Time to buy good businesses

For the short term, gold or gold ETFs would be good options

The failure of the Infrastructure Leasing & Financial Services (IL&FS) rights issue could mean an escalation of problems for the financial sector. The rights issue could have acted as a sort of backstop although the defaulting non-banking financial company (NBFC) would need a great deal more than the ~45 billion (bn) that the issue was supposed to raise.

The group has debt of about ~910 bn on the books — it’s hard to tell due to the number of subsidiaries. It is also owed about ~160 bn by the government, according to news sources. And, by end of Q1 (June 2018), the best guess is that it had short-term debt of about ~165 bn. If it cannot pay back the short-term debt, there will be cascading defaults. There's already been a run on the liquid mutual fund segment as a direct result of the IL&FS situation. Other NBFCs have seen yields go through the roof.

There are now rumours that the new Board will seek a government bailout on the basis that IL&FS is too big to fail. This could for example, be designed to give the bond market liquidity, by buying up IL&FS debt, at substantial discounts. Assuming the group eventually stabilises, perhaps deleveraging through asset sales, the government might even end up with a profit if that debt is eventually redeemed.

This may or may not happen. However, it's time for the comparisons we have all made to the Satyam rescue to be junked. Satyam was an IT company. If Satyam had gone into bankruptcy, there would have substantial damage in the form of job losses, shareholder losses, etc. But there would have been no contagion, of the sort that could occur with IL&FS.

Big financial sector bankruptcies spread the pain around in a way that doesn't happen with other industries. The shocking speed at which a toprated NBFC turned into a defaulter will also mean hard questions that need to be answered by rating agencies. There is now a lack of faith in even top-rated corporates.

So, yields are likely to stay elevated in the bond market unless the Reserve Bank of India (RBI) starts a full-on Quantitative Easing programme, which carries different risks, probably of even higher magnitude. High bond yields, or a frozen bond market, will hurt other corporates as well. Don't forget that under the new policy, all corporates are supposed to raise a chunk of new debt for capital expenditures from the bond markets.

Meanwhile, the crisis very likely continues in the banking sector. We won’t know for sure about this, until the big PSU banks declare results but its odds-on that NPAs remain elevated. The RBI's calculations have consistently underestimated the NPA situation but even those suggest that NPAs will not have peaked yet. Corporate results so far suggest that debt-servicing has not improved significantly. The IBC process has got bogged down in delays, and the haircuts so far have been large.

Another point to be noted is that, if Life Insurance Corporation of India, State Bank of India etc, are forced to bail out IL&Fs by throwing good money after bad, it means they will also be diverting resources away from other assets. In other words, the arms of two large domestic institutions will not be in a position to support the equity market with the same enthusiasm that they have shown in the past. That could mean further bearishness across already bearish stock markets.

So what we’re looking at, is a liquidity squeeze that hits bond markets, coupled to a credit squeeze that affects all corporates, and, very likely, a cutback in domestic institutional allocations to equity. Foreign Portfolio Investors are unlikely to play rescuer, given the current geopolitical situation.

This set of unpleasant coincidences could therefore, be the trigger for a further bout of extended bearishness. Is that a buying opportunity? It may be, but the market will probably not stabilise until the next government, whatever sort of formation that may be, takes charge at the Centre.

The next six to nine months would be an excellent time to identify decent businesses, which will become available at good valuations. But if prices fall over a long period, the committed investor must be prepared to buy more at lower levels, to average acquisition costs down. If you're looking for a flight to safety out of debt funds, the best short-term option could be gold, or gold exchange-traded funds.