The Risks of Debt Investments
This is my first blog , so my aim is to keep it simple. There are tons of research and professional advice that is available on fixed income ( debt) investments , propagated by brightest of minds in the industry , but my aim is to clear out some basic factors for a common investors buy and hold debt portfolio.
The material below is focused on an Indian investor..
What are Debt investments
The simplest way to think of this is when you lend money for interest (and principal) and not for a share of the business or venture
Bank Fixed Deposits, Government bonds, Post office bonds , RBI Bonds, Corp Bonds and infact even EPF and PPF savings can be thought of as debt instruments by nature (if not by form)
Why include Debt investments in portfolio - the common opinion
Common wisdom says debt is low risk compared to ,say stocks or commodities or crypto
While partly correct , this is quite nuanced. Reality is complex and a notion as such like this has the potential to completely disrupt portfolios and long term goals.
In the recent past we have seen several instances of retail investors plight caused by corporate or bank defaults. A lot of these will repeat if we continue to chase higher yield without a proper understanding of the risks facing them.
Almost all debt investments are subject to various risks and its important for an investor to understand them well.
Risk Factors Faced by Debt instruments
Credit Risk :
This is the obvious one. How likely do you think is someone to not return the money you had lend to them. The more that likely hood the more the Credit risk. For e.g. lets say you lend money to a business that is very stable vs one that is new and risky- surely the credit risk is higher for the latter.
So why would you then lend to a riskier party ? Simply because you will need to be enticed with a higher reward, in form of a higher interest rate. So what i am saying here is , if some debt instrument is offering a higher interest vs another one ( all else equal) then it must be due to poor credit.
The same logic applies to bank FDs.So if bank X offers a much higher rate than bank Y for a 5 year FD , it will mainly because X is more probable to default (i.e. not return your money).
So naturally debt issued by central government carry the least credit risk (in India) , and as a result the lowest interest rate vs a corporate bond or a bank FD.
The EPF , PPF also are government debts , so they carry almost no credit risk , .i.e. there is almost no chance that your PF savings will not be paid to you. But they do carry a higher interest rate ( this is for another time) , so its prudent to invest in them to the maximum extent possible.
For corporate bonds , a credit score is used as a measure of Credit Risk . The more the AAAs the better the credit (and the lower the interest). CRISIL is a well known provider of corporate credit rating in India. As an e.g. Infosys is rated as AAA Stable vs Shriram Transport Finance as AA+ (CRISIL Long Term rating), which says INFY has a better credit rating (and lower risk), and that the debt issued by INFY may offer a lower interest rate.
Just focusing on the interest/ yield and completely ignoring the credit worthiness will expose one to undesired credit risk , which is avoidable
Several factors like amount on borrowing relative to equity, past repayment records , financial strength and performance contribute to determining the credit scoring for Corporates.
Corporates sometime improve the creditworthiness of borrowing by collateralizing or other credit enhancement techniques to reduce their cost of borrowing
The bottom-line is that there is no free lunch, and an investor is better off staying away from the high yields offered by a higher credit risk entity , unless one is fully aware of the risk .
Interest Rate Risk :
This is often most misunderstood by many , and i will try to explain how it works.
As a rule of thumb fixed rate debt don't do well in an inflationary environment , or when Central Banks are expecting to hike rates.
As i write this in 2022, the world around us are all impacted by COVID 19 pandemic and to stimulate the economy the Central Banks have reduced cost of borrowing ( how this works , is something i will cover in a different write-up) , but the bottom-line is rates are at the low end at the moment.
Imagine you buy a 10 year Government Bond which pays you say 4% interest annually. This means for every 100 INR you lend, the government pays you 4 INR every year , for 10 years and then it returns the entire 100 INR. As we had discussed earlier this investment has no credit risk (backed by government is as good as the cash you use), but it surely carry interest rate risk as you will see.
Now imagine the following happens (which is quite likely) : RBI increases the borrowing rate to 4.5% next year ( Central banks increase rates to control inflation; again a topic for another day). What that will mean is your investment that yields 4 INR is lesser than the current market yield of 4.5 INR. To put it another way your 100 INR principal is worth 96 INR now.
- Debt investments do reduce risk (measured by volatility of returns) of an all stock portfolio, and an allocation to it is necessary to provide diversification to a retail portfolio
- Debt investments can also provide regular income - in form of interest payments , which can be desirable for income investors
- Credit and Interest Risk are the key risk factors to watch out for, while investing in debt. Remember that "risk" is not a negative term, in fact excess return can only be generated by taking on "risk" in the portfolio. The key is to be calibrated and prudent about taking on risk.
