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.

 
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