The much awaited surprise

An upgrade of India’s sovereign rating right in the middle of one of our history’s toughest economic reform programs is clearly a shot in the arm. It is a booster shot for global sentiment on India, capital raising exercises by government and companies, and domestic sentiment. This will further speed up reforms and public investment.

But, should the markets runaway? Possibly not. The markets need greater evidence on the ground to become more expensive than they already are. Current valuations of several market-leading companies are already discounting much of the good news.

And, the spoiler could be in the form of public issues that mop up much more liquidity. IPOs could play spoiler. Mutual funds are also mobilising huge sums in already overvalued categories and themes through their IPOs. This could lead to misallocation of capital. Corrections usually follow such misallocation of capital and are triggered by an accidental scarcity of capital on a temporary basis.

Measured investing is the need of the hour.

“Investing is not nearly as difficult as it looks. Successful investing involves doing a few things right and avoiding serious mistakes.”– John Bogle

Basel Norms

An Introduction

 

 

As banking systems in multiple countries evolved,the need to have an international agreement that bound them arose. The idea was to addresses regulation, supervision, and risk management for banks across the globe. The Basel Committee on Bank Supervision was set up in 1974 to create a framework.

 

 

Basel I & Basel II Norms

 

Every loan has an associated level of risk. Credit risk is the possibility that a borrower may not meet its obligations. Based on this, a risk value was assigned to each loan, making it a Risk Weighted Asset (RWA). Capital provisions were set according to the RWA.


Basel II norms further focused on three pillars.

Pillar 1: Minimal Capital
‘Risk’ was modified to include market and operational risks. Minimal capital requirements for lending transactions was specified as 8% of RWAs. Banks’ capital was tiered according to its nature.

Pillar 2: Supervisor Review
Banking regulations varied drastically across member countries. However, the requirement for improved governance and regulation remained. The solution was to authorize the banking regulator of each country to implement these rules. In India, the RBI is the regulator for the banking sector.

Pillar 3: Market Discipline
Market Discipline simply means more transparency. Banks were subjected to more disclosure requirements. This provided more insight into their activities and allowed for more informed investment decisions.

Why did we need Basel III norms?

 

 

While the earlier norms addressed legitimate risks, gaps became apparent during the 2007 financial crisis. Any framework is robust only when it is modified to address new challenges and risks.
The focus moved to banks’ balance sheets. It aimed to reduce their size and limited the scope of activities. Both quality and quantity of capital became important. The spotlight shifted to lowering risk rather than increasing profitability.
New metrics for risk management such as the liquidity coverage ratio (LCR)and leverage ratio were introduced. Banks are also subjected to standardized stress tests.  This ensures that there is sufficient liquidity for banks to proceed with day-to-day activities during periods of financial stress. The capital requirements are adjusted according to prevailing market conditions. This move protects the economy during both recessions and booms.
Ultimately, the intent is to create a more resilient banking system by reducing and addressing potential financial or economic risks.

A coming of age moment

Indians don’t fancy financial products much. A mutual fund, ETF, or ULIP is supposedly meant for investors who don’t have any idea about equities. If one can’t choose the right  stocks, he is perceived as a candidate for a mutual fund scheme. Investors genuinely believe that these products don’t have the potential to deliver big returns. Whereas the underlying assets in these products, stocks, can.

So, people think that personal portfolios of stocks can deliver more returns than funds. Everybody forgets that they too construct a portfolio of stocks which may not perform as well as their best stock picks. Aggregate performance of an individual investor may not actually be far ahead of the best performing fund scheme. Every portfolio will inevitably have stocks that don’t perform or even fail. This can retard overall returns.

Fees could be one reason why returns moderate between the underlying and the derived. But then, we have ETFs as low fee options. Why do we shun them as being investment unworthy? It is in the way portfolios of ETF schemes are constructed. A well constructed ETF can deliver competing returns. India’s ETF industry badly needs a well constructed ETF. That moment is before us. We have a very interestingly constructed ETF before us.

This is a John Bogle moment for the Indian public investor. Be at the Vanguard of a new revolution.

“When everyone believes something is risky, their unwillingness to buy usually reduces the price to the point where it’s not risky.” – Howard Marks

Non-Convertible Debentures (NCDs)

What are non-convertible debentures and why are they issued?

A company can raise capital either by offering an ownership stake (equity) or by borrowing money (debt). Debt is primarily issued in the form of loans, bonds, or debentures.

Debentures are corporate debt instruments. Some may be converted into equity shares. Debentures that can’t be converted into equity shares are called non-convertible debentures (NCDs). NCDs offer higher returns than convertible debentures.

Corporates issue NCDs because it allows them to borrow from the market. The market interest rate may be more attractive than what banks have to offer. Additionally, the company may raise money without disrupting its equity structure.

 

Features of NCDs:
An NCD is similar to a company fixed deposit. Sometimes the issues are backed by assets making them more secure. They are an attractive investment option because they cater to a wide variety of needs. NCDs are available for every income requirement, investment horizon, and risk appetite. In addition, those that are traded on the exchange may even offer capital appreciation.

 

 

What should you look out for?
It’s important to select NCDs that are issued by companies with a healthy balance sheet, a high credit rating, and no history of defaults. Secured NCDs are safer. Since NCDs can have varying tenors it makes sense to select a range according to your investment objectives. NCDs that are listed on exchanges provide more liquidity. However, trading volumes are low and the issue sizes are not large. Ideally, this is meant for investors with larger sums of capital who are willing to take higher risk in the debt space.

 

Reversion Returns

Every market opens up newer investment opportunities. There will always be businesses that nobody wants to own. Or at least, only a few people would seek to venture into them. Businesses that are shunned often drift in valuations, until they reach extremely attractive levels. Then, an event or news or policy causes a sharp reversion to mean.

Usually, the reversion to mean happens so swiftly that it catches everyone unawares. The duty of a contrarian investor is to spot such reversion opportunities and ensure that he invests early enough to catch them right. There is no other way to catch such opportunities.

This sharp reversion is happening in telecom, pharma and PSBs. It only reaffirms the long-held belief that you can’t predict. You can only prepare.

It may well be time to prepare for future reversions in sectoral valuations, thematic fortunes, and cyclical preferences. The markets will continue to see dynamic churn going forward and one must keep his investing ahead of the times.

 

“Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates.” – Howard Marks


RBI 8% Savings (Taxable) Bonds

The Premise

The RBI first issued 8% bonds in 2003.

As the name suggests, they pay 8% interest per annum and the interest income is taxable. Investors need to invest a minimum of Rs. 1,000 there is no ceiling or limit on the investment amount. Normally, the bonds have a maturity of six years. For senior citizens, the tenor may be lower. Interest is either paid semi-annually or cumulatively at the time of maturity. These bonds are transferable but are not traded on the secondary market. Essentially, the bonds accrue interest and there is no capital appreciation. Since they are issued by the government of India, the credit quality is highest.

 

Investment Strategy Investors with no tax liability (Charitable Institutions, etc.) will benefit the most from these bonds.

It also makes sense for investors who are in/below the 20% tax slab.
For investors in the highest tax bracket, the 8% interest translates into a 5.6% return post taxes. It’s important to keep in mind that the returns earned are risk-free. In comparison, the 5-year post office term deposit rate is currently at 7.6% (5.32% post taxes). A medium-term debt mutual fund may deliver higher returns from both capital appreciation and indexation benefits.