Investing successfully involves looking into the future and not taking decisions based on the recent past. No one ever made money by analyzing the recent past.
A successful investment portfolio should factor a reasonable prognosis of what may happen in the future. History may not repeat, but it always rhymes. History tells us that the only constant is change. We must embrace this by looking beyond what may have worked for us so far, and look ahead to something different! Here is an important note on changes that you should make to your debt portfolio to enjoy the success you have had during the recent past:
The debt investment strategy that worked well during the last three years may not work for the next three years. There are three things that influence returns in debt products. (1) Bond yields (2) Rating upgrades and downgrades and (3) The interest rate that the bonds pay (interest accrual).
During the last three years of a falling economy, we needed to protect from rating downgrades and rely entirely on increase in bond prices due to falling interest rates. A falling economy is always met by falling interest rates and earnings downgrades. We saw this during the last three years. We invested what was earmarked for debt allocation mostly in funds that invest in stable Govt securities. These investments enabled us to take full advantage of falling rates & protect against failure of payment obligations. We also did not have the benefit of earning from rating upgrades because all our investments were in the safest grade anyways. This strategy saw you earn good returns. The problem going forward is that interest rates are unlikely to fall further. They are actually likely to go up once the focus of central banks shift from growth to inflation control.
We now need to shift to a strategy that does not rely entirely on falling rates but relies on interest accrual & rating upgrades. In the next three years interest rates may rise.
As growth comes back there is likely to be more upgrades than downgrades. The next few quarters will see the benefits of an accommodative monetary policy and govt policy that focuses on growth rather than macro numbers and inflation. Our system has been flushed with cash to start a new debt cycle. All this will result in a good economic spurt for the next 18 to 24 months. In all likelihood, this period will be known for higher upgrades and fewer downgrades amongst borrowers.
An important factor to understand is that currently we have a large premium that slightly lower rated securities are offering. We were recently going through some details on bonds available in the market: while AAA rated companies and banks were offering 5%, a stable AA+ company had to raise money at 9%. So, while we cannot earn money because of a pause in falling rates, here is an opportunity to earn returns from a market scenario that offers unprecedented risk premium. Taking good calculated risks can earn you food returns.
In the next three years we should be able to earn money from funds that focus on interest accrual and rating upgrades. At the same time, the funds that we hold currently and that have earned handsome returns, are likely to under-perform.