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Arvind Subramanian & Khushboo Sharma

Qu’AAA’lity, Qu’AA’lity or Qu’A’lity? – An Update on Credit Markets

 

The credit default/sharp downgrades faced by IL&FS & its group entities have had a knock-on effect on the credit markets in recent months, thereby resulting in heightened investor concerns regarding select issuers and sectors. This concern and fear among investors has manifested itself in the form of increased redemptions in the credit fund category, clearly denoting flight to quality.

This leads us to the question – Is there value in credit fund category today? While value is starting to emerge in select segments of the credit markets, we still believe it may not be an opportune time to enter the segment.

 

Spreads – The Guiding Light
 
As highlighted in our note (Value Investing - The AAA Way Part 2), spreads of AA rated bonds (over AAA) witnessed massive compression in FY18, thus signaling a better risk-reward trade-off in the AAA rated bonds. However, this trend has started to reverse for AA rated bonds. Over the last few months, in order to fund redemptions, credit-oriented funds have had to resort to selling some of their relatively better rated bonds (primarily AA and above rated bonds). This selling pressure, in an otherwise illiquid market has thereby led to widening of spreads in AA rated bonds.

On the other hand, ‘A category’[1] bonds continue to be sparsely traded, thereby not transmitting the full extent of stress witnessed in the credit markets. This has resulted in continued spread compression for ‘A category’ bonds. This divergence is especially bewildering given the overall risk aversion amongst market participants and general tightening of financial conditions.

 

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Price Discovery – Mirror on the Wall
 
The true valuation of any security can be ascertained from its traded value. Securities which don’t get traded in the market can continue to be at unrealistic valuations. The same can clearly be seen in the tables below. As can be seen from a sample of trade data, Credit bonds (AA category and below) which have traded over the last few months have witnessed a yield increase of over 100 basis points (reflective of stress in the credit market), whereas the non-traded bonds’ yields have moved up only by 30 basis points. In our view, this divergence in spread can be attributed primarily to illiquidity and not necessarily any change in credit profile.
 
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This, then, brings us to the rating split of bonds that have been traded (primary or secondary) recently. The credit-risk and credit-oriented funds[2] invest primarily in securities in AA category and below. Analysis of trades[3] since 1st Sep, 2018 clearly contrasts the illiquidity in lower rated (‘A category’ and below) bonds as compared to better rated bonds (AA category and above). As can be seen from the graph, over 60% of the AA category issuers in the underlying universe have witnessed a trade in their bonds since September 1st, whereas only 23% of ‘A category’ issuers therein witnessed a trade in the same period. This clearly points towards better liquidity & price discovery in AA bucket, relative to its lower rated peers. Needless to say, AAA rated bonds have seen near 100% trades.
 

2 Universe of credit oriented funds is as per Crisil classification of “Credit Opportunities Fund” prior to March 2018
3 Source for trade data is from Corporate Bond Reporting and Integrated Clearing System (CBRICS). Inter-scheme trades and trades below Rs. 5 crores have been excluded. An issuer is considered as “traded” if any one of its securities has witnessed a trade since 1st September 2018.  CBRICS is not necessarily exhaustive, but is reasonably representative of primary/secondary market trades.

 
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(Source: CBRICS, ICRA MFI Explorer)

 

Another interesting takeaway from the above graph is the sparse trading witnessed in the AAA(SO) segment, in spite of its high credit rating. These bonds provide an illusion of higher safety but suffer from similar illiquidity and price discovery as witnessed in lower rated bonds.
 
Relook at Credit Funds?
 
From a macro perspective, financial conditions have tightened and will only get further accentuated with the recent wobble in NBFC / HFCs. The resulting slowdown in aggregate lending could adversely impact overall growth and therefore is negative for credit markets. From a flow perspective, recent redemptions witnessed in credit-oriented funds have been sizeable and was last witnessed only in December, 2015. If such level of redemptions were to continue, they can have serious ramifications for spreads across the credit curve. Moreover, a lot of the lower rated issuers may face refinancing risk in a tightening liquidity scenario (see Annexure 1).
 
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(Source: ICRA MFI Explorer)

 

Key Takeaways
 

  • Spreads in AA rated bonds have started to recover. However, this has not been the case for ‘A category’ bonds due to lack of liquidity. As a result, spreads between A and AA bonds have fallen from over 2% to almost 1%.
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  • Limited trading in ‘A category’ and below bonds results in limited price discovery relative to the rest of the market. As a result, bond valuations do not fully capture stress in credit markets and therefore lead to illusion of better performance in an otherwise weakening market.
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  • Better liquidity and price discovery in AA category relative to lower rated credits provide a better risk-reward trade-off for investors.
  •  

  • Overall tightening of financial conditions is negative for the credit markets. This, coupled with adverse fund flows into credit oriented funds calls for caution from investors’ stand-point.
  •  
    Annexure 1: Large upcoming LAS (Loan Against Shares) maturities
     
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    Source- ICRA MFI Explorer

     
    A segment of the market which heavily relies on refinancing is loan against shares (LAS), given the absence of significant operating cash-flows at the issuer level.  Over the last few years, LAS structures have gained prominence given their higher yields amidst the strong flows in credit oriented funds. The next few quarters could witness sizeable bunching up of maturities as seen in the chart above. This wall of maturities could be a source of credit risk for the weaker/lower rated issuers in light of slowing flows into credit oriented funds and decelerated pace of growth in NBFC credit.

     

    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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    Arvind Subramanian & Khushboo Sharma

    Liquidity in Credit Markets – Update..

    By: Arvind Subramanian & Khushboo Sharma

    Slowing flows into Credit oriented funds
     
    It is well known that lower rated credits have low/negligible liquidity in the bond market. This has been further exacerbated in recent months wherein debt markets have seen deteriorating liquidity for even AAA rated corporates. Nevertheless, illiquidity concerns in the lower rated credit space have seldom been at the forefront for credit fund investors due to the near secular inflows into the category. As a result, many perceive these bonds as “Held to Maturity” without needing to worry about associated liquidity to fund redemptions/ price discovery.
     
    However, this illusion of utopia, despite relative illiquidity in the credit markets could be set to change with slowing flows into credit oriented funds[1]. The chart below highlights the sharp reduction in flows to credit oriented funds in recent months after several prior months of strong growth. In fact, in May 2018, net monthly flows into credit oriented funds were at its lowest since February 2016.

     
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    (Source: CBRICS, ICRA MFI Explorer)

     
    Time to refocus on liquidity in credit markets
     
    We have always believed that liquidity plays an important role even in the credit markets as discussed in our earlier note (Liquidity in Credit Markets, 07 July 2017). To recap, we had highlighted the significance of liquidity not just in helping meet redemptions, but more importantly in price discovery of securities. Price discovery ensures better accuracy in daily NAV of funds, thus providing a fair entry/exit for investors.
     
    In light of slowing flows towards credit oriented funds, we have refreshed our analysis on portfolio liquidity across various segments in the credit market as seen below. Here, we calculate theLiquidityScore – defined as the percentage of issuers in a fund’s AUM, whose bonds/debentures have witnessed a trade[2]at least once since 1st April 2018, for each fund in the category. Higher the LiquidityScore better is the presumed liquidity in a fund and vice-versa.
     
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    In the above chart, a AAA oriented fund like IDFC Corporate Bond Fund has a LiquidityScore of 100% (rounded off to nearest whole number) which means its portfolio consists almost entirely of issuers whose securities have witnessed a trade in the market at least once in the past three months. In the case of IDFC Credit Risk Fund, 87% of the fund’s underlying issuers have had their respective securities traded at least once in the past three months. As seen in the chart above, the LiquidityScore of IDFC Credit Risk Fund is superior to peer funds in the credit category. Moreover, LiquidityScore tends to wane as the portfolio skew increases towards lower rated credit papers (“High Yield” funds have the lowest LiquidityScore).
     

    In this context, it is important to note that credit spreads have, in fact, benefitted from this shallow liquidity amidst the sharp sell-off in AAA bonds witnessed over the last few months (highlighted in our note, Value Investing - The AAA Way Part 1 & 2). Consequently, higher yielding funds with low underlying liquidity have outperformed the broader market, benefitting from this anomaly. However, this could be transient in case flows towards credit oriented funds were to continue to trend lower or even turn negative for a sustained period of time. In such a scenario, lower rated securities having weaker liquidity will possibly see a sharper re-pricing (widening of credit spreads), thereby reversing this recent outperformance.
     
    Further, we reiterate our view 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.

     

    Disclaimer:
     
    MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
     
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    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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    Arvind Subramanian & Khushboo Sharma

    A Zebra with no Stripes..

    By: Arvind Subramanian & Khushboo Sharma

    The credit fund industry has witnessed phenomenal growth, as can be seen from 45% growth (CAGR) over last 5 years taking their cumulative AUM to over 1 lakh crore. This growth has, however, been accompanied by an expectation that there won’t be any NPAs in the credit funds. In the past, any adverse credit events faced by the industry have been downplayed as “accidents” or “one-offs”. To refute this fallacy, we compare and contrast the credit fund industry with the banking sector. The following graph compares the cumulative size of the credit fund industry alongside the size of corporate loan books of some of the largest private sector banks.
     

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    Put another way, if the credit fund industry were to be considered as a bank, it would be the fourth largest private bank in terms of asset size. Here, we only consider the corporate loan book for the banks since the credit fund industry is itself predominantly invested in corporate bonds. Since all banks don’t disclose asset quality parameters separately for corporate loan book, we have taken gross NPA as % of total advances as a proxy. In our view, the corporate loan book has a larger representation in banks’ NPA.
     

    Can credit funds be any different?

    As can be seen from the graph above, some of the largest, well-run private sector banks also have NPAs on their asset book. We seldom hear banks referring to NPAs as “accidents” since NPA formation are a routine phenomenon and are part of the business of taking credit risk. Keep in mind, our above analysis does not even consider other stressed assets held by banks such as restructured loans, SDR, 5:25 etc. Therefore, the question arises whether it is sustainable for credit funds to continue growing with nil NPAs, while a certain level of credit costs (losses owing to NPAs) is considered to be routine business by banks. At such a large scale, the credit funds may no longer be immune to risk of NPAs and isolated incidents can no longer be referred to as “one offs”. Moreover, the sheer scale and pace of incremental flows in credit funds has left lesser room for cherry-picking of assets.
     
    The inevitable risk of NPAs in the credit fund industry, thus, calls for incorporating the possible impact cost of credit events in the selection of credit funds. The impact cost of such events can manifest itself in a fund’s return in two ways – the first being the valuation impact on the bond that has been downgraded by multiple notches and secondly, the investor panic that may cause a run for liquidity, thereby forcing fire sale of the unaffected securities. Both the abovementioned factors can contribute to a sharp drop in NAV, thereby creating a vicious circle of falling NAVs and redemptions.
     

    Conclusion

    Having established the parallels of credit fund industry with banks, we would like to point out, in our view,two major fallacies in the perception with respect to credit funds.
     

    a) Size of credit teams being a sufficient condition for ensuring zero NPAs in credit funds

     
    Despite the large and experienced credit teams, the largest banks have not been able to avoid credit costs. While large credit teams may be able to skew the probability of default towards a favourable outcome, large team size is not a sufficient criterion to ensure zero credit costs in the credit funds with the increasing size and complexity of the investable universe. Therefore, a certain level of credit costs should be assumed in the expected return of credit funds. However, the magnitude of credit costs will vary across funds and can be estimated from the investment philosophy and credit quality of the underlying portfolio.
     
    b) YTM – a proxy for returns in case of credit funds

     

    As we have seen in the banking sector, different banks exhibit different levels of asset quality which could be a function of various factors such as underwriting strength, risk appetite etc. Similarly, credit costs will not be evenly distributed across the credit fund industry and investor level selection of funds attains added significance. The weaker the credit quality of a portfolio (consequently higher YTMs), higher is the chance of credit costs adversely impacting its returns, thereby busting the myth of YTM being a proxy of expected return.
     

    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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    Arvind Subramanian & Khushboo Sharma

    Assessing Credit Funds..

    By: Arvind Subramanian & Khushboo Sharma

    With the rapid growth in credit funds and a plethora of options available to an investor within the category, it is important to understand the parameters on which these funds should be differentiated. Unfortunately, Yield to Maturity (YTM) has become the principal metric by which credit funds are measured. It is commonly believed that higher the YTM, better the expected return and hence, better the fund. As we will see over the course of this note; this metric of YTM, while convenient, is seldom an accurate measure for actual returns.

     

    Portfolio YTM is a poor proxy for predicting future returns

     

    YTMs of credit funds should theoretically reflect both the change in funds’ underlying credit profile and the broader movement in market rates. However, as we highlighted in our earlier note (refer ‘A Rose By Another Name: Credit and Duration’, 11th May 2017), the strengthening/weakening of underlying credit profile is not always reflected dynamically in the yields owing to the inherent illiquidity in credit markets. Nevertheless, the credit funds’ returns do in fact move in reasonable sync with the broader market. Even though credits are not actively traded in the market, they are valued relative to a liquid benchmark and are accordingly marked up/down, thus capturing daily movement in market rates. This is best illustrated by comparing the return profile of a ‘AAA’ oriented fund versus that of a ‘Mid Yield[1]’ and ‘High Yield[2]’ credit fund over the course of the past year.

     

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    Keep in mind that interest rates have been reasonably volatile over the past year and as we can see in the chart above, all three funds have exhibited similar volatility in sync with overall movement in interest rates. In this context, it is rather unfortunate that credit funds continue to be marketed as ‘accrual’ especially since their return profile is not immune to vagaries of the market as is the case with traditional fixed income funds. Here, it is useful to remind investors that the returns of any fund, credit or otherwise, is derived from the following equation:

     

    Total return of a fund = Coupon ± Mark to Market gain/loss – Expense Ratio

     
    Unfortunately, when it comes to assessing credit funds, investors tend to ignore other variables attributable to fund returns and only instead choose to focus on the headline YTM published by a fund.

     

    We have so far established that credit yields are not necessarily static and instead generally mirror the rate movement in the broader market. It is evident from the analysis above that a credit fund would have generated returns, higher than its own running yield, over the past one year via 1) higher average maturity (since overall market yields fell during the course of the year); 2) individual credit selection within the ‘Mid Yield’ or ‘High Yield’ which have outperformed the broader market; and 3) higher/lower allocation to sectors which have outperformed/underperformed. A combination of a few or all of the above would have helped generate returns which are higher than the net YTM of the fund itself. Just as is the case with traditional short term/income funds, credit fund returns are not just a function of portfolio YTM but also a function of maturity profile of the fund and individual security selection.

     

    It is also indeed ironical that investors keep chasing funds with higher YTM. This is because, for a static portfolio, if YTM of the fund keeps increasing month over month, the actual returns to a customer would be lower than the running yield of the fund. In contrast, if a fund’s YTM keeps declining (assuming a static portfolio); it only means that investors will be rewarded with returns higher than the running yield of the fund. However, this aspect gets ignored in the market’s continual search for higher yielding funds. What ultimately should matter to investors are actual returns and as seen above, running yield is not necessarily the best indicator for portfolio performance.

     

    Illusion of stable NAV is detrimental for investors

     

    We have so far demonstrated how credit yields move reasonably in sync with overall movement in interest rates. However, seldom do we see individual credits getting re-priced beyond broader market movement, to reflect their own change in credit fundamentals. History has shown us that sharp movements in yields reflecting a company’s changing credit profile generally occurs only post revision in a firm’s credit rating rather than active price discovery, given the inherent illiquidity in the credit market. This in turn gives the illusion of a stable NAV and therefore the perception of predictable returns. However, it is important to remember that this illusion of a stable NAV is detrimental to investors, especially new investors into a fund who might be assigned a NAV which does not truly represent the price of underlying securities.

     

    In the past, we have witnessed instances of sudden drops in NAVs of funds in the event of sharp downgrades of credit ratings of some bonds. An analogy to illustrate this point would be crossing a river with an average depth of 4 feet. This would give the river crosser an illusion of safety and stability. However, it may happen that the average hides volatility; so at the centre of the river its depth is actually 10 feet and at the banks of the river the depth is only 2 feet. Hence, a person crossing the river assuming stable depth would actually run the risk of drowning at the 10 feet depth (in our instance a credit event or a sudden sharp credit downgrade).
     

    A case for active management in Credits within the ‘Mid Yield’ segment

     

    Just as is the case with traditional short term/income funds, we have seen earlier how credit markets offer sufficient opportunity for funds to generate higher returns than their portfolio YTM via active management. However, this will remain academic unless supported by sufficient market liquidity, the lack of which can severely restrict the ability of market participants to execute views. Unfortunately, most parts of the credit market remain reasonably illiquid with small volumes traded on a daily basis. This is particularly true for the ‘High Yield’ segment which suffers from acute illiquidity. In contrast, credits in the ‘Mid Yield’ segment offer reasonably better liquidity thus allowing for some amount of active management.

     

    Given the ability to actively manage credit funds, especially in the ‘Mid Yield’ category due to relatively better liquidity and price discovery, it is possible to generate surplus returns over portfolio running yield.

     

    Summary

     

    We have in the past made a case for segmenting risk while investing in credit funds. The purpose of this note is to urge investors to reassess their framework for assessing performance of credit funds rather than recklessly chasing funds with the highest running yields. As we have seen above, portfolio YTM while a very convenient indicator for future fund performance is seldom accurate since it ignores both credit risk and market risk. Instead, there is a clear case for investors to look at other aspects of a fund such as the average maturity, rating profile and credit quality of portfolio. As investors have always differentiated between long duration and short-term funds in duration funds or between large-cap, mid-cap or micro-cap funds in equity funds, credit funds should also be differentiated.

     

    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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