Recent company earnings are not painting a very rosy picture of the economy. While some lenders are seeing weaker loan growth, others are seeing higher credit losses. Equities, too, lack momentum, while interest rates appear near the bottom of the cycle. The days of easier capital gains-driven returns have passed, pushing yield-seeking investors toward credit risk via bonds or targeted funds.
Over the past year, government bonds delivered near mid-teen returns as interest rates declined, with AAA yields dropping 1%. Liquid 5-year papers are yielding around 6.75%, a yield that may not excite investors who are used to higher returns. Even the traditional fixed deposit rates of banks and NBFCs are falling.
The only option left to generate returns is higher-yielding credits—a play of higher credit risk, liquidity risk, or both. There is an overreliance on credit ratings. While many avoid anything below AAA, that stance can mean missing strong companies temporarily downgraded due to cycles or expansion.
Ratings may move with the cycle, but governance ensures timely payments and no defaults.
Conversely, some investors now chase returns by taking on greater credit risk. There is nothing wrong with that either. In fact, the systemic risks in India have decreased over the past decade, providing a relatively better credit environment.
That said, being carried away by the cycle or narratives can lead one down the wrong path—narratives are true until they are not. For example, recently, NBFCs in microfinance and unsecured personal loans attracted unwanted attention as the narrative on retail lending quickly changed from “won’t default to protect credit scores” as over-leveraged end customers defaulted.
Now the narrative is moving to loan-against-property (secured lending), using a logic that customers will not want to default especially when their property is attached. Hence, whatever the point in the cycle, attention should be on risk, including, where applicable, on customer cash flows.
Remember, lower-rated credits are lower-rated for a reason. They are vulnerable to economic swings and sometimes even governance risks. Their return path is often volatile, with instruments that can’t be easily sold.
Here, an investor’s ability to hold through noise matters as much as holding to maturity. Investors should therefore not only put in a lot of effort into analysing the companies (or the funds that hold such companies) before investing, but also carefully evaluate their own risk appetite and ability to handle volatility before taking the plunge.
Vivek Ramakrishnan, vice-president- investments, DSP Mutual Fund. Views are personal.