Debt carrying same risk as equity

The last five years have seen a debt crisis building up to frightening proportions. Banks have been pushed to the edge of bankruptcy by the sheer magnitude of non-performing assets (NPAs). The defaults have happened across a wide range of sectors and involved some of the best-known corporates.  

It's important to note that many of the defaulting companies are run by highly experienced entrepreneurs who have run their businesses successfully for decades. Several defaulters had excellent credit ratings until the day that they failed to service their respective loans.

This meant lenders had little apparent cause to worry. When defaults of large proportion happen, it is indicative of a systemic problem.  The systemic issues are even larger if credit rating agencies don't pick up on the problem in time.  

As of September 2018, the RBI estimated that Gross NPAs in the banking system amounted to about 10.8 per cent. The central bank hoped “under the baseline scenario" that GNPAs would drop to 10.3 per cent by March 2019.

We will get a sense of this only when banks report Q4 numbers but the RBI's historical record suggests it is likely to have been optimistic. Anyhow, since bank credit amounts to roughly 75 per cent of Gross Domestic Product (GDP), GNPAs of this order would be about 7.5 per cent of GDP.  

There's also a lot of corporate debt, which is not part of the banking system. That consists of loans taken via commercial paper (CP) and Certificates of Deposit (CD) and also debentures. Quite a lot of this is lying with debt funds and some with NBFCs.   Funds have taken a beating every time some of that debt has experienced delay or default. IL&FS rocked the foundations of the non-banking financial companies (NBFC) system as well.  

The latest crisis has been triggered by the Zee Group's difficulties. As every reader probably knows, Fixed Maturity Plans from two of the most respected fund houses have experienced difficulties due to the Zee's group's inability to service debt. The group pledged shares of its listed companies as collateral but lenders have come to a “standstill” agreement, where they will not sell those shares until September.

In the narrowest sense, the fixed maturity plan (FMP) holders are now in some difficulty. In a broader sense, any debt investor has cause to get worried. Under normal circumstances, given rate cuts by the RBI and the promise of more rate cuts or other liquidity-inducing moves to come, debt funds would seem like a good investment.

FMPs try to lock in a specific return and offer efficient tax-management. Normal debt funds benefit when rates fall. The value of their portfolio increases since it offers a higher yield and they can cash in on capital gains. But this equation breaks down if there's serious risk of default.

Should investors be looking at debt funds? They should be very wary about FMPs because FMPs deal in unsecured debt, (or debt secured by shares as collateral) which is at highest risk. Also, as indicated above, FMPs don't get an upside from a falling rate cycle.  

Investors can look at debt funds which deal in short-term instruments, since those tend to be low risk. They can look at portfolios which are primarily GoI-oriented. But these are relatively low return. Higher return corporate debt is going to be risky, even if it has a high credit rating.  

There is a problem with secured debt as well. As we've noted from IBC proceedings, defaults do take a long time to sort out, even under that supposedly accelerated system.  The haircuts have been substantial too, under IBC.

In effect, several categories of Indian debt seem to carry the same risks as equity in terms of risks to principal. But of course, equity offers higher returns in the long-term. The risk is especially high in long-term debt instruments. If you decide to hold an instrument for over three years as you must to get the tax benefits, why would you choose a high-risk, low-return instrument?

A falling rate cycle should lead to better business activity. That will eventually mean that the crisis is contained. The Q4 results may indicate that the business cycle is pulling out of a long trough. If that's the case, the risk of default will also ease. This is the best hope under the circumstances.