When Risk Comes Calling

I started my career as a Fixed Deposit agent canvassing Fixed Deposits for Non Banking Financial companies. Given that I was really young and not really educated formally in the field of finance, I was barely able to convince potential customers of depositing their hard earned money in the companies, many of which they hadn’t heard about. That left me with my only trusting client whose money I managed to invest – my Grandmother’s.

While lack of formal education or experience was a negativity and I really didn’t fully understand the value of money at that point of time, I did understand one thing – invest in only firms that have a AAA rating.

I had zero clue about how that rating came about it other than the fact that it signified the company was a good one to invest in. I avoided investing in even companies with AA rating other than for one investment I got my grandmother to invest into which was a subsidiary of Apple Finance (which had a AAA rating) – Apple Credit Corporation. The reason for investing in a AA company was simple – higher interest rate. ACCL offered a Cumulative Deposit with 21.5% interest payable on maturity.

But the investment in itself was small – a kind of take advantage without having to really worry if the risk came home. Thankfully none of the FD’s I had my grandmother invest ever defaulted – maybe more to do with Luck than Skill, but it still felt like an accomplishment at that point of time.

The Indian Express today had an article which puts the total amount of bad loans written off by Public Sector Banks at 5,55,603 during the period when the current Prime Minister, Narendra Modi has been in Office. While it’s easy to jump to the conclusion that much if not all of the bad debts is because of the government, the real facts aren’t and will never be so straight forward.

Banks are in the business of giving out loans and not all loans despite most backed by some sort of collateral come good. But thanks to the fact that Banks are able to borrow cheap and lend at a substantially higher level, Banks are able to make money post the write off’s. HDFC Bank for instance has a cost of deposit at 4.82% vs average yield of 9.22 leading to a Net Interest Margin of 4.4%.

Banks understand Risks and even in the worst instance, there are back-up’s that ensure that the small investor’s money is never at risk. After banks, the largest lenders are Non Banking Financial Companies. Once again, they make money by ensuing that they have a difference that can take care of any bad loans that shall accrue during the course of their business.

In recent times, Mutual Funds which are flow throw vehicles have come to become on the largest lenders – and sometimes the lender of the last resort. In March 1999, India had 44 Income Schemes which in total managed 1848 Crores. This was 15% of total amount mobilized by Mutual Funds across all Schemes – Debt and Equity.

By April of 2009, total number of Income funds exceeded 500 while total assets under management had moved to 1.97 Lakh Crore. This was 47% of total amount mobilized by Mutual Funds across all Schemes – Debt and Equity.

Come 2019, and we today have 1250+ funds with total assets of 7.20 Lakh Crore. Percentage of Income funds as part of total assets declined to 30% as the percentage of equity funds have advanced strongly in the last decade (from 23% to 32% – 2009 vs 2019).

Since numbers without relative context don’t provide a real understanding, how about comparing to a real large bank. Bank of Baroda is India’s second largest public sector bank and it had at end of 20018 advanced 4.27 Lakh Crore.

Growth of Assets always has a price that needs to be paid. Small Cap fund managers for instance will either need to shut the inflows or move to Mid Cap stocks once the assets they manage start to move higher than what can be possibly deployed with manageable risk in Small Cap stocks.

Debt Fund Managers have for a while been facing a similar problem. How to deploy the large amount of money that was being mobilized while still ensuing that the risk was contained. The easiest was to deploy would be to buy Government Securities. That assures zero risk of capital loss but comes at a lower yield and if the fund wants its own pound of flesh, it makes the fund unattractive to Investors whom it wants to pitch for investment.

The riskier the investment seems to be, the higher the interest rates are. While State Bank of India can mobilize Fixed Deposits at less than 7%, a Cooperative Bank such as Mahaveer Bank offers 8.50% for a similar tenure.

Similarly, the way mutual funds are able to attract more assets under their management is by generating a higher return which in-turn asks for higher risks to be taken. The key difference between a Bank that takes similar risks to a Mutual Fund is that the Mutual Fund is like my Grandmother – I am taking risks on “behalf” of her. If a company defaults, I being the middle man have no way of compensating her.

Yet, in the quest for returns, Funds have taken fool hardy risks and for a while this seemed like the way to do business. Funds suffered literally zero defaults as ample and easy finance by Banks ensured that even the most tyrant promoter paid up his dues on Bonds the funds have bought.

The first sign of change was when companies that had kept rolling their bonds thanks to the unlimited tap given out by Public Sector Banks defaulted. The reason for the default basically lay in the change that RBI mandated Banks to make which mean that ever-greening was a thing of the past.

Yet, the caravan continued to roll on as Fund Managers (save for a few) were able to avoid that hurdle and it was back to business as usual. The more massive hit came from an unexpected source – IL&FS.

When IL&FS bombed out, it hurt not only itself but a lot of companies that had got used to raising cheap finance by selling short term bonds – many secured by nothing more than their bubbly shares. This today is what the drama around the Fixed Maturity Plans and tomorrow could be of many other plans as well.

Take for example, Adani Infra (India) has raised funds by selling its Bonds to Mutual Funds (Kotak Fixed Maturity Plan – Series 186 for instance has 10% of its assets). Bonds of this company are rated AA. In its Rating Rationale, Brickworks says this,

“The rating factors, inter alia, the strength of underlying security in the form of pledge of listed equity shares of APSEZ and ATL with the current promoter pledge of 35.5% and 44.7%,respectively, structure of the NCD, resourcefulness of the promoters of the Company, and financial flexibility of the group.”

The basic rationale behind the rating is the pledge of shares. But what use are shares if you cannot sell them in the markets without depressing the stock to an extent that rather than the borrower being hostage to the lender, it becomes the other way as we are seeing in case of Zee and what we will see in many over leveraged and over extended companies in the months and years to come.

Mutual Funds aren’t Banks, Period. The blame also falls squarely on the government which through its taxation policy has ensure that small investors pay a much lower tax on gains from Mutual Funds versus monies deposited in Banks.

This has distorted how people invest and has let investors take risks higher than what they knew them to be. Debt funds losing money due to bad calls isn’t atrocious as it may sound – it’s the way they have been sold (as alternative to fixed deposits) that is the root of the problem.

But till the time the government wakes up to the distortion, the best way is to invest in funds that are large (preferably the largest around) in the space of Liquid, Ultra Short Term and Low Duration. If you want to be really safe, get into Liquid funds like Quantum which have a portfolio of only GSec’s and Government held Entities. But the yields are lower as should be the way.

Stay away from anything that is closed (Fixed Maturity Plans) unless it’s a small investment and the Indicative Yield seems attractive enough to take such risks.

In my opinion, it’s a fruitless venture for most to chase Alpha in Debt. You are paid way better in Equity where the upsides of being right can be monstrous versus just getting paid interest and principal on time.