Take risks with stocks, not NCDs

AARATI KRISHNAN | Updated on August 17, 2011

13/05/2011 MUMBAI:A man pass by the Bombay Stock Exchange (BSE) building as the BES sensex went up by 247 points in Mumbai on May 13, 2011. Photo: Paul Noronha

If you are willing to take risks to your capital, why not take it for much higher payoffs than 12 per cent a year?

If there is one sure-fire recipe to demolish wealth, it is to make large-scale switches between asset classes at exactly the wrong times. Consider those first-time investors who, convinced that they were on to a goldmine, poured big money into the Reliance Power IPO in the beginning of 2008. Or those who switched from stocks to fixed deposits in March 2009 convinced that the Sensex was headed down to 6600 levels! The recent stampede for retail non-convertible debenture (NCD) offers from Non-Banking Finance Companies (NBFCs), because the stock market has turned ‘choppy' must be seen in the same vein.

Not bank deposits

Yes, the string of NCDs from these finance companies offer high interest rates of 11.5 to 12.2 per cent for one- to five-year terms. Those rates are higher than those available on bank deposits, but a straight comparison of that sort is flawed. Bank deposits offer interest rates of 10.5 per cent with almost complete safety of capital (even in the unlikely event of a bank failing, deposits up to Rs.1 lakh are insured). The NCDs, however, are quite another matter.

To start with, recent issuances, such as those from India Infoline Investment Services, Manappuram General Finance and Shriram City Union carry credit ratings of AA or AA minus. That, in rating agency speak may indicate a “high degree of safety regarding timely servicing of obligations”, but is certainly below the top-notch credit rating of AAA; which means some degree of credit risk. Several debt mutual funds restrict their investments to instruments rated AA + or above. Even if they do own bonds rated lower, exposure is restricted to a fixed percentage of their portfolio.

The ratings may be subject to changes too. Recent NCD offers come from some of the riskier segments in the NBFC space — companies offering loans against shares, two-wheeler loans, gold loans, and so on. Though they earn high margins on their lending operations (again, a function of their riskier loan book), the funding environment for these businesses has become quite tough in recent months, with the RBI tightening the screws on bank lending to the sector.

These businesses can be also be susceptible to macro risks stemming from falling stock or gold prices or even worsening consumer sentiment. Going by the experience in 2008, global credit problems could also tighten liquidity, making the going tough for businesses that rely on high leverage. All this makes the proposition of lending to such NBFCs for a two-three year period (which is what a retail investor in a NCD is doing) far from risk-free.

If safety of capital is the paramount consideration for investors seeking out fixed deposits or bonds, bank deposits which offer attractive rates seem to be the most suitable option. Risk on the debt portfolio, if taken at all, should be taken in measured doses. If you are buying an NCD for a return “kicker”, carve out, say, 10 per cent of your overall debt portfolio for such NCDs. Choose the issuer with the best credit rating and stick with the shortest possible term.

Stay with stocks

Selling your stock portfolio to make room for these NCDs is a particularly unwise move. After all, if you want to take risks to your capital, why not take it for much higher payoffs than 12 per cent a year? If you have money to spare for the long term (five years plus), investing it in stocks makes more sense today than it did a few months ago. The 21 per cent decline in the Sensex since November 2010 has levelled its price-earnings multiple from over 24 times (trailing 12 month earnings) to a more reasonable 18. If the prospect of stocks declining sharply from these levels worries you, restrict the risk you take by buying the many index exchange traded funds or diversified equity funds that own a portfolio of blue-chips. What if the Sensex crashes another 1000 points from here? It well could; but no one can tell you where the stock market will find its bottom. If you have a five-year plus horizon, any ‘losses' from such a fall will only be temporary.

Investors who have watched the Sensex rally all the way from its low of 8900 in March 2009 to 21000 in November 2010 will tell you that being a little early to the party is better than not being there at all!

Published on August 13, 2011

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