Bipolarity Of Market In Debt And Equity

The last two years have seen investor’s moving from euphoria to fear and now to indifference. During this period, Nifty has gone up by 4 per cent (January 2018 – October 2019). This does not paint a bad picture.  But there is a huge divergence between NIFTY and investor returns which are deep in the red. This is because the midcap and the small-cap indices where the bulk of investor allocation went is still down 26 per cent and 40 per cent respectively (on an absolute basis), since then. Nifty itself is heavily polarized with the top 15 stocks’ average return at 34 per cent during this period, while the remaining 35 are down by 5 per cent. A similar trend also appears to be in the global markets where S&P 500 index in the US is up by 9.1 per cent, while the Russell 2000 (representative of small caps) is down by 3.1 per cent in the last one year.

This trend has played out in our debt market as well. Since the default of IL&FS, the repo and 10-year G-Sec have come down by 135 and 150 basis points respectively, but for a large number of participants the cost of credit has gone up or credit has been just not available. This is reflected with the AAA spreads going up by 55 bps since the IL&FS crisis. The impact on lower rated bond is higher with spreads increasing by 70 bps. The lack of access to credit is shown by the sharp fall in CP issuance which were 45% lower from the start of the year.

A simplistic assumption would be to blame the downfall to LTCG in early 2018 and the default of IL&FS in Sep 2018. These were both triggers but not necessarily the cause. To understand the cause, we must go back to the euphoria of Jan 2018.  The markets were ebullient, 1 year returns of mid cap and small cap indices were 47 per cent and 58 per cent respectively. Investors had made money, and this led to increasing flows in equities. As always, risk and valuations are forgotten in the euphoria. The small cap indices valuations were trading at 1.4 times NIFTY valuations and the midcap indices were more than 1.5 times Nifty valuations. These were almost their historical highs and very risky valuation levels to invest. Today the same small cap and midcap indices are trading at a one-year forward PE, which are 14 per cent and 17 per cent lower than forward PE of Nifty, but there is little interest in investing in them. This is a classic case of behavioral bias where the investors focus on recent returns rather than the actual investment risk return tradeoff for the asset class.

The same story played out in the debt markets. Investors were enamored by the high returns being shown in credit risk funds without understanding the underlying risks. Again, there was massive money flowing in this category of funds. The AA 3-year spreads with G-Sec had reduced to 100 bps at the start of last year which made the risk return trade off unattractive. The IL&FS default lead to a massive risk aversion and yields spiking up. Today, the spreads are around 180 bps, but the category is seeing massive outflows and some funds have lost more than half of their AUM.

No one can really predict random events like LTCG or the default in IL&FS. Investors should not be swayed by recent returns and rationally look at the risk reward matrix of the asset class. And invest when the odds are in our favor even if the rearview mirror returns are negative. 

The author is the senior partner, Third Party Products at IIFL Wealth Management.