Warning: Don't be blinded by high interest rates

May 18, 2011

In this issue:
» TRAI will now be at par with SEBI
» Is the US alone to be blamed for cheap money?
» India's lack of reforms pose grave risks
» One more slip on competitiveness ranking
» ...and more!
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One glance through the morning newspaper these days and you find reports of economic gloom strewn all across. Biggest economies on the brink of bankruptcy. Strongest currencies on the verge of devolving. Add to that concern of spiraling rise in commodity prices and ballooning deficits. In such a scenario most investors would want to be wary of investing in high risk assets like stocks. Especially if the valuations are not particularly attractive. Bank fixed deposits have been the ideal alternative over the past few months given their relatively safe nature and assured returns. But the fixed returns in this case pale against that on stocks and prove ineffective in countering high inflation rates. Hence the greed for even higher interest rates often lures investors to instruments that pose as much risk as stocks do. But due to their seemingly safe nature they often manage to evade investor scrutiny.

We are referring to corporate deposits. These instruments have found a new lease of life in the past year after their absence from the scene for nearly a decade. In the meanwhile most investors have lost memories of corporate deposits that failed to redeem investor money almost a decade back. Most new generation investors are not even aware of them. Hence when some Indian companies are looking to raise money from retail investors rather than from banks, the response is elating. The higher interest rates as compared to bank deposits attract investors across the board. Most have an eye on the rate differences between entities. But they ignore the fact that the issuer is not a bank but a corporate whose ability to redeem the money depends upon the safety of its balance sheet. Although the bonds are relatively more secure than stocks, they carry as much risk as stocks if the issuing company meets with financial distress.

This is not to say that all companies issuing corporate bonds are bad. There are several of them with healthy long term prospects looking to genuinely allow retail investors a pie of their long term returns. But for those that offer unusually high returns as compared to average rates, you need to be more watchful. It is most likely the abnormal returns are because of the companies' desperation to raise funds. Either due to their leveraged balance sheets or poor ratings, the companies may have been denied funding from banks. Or bankers may be charging unviable rates to these entities for additional funding. In such cases, it would be wiser for retail investors to not get greedy about the additional interest rates. Warren Buffett's advice 'Be fearful when others are greedy' applies as much here as it applies to stocks.

Do you study the companies' financial health while investing in corporate bonds? Share your views with us or post them on our facebook page.

 Chart of the day
Fed chief Ben Bernanke has a new critic every day accusing him of pumping cheap money into global markets. The blame for high commodity prices and real estate bubbles in emerging markets often find their way to the US Fed chief. But one look at the growth in money supply and bank credit in China will tell you that something is seriously amiss here. There is no denying that the US' loose monetary policies have paved the way for inflation. But China's growth obsessed money supply and bank lending is not safe either. As today's chart shows, the money supply and bank credit in China have in fact outstripped that in the US. If this continues we could have yet another financial crisis closer to home.

Data source: GloomBoomDoom

1991 was a landmark year for India. At the brink of a forex crisis, Dr Manmohan Singh, who was the Finance Minister then, introduced radical reforms. These opened up India's economy (which was otherwise a centralist planned socialist model) and paved the way for faster paced economic growth in the years ahead. Sadly, since then the Indian government has failed to speed up reforms. And reforms are needed in various areas. For instance, India's GDP growth in the past few years has been robust. But there have been negative factors that have adversely impacted its image too. Thus, while the lure of strong growth prospects attracted foreign investment to India, the same in recent times has been on the wane on account of corruption scandals and inflation. In fact, the US ambassador to New Delhi Mr Timothy Roemer opines that if this negative perception does not change, India could see downward revisions of as much as two percentage points to estimates for growth this year. That too keeping in mind the high level of inflation and the firm trend in crude prices. Indeed, Prime Minister Manmohan Singh needs to dig deep into his reserves and repeat the success of 1991. This would be by introducing reforms that will improve India's image and keep it on the fast track to higher growth.

Lawsuits, jail time, scandals, and trillions of rupees. This one sector has had all the action over the past year. An effective regulatory mechanism in telecom space is long overdue. But, we might see some changes now. As per a new act, telecom regulator, Trai may soon get additional powers. The Telecom Ministry is looking at amending the Trai's Act, putting it on par with the Civil Courts or market watchdog, SEBI.

This amendment will empower the Trai to summon people, examine them under oath, ask for documentary evidence, etc. It can also then impose a monetary penalty on operators in case they violate license conditions. The proposed amendment would also empower the regulator to deal with the problem of telemarketing calls in an effective manner. Well, we hope these proposals don't just remain on paper. With Raja's reign over, we hope no new scandals are brewing. Although, we won't be surprised if there are a few more skeletons waiting to come out of the closet.

When it comes to oil prices, whatever the level, the volatility continues. And so do the speculations. After soaring to a 2.5 year high, prices have recently slid on the back of a strengthened dollar and weak economic data. Should this be seen as a reverse trend or will oil prices flare again? We believe that levels above US$ 100 per barrel are too high to be supported by fundamentals. Having said that, it will be naive to expect the slide to continue. The prime reason is that the recent rise in US dollar is more of a relative concept. The dollar looks stronger because of the relative weakness of Eurozone and others fledgling countries. While it may rise a little more as quantitative easing winds down in June, we believe the strength will be hard to sustain on account of long term headwinds like unstable fiscal and monetary situation in US. But that is just one reason. The strength in prices will also be supported by emerging countries' ravenous appetite for energy. And since most of this has to be sourced from unstable countries like Iraq, Iran, Saudi Arabia and Libya, we believe that the prices get a further nudge upwards from supply side glitches.

India has once again slipped on competitiveness ranking. The country now ranks 32nd among a list of 59 nations. According to International Institute for Management Development India has slipped one rank this year. The ranking is done based on four main parameters of economic performance, government efficiency, infrastructure availability and business efficiency. Needless to say that few of these have shown signs of visible improvement over the past year.

The Indian government is perceived to be slightly more efficient in fiscal management this year. The country's economic performance was also at least in line with emerging market peers. However, the progress in the infrastructure space leaves a lot to be desired. We hope that if not by next year, atleast over the next 5 years the country will be able to climb up the ranks by finding a solution to its fiscal and infrastructure problems.

Big institutions like to make big forecasts. Nothing wrong with that really. It is, in fact, thrilling to imagine what the world will be like in the distant future. And though not entirely useless, it could definitely give some insight about the direction in which things are moving.

So let's entertain ourselves by hearing what kind of global economy the World Bank imagines by 2025. According to the study, by 2025, the six major emerging economies- India, China, Brazil, Russia, Indonesia and South Korea- will contribute more than half of all global growth. Between 2011 and 2025, it estimates an average annual growth rate of 4.7% for emerging economies and 2.3% for developed economies. This means that there will be a wide divergence between the growth rates of emerging economies and developed economies. Likewise, economic changes will have definite monetary implications. The global economy will move away from single reserve currency towards multi-currency comprising the US dollar, euro and renminbi.

We don't see any radical insight in the study. Most of what it concludes has been repeated umpteen number of times by many other studies. And whatever the world be like in 2025, nobody is going to blame the World Bank for what it forecasted in 2011. Because as the noted economist John Maynard Keynes has said, "In the long run, we're all dead."

The benchmark indices in the Indian stock market oscillated to either side of yesterday's close since the start of the day's trade. At the time of writing, the BSE Sensex was trading lower by 10 points (0.1%). Most other Asian indices closed higher, with Japan and Korea leading the pack of gainers. Europe has opened on a positive note.

 Today's investing mantra
"When purchasing depressed stock in troubled companies, seek out the ones with the superior financial positions and avoid the ones with loads of bank debt." - Peter Lynch

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4 Responses to "Warning: Don't be blinded by high interest rates"

Abhisek Shroff

May 18, 2011

In 1991 what was done, had to be done. Our Gold (A plane full of Gold) was pledged as against the loan and the trio- Shri. Narshima Rao, Shri. Manmohan Singh and Shri Montek Singh had to act not by choice but by compulsion.

In contrast if we see now, India is much stronger in every which way. Now is the time to push for major Finaincial reforms. Liberalize labor laws in India, DisInvestments, De-Regulations should make way.
With this, Oil price, China US worries would be taken care of by itself as we as an economy would grow stronger intrinsically, and Nifty/Sensex would eventually boom boom.



May 18, 2011

Post elections, the government needs to prioritize over pending issues like reforms, large scale corruption , infrastructure projects clearance and execution, and subsidy. It needs strong will power to have political consensus, quick action on corruption, time-bound plan for infrastructure and check on corruption accompanying subsidies, all within the coalition compulsions. The important bills on land acquisition, taxation etc. need to be made into law sooner than later. Inflation is getting beyond control, and if quick financial/ supply-side booster steps are not taken, it will get into viscious circle with higher subsidies.


Abhay Dixit

May 18, 2011

Re 1991 and Dr Manmohan Singh. I think too much credit was given/is being given to him. Without the PM Narsimha Rao's political astuteness and support, it was impossible. I can say that MMS was a technician and PM was the entrepreneur. I conclude this from the insipid, spineless leadership of MMS and lack of reforms when he is PM.


deepak mitra

May 18, 2011

stockmarket is tumbling down mainly because of oil price and uncomfortable inflation. rbi is trying their best to tame inflation . sooner or later things are likely to be under control. it is therefore time to start bying good stocks in instalment

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