The credit market had approached the first wave of the pandemic last year with a certain amount of caution. The economic fallout was hard to predict given the unique nature of the shock. This, alongside recent specific events in the market, was justifiably weighing on risk perceptions even as spreads on offer were fairly lucrative.
As it turned out the right analytical construct for assessing the Covid shock was that of the ‘K’ shaped recovery. Thus for the larger / better to do companies and individuals this was largely a stoppage in time without much impact to survivability. In fact many companies actually succeeded in meaningfully deleveraging themselves and creating cash on balance sheet.
Financial institutions, as lenders to such companies, also benefitted in their risk profiles even as many proactively raised additional capital to further buffer their balance sheets. Many individuals also emerged financially stronger from the first wave since there was an element of forced saving owing to curtailment of activity. For the bottom half of the K, however, things became worse as economic survivability was called into question. Both firms and individuals here have much less financial flexibility and are prone to suffering the brunt of economic shocks given very thin safety buffers.
While this constitutes a major welfare issue, there is little immediately obvious impact from this in the kind of data that generally gets viewed from the cold prism of financial markets.
The Price of Caution and the Rewards for Keeping the Faith’
As a result of the above dynamics, the risk perception of the market improved dramatically in the months following the first wave. Supply of paper from issuers dwindled following the deleveraging efforts by many companies. The economy bounced back strongly as well thereby further cementing risk perceptions. These have resulted in dramatic compression in credit spreads for the most part (some segments have still struggled with narrative perceptions or business model vulnerabilities but these increasingly have been fewer and farther between).
An important contributing factor has been the extended period of very low overnight rates, which has further contributed to the ongoing chase for carry. To be clear this isn’t a criticism of RBI policy since the accommodation provided is more than justified given the economic shock, but merely an observation on what extended periods of loose financial conditions invariably bring.
Investors who had kept the faith’ last year have been rewarded handsomely as credit conservatism got heavily penalized owing to the above developments. Now a more damaging second wave has hit the economy, but recent experience has been very reassuring for the market and hence there has been no pressure at all on credit spreads so far.
The market has RBI’s proactive assurance that the central bank is battle-ready and is thus expecting loose financial conditions to continue for the foreseeable future. Embedded in recent memory also is the fact that there was a substantial price to pay last year for conservatism given the financial impact of the first wave as described above.
The financial system looks largely robust, a point that we have noted since end of last year as one of the tailwinds now for the Indian economy. Additionally, the global construct is very different now. Large parts of the global economy (especially the developed world) have been fueled by extra-ordinary fiscal stimuli and have progressed well on vaccination. As a result they are coming back strongly thereby lifting prospects of our own exports at least for a while. Also basis this global optimism, commodity prices have risen sharply to multi-year highs thereby creating strong tailwinds for many business models in the credit space.
The Euphoria Safeguards
There are certain standard aspects of euphoria that need to be taken note of: 1> The investment narrative sounds very compulsive and hence risk perceptions are therefore that much weaker.
2> Risks even if assessed seem too theoretical and far-fetched especially when seen in the light of concurrent experiences 3> Lower levels of risk compensation sustain owing to pressures of the day to day’ and because longer term narratives seem supportive of lower risk perceptions (market knows best).
If some of what is happening today meets the above definition, then it may purely be coincidental. Almost by definition, naysayers are often early and mostly wrong (at least for all practical purposes) in times like these. The objective here is certainly not to stand in the way of the flow or the narrative, for fear of the great risk of injury that often comes with such a course of action. Instead the idea is to merely flesh out the nuance and put some pointers on the table which will hopefully help with navigating this phase of fixed income markets.
Consciousness versus Conservatism
Consciousness pertains to a level of awareness whereas conservatism describes one’s general philosophy. This distinction, and the nuance associated, is very important in the current discussion. In the context of fixed income, there is reason now to raise one’s level of consciousness even as the general philosophy is a matter more of personal choice. The starting point of this adaptation is a recognition grounded in basic humility that one can’t see all risks especially when the pro-cycle narrative is as strong as it is today (this is notwithstanding a robust credit assessment process which is a given).
One then overlays two additional points:
1> The economic damage from the second wave seems both intense and widespread and may weigh on certain pockets of issuer risk perception with a lag.
2> The spreads on offer versus the additional risk taken are now quite modest for the most part (one has to allow for exceptions that would represent the pockets’ of opportunities). Put another way, the costs associated with preferring quality have diminished substantially. This is especially true as term spreads continue to be quite wide.
This is relevant since in order to enhance yield an investor can always choose to increase average maturity of investments by a couple of years and remain in the highest quality rather than dilute quality by taking on more credit risk.
Apart from everything else that they have been, the past 14 months have been an analytical whirlwind. The sheer magnitude of the initial shock justifiably triggered the need for safety in investments for many. As it turned out, however, the nature of the shock and the subsequent behaviour of lenders and companies ended up substantially rewarding the risk taker during that phase.
The current phase is marked by a meaningful compression in spreads reflecting these developments, continuation of highly accommodative financial conditions, as well as a global narrative that is overwhelming pro-cycle. In the midst of these, India’s second wave has (at least basis anecdotal evidence) wreaked havoc to purchasing power and financial security across a large swathe of economic agents. Even given the hangover from last year’s implications for conservatism, spreads on offer now are generally very low thereby tilting the scales towards preference for quality.
At the very least, this backdrop calls for greater credit consciousness and a heightened awareness of how much reward one is getting versus risk taken. These also need to be measured in context of significantly elevated term spreads.
(Suyash Choudhary is Head of Fixed Income, IDFC AMC. The views expressed are personal)