Changing equation

The seizure of the US mortgage-security market and India’s FCCB defaults show that debt is becoming as risky as equity

By Mohan Sule

The decision of the US government to sue Standard & Poor’s for assigning investment-grade rating to mortgage-backed securities has once again brought into focus the difficulties in making investing secure. As against the inbuilt uncertainty associated with exposure to equity including volatility in earning, debt is considered dependable for the stability in cash flow and protection of principal. Chances of projections about future earning going wrong are high for stocks but so is the potential for return. A credit rating for a fixed-income product, in contrast, is supposed to accurately predict the likeliness of default by the borrower. The advantage is neutralized by barely-above inflation return and higher tax compared with equity. This traditional equation of risk being directly proportionate to reward that divided investors into the adventurous and the conservative now looks close to collapse. This is because of the strengthening of the link between capital and leverage. Servicing of loan is dependent on the timely execution of projects, which, in turn, hinges on the financial performance of the borrower. Rating of debt, on the other hand, is influenced by the track record and the current health of the issuer unlike buy or sell calls on stocks, which pivot on the outlook for the company and industry. In fact, neither discounts sudden changes in the macro environment. This is because interest in issuance of paper increases during a bull period. This means the issuer has two choices: dilute equity by offering shares at premium or increase leverage through attractive coupon rates. Both are fraught with downsides.

With the world becoming flat, the power of the commodity cycles to pull up or push down markets is weakening. Rather fiscal policies such as taxes and spending cuts to balance the budget and monetary policies such as easing liquidity or increasing the cost of money sway the markets more dramatically. An unexpected decline in demand for products and services affects return ratios as well as the ability to service debt. Complicating matters is the popularity of derivatives. Cloudier the future, more is the hunger for these exotic instruments to hedge against future reversals. Mortgage-backed debt paper comprised securities of different profiles. Rating agencies erred in not alerting subscribers to the inherent volatility due to the composition. Instead, they clubbed it in the highest-safety category. The reasoning probably was that the mix of the dodgy with the credit-worthy would eventually spread out the risk. Instead, these papers turned out to be combustible. The fact is rating agencies that keep a hawk’s eye on countries’ fiscal health turned sloppy when it came to monitoring their clients. The legal battle will offer a glimpse of the method behind the madness. Protracted court proceedings, however, could also chip away confidence in these firms, supposed to be investors’ gatekeepers, and in the financial markets. If this happens it would lead to another seizure of the credit market in the absence of benchmarks at a delicate stage, with the US economy showing signs of recovery and the euro zone expected to bottom out. Instead, the opportunity should be used to clean up the system.

In view of the vital role they play, how can rating agencies avoid the conflict of interest of rating their clients? Are country downgrades quicker and harsher than those for companies? Is it because institutional investors pay for the intelligence, while ordinary investors do not? If market regulators are prickly about investment banks maintaining a Chinese wall between their underwriting and brokerage functions, rating agencies, too, should have two teams, one for client servicing and the other for third-party investors. Perhaps this is an appropriate time to examine if there is need to fall back on the volatility indicator used to determine the movement of stocks during different phases of the market for debt offerings, too. If a counter with higher beta can outperform during an upturn, its ability to service loans is also bright. Most times, rating alerts come after the equity market has passed its judgment. For investors the lesson is that fixed-income products could turn out to be as unpredictable as stocks. The increasing incidence of defaults by companies in redeeming foreign currency convertible bonds should be a clinching evidence of the tenacious relation between shares and debentures. Issued during a period when interest rates were soft and the markets surging, these instruments allowed companies the safety of conversion in case of stress in repayment. The calculation went horribly wrong as the subsequent bearish undertone hammered stock prices and also squeezed cash flows. Many issuers have had to bloat their balance sheets further to meet current obligations. If equity investing is like braving a hurricane, debt can be an iceberg, which hides more than it reveals.

Small strokes

The small investor, the small homebuyer, the small saver, and the small enterprise 
are the focus of the budget for 2013-14

By Mohan Sule

There were three challenges facing the finance minister as he rose to present the budget for 2013-14. The first was to revive growth. The second was to stick to the fiscal deficit target. The third was to keep inflation low. Confronting even one of them head-on would have resulted in the resolution of the other two. Balancing demand and supply could have dampened prices without sacrificing growth. Ironically, the roots of these problems could be traced back to the heydays of 8% plus expansion of the economy, which increased the level of income of a large number of people, requiring the import of more energy and thereby fuelling prices. The textbook solution would be to tighten money supply so as to slow down demand and cool inflation. The global credit crunch, however, ensured that traditional solutions that had stood the test of time were no longer relevant. Funds in search of better yields flowed into India despite the fragile health of the economy as the central bank had to keep interest rates high to due to increase in consumption. As a result, the stock market’s surge was not accompanied by the strength of the underlying economy. Complicating the efforts to bring back growth on track was the policy paralysis stemming from a series of scandals. Prickly coalition partners that opposed the rollback of subsidies to blunt the falling revenue and policies that relied on government handouts to erase poverty rather than creating more jobs were the other obstacles.

The year also flags off the election season. Not the best of time even for the most fiscally conservative finance minister. In such a situation, the temptation is to nurture the traditional constituency. Hence, 30% increase in Plan allocation besides 22% more for agriculture, Rs 10000 crore for food security, and Rs 6000 crore for rural housing. Yet there is no major ramp-up in direct or indirect taxes to balance the spending spree. There could be four reasons. First, as the Economic Survey 2012-13 points out, the worst for the domestic and global economy could be over and any tinkering could have delayed, instead of aiding, the recovery. Second, revision in taxes could have been short-lived as the rates would have to undergo another makeover if the Direct Taxes Code bill is passed in the current session of parliament and consensus emerges among states on the Goods and Services Tax rates. Third, of course, is the prospect that such a move would contribute to inflation, which is at a delicate stage as the economy absorbs the partial rollback of fuel subsidies. Fourth, the increasingly vocal urban middle class could be the reason for the feeble attempt to increase the income or service tax rates and base such as levying a token surcharge of 10% on those whose taxable income is more than Rs 1 crore per annum, 6% more excise duty on mobile phones above Rs 2000, 1% TDS on transfer of property above Rs 50 lakh, 100% customs duty on luxury cars, 30% excise duty on SUVs, and service tax on AC restaurants.

Despite the ballooning expenditure without matching revenue-raising steps, the finance minister is confident of bringing down fiscal deficit to 4.8% in the coming year and maintaining it at 5.2% this year. Besides austerity measures and decline in the fuel subsidy burden that allowed him to keep expenditure at 96% of this year’s budget estimate, the bet seems to be on the record 250 million tonnes of food grain production in 2012-13 to bring down food inflation, the main component of concern in the headline inflation. This could pave the way for softer interest rates and allow industry to borrow cheaply. Going by the budget’s efforts to attract them including cutting STT on sale of equity futures, foreign portfolio investors have been recognized as the growth drivers and so also debt as a better option to meet resources: There will be 10% surcharge on distribution tax on dividends, one of the  attractions of equity investing. Road infrastructure is to get a regulator, tax-free infrastructure bonds will make a comeback, and stock exchanges will have a debt segment, satisfying foreign investors and the small saver. Pension funds can now participate in debt and exchange traded funds. Another crucial source of revenue for the infrastructure sector is insurers. Public sector banks will see Rs 14000-crore capital infusion and along with those in the private sector can act as insurance brokers. LIC will have a presence in towns below population of 10,000 in a belated move to reclaim the space occupied by shady chit funds. By introducting tax sops for home loans up to Rs 25 lakh, reducing STT on redemption of mutual funds and ETFs, and imposing surcharge on DDT for debt funds to blunt their advantage over fixed deposits, the overarching theme of the status quo budget is the small saver and the small enterprise: there will be 10% surcharge on corporate tax for those with profit of more than Rs 10 crore. And if India manages by default to become the second fastest economy in the world after China next year not due to any bold efforts but because of the global sluggishness, it will indeed be a small consolation.

Cosmetic facelift

Instead of safety nets to lull investors into complacency, focus should be on the ease and the cost of entry and exit
By Mohan Sule

The market surge of 2012-13 is rekindling memories of the boom in 2007-09. Just like in the past, the recent buoyancy is due to foreign portfolio inflows. Low interest rates in the US are once again contributing to the liquidity. The similarities seem to end here. The expensive stock valuations when markets were hitting new highs in a matter of days four years ago seemed justified due to the robust health of the global economy, particularly emerging nations. China was notching up around 10% growth rate and India about 8% per annum in the second half of the last decade. The clawing back of the market to reclaim past glory is evoking concern instead of exuberance as most of the developed countries are in recession and some like the US are showing weak signs of recovery. China is tenaciously fighting to get back to the past years of high growth rate, while India is scrambling to put its balance sheet in shape just to avoid credit downgrades rather than to grow in double digits. Foreign investors have been assured of a benevolent tax regime till FY 2015. PSUs are being dusted off the shelf by the government to capitalize on the market momentum. The Reserve Bank of India has shifted its focus from fighting the still-high headline inflation to boosting growth. If retail diesel prices are being raised in slow steps, the cap on subsidized LPG cylinders has been enhanced to nine in a step backward. The scurrying about seems to be to reach the short-term goal of getting past 2014 intact. In short, a coat of paint is being given to make the house appear presentable to foreign visitors rather than carrying out structural repairs to make it livable for its inhabitants.

The weak economy, which is expected to grow just 5% in the current financial year, in a way has proved to be a blessing, shaking off the government’s policy paralysis and forcing it to act. This is in contrast to what happened for most of 2003-10. Instead of divesting PSUs to take advantage of the market boom and initiating second-generation reforms, the UPA II government launched treasury-draining welfare schemes like guaranteed rural employment. Not only did the giveaway contributed to fuelling food inflation, it boosted manufacturing prices too as the private sector had to raise wages to compete for workforce, The worry now is that in spite of the government’s belated realisation that there is no substitute for reforms, the inflows could reverse as quickly as they rushed in if the domestic economy does not respond to these stimuli. Recovery in the US, the euro zone and Japan too could help the turn the tide. Another reason is that equities in India are now fully valued based on their historical earning unlike at the start of the fiscal. Any further upturn will be justified by the economy surpassing the central bank’s estimate of 6.5% expansion next fiscal. This can come about only if the government quickly puts in place a transparent land acquisition and environmental clearance mechanism. The euro zone could be the next hotspot for inflows. Already yields on corporate bonds are rising in the region.

The high fiscal and current account deficits are slowing the central bank from aggressively cutting interest rates. Also, the government’s neglect of retail investors and tilt towards big-bracket overseas investors are not helping matters. Apart from the solace that long-term capital gain tax is unlikely to be raised from nil currently, the transaction costs including demat and brokerage charges and the securities transaction tax remain high for small investors. Book building has further marginalized the retail segment. Yet the recent attention on listing gains raises the possibility that the equity market is being given a cosmetic facelift to resemble a risk-free investment option. Toying with concepts like issue grading, market making, buybacks by promoters on dip in stock price over a fixed timeframe, however, are dangerous as they will lull stock pickers into false complacency just as US buyers, backed by cheap mortgage rates, came to believe that prices of property always go up. Instead of solely focusing on supply-side issues, the need is to encourage demand. Shrinking the period for listing and minimum 25% public float will ease entry and exit. Sebi has tried to create a level-playing field in the primary market by insisting on upfront margin and no-cancellation policy for big ticket investors and introducing ASBA facility that allows debit of subscription amount only on allotment. Another measure to reduce cost could be releasing of investors’ funds as per the progress of capital expenditure rather than on distribution of shares. This would enable retail players to earn interest on their unutilized portion and tamp down expectation of super listing gains, thereby de-risking companies from having to explain the fall in share prices due to delays in project execution.