Debt Markets Work In Cycles Too

In good years, defensive investors have to be content with the knowledge that their gains, although perhaps less than maximal, were achieved with risk protection in place, even though it turned out to be not needed.
– Howard Marks




Every investor scrutinizes the relationship between risk and reward before entering an investment. The risks associated with equity investments are well understood – over time, risks even out, while rewards accumulate. But, what about debt?

Markets work in cycles. People often ignore that debt works this way too. The monetary policy determines the trajectory of interest rates in an economy. Interest rates could trend downwards, bottom out and move upwards again until they peak and begin to descend. The interest rate cycle is what makes debt markets cyclical. Typically, when inflation is benign, and growth looks dull, interest rates are cut to stimulate the economy. On the other hand, when inflation rises and liquidity increases, interest rates are raised to cool the economy. Clearly, the interest rate cycle is linked to economic growth and inflation.

We can expect interest rate cycles to shorten. The RBI has a mandate to target inflation and keep it at 4% (+/- 2%). So, inflation is clearly range bound. In a growing economy like ours, inflation is the key determinant for interest rates. Consequently, even interest rates will be contained within a band.

Playing a shorter cycle requires an altogether different approach and can be quite challenging. Mitigating risk should be at the core of the investment strategy. Constructing a sensible portfolio takes time and involves a significant amount of preparation. The current market scenario may be more favourable to debt investments in terms of the risk-reward metric. Sensible allocation to debt could help construct a well-rounded portfolio.

Our focus has always been on quality. This helps us effectively manage risk. We offer solutions customized to our investor’s risk appetite and investment horizon. Our strategy involves analysing trends in the debt market and taking advantage of market volatility to construct a layered debt portfolio.

Explore your asset allocation options by fixing an appointment with our team.

The Power of Prescience

The power of prescience is not something that is easy to practice in our investing. Knowing something in advance can be unfair advantage if it is from knowledgeable sources. So being fair and prescient at the same time is very important. But, there always is the option to independently anticipate what can happen. It was fairly easy to say that ING Vysya bank would someday be acquired by a better bank. Being prescient is always possible. An investor can visualise what can happen beforehand, validate one’s expectations and then wait for events to unfold. In an event driven stock market like India, a lot can happen in one’s Portfolio if we use the power of prescience well. In fact, it is the only way to make our investing proactive. There is a lot that can be done now applying the power of prescience. An array of positive events will unfold over the next two or three years in our economy. There is no better time to use the power of prescience. But, that would mean a lot of application, homework, anticipation, arriving at a thesis and active validation. This is going to be a constant pursuit. But, the power of prescience is going to be a very interesting and positive investment driver hereon.

Lock into Debt

The purpose of monetary policy is to manage inflation, facilitate growth, and regulate credit in the economy. The RBI’s Monetary Policy Committee (MPC) has a clear mandate to target inflation and maintain it around 4%.

In terms of bond markets, 2017 and 2018 are like chalk and cheese. 2017 witnessed the after-effects of demonetization. Excess liquidity needed to be neutralized, India’s growth prospects required attention, and inflation was persistently low partially supported by low oil prices. The markets expected the RBI to cut interest rates to boost the economy. By contrast, 2018 records almost neutral liquidity, volatility in the inflation prints, and elevated oil prices. This time around, the market anticipates rate hikes. Yet, the RBI has chosen to maintain the same neutral stance through both years.

Bond yields have moved almost 1.5% from corresponding levels last year. A rise in yields indicates a reduced appetite for bonds. This can be attributed to geopolitical tensions, increase in interest rates in advanced economies like the US, higher oil prices, increased supply of government bond, and expectations of rate hikes. The RBI has raised interest rates twice already this year. We could expect further rate hikes on the back of a higher MSP, increased government spending, higher fiscal deficits, and elevated oil prices.

Now is the time to lock into debt. Bond yields are attractive. Following a sensible asset allocation strategy can help diversify risk and bring balance to an investment portfolio. Constructing a layered debt portfolio requires preparation. The debt market could witness continued volatility, but volatility is an investment opportunity. Prepare now for the chances that come your way.

Seek Safety

Indices do have their own way of peaking out. Up moves and peak outs are connected. What happens around an up move leads to a peak out. The up move must be clearly understood.

So, let us now deconstruct it. Usually, the defensive stocks lead the index movement. But, this time seems different. In the current move, it was infotech that moved first. Then, the beaten pharma stocks moved up. The consumer stocks followed with a swift surge. The financials, a handful of private financials actually, came up with a rear guard up move. Lastly, the commodity bellwethers moved up swiftly.

Most of them were raising monies using the uptrend. They either sold their own stock through a fresh issuance or monetised subsidiaries or intend to sell promoter stock. Clearly, a capital raising intent is very visible.

Broadly, this sums up how NIFTY trumped active managers. But, being too nifty isn’t good for the NIFTY. History has many instances when the NIFTY toppled when it was too nifty, right in the middle of aggressive capital raising by its prime movers.

So, racing the NIFTY maybe a mugs game in the near term. On the contrary, racing to safety maybe a better idea. Decipher how you can achieve safety with the right calibration.

Debt Note: Minimum Support Prices

Investment Strategy

Bond markets may witness volatility over the next few weeks. Debt portfolios could see notional losses because of this. Portfolios can be protected by sticking to instruments with shorter maturities or by either holding investments until maturity. Fresh investments should be made in a phased manner, taking advantage of market opportunities.




Market Outlook

A rate hike seems more likely now than ever before. Inflation is undoubtedly the centre of monetary policy decisions. The upward pressures to inflation (oil prices, disposable income, government policies, etc.) are gaining momentum. Oil prices still loom as an obvious threat. well-distributed monsoon is good for the economy. When growth prospects improve so does disposable income. Minimum Support Prices (MSP) will play a key role in determining the inflation trajectory.

The MSP is the lowest price at which the government purchases crops from farmers. The MSP is set at the beginning of every sowing season and is not based on the actual market rate. It is central to the government’s agriculture policy. The purpose is to encourage crop production, secure farmers’ financial interests, and provide food security. The efficacy of MSPs on these parameters can be debated, but our objective is to explore its effect on bond markets.

A higher MSP obviously means an increase in food prices for end consumers. This automatically means an increase in food inflation. Since the intention is to secure farmers’ interests, we could see a spurt in rural incomes. Discretionary spending moves in tandem with the rise in disposable income. An increase in spending translates to a rise in inflation. The policy could also increase the fiscal deficit.

If inflation rises, the RBI may resort to hiking rates to cool the economy. A wider fiscal deficit may lead to more government borrowings. These factors could cause bond yields to move up and induce volatility in the debt market. Caution is the watchword.

Recalibrate Risks

Risks and returns are always meant to be viewed holistically. But, how many of us do that? An interesting incident only reminded us how little people respect risks.

An investor had been invested in equities for the three-year period between 2014 and 2017. At the beginning of 2018, just as oil prices began to rise and Indian macros started to appear shaky, the prudent move of booking profits in over-valued parts of his portfolio was advised. He went ahead and moved monies to liquid instruments. Subsequently, his returns dipped to the more moderate levels that liquid funds usually generate. But, the investor was still obsessed with Nifty returns. He was dissatisfied that he wasn’t making Nifty returns.

The value of lowering risks and returns was not adequately understood. Making returns seemed to matter far more than managing risks. Where one invests matters. Changing the asset allocation of an investor to recalibrate his risks will always come at a cost. Similarly, even when our approach chooses relatively cheaper parts of the market and advises investors to put money into them, they still run the risk of becoming cheaper.

Returns will be lumpy and investors should learn to always shift their focus on risks while evaluating advice. As long as the advice is sensible and moderated in its risk approach, we should not worry about the returns. After all, markets habitually reward investors who take risks in a disciplined, organized fashion. The key thing to be done now is to follow a disciplined and organized approach to risk taking and deployment of savings.

Returns will follow those who stay mostly sensible when taking risks.

Redo Asset Allocation

At a time when everybody has overdosed on equity, elections are looking imminent, macros are getting challenging, and benchmarks are outperforming portfolios, it makes sense to take a re-look at asset allocation. Clearly, the most important thing now is to get our asset allocation right. A wrong allocation can affect our overall returns significantly over the next few years.

Elections always bring political risk that may impact returns and it makes sense to keep risks within control. The best way to do that is to rejig asset allocation quickly and to gradually return to risk over a period of time. For portfolios that are steeped in midcaps or small caps, this is not going to be easy.

But, what is good for one’s wealth creation is never going to be easy. Rejigging asset allocation requires liquidity in the stocks we want to sell. This is going to become increasingly challenging in microcaps and small caps. This is not going to be easy in midcaps either. The absence of liquidity in trade could worsen over the rest of the year and this represents the greatest risk to our wealth.

A sell-off can significantly impact portfolio valuations with liquidity hurting far more than fundamentals warrant. Ensuring we are protected from that phase can be effectively achieved by exiting the potentially volatile space and seeking safer asset options. That makes reviewing asset allocation the most sensible option right now.

Dealing with Valuations


Podcast Transcript

When we find valuations at extremes, it usually is at the most difficult time. We struggle to decide how to deal with them. Mostly, amongst us, the risk averse find it convenient not to deal with them. We find it natural to do nothing. We avoid them. Our natural discomfort with difficult decisions stops us from approaching them. So, we simply stay away.

Alternately, if we are risk takers by nature, we may actually deal with them wrongly and end up hurting ourselves. Risk takers believe it is their will that brings outcomes. But that is completely dependent on the context. Most risk takers fail to acknowledge that when the going is good. We believe more in our risk taking that we ignore the context. But, the context is so important. And, how we deal with the context means everything to the outcome.

But the moment tends to overwhelm risks takers. We don’t want to be left out of a moment. So, we simply stay put in the game when we should have withdrawn to safety. We often fail to take a rational view of things.

Here, our understanding of risk and our acceptance of the limitations matter.

Firstly, risk taking is more of an art. It is a personality trait. It is an attitude. It is a way of life.

It rarely comes easily to anybody. So, in the world of investing, most of us seek the wrong kind of risks around the wrong hour. And, we then live through the excruciating pain of time. Seeking the right kind of risks at the right time requires a definitive personality.  It is the personality that causes one’s investing to be fashioned in a particular way.

So, when valuations rise to stratospheric levels, selling can happen only if we have the personality to do it. Or, if the decision is made by someone with that kind of personality for us. If everybody is into risk taking when it is the wrong hour, the situation will lead to an “All fall down”.

Strangely, we are in a market where indices are at all time high and most portfolios are down. The active risk takers are clearly badly down. This situation can lead us to an even more difficult place if we don’t deal smartly. A smart mind will not show excess in risk taking now. It may be a while before risk taking will work well again. An intelligent investor must seek the right risks, avoid the higher risks, and strive for return of capital.

Return on capital may anyway not be all that great in the coming months for risk seekers. Pragmatists would rather seek return of capital now. When valuations are not really in favour, one must deal with investments in a clinical, pragmatic, and decisive manner. The time to do it is now.

Redux Hour Returns

Stock picking takes far more mind space, time, and effort in every investor’s life. The time dedicated to stock picking far exceeds the time spent on investment strategy. Stock picking and investment strategy are connected in the middle. The reasons are not difficult to decipher. Deep within, we believe that stock picking is all that is required to deliver returns. By extension, if we buy the right stocks, then we think we will be on top of the game. In rising markets, this works very well. The celebrated investors and managers always float on the stocks they picked and how well they performed.

But, there comes a time in every cycle, when it is not easy to create reinvestment. Stocks you sell end up being far superior to the stocks you buy. At this stage, stock picking stops working. Actually, it begins to hurt. What can salvage such situations is a focused, holistic investment strategy. But, that hardly comes naturally or easily.

Developing and practising an investment strategy on which stock picking is an intrinsic essential is what we have long referred to as a process driven investing. But, in every cycle, this process gets dominated by rushed stock picking. This eventually derails the very process itself. The process then needs to be put back on the rails by focusing intensively on the strategy.

Risks need to be treated on an even keel with returns. Investing seems headed into a phase of concerted process redux.

What Next?

Podcast Transcript:

Events are flowing thick and fast. Let us look at macros first.

A falling rupee. Rising oil. Spiking prospects of food prices. Rising inflation. Looming trade battles.

The setting reset has already started reflecting in stock prices.

A sharp cut in midcap stocks and indices reflects a clear reversal of investor optimism. This reversal is still fluid and nowhere near pessimism. There is a tentativeness in the air. Fence sitters stand watch, looking for sentiment to improve in midcaps. Contrarian buyers are thinning. Fewer people think that this situation will reverse soon. But, not too many think it will get much worse. The majority think valuations will stay this way.  That prediction stands delicately on thin ice.

The construction of benchmarks, the portfolio orientation to benchmarks, alignment of domestic flows to specific parts of the markets, and the risk aversion of professional managers are all likely to work against the dominant investing styles that worked in 2017-18.

Governance is sharply in focus right now. Auditors are resigning rather than signing books they are not comfortable validating. This trend is likely to gain further momentum. Evidently, more midcap, small caps, and microcaps are likely to be affected by this trend.

Meanwhile, the index seems to be stronger than the rest of the market. It is ironic that investors have failed to capture the emerging strength within even the index. Large cap funds are struggling against the very index they choose their stocks from. Thus, it seems like a nightmare to even beat the benchmarks.

Investment performance in times like this is going to be choppy.

All the while I talked about the returns beating benchmarks. Now, let us discuss the prospect of negative returns. This is a very uncomfortable thing to talk about. But, investing will grow and succeed only if we can face our mistakes with honesty. This concerns smaller companies, their valuations, and the downside that seems probable.

We saw small, mid, and micro caps beating the benchmark by miles. The outperformance was so strong that it almost became a de facto strategy for many investors to focus only on them. This approach has not played out well. The midcap and small cap indices have taken a beating in the past few months. We see further downside in these segments.

With sentiment seeing churn and with index showing a clear rebound, a rethink is now inevitable. As losses mount in the smaller companies, the flight to safety is going to be crowded with scarred and scared investors. Those who got in towards the end of the bull run are going to run out of this space. This could lead to much pain.

Staying away from midcaps has been a good strategy. It has worked very well for those who chose the difficult path. Losses have been avoided. Profits booked have been protected. Getting into them should be gradual, rehearsed and well thought through. There is no rush to take more risks in one’s portfolio. Clearly, one’s risk mosaic is needing a quick reset if it hasn’t gotten one yet.