Nowadays, most of the retail investors are optimistically investing in Debt instruments as a guarantee of safety of their funds. Main reason behind this is the society’s strong beliefs of safety and emotions attached to debt as safe and good investment. Is Debt investment really safe? Are society’s convictions and emotions about debt based on facts or are baseless? We will discuss about it in this article.
Where do people invest?If I ask you, which are the avenues where you can invest your money? You will promptly start listing them: Bank FDs, Company FDs, NSC, PPF, KVP, Govt./Railway/Infrastructure Bond, Debenture, Share, Life Insurance, Fixed Maturity Plans, Deep Discount Bonds, Loan to friend/relatives or some trader, etc.Oh my God! So many of them! Seems very difficult to decide and select, isn’t it?Let us make it easier by categorising them.
Actually, we can only invest money in two ways (except buying land, property OR Gold/ Silver/ Jewelry):
(i) by giving loan to somebody
Or
(ii) by investing it in a business (starting your own business or by becoming a partner in somebody else’s business).
So, all the money invested with an objective to receive it back after a certain period of time -with a guaranteed interest income added to it or received annually – should be listed in the column of debt;
and,
all the money invested with a business to receive proportionate profits (or losses) from that business -which are totally uncertain- should be listed in the column of capital /equity.
About your life insurance policy: if it is a pure term policy -where you aren’t going to get any fund in return if you’re alive- it does not categorise as investment, it is a purchase of a service. You have bought a financial guarantee or assurance; but, if it is a policy wherein you will get certain fund at the end of the tenure, even if you are alive, it is a debt investment. Suppose if you had a spare fund of Rs. 1 lakh and you gave it to your friend as a loan for his business, it is your debt investment. And suppose you gave it to your friend to become a partner -in profit or loss- in his business, it is your equity investment.
Easy now? Please categorise all kinds of investment into these two on your own. One is Debt and another Equity. We all have been brought up with such information or instructions that giving loan to somebody is safe whereas investing our capital into a business or as a partner is risky. Is it really so? Let us study facts to ascertain how much safe or risky is debt investment.
Classification of Debt instruments by SEBI: SEBI (The Securities & Exchange Board of India) is an agency established by the Government of India to create rules, regulations and oversee the securities market. SEBI has classified Debt Instruments as follows: Call Money, Bonds, Debentures, Govt. Securities, Deposit Certificate, Commercial Paper, Debt funds as per different time periods: Liquid Funds, Ultra Short Term Funds, Short Term Funds, Gilt Funds (Govt. Securities are very safe, so are called Gilt Funds), Income Funds, Credit Opportunity Funds, Monthly Income Plans, Fixed Maturity Plans, etc., These classifications by SEBI mention the risk types.
Rating Agencies:Does SEBI’s guidelines show us the Risk of Interest or Principal? No.SEBI’s classification does not indicate the intensity of risk in any particular debt instrument. It only classifies them broadly time period wise, issuer wise or objective wise. So, how do we know its intensity? For this, we have to take help of the Rating Agencies which are global, big and renowned private consultancy companies. It is the ratings given by these agencies upon which debt investment all over the world is decided and based.Now the question arises, can we completely trust the ratings given by these agencies and invest our hard earned money and become free of worry, anxiety and doubts? Are the best rated debt instruments completely safe? Yes and No. Because, in the past there have been many incidences of the best rated (AA & AAA by one of the top 5 ratings agencies worldwide) companies and its debt instruments going bust. When this happens, it is the investor who loses all his principal e.g. Enron Inc. (2001), AA Rated: AIG, Merrill Lynch, Bear Sterns, AAA Rated: Fannie Mae & Freddie Mac (in 2008) and Jaypee Infra, Jaypee Associates, Bhushan Steel, DHFL, IL&FS, etc. in India. Zee/Essel group and YES bk. are passing through debt problem. A US financial newsletter ‘Motley Fool’ (#) states: Don’t depend on rating agencies for ascertaining the quality of an investment because they are the last to know!If this is the scenario, how do we analyse and know the actual risk?
Know the Risk:When we lend our money to somebody, basically we must know his financial strength. Here, we will discuss how to check it. In the business of lending, the most important risk is: ‘Counter Party Risk’ meaning, a debtor becoming incapable in returning the principal either partly or fully to his creditor. Let us try to know the due diligence process to ascertain whether a person or company is fit enough to get our loan?
1. Terms & Conditions of the Loan: We shall try to know: What are the terms and conditions (T&C) of the debt instrument we are going to invest in? How many years will our investment remain fixed? Is there a Mortgage@? If there is, Which agency is it with? If it is with a neutral/3rd party, is it a renowned Bank/agency? Are both viz., Put and Call Options open? Or is there only Call option open with the Co.?
Put Option empowers the Creditor to demand his money back from the Debtor any time during the term of the debt or at certain intervals as per the terms.Call Option empowers the Debtor to repay his loan back to the Creditor any time during the term of the debt or at certain intervals as per the terms.Such a T&C can harm the goal set by the investor (Creditor) in two ways. If creditor suddenly gets his money back in case the Co. exercises the Call Option, the goal set by the creditor may get disturbed. He may not avail another deal of investment at similar Rate of Interest with similarly renowned debtor. Therefore, he may then have to go with a lower Interest earning debt security with probably lower credit rated Co.There are similar examples for such a situation:a. Unit Trust of India – a Govt. of India Undertaking, came into market with ‘Rajlakshmi Unit Scheme’ in the year 1992 with a promise to secure better future of girl children. Lump sum investment in this scheme would earn compounded interest @16.20% to 16.75% per year and mature when the girl attains 21 years of age. The parents investing in this scheme had counted on it for higher education, marriage etc. expenses. But their calculation went wrong as they received the money back in the year 2000 with UTI exercised its Call Option. (It paid Interest on it only till that period).b. Similarly, in the year 1996, IDBI came into the market with Deep Discount Bonds wherein the investment was in multiples of Rs. 5,300 fetching Rs. 2,00,000 after 25 years i.e. in 2021 @ 15.62% CAGR. But in a few years, i.e. in yr. 2000, IDBI exercised Call Option and returned all the money back and pushing the investors again in search for a good investment instrument that can help them achieve their long term goals.
2. Secured and Unsecured Loans:Now in debt, there are 2 kinds of securities: one, ‘Unsecured loan’ (bonds/debentures and debt etc. securities not backed by anything) and another, ‘Secured Loans’ (Debt backed by some collateral mortgaged with creditor or a neutral 3rd party which can be a bank/trustee). Most of the debt securities that people invest in are unsecured (not backed by a collateral).So, when you put deposits in banks or corporations, buy bonds, debentures, it is unsecured; Please be awake, be conscious. Just don’t take safety of bonds, debentures or your deposits for granted, only because you studied so in ‘mainstream’ academics. In fact, they are ‘unsecured’ if not otherwise mentioned, as classified by SEBI. There can be insecurity even in case of ‘Secured’ Bonds/Debentures. Suppose a company has liability of 10 crores including secured liabilities of 4 crores, and all its assets are worth only 1 cr. as per current market value, how are its ‘secured’ depositors going to get 4 crores back? Such incidences have actually happened several times and will keep happening in the future.
3. Company’s Profitability:It is a must to know about the Co. we are going to give debt as to how much is its total Capital, free Reserves, Net Profit, Total Liabilities and Debt. For example if Debt is 100 Cr and Net Profit is 20 Cr. it is or may be a safe co. because it can return its debt in 5 years, but if a Co. is making loss, is it worth putting money into?
4. What makes Debt riskier?If we are required to give loan, we would like to check his financial stability. To check the financial stability of a Co., an individual, or the Government, we must check their Net Worth. For a layman, Net Worth is that figure which can be arrived at by deducting total liabilities from total assets. If the answer is positive, there is a Net Worth else it can be zero or negative Net Worth.
Normally when we lend someone, we check his financial stability: what is his income? what is the amount of debt he has already taken till now? Suppose Ramesh and Mahesh are your colleagues and for example, Ramesh’s annual income is ₹ 12 lacs; he has taken debt of ₹ 2 lakh till now and he wants another 2 lacs as a loan from you at 15% interest. Will you give him? Perhaps yes. On the basis of your relationship with Ramesh you would give him the loan along with some documentation. Now let’s talk about Mahesh. Mahesh’s annual income is ₹ 4 lacs. He has already taken debt of ₹ 5 lacs till now and he wants another 2 lacs @ 20% interest from you. Will you give him? Perhaps no. Why? You could actually receive ₹ 40,000 as interest every year! Not even then? No? You are correct. Because you understand the risk in giving loan to Mahesh. A person can use approximately 25% (maximum 40%) of his annual income in returning the loan.In the event of a company, we have to check its debt equity ratio, debt asset ratio, debt cash flow ratio, and debt to profit ratio.
Have we ever analysed any debt investment in this way before making investment directly or indirectly (through mutual funds or some intermediary)? Mostly not.
What can we know from the above topic? Debt is the problem. By putting money into debt, we are actually increasing debt of a debtor, which again creates a bigger problem. The solution to inadequate capital can be more capital whereas, taking a higher debt to return debt is not the solution but a problem. So, in other words debt is the enemy of debt.
5. Debt Vs. Inflation: All the risk parameters mentioned above are mostly counterparty risk parameters. But there is a greater risk which most of the investors don’t know and mostly they ignore it, if they know.This risk is: Risk of missing the goal. Let us understand it by an example: Suppose you wanted to buy appliances for your home like LED TV, fridge, washing machine, microwave oven, dishwasher, kitchen cabinet, sofa set, wardrobe, double bed, etc., which cost rupees 10 lacs 5 years back. Now you exactly had 10 lacs only so you thought it’s better to save this money rather than spending it all in case if there are contingencies. Therefore, you invested this money at a ‘safer’ place @ 6% to 7% interest. But your enemy is inflation. Let’s see what happens now after five years, your savings have now increased to ₹ 14 lacs. In terms of numbers you have definitely grown ahead, but in real terms what is the condition? With 14 lacs at your disposal you reach the market with confidence and ask for these same appliances and you come to shocking reality that they are now available at 14 lacs. Why couldn’t you grow with your savings? How did the price of appliances of 10 lacs increased to 14 lacs? This is inflation at work.So in real terms, you are at the same place where you were five years back.
6. Intention, morality OR ethics of the management:Although mentioned as the last parameter, there cannot be any other parameter more important than this one. Management ethics have always been an important parameter, but in current times, it has become very important.Even a profit making company cannot do anything if its promoters or management are involved in siphoning off company’s funds by articulating the account books.Here you trust the management and there management siphons off companies funds!You will promptly ask: “Then how can we recognise such a management?”Excuse me, there is no ready made formula to know this. The biggest CA firms have miserably failed in finding out such embezzlements. The only solution to this is to consult an experienced, knowledgeable and client centric investment consultant.
Still you can always do some analysis on your own, like knowing its history as to has it repaid its old loans on time every time, etc. This will give you an approximate idea about the eligibility of the company to become your debtor.
Parameters without numbers:
- · How do you foresee the probability of growth 5 years hence in the field of business the company is in? Bright or full of struggle?
- · Is management seriously interested in growth through business or is it just interested in amassing money?
- · Is the company’s turnover continuously rising? Is it sincere and puts continuous efforts in growing it?
- · Where are its products sold?
- · How many customers are buying it – 1, 2 or many? If any one or two customers are buying 40 to 50% of its total sales, it is a negative for the company.
- · Does company pay its suppliers, employees etc. on time?
- · Does company take any steps to reduce the time of credit? (Debtor’s Turnover Ratio – Days)
- · How is its cash flow? If it does not correspond to its sales, then your loan maybe at risk.
- · Does company take any steps in reducing its unworthy expenses?
(Note: It is important to consult a successful and client centric Financial Planner to reach your goals at a faster pace, because he knows it better as to how much fund shall be invested into which instrument.)
The purpose of writing this blog is that you shall not encounter in your life an experience similar to Julius Ceasar with Brutus ‘Et tu, Brute?’ or You too, Brutus? Or the realisation that Geet (Kareena) of ‘Jab We Met’ had of “Kitni Gadhi thi mein?” (“What a stupid I was!”)
If you find this blog interesting and you got some real knowledge out of it, do mail me so that I can mail you 2nd and more knowledgeable part of this article.
(# https://www.fool.com/investing/general/2012/03/14/ratings-agencies-are-always-the-last-to-know.aspx)
(Blog written on: 04th July, 2019)
Special Note added later on: The recent #PMC Bank debacle and the consequential horrible actions due to it shall not have taken place if only the individuals had not taken totally silly decisions regarding investment of their money. Had they consulted some experienced and prudent Financial Planner before doing financial blunders themselves, they would have saved their lives and fortunes of their families at a meager fee; in fact, they would have been happier and wealthier today. Why don’t we consult experts?_________________________________________________________________________– Amish Saraiya (Email: amish.saraiya@gmail.com) Author is an ethical Financial Planner & Wealth Consultant with over 27 years of field experience. Apart from being fully involved in Research in equity and all asset classes, he has varied interests in the study of Behavioral Economics, betterment of Environment, New & Free Education system, Healthy and Happy living through New Diet System, Bird watching, Star gazing, Trekking in the Jungles, Mountains, etc.