Fixed Income Deserves To Be Part Of Core Portfolio

Fixed income should be a core part of any portfolio.  Generally, bank deposits, savings accounts, etc formed the base for fixed income.  However, over time mutual funds with liquid plans gave better tax-adjusted returns than bank deposits shifting the preference for savers.  However, direct bonds, Non-Convertible Debentures, securitised products have not gained traction in our portfolios due to a lack of investor awareness as well as risk pricing of these alternatives.

In contrast, in the global market, fixed income dominates the investment portfolio and the much talked about 60:40 (Stock: Fixed Income) portfolio is a reflection of it.  Granted emerging markets are more prone to volatility – hence one would want compensated to take the risk – which is rightly available in the equity world.   Nonetheless, equity-heavy, real estate-embedded portfolios have idiosyncratic risks in times of downturn and need for liquidity.

Indian bond market is dominated by high-grade issues – government-linked companies and government bonds form the dominant portion.  While high-quality corporates have tried to diversify their funding by accessing the capital markets, the reliance on bank finance still dominates the funding plan.  Government bonds, PSU bonds and high-grade corporates (AAA or AA rated) are more of interest-rate products than credit.  Their returns are mostly a function of prevailing interest rate and expected interest yield curve – less linked to the credit quality of the borrower given the high quality and tight credit spread.  For illustration purposes, the rating difference between JSW and G-sec is only one-notch in India, and the spread difference that one can get for the extra risk is 86bp (it is not like for like as JSW is 5-year NCD versus government security of 10-year benchmark, but the concept is illustrated).

Snapshot of Indian NCD

Note: There are no hedging instruments for 10 years.  Have used 4.5% as illustrative hedging cost which is empirically true over the past.

The high-yield market is all but non-existent in India.  A simpler analogy would be stock markets.  Imagine the stock exchange with only blue chip companies being allowed to list.  That would make the markets very boring, not giving a choice of the risk-reward spectrum to investors.  In practice, the market has choice of blue chips all the way to small caps and retail investors are making those choices every day – in an environment where the regulators are ensuring proper disclosure and regulatory actions.  The same should be the case for bonds.    There is no reason not to have choices of bonds from AAA to CCC and with appropriate disclosures, the investors would make their decision.

In global markets, this has been the norm.  From AAA rates US Treasury to high-grade corporates but also extending to emerging market bonds as well as high-yielding bonds have been available to investors with certain disclosures and eligibility criteria. The global markets are vibrant with USD dominating currency in which not only the US domestic issuers are issuing bonds, but global companies, as well as sovereigns issue bonds, benchmarked and compared with the universe of bond issuers with ratings, tenor, country of origin, etc.

Snapshot of USD Bonds

Note: Rating by S&P, Bonds are just illustrative of the asset class/rating category.  There are thousands of bonds in each such class/rating category to choose from.

The bonds of P&G are compensating investors by 56bp over the risk-free US Treasury – a kind of similar analogy of JSW versus G-Sec in India.  However, the rating divergence of JSW in the USD bond market is more – primarily due to the fact India is rated BBB- compared with the US at AA+.  The premium JSW bonds pay is 326bp over the US Treasury (again not like for like due to different tenors, but the point is illustrated).  As India does not have USD bonds issued by the government, there is no way to compare what JSW is paying as a premium over Indian sovereigns in the US markets. One can use the State Bank of India bond to give an indication – which is 187bp.  

Therefore, the pricing of the same issuer is benchmarked against a multitude of factors due to the breadth and depth of the USD bonds. In the illustration above, JSW is paying a premium of 187bp in USD, which is higher than 86bps in India.   Furthermore, in absolute terms, USD bonds pay higher than INR NCDs due to the peculiarity of the INR markets, and partial capital controls in India. There is a jump in yield premium as one moved from investment grade to high-yield bonds.

While the mutual fund is a good way to participate in the bond markets – very similar to the mutual funds for equity markets – there should also be an opportunity to construct a dynamic portfolio based on personal preference of individual bonds. Unless there is concentrated effort from multiple angles to develop the markets, it would take much longer for the markets to develop on their own.   In the US, Mike Milken of Drexel can be thanked for acceleration in the bond market development as the leveraged buyout wave swept the markets in the 80s which Milken financed by developing the “junk” bond market.  Such ideas were non-existent before that.  

In particular, given the Indian context, the following could be helpful:

1. Encouraging individual participation in the bond market.  This can be done by reducing the denomination of bonds, providing tax incentives and improving disclosure of issuers that would give confidence to the retail investors.
2. Allowing financial institutions such as pension funds and insurance companies to invest in sub-investment grade bonds – albeit slowly.  This would allow institution-level scrutiny of the credit quality of the issuer.
3. Simplifying the tax deductions for the issuer without having to know the status of the holder.  The onus should shift to the holder to pay their taxes other than foreign investors.
4. Allowing tax deduction for leveraged buyout transactions.

As India embarks on high single-digit GDP growth over the next decade or two, it would need a well-functioning bond market alongside its relatively developed equity markets to provide the necessary financing to the industries for their growth needs in the times to come.  Who could have imagined the level of retail participation in equity markets in the late 90s – but it has increased multi-fold making the markets more vibrant and deep?  There is no reason why the same should not be applicable to bond markets.  After all, fixed-income markets globally are multiple equity markets!

The author is Founder - Nextinfinity

Shyam Maheshwari

Guest Author The author is Founder - Nextinfinity. He also co-founded SSG Capital Management, one of the largest special situations and credit-focused investment houses in Asia-Pacific and has been active IBC-related cases.