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On This Day - 11 MAY 2020
A Warning from the Bond Market
Financial markets are all interconnected. You can't be just an equities trader or just a commodities trader. You need to look at how each market affects the other.
On Friday, the Indian 10-year bond yield fell below the psychologically important level of 6%.
What does this mean for you as a trader?
Find out in today's video...
Hi, this is Vijay Bhambwani here, and I'm recording this video from my residence because the lock down for Corona still continues. I hope you're keeping indoors and protecting yourself and your family as well and looking after the investments and trading game, staying in touch with the market so that you don't get out of touch or miss the pulse of the markets.
This video is something that I thought about two days ago because I am deeply anguished, deeply pained by what I saw in the market on Friday. I have been talking about, especially bond yields, fixed income securities and how I had recorded a video at the end of the calendar year 2019, as to how the year 2020 will be a year of falling yields and a great deal of discomfort for the fixed income investor.
I can imagine if you get this feeling that you're not exactly a guy who invest in bonds of fixed deposits or other instruments of fixed income of passive income. So, why should I worry? This is not a market that I am concerned with. I'm an equities only investor or commodities only investor or a landlord who rents out a commercial or residential space for monthly rent. And I don't really need to.
I beg to differ. I think it's time for you guys to wake up and smell the coffee. I have news for you, and over the next couple of minutes I want to share my thoughts with you. You may agree to disagree. That's all right. But you should give it a few minutes of your time and hear me now.
What happens when fixed income yield starts to fall? I belong to a generation which has enjoyed returns on fixed deposits from public sector banks in the 1980 and a very early 1990s of as high as 14%. You heard me right. There was a time when the Indian banks gave you 14 and 15% interest.
In those days, when I was in college studying for my management exams, our finance professor came and spoke something to us, which is still stuck in my mind, he said, if you want to dare to dream of retirement, first collect an equivalent of 25 years of monthly expenses at today's levels. Keep that liquid money in an interest yielding investment, fixed income yielding investment. The interest that you will receive and remember, we're talking about 14 and 15% interest per annum, the interest that you will receive on this figure of forward 25 years of household expenses, will take care of your living expenses and provide you with slightly more. Now that slightly more was supposed to take care of your inflation.
Today, unfortunately, inflation has risen faster and your interest on fixed income securities has come down. As a matter of fact, on Friday, I was alarmed to see the India 10-year bond yield fall below the psychological threshold of 6%.
If that is not ringing alarm bells in your mind, I guess nothing else will, because now we are joining Western countries where yields for fixed income investors are collapsing.
Even if you're not a fixed income investor the reason why you should worry is because your asset class, whether it is commodities, currencies or equities, will ultimately be affected.
What happens when you push a fixed income investor into a corner and box him or her into a corner and say look, instead of 15% I am going to give you 6% interest?
Now to make both ends meet either the guy puts in 2.5 times more money into a fixed income yielding security to maintain the same level of interest. Now the problem is, what if I do not have 2.5 times more money? I either start to cut expenses, which means the GDP growth rate flattens out or which is even more worse, I start to take risks so that I can earn higher amount of profit, profit that the finance industry, which specialises in complicating matters so well, calls alpha.
Now there's a problem with taking higher risks. Not everybody is geared to be savvy enough to understand risk in the first place. And when you take on risk, which you do not understand, the problem, sadly, is that for most people, it will not end very well.
People who have never seen a bear market because they are not equity investors, have been sucked into the equity markets because the fixed income yielding securities are progressively giving lesser and lesser returns and therefore inconveniencing a lifestyle or a survival expense threshold.
You have taken risks which you should not have taken, and now the investments are not doing well. Now there are two possible outcomes. Either our senior citizens will lick their wounds, pull money out of whatever high risk instruments that they have invested in and learn to survive.
Or they will possibly and which is worse in a panic, dump everything and go back to fixed deposits. Now, which is something, if you were to read the mainstream media in the last couple of days, is what is happening. There is a massive exodus or exit from a debt mutual funds, especially after the Franklin Templeton fund closed down six of its debt schemes. And there is a massive rush towards fixed deposits.
Now behavioural finance tells you that neither a crowded exit nor a stampede to get into a particular asset class can be rational or good for you. Things have to be at an equilibrium, and right now we just broke the debt market by pushing our yield under 6%.
A whole lot of people who are not savvy enough to handle risk will now be taking on risk in the sunset years of their life, the twilight years of their life. Now this is money which people cannot afford to lose, and they are risking money, which means in mutual funds.
There are two things that you need to look out for. One is the efficiency frontier. You either earn higher amount of alpha of profit on the same amount of capital, or you earn the same amount of alpha on a reduced amount of investment. In both cases, you are increasing the efficiency of your money.
The other is the Jensen's measure. Basically, what you're seeing with the second measure is whether you're earning one unit of income for every additional unit of risk that you're taking with your capital. The problem is people who are a kind of burnt or badly impacted by the yields on debt funds might just take some optimal risks on the Jensen's measure, which means that for taking on every additional unit of risk, they might earn less than one unit of profit.
I'm afraid it's not going to end very, very well for them. At some point in time, your investment might go wrong as it's invariably does. You can never have all your investments doing fantastically well for you. If you are one of those who claims to have done that, hats off to you. I can't. I invariably, if I was to make 10 investments, I invariably see some laggards or some even losing money. Net I might make some. But you can not dream that all your investments will work out.
So at some point in time, when things begin to unravel, you will realise that the risk that you have taken is actually do high as compared to your risk profile, so that debt investors who are now taking on additional risk will in the later stages provide a potential selling pressure in the markets, which they did not understand well enough to be there in the first place. So even if we are all equity investors, we should bother about what is happening in the debt market because the guys from the debt market will now come to equities and impact our market.
The engineers who built the Titanic boasted the ship could never sink. This boast was based on the fact that the Titanic had hermetically sealed steel doors which could basically lock out that portion of the hall should in case a leak occur. It was scientifically a flawed argument. Water could not be controlled once the Titanic fractured. It's steel doors only delayed the sinking of the ship.
Money is like water. It flows out of avenues where the returns are falling and it enters those avenues where returns are rising. Today, you might see an outflow from the debt funds and inflows into equities. But believe me, when the risk turns you don't want to be there in the equity markets.
When people are exiting, it would make it a crowded exit. Do not push the investors to accept lower rates of interest. The analyst community is basically programmed to look at interest rates from the borrower's point of view. They feel that lower interest rates are good for corporate India or the corporate universe, which is fine. I actually have a lot of friends in the analyst community, no offence to them.
But there is another aspect to interest rates. The aspect from the point of view of the investors when the investors are boxed into a corner and forced to accept lower rates of interests, they may stop writing out the cheques. They may stop investing in those schemes and then money markets clamp up, may simply freeze over.
Or the investor is forced into taking higher levels of risk by going from debt funds to equity mutual funds and then withdrawing out of sheer panic and causing turbulence in the market. Is any one of the two scenarios acceptable to us? I'm afraid not. Are you looking at things from the borrower's perspective when you're looking at interest rates, or are you looking at it from the investors perspective? These are hard questions that we need to ask ourselves today.
This is Vijay Bhambwani signing off from this video for now, till we meet again in my next video.
Do not forget to like this video if you're watching it on YouTube. In the comments section, do let me know what you think of this video and what fresh videos you would want me to record in the future.
Please do not forget to share this video with your family and friends and help me reach out and spread the cult of knowledge based investments. I hope you've joined Equitymaster's Telegram channel with the handle Equitymaster official where in I put at least 2 to 3 updates Monday to Friday which I would love you to read.
Vijay Bhambwani signing off. Take very good care of yourself and your investments. Thank you.
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