Is this the most misunderstood asset class?

Dec 12, 2011

In this issue:
» The cheapest form of energy
» India Inc shying away from investments?
» China's US$ 300 bn foreign investment fund
» Is SEBI's FII data flawed too?
» and more!
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Think investments. Think equities, mutual funds, gold and real estate. Unfortunately most investors today do not even count debt as an asset class for their investment portfolio. Fixed deposits are means to park surplus cash for liquidity needs. Tax saving instrument like PPF becomes priority during the tax saving season. But India's immature and opaque debt market gives little reason to investors to look forward to returns from government or corporate debt papers. That the returns on such instruments may not be an ideal inflation hedge acts as an additional dampener.

According to Richard Bernstein, the former Chief Investment Strategist of Merrill Lynch, even in matured debt markets like the US, treasuries (government debt) are an ill preferred asset class. This is despite the fact that long term US Treasuries have offered attractive yields during periods of stock market underperformance. That makes debt instruments one of the most misunderstood investment avenues. It has also been observed that investors tend to get enticed by debt instruments offering relatively higher yields and thus often settle for low quality papers. This again proves harmful for their portfolio if and when the low quality debt paper loses value.

But, just like we prefer to have clothes for every occasion in our wardrobe, it makes sense to have asset classes to suit all economic scenarios in our investment portfolio. High quality debt necessarily needs to feature as a reasonable proportion in that. True, debt may not serve the purpose of building wealth over the long term. That is best offered by good quality stocks bought at bargain prices. Again gold and real estate serve specific needs of inflation hedge and hedge against rise in property prices. But during times of short term uncertainty, returns from debt instruments, like high quality corporate bonds, offer the much needed liquidity. The interest receipts may not be tax efficient but at least save the necessity to liquidate stocks, mutual funds and properties when their market value is under priced. Thus debt serves the purpose of much needed diversification in one's portfolio. Ignoring that by considering debt as a laggard in the long term may be a mistake that every smart investor would wish to avoid.

Do you think some proportion of high quality debt is a must-have in one's portfolio? Let us know your comments or post them on our Facebook page / Google+ page.

 Chart of the day
The American economy might witness a significant turning point in the way energy is consumed. Going by what one of the leading players in the energy domain has to say, natural gas will overtake coal as the key fuel to generate electricity in the US 13 years from now. As seen in today's chart, natural gas is the cheapest form of energy when it comes to cost of generation. Displacing coal fired power generation will thus have multiple benefits - less costs of generation, reduced gestation periods for setting up plants and most importantly, lesser pollution. Such a prediction seems convincing for the US where natural gas is in abundant supply and available at reasonable prices.

However, the scene back home is in stark contrast to the US. Here, power generation strongly leans on coal supplies. To dream a similar shift in India will be a little overambitious due to a number of constraints. To begin with, we are struggling with declining domestic gas supplies and high costs of imported gas that have put already existing gas based projects to the risk of capacity underutilization. Besides this natural constraint, we lag far behind US when it comes to having a conducive environment and policy framework for such a revolution. This is because for gas based power generation to be viable or compare favorably with other sources in India, the gas prices need to be at least at the level of US$ 7-US$ 8 per unit, almost double the level they are priced now. To take our country to that level will need strong commitment to sectoral reforms - especially addressing the availability issues and pricing.

Data source: EIA, Outlook 2011

While the Indian economy has had its share of ups and downs, the clouds of pessimism were never as dark in recent years as they seem to be now. Entrepreneurs and corporate barons seem to be sick and tired of what's happening here. So much so that some of them are even contemplating shifting base to other countries and slowing investments in their own motherland down to a trickle. The impact of such a move in the long run should be under estimated at its own peril. While demographic dividends and democratic set up is all good, a nation cannot grow its GDP without making adequate investments. This is because the investments provide the new capital base from which a firm and consequently an economy can grow its revenues and GDP. As it is, we are not covering ourselves with glory when it comes to attracting capital from overseas. Even puny nations steal a march over us on this front. And now with domestic capital also staring down an abyss of uncertainty, our policymakers sure have their work cut out for them.

China in recent times has become increasingly jittery about the vast quantum of dollar reserves that it holds. Especially at a time when the US government has been looking to solve its problems by printing more money and thereby reducing the value of the dollar. That is why China's central bank plans to create a new vehicle to manage investment funds worth a total of US$ 300 bn to improve returns on its stockpile of foreign exchange reserves, which is the world's largest. The vehicle would operate two funds one targeting investments in the United States and the other focused on Europe. The investment vehicle would be affiliated with China's State Administration of Foreign Exchange (SAFE), the part of the central bank in charge of the daily management of China's US$ 3.2 trillion in foreign exchange reserves. In the US for instance, China has substantial investments in US Treasuries. But given how Europe is teetering on the brink with its massive debt and the US too is saddled with huge debt, the sovereignty of these countries has increasingly come into question. And China wants to ensure that it does not end up catching the wrong end of the stick.

In the 1990s, India removed all restrictions on its current account. This was after enacting a number of important reforms. Since then the big questions was as to when the country will move to full convertibility of its capital account. This refers to the removal of restrictions on international flows on India's capital account.

But, the recent sharp drop in the value of the rupee has spooked policymakers. It has sparked concerns that India may impose more restrictions on its capital account. RBI Governor Duvvuri Subbarao ruled out full convertibility for now. He says that India first needs to achieve stability on many fronts. Growth needs to stabilize and so does inflation. Fiscal stability is needed and so is a more developed and integrated financial markets. Hastily implementing reforms without these in place may lead to more trouble in the system.

A couple of months back we had written about a how a report by Kotak had pointed out some wide discrepancies in official figures on exports and Foreign Institutional Investors (FIIs). Last Friday the government finally admitted that it had 'accidentally' inflated this year's export figures. Let us remind you, the size of this accident is as big as US$ 9 bn. All eyes are now on the credibility of SEBI's data. As per the Kotak report, while SEBI reported FII inflows of US$ 22 bn, they could account for just US$ 4.5 bn with their bottom-up study. How can there be such huge discrepancies? This either means that government figures cannot be relied upon, or even worse, the government is lying. Whatever be the case, it is not at all an encouraging sign at a time when the Indian government's credibility has been stained by a slew of big ticket scams.

After starting off marginally in the positive, the indices in Indian stock markets slumped below the dotted line as data on fall in IIP number for the first time in two years dampened investor sentiments. The selling pressure was mainly seen in commodity, banking and telecom stocks. At the time of writing, the BSE Sensex was trading lower by 225 points (down 1.4%). Indices across other key Asian markets closed a mixed bag while Europe has opened on a positive note.

 Today's Investing Mantra
"You're looking for a mispriced gamble. That's what investing is. And you have to know enough to know whether the gamble is mispriced. That's value investing." - Charlie Munger

Click here to read our series on 'Lessons from Charlie Munger'

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4 Responses to "Is this the most misunderstood asset class?"

Ganapathy Sastri

Dec 13, 2011

It will be incorrect to say that Indians do not invest in debt. Retail persons may not buy government debt but they invest in bank deposits, company deposits. Unfortunately there is no vibrant market for Corporate bonds, HIGH RISK bonds, or even government debt. For investing in these, the simplest way for most persons is through MFs. Unfortunately, the charges are generally HEFTY compared with US based funds like Vanguard.
Another aspect is that is very difficult to BEAT inflation. Inflation in India has always been HIGH and during last years it has been MASSIVE at over 15% CAGR. Investors in all classes of assets - Equity / stocks, debt, gold, commodities etc. , must necessarily expect their investments to lose purchasing power. Just remember, thirty years back one could retire comfortably with Rs. 5 lacs. Today, you need several fold to have the same comfort.



Dec 12, 2011

A couple of points on your todays' note. It is only the independent working of the RBI that has saved us from disasters. These have been proved time and again. The predecessor of Mr. Subbarao, Mr. Reddy , who with his firm handling at that time ensured that we survive the 2008 Banking crisis of the West. If we have full convertabilty, please be assured that we will have huze problems. We have to pass huze reforms before we can think of FC.

Seondly as rightly said in your article, we do not have any government at present. The working of the UPA 2 is horrible to say the least. As if there is not govt. at the centre. If the country cannot have the PM with the final word, what can you expect? This ntelligent "Sardar", may go down in history as a good FM but a very bad PM. Only sincere regrets for the poor fellow.
Thanks Damani.


Suresh Kumar

Dec 12, 2011

It's best to stick to asset allocation between debt and equity.
India is a unique and blessed country. It grows at 7% despite lack of investment in infrastructure, government overspending, lack of reforms, higher land costs, corruption, slow government approvals (Vedanta was extremely lucky to get clearance for Cairns acquisition in 18 months), and delay in land acquisition. EU, US find it difficult to grow at 25% our speed despite not having above bottlenecks. Imagine our growth rate if we did not have above bottlenecks.
It's strange that nobody in the government does the back-of-the-envelope calculation to check the export / import data or any data of investments.



Dec 12, 2011

The article mentions only PPF, but EPF is the biggest debt instrument that most salaried employees and hold it for a long term. Along with EPF there is superannuation contributions which get directed to a combination of debt and equity (equity being a small component). In this context how should one look at building his portfolio. What should be asset allocation.

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