Credit crisis lessons unlearned

Recently I have had the privilege to participate in DH Sparks, where one of the participants, the CEO of an Asset Management Company raised an interesting point: why is it that there are so many retail equity investors and but not bond investors? Unlike the global scenario? The context was the recent shuttering of 6 debt / hybrid funds from a global asset manager.

So, what are these bonds? Investments that payout (or accrue) a specified amount/rate on the face value over the life of the instrument and the instrument can be transferred to another individual/entity and traded are called bonds or Fixed Income securities. Supposedly safer than equities bonds should be popular with investors especially the highly rated ones. In a so-called balanced portfolio, they also provide a counterweight to equity investments.

If they are supposed to be safer (most were investment grade and rated AA which should afford ample liquidity), what went wrong?

While experts have been waxing eloquently about how the pandemic was responsible or it was the lockdown or even the moratorium, I believe this problem stems as far back as the credit crisis of 2008 where lessons (and some global frameworks for dealing with illiquid bonds) have been ignored.

During that time, sub-prime mortgages were packaged as bonds (CDOs) were sold to asset managers, pension funds, Norwegian village. Brokers provided prices (mostly an opinion) and investors accepted those for the want of a better source. When the crash came, there were no buyers and values plummeted pennies to the dollar.

There were some winners (and not just the lot glorified in Michael Lewi’s The Big Short), these were institutions that had seen through the mispricing and internally marked down their investments and where required provided an adequate capital buffer for their clients/investors. What they did differently was to a) include an illiquidity premium i.e. a bond which is not well traded, buyers will demand a premium to buy that security b) the effect of interest rate movement (bonds will loose value if interest rates move up) c) prepayment of underlying loans by borrowers and d) the probability of default among other factors.

They also did not use the market price if the bond was thinly traded and therein lies the crux of the issue. Furthermore, they could one other and is to buy credit default swaps (CDS) - an insurance policy for bonds that pays out when the issuer of that bond defaults.

What happened in March was, unfortunately, the perfect storm: as the lockdowns progressed and cashflows dried up (temporarily), bonds which were not fairly valued found no buyers (not even the banks which normally would be happy to buy bonds issued by their borrowers from the market subject to internal limits). As these risky securities became worthless, managers were forced to recognize the true value and take significant losses in their funds. Ordinarily, CDS would kick in such a scenario but that market in India is dead in the water, leaving investors high and dry, seeing their supposedly safer investments loose value.

The solution to this problem lies primarily with the CDS market to provide a safety net to bond buyers. Insurers will also determine “premiums” (price of the CDS) to accurately reflect the value of the instrument thereby leading to better price discovery and preventing massive sudden markdowns. The other significant shock absorber is the ubiquitous Bond ETF – investors (and the FED) found it simpler to value the basket and therefore trade it rather than single bonds.

While a developed CDS market may be some way off, and FMP-esq Bharat Bond ETF having not quite delivered, there are a few other measures which can be implemented immediately to safeguard investors. First, pricing is the responsibility of the fund accountant and not the fund manager - markdowns and recognizing defaults should, therefore, be the eternal independent fund accountant’s job. Thinly traded securities should not be priced off ‘last traded price’ but should ideally be a model-based price, services, and frameworks for which are readily available in India and globally. Till then, we may yet see another blip or two in the future.