Are the 'safe debt investments' backfiring? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Are the 'safe debt investments' backfiring? 

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In this issue:
» Has India's poverty level reduced dramatically?
» What helped Wells Fargo become the most valued bank?
» Bribery in China's healthcare system
» Amartya Sen's views on India's labour laws
» ...and more!

Financial media tends to re-define 'safety' of asset classes every time there is a change in market sentiment. Prior to the financial crisis of 2008, even derivatives were sold as safe investments. Ironically the weapons of mass destruction have only made the case for so-called safe investments stronger. So much so, that post crisis, the adage of safety shifted from smallcap stocks to gold to finally debt funds. Many Indian investors who managed to sail through the crisis of 2008 lost their shirt betting on risky smallcaps. Gold then became the favourite asset class endorsed by financial media and banks alike. Once the sterling rise in gold prices halted and government cracked down on gold buying, even the yellow metal lost its luster.

The street then shifted focus to debt funds. Until last month every major financial daily propagated the wisdom of putting tons of money in 'safe' debt funds. Banks too were happy to tie up with mutual funds to propagate the safety of their debt funds. All they had to do was convince prospective investors that the RBI's move in the next monetary policy was a 'rate cut'. After all with the Finance Ministry breathing down its throat, the Reserve Bank of India (RBI) had little option! Reducing interest rates would be the most certain way to push GDP growth rates higher. And the cut in interest rates would be a blessing in disguise for the debt funds. Given the inverse relation between interest rates and bond prices, investors would not just keep their money 'safe' but also reap rich gains in a short time.

The promise of 'safety' and quick returns worked wonders for debt funds. Even while equity mutual funds saw lumpsum redemption, inflows into debt funds touched record highs. Brokers and advisors even convinced their clients to shift money from long term equity funds to short term debt funds. The dream run lasted only until the RBI's sudden rate hike caught both mutual funds and investors unawares. In its typical style the RBI chose to curb liquidity to stem the rupee's fall against the US dollar. The concern over higher rates impacting near term growth is not on the central bank's mind. Yesterday, once again the RBI indirectly hiked the cash reserve ratio (CRR) for banks. These measures took the 'safety' quotient of debt funds to new lows. Investors who had been lured into them painfully realized that no investment is 'safe' if the underlying rationale is speculation as against fundamentals. Also those who chose to shift funds from long term equities did so at their own peril. Not just debt mutual funds but corporate bonds too have been mis-sold in recent times citing 'safety' of capital. In the recent webinar, Mr. Ajit Dayal discussed the risks of investing in so-called 'safe debt instruments' in more detail. We wonder if investors would finally start evaluating riskiness of asset classes more carefully.

Do you think the financial media is responsible for mis-selling debt funds as safe asset classes? Please share your comments or post them on our Facebook page / Google+ page

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01:30  Chart of the day
While the election focused government does not wish to think twice about doling out subsidies, how will it impact its balance sheet? If the statistics over the past decade is anything to go by, the rising burden of subsidies has taken a toll on the government short term debt liabilities. It therefore goes without saying that additional subsidies will make India's fiscal situation worse. At nearly 25%, the government's short term debt liabilities have nearly tripled as a proportion of GDP over the past 8 years alone. Unfortunately, the government seems to be ignoring the statistics altogether. It is too busy sprucing up its image for the upcoming elections instead of running the country, which is its job in the first place.

Data source: CMIE, RBI

What is the level of poverty in India? Poverty levels in India have fallen sharply during the UPA regime. This is as per latest Planning Commission estimates as reported in the Economic Times. During 2011-12, poverty line dropped to 21.9% of the population. The same stood at 29.8% in 2009-10 and 37.2% in 2004-05. Urban poverty levels declined from 25.7% in 2004-05 to 13.7% in 2011-12. Rural poverty, on the other hand, declined from 41.8% in 2004-05 to 25.7% in 2011-12. In other words, close to 20 million people were lifted out of poverty each year from 2004-05 onwards. What is the reason for such a significant decline in poverty levels? As per the Planning Commission, high real growth in recent years is the reason for poverty alleviation.

While poverty levels may have declined overall, we are not sure if the sharp declines reported by the Planning Commission represent the reality. A major caveat is the assumption of the poverty level. A flawed poverty line would show decline in poverty only on paper. The Planning Commission's estimates are vulnerable to such drawbacks. It must be noted that the 2011-12 poverty estimates are based as per the methodology recommended by the Tendulkar committee. If you recall, the Tendulkar methodology had received criticism in the past for fixing poverty levels too low.

The UPA government would certainly gain some political mileage from this report. Whether poverty in reality has really gone down is a different question. On paper, at least, things appear to look good!

The business of banking can really be a two edged sword. If the management is able to keep its head, it is really the best business in the world. You take in money at a certain rate and lend it out at slightly higher rate and just pocket the spread. That's it. However, lower your lending standards a bit and your net worth can get into trouble in no time. If you need a real life example, look no further than ICBC. This Chinese banking behemoth was until recently the largest bank in the world by market cap. However, the crown seems to be slipping off its head as doubts over credit quality come to the fore. The Wall Street Journal reports that Wells Fargo, a large US bank, has now replaced ICBC as the world's biggest bank by market cap. But given our belief that most of the growth in the US seems a result of stimulus, we wonder how long can Wells Fargo survive at the top. Sadly, it could take ICBC even longer to clean up the problems it is finding itself in the midst of. Long term though Wells Fargo seems better placed as its lending is more shareholder oriented as opposed to ICBC which has to lend based on Government diktat.

If you thought corruption and bribery in government organisations was a feature unique to India, think again. China seems to be a suffering from a similar situation. What is more alarming is that rampant bribery appears to be a regular phenomenon in Chinese government run hospitals. Imagine a scenario where doctors and other staff are paid extra to perform operations and also receive kickbacks from drug companies and medical equipment suppliers. The sad fact is that Chinese doctors have acknowledged this. But they defend themselves on the grounds that they are left with no choice as they cannot survive on existing salaries.

So is the Chinese government and the way it runs hospitals across the country responsible for this? As reported in an article on Reuters, over the past 30 years the Chinese government has made its healthcare sector more market-oriented. But there is a catch. Hospital administrators can set fees for in-patient care, nursing and laboratory tests. But the state fixes the cost of operations. This is because China has made a commitment to make healthcare affordable for its people. And it also caps the cost of many prescribed medicines by setting a suggested price. This does not leave much room for hospitals to increase wages. Whatever be the case, bribery is certainly not the way to go about things. If the Chinese government is serious about curbing corruption, then it needs to take a long and hard look at the management of hospitals across the country. And come across a solution that not only considers the wants of the doctors but does not put the lives of millions of Chinese at risk.

How do you gauge a financial crisis? Excessive use of leverage is one indicator. Easy monetary policies inject excess liquidity into the system. And this liquidity finds its way into asset prices thereby creating a bubble. Even this is a sign of impending financial crisis. However, recently we came across an interesting correlation between skyscrapers and financial crisis. Anytime a skyscraper is being built in a country what follows is a huge financial crisis. Take the example of New York, Kuala Lumpur or Chicago for that matter. In 19th century quite a few tall skyscrapers were built in US. And what followed was the great depression of 1930. In Chicago too, once the Sears Tower was built in 1974 the US faced stagflation. And we all know about the East Asian crisis which immediately followed after Petronas tower was built in Kuala Lumpur.

So, is the past a mere co-incidence or is there a genuine correlation between skyscrapers and impending financial crisis? Well, skyscrapers in one sense are indicators of construction boom. However, if there is not enough demand yet the construction goes in full swing it suggests widespread misallocation of capital. This indicates price correction is likely. It signals that the roots of crisis have already been laid here. Think subprime mortgage crisis.

So, based on this analogy which country is next to face a crisis? Well, we have the largest skyscraper coming up in China by 2014. In fact, the country has 53% of the entire world's skyscrapers under construction. So, if history is anything to go by investors need to be vigilant of investing in this dragon nation.

Noble prize winning economist, Amartya Sen, seems to have hit the nail on its head when it comes to understanding why India's growth has slowed down. In his opinion, the high growth that we saw in the past decade was problematic to begin with. It was brought about by an unskilled work force. As a result the growth was concentrated only in a few pockets and sectors like IT, etc. And when these sectors took a turn for the worse following the global crisis, the growth in India came under pressure too. According to him the main reason for the slowdown is the bulk of unskilled work force that is not really concentrating on increasing its productivity. Unfortunately the labour laws in the country have not helped either. In his opinion, the labour laws have actually been counterproductive because they favor the labor rather than the employers. This makes it tough for employers to discharge the labour force even if they are unable to deliver in terms of performance.

Lack of labour reforms in India is something that India Inc too has been harping on for a while. Unfortunately the government has turned a deaf ear towards this. Perhaps Mr Sen's words would have some effect. But any reform on this front would not bode well for the populist image that the government is trying to build for itself before the state elections.

The Indian equity markets continued to slip further below the dotted line. At the time of writing, the benchmark BSE Sensex was down by 284 points (1.4%). Barring software, all sectoral indices were trading in the red with stocks in the banking and capital goods space leading the losses. The other major Asian stock markets were trading mixed with China leading the losses. However, the stock markets in South Korea and Singapore were witnessing gains.

04:56  Today's investing mantra
"Although its easy to forget sometimes, a share is not a lottery ticket. It's a part ownership of a business."- Peter Lynch
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4 Responses to "Are the 'safe debt investments' backfiring?"

Manoj Kumar Mondal

Jul 25, 2013

How do you gauge a financial crisis? skyscrapers and economic doom!!!
The data seems eye-catching. Give it to a statistician – the apocalypse will appear knocking at our bedroom door. But hold your breath and don’t panic. A deeper look beyond the horizon may frustrate the doomsayers. In all the examples mentioned, the economy took a sharp up-turn immediately after the harsh period. Looked holistically, it may at best appear like labor pain that follows birth of a new life. The weak hearted will surely miss the later part – the greatest wonder of the universe. The bold always looks beyond and that gave us everything beautiful.



Jul 25, 2013

Why do we always blame the financial media for all our losses ? We should all appreciate that they are there for only one thing - MAKE MONEY FOR THEMSELVES. I too am one of those who invested in these 'safe debt funds' but we all walk in with our eyes open. We all took the call that interest rates are on the way down despite missing the writing on the wall - our FD Rates of 8.5% was less than or equal to the inflation. We got greedy and we have to pay the price. Period. Even in the 'derivatives' disaster many Companies tried to say 'we were not told', and resorted to various means to avoid and/or reduce the losses. If you decided to bat against fast bowlers, then we cannot say I was not told that they will bowl bouncers. We have to accept the consequences of our decisions. The way MF's "sell" their funds is questionable, but then we all need to understand the games - it is our money at stake. If one does not understand the debt market stay with FD's and Tax Free Bonds. Simple. What do you lose. Maybe 1% less the 'smarter' guy, who turns out to be the 'dumber guy' (like me).



Jul 24, 2013

A Debt-fund portfolio would "swing" lesser than an Equities one. So, in that sense they do give a feeling of safety. A trade-off for this safety is that one gets a lower return.


Jagadeshwer Rao

Jul 24, 2013

Can I have the gist of Mr Ajit Dayal's take on so-called safe debt funds?

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