There’s over-reliance on rating agencies
India has one of the larger and more liquid bond markets in Asia. But compared to the size of outstanding bonds, trading is limited. Liquidity is concentrated in a few benchmark G-secs. Portfolios hold cash causing a drag on yields.
Illiquidity means traded prices are not readily observable. Different participants (banks, mutual funds, provident funds, etc.) use different valuation models. Incorrect marking to market itself can be deterrent to trading.
Another reason for illiquidity is the preponderance of private placements with a buy and hold approach, as is the lack of market makers who provide liquidity in global markets.
Market makers also usually provide bond buyers with research. Their absence means an over-reliance on rating agencies. Equities offer a stark contrast. Brokers provide primary coverage (e.g. data) while asset managers focus on more value-added secondary analysis.
Four years ago, the Economic Survey called for a bond-currency-derivative nexus comparable to equity market levels. Alas too little has been done in that direction so far.
Relative illiquidity in corporate bonds
The relative illiquidity in corporate bonds is one of the key challenges as lack of depth in the market can hamper a quick and efficient response to redemption requirements and in turn to overall portfolio management. The recent experience with investor outflows from liquid funds and income funds had a broad-based impact and highlights the nature of this challenge. Diversification of the investor base and a well-oiled, active corporate bond repo segment can help assuage this concern. Relaxing the rating restrictions for large institutional investors will also be conducive in this regard. In the light of the recent events, ability to analyze credit quality, arrive at appropriate risk premium and early detection of deviations form a core differentiated skill set that portfolio managers should sharpen. This becomes all the more important while balancing risk-reward expectations, especially when viewed in conjunction with shorter economic cycles and frequent jolts of volatility.
—Ajay Manglunia EVP and head fixed income markets, Edelweiss Financial Services Ltd.
Investors have similar risk appetite
In India, the debt markets are fairly populated in terms of instruments with various risk and returns pay-offs across maturity and credit spectrum. Hence, as long as the portfolio positioning is well understood and adhered to, the selection of instruments to fit the same is fairly easy. The problem is when one tries to maximize potential returns by going beyond the portfolio positioning, or misreading the risks. Investors who have seen cycles, and are well equipped in terms of research inputs have lower probability of making mistakes. However, we are still work in progress in this fast changing environment. The hedging environment still remains inadequate. Second, we still are dominated with investors of similar risk appetite and co-cyclical flows, meaning you are either a buyer or a seller, and never a balanced one. Liquidity continues to remain the biggest challenge, which has an impact in terms of risk appetite and on efficient pricing, thus ultimately increasing the borrowing costs for the economy.
Appreciate volatility and default risk
The perspective of most retail investors, while looking at fixed income mutual funds, is that it is a ‘fixed income’ product, and is benchmarked with a bank term deposit.
In reality, debt mutual funds are market-oriented products where there is a price discovery every day. The issue is about appreciation of the risks involved; in equity, it is well understood that the market can be volatile and returns can be impacted adversely.
In debt, return volatility is accepted to an extent in long duration products. That apart, volatility in short duration products and default risk in any debt product is part of life, which needs to be appreciated.
The rationale for allocation to debt is not zero-volatility, but relatively lower volatility than equity, tax-efficiency over direct exposure to bonds and expectation of inflation-plus returns over an adequate holding period.
The solution to inadequate appreciation of the risks is spreading awareness, right-selling by advisors or distributors and right-buying by investors, and investing in it with proportionate expectations.