Impact of U.S. debt downgrade

Global economy | India economy | Rajan Ghotgalkar | U.S. debt crisis

Standard & Poor’s has cut the U.S. triple-A rating down to AA+ which if one is to go by the technical meaning, says the U.S. is no longer as reliable as it was last week when it comes to repaying its debts.

U.S. debt is now hovering around 100 pct of its GDP ($14-15 trillion).

However, what’s more worrying is the manner in which U.S. politicians driven by short-sighted electoral objectives pushed the country to its reputational edge, making them look very similar to some of the much maligned emerging market leadership which lacks political will to take hard and nonpartisan decisions.

The game was not very different with the Republicans sheltering the rich with lower taxes and wanting to prevent the Democrats playing to their gallery by spending on welfare.

As a lender would put it, the quality of management and ability to deliver the growth agenda while keeping its accounts balanced is in doubt.

This has not gone unnoticed by S&P and has contributed to the downgrade decision which it also says is based on projected growth leading to the debt reaching $21 trillion in ten years.

China is really the U.S. production shop set up to keep production input costs as low as possible in an attempt to stem inflation and migration. Seen in a different way, the U.S. and China are really two parts of one economy separated by sovereign borders and resulting political considerations.

The dollar surpluses get invested back into U.S. Treasuries. The dollar’s exchange value will depreciate causing heart burn for countries like China and Japan which hold more than $1.2 trillion and $900 billion in U.S. debt. China also faces a possible depletion in its already meagre export margins. The U.S. slowdown therefore, means slower growth in China and its riled response questioning Washington’s ability to pay its debts and enforce fiscal discipline is quite understandable.

The U.S. debt at $14.5 trillion is like 100 pct of Italy’s GDP. However, that’s where the similarity ends.

The situation is more like Japan whose debt is over 220 pct of GDP which it continues to service through low cost debt, a scenario which may well get replicated in the U.S.

In the immediate term, the U.S. interest rates may see a marginal increase considering it will be rated lower than rates quoted on other AAA rated countries like Germany.

With the challenges facing the euro, there seems no easy alternative to the U.S. dollar and U.S. Treasuries especially when gold is already in bubble zone.

Unlike China which has about 40 pct of GDP from external trade, India’s is only about 15 pct of which the U.S. may be about 9 pct. This may well be time the Federal Reserve may do a QE3 to stimulate the economic momentum.

India is largely a domestic economy which is what pulled us through the post nuclear test U.S. sanctions and even if we are more integrated into the global economy today; I would believe the fundamentals supporting the India economy remain valid.

Therefore, the impact on India in sheer economic terms is really nowhere as material as the challenges posed by our internal challenges particularly stubborn inflation and deficits.

The RBI has acknowledged ample liquidity and market hygiene in India. The Prime Minister’s economic adviser has assured us that growth will remain unaffected.

A slower global economy could cool commodity and oil prices which may help in bringing down India’s stubborn inflation thereby giving the government time to put its languishing reforms agenda through and RBI the time to test the transmission of its monetary policy measures and slow down its interest hikes.

All said, I would believe that S&P’s downgrading should have been discounted by all markets much earlier and the Friday fire sale was triggered more because of the ‘in the face’ nature of its declaration.

Even if India GDP grows by 7 pct, it would easily be 3 times of global growth. Therefore, in the medium term, India which has now corrected itself to a FY12 PE 14-15 and FY13 PE 12 multiple, is possibly the best alternative for FIIs.

Indian equity markets could possibly see a rise in Q3 and Q4 of FY 2011.

That a country whose currency makes up 61 pct of global reserves should be subjected to a downgrade is bound to unnerve the global financial system because it reflects poorly on the future outlook for the global economy. It would be naïve to assume any country would go unaffected.

However, the truth really is that this is an unprecedented occurrence, the impact of which will get revealed only with the passage of time.

Irrespective, it’s another indication of the centre of economic epicentre’s gradual shift to emerging markets and Asia in particular.

Retail investors should only invest through mutual funds, stay on with their SIPs. It’s a good time to invest in emerging markets and more so in India.

Source: http://blogs.reuters.com/india-expertzone/2011/08/08/impact-of-u-s-debt-downgrade/

Losing their edge: Infra funds seem to be out of focus and out of favour

This could well be the great Indian mutual fund conundrum: infrastructure funds vs diversified funds. An analysis of the portfolio of infrastructure funds shows that they mirror the portfolio or have the same basket of stocks as diversified equity schemes.

Healthcare, FMCG and IT are the few notable sectors missing from their portfolio. Then why have these funds not performed yet? Infrastructure funds were part of the huge buzz about the Indian economy back in 2005. Consumption and outsourcing were the other hot themes.

Of these, infrastructure caught the fancy of quite a few mutual funds. Many new funds were launched and the category alone reported assets under management of Rs 20,000 crore till the start of the global meltdown.

During 2006-07, these funds did spectacularly well and investors were barely able to contain their excitement. But during the downturn, these funds were hit badly. The recovery came, but the infrastructure category failed to gather any momentum. It has been three years since then and the infrastructure funds are yet to report positive returns.

These funds have, in fact, ended up eroding investor wealth. Funds which were launched with a narrow investment philosophy changed their portfolio composition. Fund managers decided to go underweight on core infra stocks and diversified their infrastructure fund portfolio to other sectors such as banking and finance, metals and telecom which were initially not part of the infrastructure segment. Their argument for the diversification: the sectors are enablers of capital formation in the economy.

For example, UTI Infrastructure initially did not have banking and finance in its portfolio. However, in 2009 when the economy rebounded, the fund added the financial sector to boost its returns. This fund now has an exposure of over 25% to banking and finance alone. Others fund houses resorted to changing the fund's benchmark to show outperformance. ICICI Prudential changed ICICI Infrastructure's benchmark from the Nifty to the CNX Infra.

Thanks to that switch, the fund which was underperforming its benchmark over the last three years has now started outperforming the new benchmark. Basically, infrastructure funds today are much like equity diversified funds, but without exposure to FMCG, healthcare and technology. Reliance Mutual Fund is the only fund house which has stuck to the core philosophy of the infra fund. It has an exposure of close to 40% in the engineering and construction sectors, one of the highest in the industry.

According to a few fund managers, the returns trajectory of infrastructure funds has been low mainly due to the absence of a few sectors such as FMCG, healthcare and technology. These sectors constitute only 30% of the Nifty or BSE 100, but generate more than 70% of returns in the index. Some funds such as the HDFC Infrastructure fund even with an exposure to such defensive stocks failed to outshine its diversified counterparts. So, does it still make sense to invest in infrastructure funds?

Although infrastructure stocks have a more attractive valuation than consumption stocks, growth in the infrastructure sector is expected to be slow. This is because of problems in project execution and completion, working capital funding for developers and rising interest rates. Considering the bottlenecks in the sector, the returns of infrathemed mutual funds are also not very encouraging.

Moreover, fund managers also believe that it will take at least two to three years before infrastructure funds start performing and generating positive returns. Also, if there is a rally in the infrastructure segment, equity diversified funds have the leeway to raise their exposure to some of these sectors as they did in the recent recovery period in defensive stocks.

There is not much to lose in diversified schemes as one can profit on the upside at a lower risk than investing in infrastructure funds which have a higher risk quotient in comparison to the returns offered. Those who are investing in infrastructure funds from a mere portfolio diversification perspective could try out gold ETFs and other thematic funds like value and contra schemes as their returns have been healthier than infra funds.

Source: http://economictimes.indiatimes.com/features/investors-guide/losing-their-edge-infra-funds-seem-to-be-out-of-focus-and-out-of-favour/articleshow/9507897.cms

Five things to check before you invest in NCDs

The weakness in the stock markets and the high returns offered by debt instruments are making investors rush to the safety of fixed income options. After fixed deposits and FMPs, non-convertible debentures (NCD) have caught the fancy of investors. Right now, the NCD issue of India Infoline Investment Services is open for investment, with the company offering 11.9% on the 5-year bonds. Three more issues are in the pipeline. However, before investing in these bonds, here are a few things you should check.

How safe is your capital?

You are investing in debt because you want safety, right? However, private issuers can default on the repayment of the principal. This is where the credit rating of bonds comes into focus. Credit rating is an independent assessment of the ability of the issuer to meet its financial commitments. It's important because it also determines the price that a bond will command in the secondary debt market. A high rated bond will fetch a higher price than a bond with a lower rating.

The rating assigned to a bond is not for perpetuity as it may change with the fundamentals of the issuing company. Any downgrading of rating will bring down the price of the bonds in the secondary market. So, you need to keep your eyes open for any change in the rating of the bonds that you hold. Any variation in rating is usually announced by the agency and reported in the media.

Is the issuer on a sound footing?

Unlike in the case of bank deposits, which are insured up to `1 lakh, investments in non-convertible debentures are not backed by any guarantee. However, as a lender to the company, an investor in NCDs has the first right over the company's assets if it faces liquidation. However, this information is useful only if the company has sufficient assets. So, before investing, take a look at the company's financials. Check whether it is sufficiently capitalised and if it has a healthy book value. "Stay away from companies that have a highly leveraged balance sheet," says Ritesh Jain, head of investments, Canara Robeco Mutual Fund. A little bit of spadework here can save you a lot of heartburn later.

How liquid is the investment?

The investor is not obligated to hold the debenture till maturity because it can be traded in the secondary debt market. That's the theory. The reality is that these instruments are not very liquid and have very few buyers. So, check the liquidity of similar instruments issued by the company before you are taken in by the sales pitch. You may find that some NCDs are not traded for days, which is not the state of liquidity you expect from a product sold on a national exchange.

Is there a put and call option?

Some NCDs come with riders called put and call options. The put option means that the investor has the right to sell the NCD back to the company after a specified period, while the call option gives the company the option to repay prematurely. While the put option favours the investor in a rising rate scenario, the call option acts as a cushion for the company if the rates fall and it wants to retire the high-yielding NCDs prematurely. Find out whether the put and call options suit your needs before you invest in the NCD. For instance, the five-year NCDs by Shriram Transport Finance have a put and a call option after 48 months, whereas the Indian Infoline Investment Services NCD does not have any put or call option.

What is your post-tax yield?

Lastly, consider the tax implications of the investment. The yields being advertised by the issuers obviously do not take into account the tax liability of the investor. Any income from the NCD is to be added to the total income for the year and taxed at the normal rate. In the 10% tax bracket (income of up to `5 lakh a year), the 11.5% yield drops to 10.35%. In the 20% tax bracket (income of up to `8 lakh a year), it falls to 9.2%. And in the highest 30% tax bracket, it is barely above 8%, which is no more than that offered by the PPF.

Source: http://economictimes.indiatimes.com/markets/bonds/five-things-to-check-before-you-invest-in-ncds/articleshow/9506377.cms