When the world is flooded with cheap money, many believe that asset classes such as equities, Gold, and real estate are expensive, but very few realize that debt is also very expensive and thus highly risky.
Let me explain with a simple example.
In a normal situation (no excesses on either side), a 10-year bond is available in the market with 6% coupon rate and a face value of 100. But when there is excess money in the system, chasing this bond, the price of the bond goes above 100 to 110. When someone purchases at 110, the net yield drops to 4.72%. Yield is inversely proportional to price. Excess money printing reduces the available yield on debt investments.
Now, when that happens, investors want to look out for bonds with higher yields. In their desire to invest at higher yields, investors end up picking substandard debt papers. They forget that higher yields also come with higher risks. Risk that could not just impact interest payments but put the entire principal at risk.
Many people are familiar with the risk of default in debt investments, but a very few understand credit spread risk.
Credit spread is the difference between the yield of a corporate bond and a government bond. A bond of similar tenure and coupon payment schedule.
The credit spread depends on the rating of the corporate bond. The lower the rating, the higher the credit spread over the Govt. bond of similar tenure and payment schedule.
The credit spread is not static, and it changes with the investment scenario. When the investment community is very confident of the global outlook, the credit spread shrinks. Whereas, when there is fear regarding the future prospects, the credit spread expands.
For example, in normal times, a 10-year AAA-rated bond will have a credit spread of 1.75% which could shrink to 0.90% when sentiments are highly optimistic and can expand to 2.70% when the sentiments are depressing. For BBB-rated bonds, the range could be wider depending on the market sentiment.
So when the credit spread increases from 0.90% to 2.70%, the price of the bond goes down significantly, leading to severe mark-to-market losses.
The extremes in the system can easily be understood when the market for unrated private credit has been expanding massively because investors want to chase higher yields while ignoring risks. These level of speculation most of the time leads to high losses and disappointment.
If you are holding low-rated/no-rated Debt investments, it’s high time you reevaluate your holdings and exit if you are not confident about the underlying business. Low/No-rated long-duration corporate debt papers should be avoided in an uncertain macro-environment.
Always remember, when you invest in debt instruments, return of investment is more important than return on investment. And to ensure return of investment, one needs to understand the potential risks of such investments.
Originally posted on LinkedIn : www.linkedin.com/sumitduseja
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