In recent times, discussions regarding Credit Risk funds often veer towards speculating which company will default next and when! This is fallout of a spate of defaults/sharp downgrades that we have witnessed ever since the IL&FS default in September 2018. However, in our view, such speculation is potentially foolhardy and seldom leads to actionable investment decisions.
In this note, we provide an alternative approach for investors to assess credit risk in a portfolio via assessing Yield-to-Maturity (YTMs) of individual securities. In our study below, we analysed the defaults/downgrade to sub-investment grade of each company over the last one year and then plotted their prevailing YTMs of their respective securities[1] prior to the eventual default/downgrade to sub-investment grade. The results are plotted below:
(Source: ICRA MFI Explorer, ICRA/CRISIL Bond Valuation, IDFC MF Estimates)
[1] For each issuer, we calculated the average YTMs of all their outstanding securities as on the respective dates. The YTMs for each security are provided on a daily basis by ICRA and Crisil.
It is evident from the table above, that in almost all the cases, the YTMs of the issuer were high and were on an increasing trend up until the eventual default/downgrade to sub-investment grade. In our view, the efficacy of using YTMs as a signalling tool for distress is gradually starting to improve. This could be owing to increasing instances of trades in the distressed credit space coupled with a more structured (albeit improving) polling mechanism which has helped improve yield discovery to some extent. As a result, we believe it is time for investors to move beyond just looking at credit ratings and also start looking at YTMs of individual securities in a portfolio.
It may be remembered that in our last note (refer to the previous note Mirage of High YTMs); we had highlighted the increasing exposure of the Credit Risk category to ‘High Yield’ bonds (bonds which have YTM of greater than 12%). We had argued that it is this segment of ‘High Yield’ bonds which could prove to be the potential source of emerging credit stress. The above analysis only strengthens this argument. In this context, it is important to note that the total quantum of ‘High Yield’ bonds held across Credit Risk funds remains large at ~Rs. 7,900 Cr which accounts for 13% of the overall category AUM (data as of 31st December 2019).
(Source: ICRA MFI Explorer, ICRA/CRISIL Bond Valuation, IDFC MF Estimates)
Conclusion
Predicting the next default or its timing will always remain a foolhardy exercise. However, investors would do well to try and pre-empt this by closely watching YTMs of individual securities in a portfolio. Pre-empting risk is especially useful in fixed income investing given the limited upside and significant downsides associated with the asset class.
Limitations of the YTM based study
The concern with interpreting such data is the common pushback that liquidity in fixed income markets, especially for lower rated credits, is fairly limited. This observation is reasonably valid and hence YTMs may not always be a perfect indicator of emerging stress. Further, it is not always true that all bonds displaying a high YTM may necessarily be under stress. Given the limitations, we only suggest that investors use YTMs as an additional input into their assessment of portfolio risk along with other indicators such as credit rating etc.
Disclaimer:
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