Should you still invest in the bond market?

Feb 21, 2014

In this issue:
» The CV industry is in a sorry state
» Will the new M&A policy revive telecom?
» OPEC's supremacy has been challenged
» Has the emerging market scare been overdone?
» ...and more!

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Are bonds the only investment option that one should consider when there is uncertainty in the economy? Not always. Although bonds are not perceived to be as risky as stocks, it would be folly to assume that there no risks attached to it at all. And this applies not just to bonds issued by corporates but holds true for government debt as well.

Consider the current global macro environment. Because of the loose monetary policies of central bankers wherein most of the developed world has kept the interest rates close to zero, even company with shaky fundamentals are able to borrow funds and not pay much for it. But the problem does not end there. The notion that government debt is the safest in the debt market is also increasingly being questioned. Because of massive quantitative easing programs, the government in the US, Europe and Japan have racked up massive debt with a big question mark on their ability to service the same. Thus, in the global economy at least, at a time when equities have run up too much with not much fundamentals to back this rise, even the bond markets do not look that promising. Indeed, inflation in the US, Europe and Japan has averaged at around 1-1.5%. And the interest rates being close to zero, bondholders are not really earning anything in real terms.

In emerging markets such as India, inflation has been a big problem. Although the RBI has been raising rates, adjusting for inflation, the real return on bonds post tax is hardly anything to write about. Infact, investment in stocks of companies that have strong fundamentals and were bought at reasonably valuations would certainly have rewarded investors more than putting money into bonds.

Having said that, we do not want to write off bonds entirely. We are of the view that investors need to have a healthy representation of various asset classes in the overall investment portfolio so that risks of one asset class can be offset by another. Thus, while equities have proven to reward shareholders more than bonds in the long run, we are of the view that bonds must also form a part of your portfolio. The amount that investors should set aside for stocks and bonds would depend on their age and risk profile. Further, whether investors invest in corporate bonds, government bonds, fixed deposits, bond funds etc, the credibility of the issuer has to be given a lot of importance.

Do you think that investing in bonds is the worst type of investment? Let us know your comments or share your views in the Equitymaster Club.

 Chart of the day
The commercial vehicles (CV) industry has been in a sorry state since FY12. Given that the fortunes of this industry are closely linked to that of the economy, slowdown in the latter has considerably taken toll on volumes. The severe impact of the slowdown has especially been more pronounced for the medium and heavy commercial vehicles (MHCV) space. Given that industrial activity has largely been sluggish and many projects have been stalled, this segment of the auto industry has been badly hit. That is why market leaders in this space viz., Tata Motors and Ashok Leyland have also been adversely impacted. The timing of the revival is anybody's guess. But it is unlikely to take place before the general elections. And post that, increased focus of the new government on infrastructure spending will go a long way in bolstering the performance of this sector.

The sorry plight of the CV industry

A capital intensive nature of the business with little pricing power is in itself a huge challenge for any owners to deal with. Throw in frequent regulatory flip flops and a huge technological disruption and you have a sure shot recipe for disaster we believe. We certainly don't want to wish these challenges upon any sector. But they seem to be cutting right through the heart of the Indian telecom space currently. An article on Mint has tried to highlight how there is great anticipation for the new M&A policy for the telecom sector. Especially amongst the smaller players. For the policy would help put them out of their current misery. The misery is nothing but the challenge of growing revenues against a cost base that keeps on rising continuously. One look no further than the recent acquisition of what's app, arguably the fastest growing messaging service. It is these kinds of apps that are causing a big dent in the revenue model of telecom companies and hurting them where it matters the most. One consolation could be that this is the trend not just in India but is a worldwide phenomenon. At this rate, we won't be surprised if the telecom industry goes the way of the airlines, doing lot of social good but not creating value for shareholders.

That the Reserve Bank of India's (RBI) monetary policy actions do not find much support in the Finance Ministry is no news. In fact not just Dr Rajan but also Dr Subbarao have in several instances drawn flak from the FM for their anti-inflationary stance. The government's view that the central bank is responsible for low GDP growth certainly does not hold much water. Especially since despite repeated warnings the government itself has done nothing about curtailing price rise. That much needed reforms have been in the backburner has always skipped the FM's notice. And every time the RBI has curtailed liquidity it has become the target of accusations. Turns out that none other than the International Monetary Fund (IMF) has come out in the RBI's support. According to the Economic Times, the IMF has actually lauded the RBI's efforts to contain inflation. Moreover it warned the Indian government of a possible rise in interest rates and insisted on policy reforms to accommodate that. We believe that if the government does not pay heed to such warnings, investors should know whom to blame for India's economic misery.

Energy is the backbone for any economy that aims to grow and prosper. Now that recovery seems to have set in Europe and America, the demand for oil is likely to get a boost. This would have been undoubtedly positive for Oil and Petroleum Exporting Countries (OPEC) some years back. But things are different under current settings.

OPEC accounts for around two thirds of the global oil supply. It has often been perceived as a cartel that keeps manipulating production to keep the price levels up. But with oil production in America witnessing an upswing, OPEC's supremacy has been challenged. Its position is weakening further as production scenario from other sources like Libya, Iran and Iraq seems to be improving.

As suggested in an article in Economist, OPEC has two ways to deal with it. The first is to curb the production to keep pricing strong. But then the quotas have hardly been taken seriously by OPEC members in the past. Another way is to infuse an oversupply enough to bring down oil prices to a level where oil production business becomes unviable for high cost producers like America. In the meantime, the best it can hope for is that America will prefer to consume most of the oil and gas itself instead of exporting it to other regions and making things more difficult for OPEC.

In the previous decade, emerging markets were deemed as the future growth engines of the global economy. Even after the global credit crisis broke out, emerging markets showed resilience. Many market commentators espoused the view that emerging economies would lead the global recovery. But in recent years, the vulnerabilities of emerging markets have been exposed. Political instability, volatile currency and slowing growth have impaired their economic prospects. This has resulted in mass exodus of investors from these economies. As we saw in a recent chart, global fund managers have turned increasingly bearish on emerging market.

Has the emerging market scare been overdone? Would this be a good time to invest in them instead? If the views of Mark Mobius, a renowned emerging market fund manager, are to be believed, emerging markets could be bottoming out. Here is his logic. According to him, emerging markets stand way better than developed markets as they have higher economic growth potential, increasing foreign reserves and lower total debt relative to gross domestic product. Of course, the risks and concerns are there. But the big picture remains positive for emerging markets.

The news of US Fed taper sent emerging market (EM) equities and currencies in tailspin. Taper indicated that the US economy was recovering and hence money moved out of EMs into the developed world. This led many to believe that the US dollar should appreciate. Also, tapering should effectively reduce bond buying by the US government. Thus, dollar injection/supply into the system should reduce making it rise in value. However, the opposite seems to be happening. The US dollar has been depreciating since the announcement of taper! This seems counterintuitive, isn't it? This paradox can be explained by the simple reason that the money that flew out of EMs did not move into US. It effectively chased other asset classes and currencies. Hence, the US dollar did not benefit from the tapering exercise as it was intended to. Also, the fact that US equities were already trading at high valuations due to excess liquidity available in the system further upside potential appeared limited. Hence, investors did not buy US stocks thereby reducing the demand for US dollars. As a result, the US dollar depreciated. This cycle may turn once US equities become more attractive.

In the meanwhile, Indian equity markets continued to trade high. At the time of writing, the benchmark BSE-Sensex was up by 158 points (+0.8%). Banking, FMCG and IT stocks were the biggest gainers. Barring China, all the Asian stock markets were trading firm led by Japan, Indonesia and Hong Kong markets.

 Today's investing mantra
"Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value"- Warren Buffett

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1 Responses to "Should you still invest in the bond market?"


Mar 2, 2014

given the current state of the economy i think fixed deposit is a better option as over 9% is assured per year

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