Widening spread opens window for debt MFs to raise credit risk slightly

Difference in G-sec and AA corporate rises to 113 bps from 88 bps in six months

The rising differential in yields being offered by the top rated bonds and the riskier debt papers has created room for debt fund managers to generate extra returns by raising the credit risk in portfolios to a certain extent.

The yield differential (known as credit spread) has been on an upward trajectory since October 2022. The difference in yields of government bonds (g-sec) and five-year AA corporate bonds rose from 88 basis points (bps) in September 2022 to 113 bps in March 2023. During the same period, the spread between five-year AAA corporate and g-sec rose from 16 bps to 54 bps.

"Spreads are normalising after shrinking to a record low a year back. There has been a gradual expansion since then. It may still go up marginally," said Joydeep Sen, an independent debt market analyst.

When the spread is low, investment in papers other than the top rated ones is not prudent from a risk/reward perspective. However, now that the spreads have almost normalised, bonds rated below AAA are making a comeback in debt fund managers' investable universe.

"We have been increasingly investing across structured high grade assets as well as good quality high yield assets, as the pricing environment has improved, albeit as per the overall fund mandate," said Amit Tripathi, CIO-Fixed Income Investments, Nippon India Mutual Fund.

"The credit scenario has surely improved. Our funds have the mandate for some credit risk and we will buy such papers if we like the issuer and there's enough liquidity," a fund manager at another AMC said.

Apart from credit risk funds, all other debt schemes have limited room to invest in lower rated papers. Most medium-to-longer duration funds are alowed to invest up to 20 per cent of the corpus in lower rated papers. However, most fund managers keep the exposure to below 10 per cent.

The rationalisation in credit pricing has happened amid an improvement in credit environment due to deleveraging of corporate balance sheets and improved asset quality of creditors.

"Balance sheets are in good shape, both financials and non-financials have deleveraged. The consolidation across sectors and change in regulatory landscape has led to an improvement in the credit environment," said Tripathi.

Enhancing returns through a higher credit risk is one aspect that some AMCs are looking at post the loss of tax advantage.

"To retain investors, returns have to improve. After the change in taxation, it would not be easy to generate competitive post-tax returns without taking some credit risk," said Rahul Jain, senior vice-president-research, International Money Matters.

However, now that the deleveraging cycle has come to a near halt with a surge in corporate loans, there are concerns as to how long the present credit environment can sustain. In the second half (H2) of financial year 2023, CRISIL Rating's credit ratio moderated to 2.19 from 5.52 times in the first half. The agency upgraded the credit rating of 460 companies in H2 and downgraded 210.