Risk in debt investments.

When it comes to investing in debt securities, like corporate bonds and bank fixed deposits, there is a sense of safety that many investors have. Debt investors have a higher priority over equity investors at the time of repayment and especially when a company goes bakrupt. However, the credit quality (the ability of the business to meet its interest obligations and payback its long term debt) has a high correlation to its profitability and hence should be equally important to an equity investor as well.

The examples below explain instances where debt investors faced issues in repayment in the most unexpected ways. The conclusions reached are not rare exceptions, they should be expected and prepared for.

All lenders take risk - that the debt investor takes implicitly.

Generally with debt funds, you would expect to lose interest in the worst case but never lose principal. But it happened and here are a few examples.

The good old bank FD: PMC bank was in the news for a fraud they confessed about to the RBI. They lent a lot of money to only one client (HDIL), which is bad banking practice and created fake accounts to show that they’ve lent it to others. As a result of the discovery of this fraud, the RBI restricted customers of PMC to ₹1,000 per day. Later they increased this to ₹10,000 and then to ₹25,000 per account.

Corporate loans of a reputed promoter: Right now in 2019, Piramal Housing Finance has lent a big part of its total loan book to Lodha Developers. If that one account fails, it loses a lot of its book value, although it has lent to a lot of other builders. They can say that they have a diversified loan book, but it really isn’t.

Debt funds’ upselling by the MF industry: Back in 2008 and in 2018, there were plenty of debt mutual funds that reported a decrease in the scheme’s NAV. The reason was that they had lent money to accounts where there were defaults in interest payments. Later some accounts were unable to recover the principal either.

Indian government securities are now available to the retail investor at no frictional cost, and they are the safest debt investments in the country.

The Indian government issues T-bills (treasury bills, duration < 1 year) and G-Secs (government securities, duration >1 year) that are backed by the Indian government. When you lend to the Indian government, it is almost guaranteed that you will get your interest payments and principal back. If the Indian government defaults, no one else could be pay us. That forms our benchmark for returns rates on debt securities. Now individual investors can also invest in government bonds too.

Anyone borrower offering above average interest rates, is taking some risk while lending to get higher returns.

This is usually in the form of business risk. If you are a long term investor, it makes sense to take no risk via debt. You get a sense of safety in holding bonds instead of stocks, but you are still taking the same risk essentially. If you can’t justify not holding stocks of the same business/bank (except for the reasons of short term liquidity and market volatility) you should think hard before buying the bonds of the same business, or putting you money in the bank deposits of the same bank.

Argument: If every percentage of return matters in the long term, why settle for lower returns of government securities and not just go for bank deposits or corporate bonds?

If your bank deposits are in private, regulated and reputed banks, the real risk of default does reduce a lot. However, risk management matters more than returns, and you can never really know any details of the lending process of your bank. No debt security can provide capital protection better than a government bond, theoretically. That extra 1% of return will not matter much when the company/bank defaults on its payment. Get your investing priorities straight. Decide for yourself if you would like to take any extra risk that banks take.

Demand and productivity trump everything else.

The nature of the security, debt or equity matters less than the product demand, business operations, its balance sheet, and soundness of its business pratices. This doesn’t mean that you shouldn’t invest in any corporate bonds, or bank FDs. But if you’re chasing returns higher than what the government bond returns, you should really consider if that extra risk is worth the few basis points of returns. You should determine that by thoroughly studying the business.