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Investment Insights

Arvind Subramanian

In the aftermath of the IL&FS default in September’18, we have witnessed a steady rise in credit spreads. To recap, the first round of spread expansion was observed in the more liquid AA bonds owing to better price discovery (refer to the previous note Qu’AAA’lity, Qu’AA’lity or Qu’A’lity? – An Update on Credit Markets). This has now been finally followed by an expansion of spreads (albeit slowly) in the lower rated/ illiquid segments. Does this spread expansion provide investors with an attractive entry point into credit-oriented funds?

 

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Spread expansion in lower rated bonds is perhaps overstated
 
A deeper analysis of the recent round of spread expansion in the lower rated space throws up some interesting observations. Firstly, a large part of this expansion has been driven by sharp downgrades witnessed by a few NBFC/HFCs from AAA/AA+ to A. Such sharp rating downgrades could perhaps overstate the actual expansion of spreads. Secondly, the stress witnessed in the Loan-Against-Shares (LAS) segment has also been a contributor to this expansion. Adjusted for these two segments, we notice that the effective spreads in the ‘A category’[1] is only 3.09% (as against 3.77%), almost 70 bps lower!

 

Further, the spread expansion in the ‘A category’ could be viewed as nothing more than a catch-up post the artificial compression witnessed in December 2018. This is clearly visible in the chart below, where we notice that spread between A and AA rated bonds have only normalised to levels last witnessed a year back. Keep in mind, the credit environment last year was far more benign as compared to today. Hence, one would have to expect a further expansion in ‘A category’ spreads reflective of the current environment.

 

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Outflows from Credit oriented funds continue
 

As we have highlighted in the past, a key determinant for credit spreads is the pace of flows into credit oriented funds[2]. Post the IL&FS default in September 2018, the trend of outflows continue unabated as can be seen in the chart below.

 

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In addition, several Credit Oriented FMPs totalling Rs. ~9,000 Cr are due for redemption this financial year which in a way can be construed as further redemption from the credit category. Hence, the total outflow from both open ended and close ended credit schemes is sizeable.
 
In this backdrop of redemptions, we notice that some schemes are also getting increasingly concentrated towards lower rated assets. In fact, as of March 2019, a total AUM of over Rs. 20,000 Cr (across ~25 open ended schemes) have concentrated exposures of greater than 10% to a single issuer rated A+ or below. The chart below highlights the total AUM of open ended schemes with relatively higher proportion of lower rated asset (A+ and below).

 

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2 Universe of credit oriented funds is as per Crisil classification of “Credit Opportunities Fund” prior to March 2018
 
It is noteworthy that higher exposure to lower rated assets is not limited to Credit Risk funds alone. As we can see in the chart above, schemes outside the Credit Risk category also have outsized exposures to lower rated assets.

 

What now?
 
It may be premature to view the recent expansion in spreads as an investment opportunity. The credit market is still grappling with concerns around redemptions and concentration risks coupled with sharp deterioration in perception of certain companies. Further, the recent expansion in low rated spreads may be nothing more than delayed harmonisation of artificially compressed spreads witnessed in the past.

 

In our view, it is vital for some of the above risks to show signs of abating before investors revisit this category. Needless to say, once the opportunity were to present itself, it is essential for investors to participate via relatively liquid/tradable bonds in the AA category rather than the lower rated category (rated A and below). Recent experience suggests that Mutual Funds may not necessarily be the appropriate vehicle for low rated/complex structures given its inherent illiquidity and high risk.

 

Key Takeaways

 

• In the aftermath of the IL&FS default in September’18, we have witnessed a steady rise in credit spreads. This spread expansion is now visible even in the lower rated/illiquid bond space.
 
• However, the recent spread expansion in lower rated/ illiquid bonds could perhaps be overstated. This is because, two stressed segments namely weak NBFC/ HFCs and LAS have contributed significantly to this expansion. Adjusted for these two segments, the spread expansion is not so stark.
 
• Further, this spread expansion in lower rated bonds may be nothing more than delayed harmonisation of artificially compressed spreads witnessed in the past.
 
• The sustained outflows from credit oriented funds continue to have a bearing on spreads. In addition, several Credit Oriented FMPs totalling Rs. ~9,000 Cr are due for redemption this financial year which in a way can be construed as further redemption from the credit category.
 
• The credit market is still grappling with concerns around redemptions and concentration risks coupled with sharp deterioration in perception of certain companies. It is vital for some of the above risks to show signs of abating before investors revisit this category.
 

Disclaimer:
 

MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 

The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the security may or may not continue to form part of the scheme’s portfolio in future.  Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. The decision of the Investment Manager may not always be profitable; as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. Neither IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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Arvind Subramanian

Liquidity in Credit Markets..

By: Arvind Subramanian

As we have highlighted in our recent notes, price discovery in credit markets involve two key aspects. The first aspect is the movement of bond yields in sync with the broader market. This, we believe, is captured reasonably well since all securities are continually valued relative to a liquid benchmark and are accordingly marked up/down, thus capturing daily movement in market rates. The second aspect, namely credit spreads, is the movement in bond yields due to relative strengthening/weakening of underlying credit profile of the issuer. This is seldom captured dynamically due to inherent illiquidity in credit markets.
 

In this note, we aim to provide an assessment on liquidity by analysing the frequency of bonds trading in the credit market. This is important because sufficient liquidity or lack of it has a bearing on price discovery of credits which in turn determines the accuracy of the daily NAV of a fund. To quantify this, we measure the number of days since last trade of any bond of each company. Higher the number of days since last trade means the bond is relatively more illiquid than one which has traded in the recent past. For the purpose of our analysis, we bucket these into the following time periods- 1 week, 1 month, 3 month, 6 month and Over 6 months. Subsequently, we map individual companies in the credit market to these buckets basis frequency of their trading.

 

Liquidity in credit markets is relatively thin; ‘Mid Yield’ exhibits better liquidity than ‘High Yield’
The relative illiquidity in credit markets is apparent in the chart below which shows the distribution of securities across the various liquidity buckets. For this analysis, we have bifurcated securities into ‘Mid Yield’ and ‘High Yield’ .
 
1‘Mid Yield’ refers to securities in the YTM range of 7.5% to 9.5%. Such securities predominantly belong to the AA- to AA+ rating category.
2‘High Yield’ refers to securities with a YTM higher than 9.5%. Such securities predominantly belong to the AA- and below rating category. YTM for securities is as on 30th June 2017.
 
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As seen above, only a small percentage of securities trade frequently, evident from the lower distribution of companies in the shorter tenure buckets (‘1 week’ and ‘1 month’). In the case of ‘High Yield’ segment, the illiquidity is stark with a majority of companies belonging to the ‘Over 6 month’ liquidity bucket. Overall, it is visible that liquidity is relatively thin in the credit market, within which the ‘Mid Yield’ segment exhibits comparatively better liquidity than the ‘High Yield’ segment.

 

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We apply the same metric to IDFC Credit Opportunities Fund (IDFC COF). In contrast to the broader credit market and even the overall ‘Mid Yield’ segment, the liquidity profile of IDFC COF is visibly superior. As seen above, a significant majority of companies held by the fund trade frequently (higher distribution in the ‘1 week’ and ‘1 month’ buckets).

 

To recap, we believe that investors benefit from investing in funds wherein the underlying securities are reasonably liquid. This ensures better price discovery for such securities and thereby improves the accuracy of the daily NAV, thus providing a fair entry/exit for investors.

 
Data comprises over 300 companies held by the credit fund industry belonging to the ‘Mid Yield’ and ‘High Yield’ segment. For the purpose of this analysis, we have considered trade data from Corporate Bond Reporting and Integrated Clearing System (CBRICS). Inter-scheme trades have been excluded. CBRICS is not necessarily exhaustive, but is reasonably representative of primary/secondary market trades. Subsequently, last trade date/primary issuance of any security by an issuer is considered. YTM for securities is as on 30th June 2017.

 
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Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the stocks may or may not continue to form part of the scheme’s portfolio in future. The decision of the Investment Manager may not always be profitable; as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. Neither IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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