Recent reports suggest several companies are defaulting on interest payments to investors (see box). This, and the fact that returns from fixed income instruments are falling steadily, is likely to make fixed income investors quite unhappy. There could be a temptation to invest in riskier papers, to get more return. However, this isn’t the best time to do so.
When evaluating a company’s offering (fixed deposit, debenture, etc) look closely at its credit rating. “Our strong belief is that investors should only go for bonds with the highest credit rating, even if that means giving up a few basis points in return. When you invest in debt, safety of capital should be your first priority and you should be satisfied with a reasonable rate of return,” says Manoj Nagpal, chief executive officer, Outlook Asia Capital.
In India credit ratings could fall by several notches at one go. Which is why this advice is important.
Recently, Axis Bank, which saw a spike in its non-performing assets (NPAs), issued a warning on three sectors where the bad loan problem is acute — power, iron & steel and infrastructure. Avoid these for the present.
Savvy investors should go through a company’s financial statements. Check if its cash flows are sustainable. The debt to equity ratio should not be excessive. While a 1:1 ratio is regarded as safe, you could invest in the case of some capital-intensive sectors if this is a little higher.
When a company issues debt, ask why it is borrowing capital from the market and not a bank. “While high-quality companies raise money from the market because banks can’t lend to them at below the base rate, poor-quality ones do so because banks won’t lend to them or will only do so at very high rates. Avoid the latter type,” says Deepesh Raghaw, a Sebi-registered investment advisor and founder, Personalfinanceplan.in.
Investors also need to look closely at the rate of interest the company is promising. “Is it a simple or compound rate? If a company borrows Rs 1 lakh from you and promises Rs 1.6 lakh after five years, and it advertises that it is offering an interest rate of 12 per cent, it is conning you. The compound rate of interest is only 9.86 per cent,” says Raghaw.
Avoid taking excessive credit risk via mutual funds (MFs), such as high-yield FMPs (fixed maturity plans) and credit opportunity funds. Steer clear of FMPs that promise an excessively high rate of return. Since you can’t see their portfolios before investing, you could well find out later that it is more risky than you had anticipated.
Credit opportunity funds should also be avoided by risk-averse investors. Savvy investors could invest in these after evaluating the portfolio’s credit quality. Don’t invest in a fund having paper below an A-rating. “Excessive credit risk should also be avoided in MFs because there is no empirical evidence of how good they will be at recovering dues from companies that have defaulted or whether they even have the capability to pursue such cases, unlike banks, where the processes are well established,” says Nagpal. If you do invest in a credit opportunity fund, keep reviewing the portfolio regularly, as it could change in a few months.