Safe capital and negative returns

In India, low-risk debt has offered consistently negative returns when inflation is high

In the Doing Business 2013 Report, the International Finance Corporation ranked India 132th out of 185 countries on ease of doing business'. India's rank was 184 in enforcing contracts, 182 in dealing with construction permits, 173 in starting a business, 152 in paying taxes and 127 in cross-border trading. It takes 27 days to start a business in India, versus 19 in South Asia and 12 in OECD countries.

The combination makes India a toxic business environment. These issues arise because an inefficient, corrupt government cooks up complex regulations. Tackling these problems head-on could actually yield far more positive results than tinkering with interest rates. But it's not going to happen.

Let's focus on the first variable. India shares the worst rank in that report when it comes to enforcing contracts. It takes an average of 46 procedures to enforce a contract and around 1,420 days. It costs around 40 per cent of the claimed amount.

In effect, you cannot enforce a contract within any meaningful timeframe. This is despite having a legal system which, in theory, is solidly based on rule of law. One of the ancillary issues arising out of an inefficient justice system which cannot enforce contracts is that debt collection is almost impossible by normal means. This means anybody lending to a non-government entity is taking a huge risk.

This distorts the normal matrix of investment allocation. Equity is risky but at least the returns can be very high and equity is liquid. In India, high-yield corporate or personal debt is extremely risky as well, while the returns are limited and the asset is illiquid.

Investors look at the risk-reward equation. The investor assigns an expected risk in terms of how much he might lose and also assigns an expected reward in terms of what he hopes to gain. The reward is divided with the risk. This is subjective in itself but it throws up a ratio that helps with allocation decisions.

First of all, the reward should exceed the risk - the ratio should be greater than 1. If two investments have equally high positive ratios, go for the one with the lower risk. If two investments have different positive ratios, go for the one with the higher positive ratio, unless the risk involved exceeds your personal appetite.

In India, low-risk debt - government debt and guaranteed bank deposits - has offered consistently negative returns when inflation is high. So, the ratio is negative though the chance of losing principal is near-zero.

When it comes to high-yield debt, the returns can be high but limited. The risk is very high. If the debtor refuses to pay, the creditor could lose anything up to 100 per cent. The risk-reward ratio is lower than 1.

If India had a secondary bond market in corporate debt, the risks would be lower as the investor could get rid of debt holdings, even at a loss. However, India doesn't have one and is unlikely to develop one quickly.

If you are risk-averse, your only option as an individual is to invest in bank deposits and, perhaps, in debt funds dealing in government securities. Neither will give returns that consistently beat consumer inflation.

Even if you are comfortable dealing with higher risks, the asset allocations are skewed. Whatever proportion of your portfolio is allocated to debt is either guaranteed to under-perform or is just about as risky as equity. The extra risks for equity are balanced off because, unlike debt, equity can be sold in the secondary market to exit a bad investment.

There are specific circumstances when one would invest in debt. One is if interest rates are falling and likely to fall for a long cycle. Another is when equity is highly over-valued. Right now, interest rates look set to rise while equity looks over-valued!

This means you will make somewhat negative returns from "safe" debt but there is a risk of losing principal if you are invested in equity. Short-term fixed maturity plans could be the best option if you want debt in your portfolio and you are willing to take some risks in the hope of profits.