By: Punam Sharma
A couple of months back we had highlighted in a note how the sharp rise in AAA bond yields over the past year or so hasn’t been accompanied with a similar rise in yields on lower rated assets. Owing to this, there has been a significant yield compression between AAA oriented short term funds and high yield funds. We had noted that this compression has been largely owing to AAA rates faithfully transmitting the interest rate rise over this period and not due to any sudden change in credit prospects of lower rate bonds. Indeed, such compressions should almost be expected in periods of large interest rate volatility given that AAA rates are more liquid and get better price discovery in the market compared with their lower rated counterparts. To that extent, the intent there was merely to point towards the quantum of spread compression that has occurred and to note that AAA oriented funds are now offering much better risk / reward compared to those in the high yield category. For further details please refer “Value Investing – The AAA Way”, dated 1st March.
The intent in this note is to explore and illustrate this same phenomenon further. It is also to ascertain action biases that may threaten to creep into allocation behavior given the context of recent historic returns, during the time when this significant spread compression was underway.
Source: ICRA/ Crisil Bond Valauation, IDFC MF Estimates
* Calculated as average of all securities maturing in the year 2020 in their respective rating category
The graph above quantifies the average spread compression that has occurred between AAA and AA across all securities of a particular short end bucket. As the graph shows, there has been an almost 40 bps compression between the two since March 2017. One aspect of this compression is that the difference in portfolio running yields of a AAA and non AAA fund is now lower, thereby making risk versus reward better for investing in AAA. The other equally important aspect also is that because of this compression, a AAA oriented fund would have under-performed a non AAA fund over this period even if the modified duration of the two funds were exactly the same. This point is demonstrated below, using the example of security performance.
Source: ICRA MFI Explorer, ICRA/Crisil Bond Valuation, IDFC MF Estimates
1. Annualized return from 1st April 2017 till 20th April 2018
2. Universe comprises underlying securities of 34 short/medium term funds having a combined AUM of 1.58 Lakh Crore as on March 2018
3. Sovereign- includes SDL and UDAY bonds
The table tracks average annualized returns for securities across maturity buckets and ratings over the last one year or so. This period captures the recent episode of extreme interest rate volatility. As can be seen from the table, AA/AA(so)/AA+(so) rated securities have posted an outperformance of between 100 – 200 bps in many cases over this period. The comparison is even starker when compared with bonds in the perpetual category, where one also includes the bank AT1 bonds. Thus some of the lower rated AT1 bonds have outperformed the equivalent AAA by between 200 – 300 bps.
Thus a fund with even a 15 – 20% allocation to a basket of such securities would have outperformed a pure AAA oriented fund by a margin wide enough to influence future allocations in its favor.
Conclusion : Objects In The Rear View Mirror
The past year has thrown exceptional volatility at the fixed income market, resulting in almost a 100 bps odd re-pricing at parts of the fixed income market. Through this period, lower rated / higher yield securities have benefitted as they are traditionally slow to transmit interest rate changes. In many cases the full change may never get transmitted at all given the opacity of that market and because flow dynamics there may from time to time be different than the larger AAA / sovereign market. The objective here has been to show that for the same underlying duration of the fund, merely the allocation effect due to mandate to buy lower rated securities (or not) would have resulted in substantial out/under performance during this period.
It is a point of fact that recent historical returns matter for future allocation by investors as well. However, in many cases over the past year the relative outperformance of a fund could merely be because of mandate driven allocation effects to various classes of securities. The question then is whether such outperformance is likely to continue in the future. It is our strong view that this is not likely to be the case. Rather, we would view this recent significant spread compression as an opportunity for investors to rebalance in favor of AAA oriented funds. Not only would this be a move towards better value, but this would also entail a much needed de-risking of fixed income books and make them somewhat more ‘counter-cyclical’ in nature.
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