At the start of the current financial year, Credit Risk funds witnessed limited investor appetite owing to sharp risk aversion with the onset of Covid19. In the ensuing period, the high YTMs (Yield to Maturity) on offer at the time were of little significance to investors who tended to prefer the perceived safety of AAA oriented funds. However, post a sharp rally in rates, the relatively higher YTMs offered by Credit Risk funds has started to attract investor interest, albeit gradually.
Headline YTMs amplified by ‘High Yield’ securities
While headline portfolio YTMs of Credit Risk Funds do indeed offer a relatively higher spread today over AAA oriented funds, one must dig deeper to understand its constituents. An in-depth security-wise analysis of the Credit Risk fund category shows that a significant part of the excess portfolio YTM is contributed by a small portion of High Yielding securities.
First, the chart below shows the distribution of securities in Credit Risk Funds across various yield buckets (data as on 31st December 2020).
Next, we undertook a sensitivity analysis of the Credit Risk Fund category by eliminating a portion of the highest yielding securities. The chart below highlights the disproportionate impact the higher yielding securities have on overall YTM.
In many ways, the credit market has witnessed a sharp divergence in performance between the Haves and Have-nots. Wherein, the acceptable corporate borrowers belonging to strong promoter groups/ resilient sectors have witnessed sharp spread compression while the bonds of perceivably weak corporates have continued to languish owing to issues such as weak perception of corporate governance/ sectoral issues etc. As a result, this latter category has limited access to the Mutual Fund market today and also happens to constitute the bulk of the ‘High Yield’ (defined as securities with yield greater than 9%) category. It is instructive to note that less than 5% of today’s ‘High Yield’ issuers have managed to raise fresh bonds via primary market from Mutual Funds in the current financial year! This is probably indicative of weak investor appetite to take incremental exposure or inability of the borrower to raise money at a competitive rate or both.
To clarify, we are not suggesting that all ‘High Yield’ securities suffer from a weak credit profile. Instead, the purpose of the analysis is to merely highlight the limited incremental market appetite for such securities and their disproportionate contribution in driving excess portfolio YTM (classic case of tail wagging the dog!). In fact, future headline portfolio YTMs can easily get diluted (lower) if/when these ‘High Yield’ securities mature or schemes get significant inflows without commensurate replacement/fresh purchase.
Aggregate credit spreads are also equally misleading
It is for this very reason that one also needs to guard against interpreting credit spread data at an aggregate level. While aggregate AA category (AA-, AA & AA+) spreads may be at near term highs, this could again be owing to disproportionate contribution of ‘High Yield’ securities in these buckets, as seen in the chart above. Adjusted for these ‘High Yield’ securities, AA or lower rated spreads may not be as attractive in the context of the current environment.
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