Be judicious in asset allocation

The situation in India’s debt markets is puzzling. The Reserve Bank of India (RBI) has cut rates multiple times in succession. That should in general, be good for debt investors (and for equity). However, the RBI admits that the policy rate cuts have not been transmitted. Bond yields have barely fallen while banks have marginally reduced commercial rates. 

At the same time, there has been an increasing trend of defaults. According to a Bloomberg study, there have been a record Rs 7,600 crore worth of defaults in 2019, and the defaulting entities have roughly 17x that amount outstanding in loans. What’s more, the credit rating agencies have failed to flag these risks, with many defaulters having excellent ratings. This means we have few benchmarks beyond market gossip to judge if a given corporate is about to default. 

Sentiment has been affected across the financial sector. The recent mess in PMC Bank shocked depositors, for instance. The RBI’s data for March 2019 versus March 2018 shows that NPAs in public sector banks have reduced mainly due to write offs on bad loans. Gross NPAs at around Rs 7 trillion was still above 12.5 per cent to advances despite Rs 1.7 trillion being written off. Provisioning had actually increased, to Rs 4.25 trillion from Rs 3.99 trillion in March 2018. Write-offs were twice the amount of loan recoveries. Given a slowdown that is now in its sixth quarter, it’s not surprising that corporates are struggling to service loans. 

There is a huge drop in commercial credit. New lending as a proportion of gross domestic product (GDP) may dip to 6.6 per cent this fiscal year from 9.5 per cent in 2018-19 owing to a large squeeze in credit from non-banking financial companies (NBFCs). Again, drawing upon the RBI data, credit (bank and non-bank) to commercial sector dropped from Rs 7.36 trillion in April-September 2018 to Rs 909 billion in Apr-September 2019. That’s 87 per cent reduction. It’s inconceivable that growth rates can be maintained if this trend of a credit squeeze continues. 

So we have lower policy rates, coupled to a trend of defaults and a corporate slowdown as the financial sector turns cautious. Where does that leave a debt investor? If you go by policy rate cuts, at some stage this should result in transmission to commercial rates. In that case, medium-term and long-term debt funds should do well. 

But the trend of defaults and the lack of transmission are both red flags that suggest debt funds are actively dangerous assets. It’s hard to judge if a given fund is exposed to default by a specific entity and every long-term and medium-term debt fund is surely exposed to contagion. Short-term funds are not exposed because they deal in money market instruments. However, it’s equally true that short-term funds don’t possess too much upside even if rates do continue falling. 

One of the reasons why rate cuts have not translated into lower bond yields and lower commercial rates is simply the government’s rising need for borrowed funds. There are estimates that the Fiscal Deficit may be overshot considerably. 

The corporate tax cut is projected to lead to a drop of Rs 1.4 trillion in direct tax collections, while Goods and Services Tax is expected to undershoot Budget estimates by at least the same amount, probably more. Government borrowings will crowd out other demand, especially where corporate bonds look risky. Also, the sheer quantum of government borrowing (Centre plus States) is large enough to ensure yields don’t fall. 

On balance, debt is looking really risky despite the rate cuts. Equity presents a different type of paradox. There are good, even great companies, operating across the Indian landscape. 

However, the elite list is over-valued, perhaps massively over-valued, given so many quarters of sub-par growth. Smaller firms are struggling and more at risk, although they have also seen corrections. There isn’t a single sector which looks like being an outperformer. Even the export-oriented IT service firms have issued gloomy advisories pointing at reduced demand as the world economy slows down. 

As asset classes, debt and equity both look unattractive at the moment. But an investor cannot avoid exposure to both and it would be sensible to continue investing.  Going into the new Samvat, you’ll need to be very judicious in asset allocation to navigate the apparent dangers. Happy investing!


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