By: 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?
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’ 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.
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. Post the IL&FS default in September 2018, the trend of outflows continue unabated as can be seen in the chart below.
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).
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.
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.
• 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.
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