Be Aware! Bonds Are Not Simple
Neither a borrower nor a lender be; For loan oft loses both itself and friend.
It's almost every week. I discover a new financial platform. On the equity front, it's primarily mutual funds and a portfolio of stocks. Primarily Robo-Advisory or momentum packaged in a new way, but it's mostly the same thing.
But exciting things are happening on the other side, on the debt or bond investment platforms. There are various kinds of websites, a lot of them attractive. I have seen somewhere you can buy equipment or furniture and lease them to companies—all seamless.
These platforms advertise lucrative returns of 9-11% or even more, as much as 20%. I mean to earn an 11% return without bothering about going up and down based on market sentiment is enticing.
However, investing in debt is risky. Why? We'll try to explain why:
Default Risk
Investing in debt comes with the inherent credit risk. For earning a return of 11% with greater certainty (of not being exposed to market sentiment), comes the possibility of losing your capital in case the borrower defaults and goes bankrupt. That's not a remote possibility but a clear and possible danger.
With interest rates low and fixed deposits yielding 5%, companies trying to raise loans at high rates are far from being the safest bets.
Probability of Recovery And Timeline
In the last decade, you have heard of large corporate houses ending up in bankruptcy court, where the process in many cases is still underway. Hence, it's very likely that you'll see more issues at the end of this cycle. Unlike previous cases, which mainly involved banks and financial institutions, you'll see many individual's investor's interests represented directly by them.
Complexity
The other thing is bonds do not work as a fixed deposit, and it's often wrongly sold as one.
A bond has many layers to it, such as credit rating, seniority of claim to assets in case of default, repayment risk, embedded call or put options, current and future interest rate environment, tenure, and liquidity.
A typical investor might be unaware of the differences between various bonds, types of bonds such as perpetual bonds, or commercial paper.
I mean to say, there is a lot more knowledge required to invest in bonds than stocks. There are more chances that something can go wrong, and when it does, the damage can be much worse.
Liquidity
The secondary market for bonds is thinly traded at best and non-existent at work. And when things go wrong, it also dries up. So unlike an FD that is possible to liquidate prematurely, you might not have that option when investing in bonds.
Locked-in when things go wrong
Last year, during the height of Covid-19 fears, Franklin Templeton was forced to wind down six debt funds due to pressure of redemptions in a market where liquidity had dried out.
Investors so far have got back only 71% of the money they invested in these funds and are still waiting for the rest.
If this can happen to Franklin Templeton, it can indeed occur in these bond investing platforms.
Conflict Of Interests
A mutual fund manager has a fiduciary obligation to represent their customer's interests. The borrower generally compensates a debt investing platform, a commission for the total funds they help to raise. So if a borrower goes under distress, a debt investing platform does not have the same obligation that Franklin had. It might end up being the investors forming their association to represent their interests in bankruptcy court.
We don't know how this will play out because it's still early days for debt investing in India.
Don't believe something that can't be true.
What can, will go wrong. So when something seems like a high return and it's sold strongly with the underlying message that it's safe etc. Please don't believe it. In the past, I have had brokers who have tried telling me NSEL is safe and 'exchange guaranteed' to have had only blown up a few months later.
AT-1 bonds of Yes Bank and maybe even other banks were sold to retail investors with the assurance that this is guaranteed. Still, all the holders had to take a significant loss.
Should be primarily institutional participation
We have been very keen that bond markets open up in India; there is more money raised through bonds than direct bank lending, especially for corporates or large projects. But we also believe that this should be a primarily institutional play. Retail participation should be mainly through the indirect route via funds or so because it's a much more challenging market to navigate.
If you want to take a dip, go ahead, but only your leg.
We will strongly advise not investing a large percentage of your assets into bonds directly via any of these online platforms. You'll avoid a lot of potential stress. It's always better to prevent a problem than trying to fix it.
So go ahead and try investing in debt directly. There are plenty of platforms that offer lucrative returns. You might be encouraging exciting ideas, which are beneficial to society.
However, try to limit your exposure within your comfort level. It knows that you might not have liquidity and run the risk of default and significant loss of capital in that event.