth forecasts and hence our continued export contraction could be a prolonged drag on growth. Also new investment demand remains subdued , notwithstanding some improvement in stalled projects. Corporate capacity utilization and new orders remain flat, while corporate sales growth is declining. All in all, growth forecast for the year has been retained at 7.6%.
 
Takeaways
 
All in all, the policy seems more balanced than the previous one. The signals being given by the RBI also seem more consistent and in the same direction. Thus the central bank is cognizant of the recent pressures on inflation and is waiting to see whether the mitigating factors in play will be enough to offset these pressures. Given that it has reduced its forward inflation forecast, it looks likely that it assesses that the mitigating factors will ultimately prevail. While it waits it has been careful to reiterate the accommodative stance of policy as well as emphasize that it will look for emerging room for more accommodation. In the meanwhile, it expects that banks will be encouraged to further transmit its previous monetary easing as loan demand picks up in Q3. Also the government’s recent decision to step up capital infusion as well the current easy liquidity conditions should aid the transmission.
 
To us this policy is a pleasant contrast from the June policy given that the bias for monetary policy has been clearly emphasized while keeping future actions open ended. Also, while risks are mentioned, the RBI seems to be somewhat guiding market’s assessment of these risks as well; most obviously by pointing to mitigating factors and by reducing its own forward inflation forecast. In our view, such a policy drafting should enforce the transmission channel, all other things remaining constant. The seeming more relaxed approach on liquidity, while always ensuring that call rates are anchored to policy rates, should also alleviate some market concerns with respect to concerted steps to absorb system liquidity.
 
Finally, the Governor in the post policy press conference also alluded to approach towards FPI participation. The RBI and government seem to be working towards an institutional framework wherein limits will be increased by a quantum based on FPI’s ownership of the market. The setting will happen twice a year. There has been some expectation in the market about an imminent effective hike in limit basis re-designation of quota in INR terms at the current exchange rate. This would have effectively hiked government bond quota by approximately INR 35,000 crores. The Governor has somewhat
poured cold water on this expectation saying that the next round of limit review will factor in potential volatility around Fed and domestic liquidity. Basis these triggers, it looks like the limit may get reviewed in the October – December quarter. This disappointment is reflected in short term price action in bonds post the policy. However, given banks’ incremental credit to deposit ratio (tracking 41% YTD) lending more appetite for bonds, and a large sized commodity downswing in play currently, we would expect market interest to be quite stable. Our medium term view remains unequivocally bullish bonds.
 
Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency and should not be treated as endorsement of the views or as an investment advice. The information/recommendation provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. This update has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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