Skip to main content
Scripbox Logo

A lesson in risk – The Yes Bank Crisis

Risk shows up infrequently, but it is high impact. This is why one must always be aware. In the current set of events, it’s the risk attached to bond investing which has had a greater impact than equity investing. Understanding both the risk of bond investing i.e., credit risk and the risk in equity investing i.e., risk of quality, are important.

It seems to be the season for risk. In investing, for many months and years you only see returns and no risk. However, recently in the capital markets, we have mostly seen risk play out and a fall in growth . 

Risk shows up infrequently, but it is high impact. This is why one must always be aware. In the current set of events, it’s the risk attached to bond investing which has had a greater impact than equity investing. Understanding both the risk of bond investing i.e., credit risk and the risk in equity investing i.e., risk of quality, are important. 

What has happened?

For those who aren’t aware, last week marked the temporary takeover of a mid-sized private sector bank in India by RBI. While equity shares were trending lower for a while, the bank’s credit rating had reached default grade. At least 11 fund houses held investments in bonds issued by it with a total value of around Rs 2,800 crore (of this, a single asset manager has a holding of Rs 1800 crore) and at least 6 mutual fund houses have investment in its stock with an aggregate current value of around Rs 186 crore ( remember the stock has corrected more 70% in the last 6 months).

The Reserve Bank of India intervened and the functioning of the bank got taken over, it was no longer in control of the bank’s management. Among the other consequence, a large chunk of the bank’s debt was written off, thus, delivering nil return to those who owned this debt, including to the mutual fund schemes which had invested in it. The equity shares also crashed, but post the announcement of a bail out scheme, there seems to be some renewed energy there. 

The fact is, as of now both bond holders and shareholders have lost value. The former more than the latter. A bond write-off means you get back zero value for your principal investment. Whereas, stock price loss may or may not recover, so there is still chance there.  
 

Credit risk and quality

The fact is, as of now both bond holders and shareholders have lost value. The former more than the latter. A bond write-off means you get back zero value for your principal investment. Whereas, stock price loss may or may not recover, so there is still chance there.  

Credit risk means, which is the risk of a bond default, if it plays out then it is a permanent loss. How do you know if a security or bond has high credit risk? 

One way is to compare the interest coupon it is offering with the interest on a similar period Government security. Let’s say the bank’s long-term bond was offering around 9.5% annual interest when a 10-year Government bond was giving 6.5% annual yield. This premium earning of 3% per annum, is the return you are offered for taking the high risk. There is no way you can earn a high return without higher risk. If the risk plays out, you stand to lose not just the interest but your capital too. 

In the current case of the private sector bank, with the recent restructuring proposal of the bank, there is a section of the market which believes that the stock price can be revived and gains are in the offing. 

However, there is little doubt that the reason the stock has crashed is the poor quality of the balance sheet of this bank and mis-management over the years. Hence, by committing to buying the shares today, despite the low price and expectations going forward, you will still be buying a poor-quality stock. 

This is one of the biggest risk in equity investing, the risk of buying low quality shares. Prices may go up, but if things sour, like we saw for a brief period last week there may be no buyers for the stock even in the secondary market. If that happens, you will not be able to sell. 

If you aren’t prepared for the worst-case scenario, do not add on this high risk, be it in bonds or in shares. 

Fund risk and diversification

As a mutual fund investor, you are better off because the portfolio is diversified and the impact of one bond/share can be covered up by gains from the rest. What you need to be careful about here is that the fund itself should not have too high a proportion invested in one company’s bond/share. Moreover, make a choice of the kind of portfolio you want to be invested in, both in debt and equity – high quality or low quality.

Individual investors are better off letting advisors make this difficult choice of risk and quality on their behalf. Once committed, risk can’t be wished away and you end up paying for it with your invested capital. 

 

Our Most Popular Categories

Achieve all your financial goals with Scripbox. Start Now