Include mid-rated bonds in your portfolio for higher risk-adjusted returns: Crisil

It may be time to alter the balance in the Indian corporate bond market, which has been skewed towards 'AAA' and 'AA' rating categories for long now

Given the reduction in default rates and strong debt protection metrics of ‘A’ category rated corporates, proactive government and regulatory measures, quicker and structured insolvency processes and favourable risk-adjusted returns, the current environment is ripe for investors to opt for  mid-rated bonds, rating agency Crisil said in a note. 

Risk-adjusted return is the difference between market yield and required yield. Market yield represents the 12-month average of the daily quoted yield on bonds outstanding with modified duration of 2-3, as per CRISIL bond matrix.

Crisil believe that it is an opportune time to add debt instruments of ‘A’ category issuers to the investment portfolio as it provides diversification benefit through exposure to larger set of industries compared to ‘AA’ and ‘AAA’ category rated issuers. Further, given the lower debt size of ‘A’ category rated companies, investors can improve granularity in portfolio with reduced risk of a single large default. 

 

Additionaly, higher returns on ‘A’ category rated corporate bonds can compensate for their moderately higher risks, it added.

"Deepening of the bond market will be a win-win for all. Inclusion of mid-rated bonds in investor portfolios will not only provide higher risk-adjusted returns but will also enable better portfolio diversification as ‘A’ category rated corporates are spread across more industries than their higher rated counterparts," said Gautam Shahi, Director, Crisil Rating.

Additionally, with the rise in yields on bonds across rating categories, after a slew of repo rate hikes by the Monetary Policy Committee of the RBI starting May 2022, there is a strong case for investment in issuances of ‘A’ category rated corporates, said Shahi.

Crisil has laid down four reason why the Indian bond market needs ‘mid-rated’ corporate issuances.

1. Mid-rated companies are also on the lookout to develop alternative sources of finance beyond bank loans, given the government's focus on infrastructure buildout and rapid economic expansion. Therefore, there exists a ‘win-win’ opportunity for both investors and companies.

2. An analysis of the CRISIL Ratings portfolio shows that performance of ‘A’ rated category corporates have been strong and resilient, with low default rates over the past decade. Their debt protection metrics have also improved significantly over the past five years. For instance, mid-rated ‘A’ category rated corporates today showcase leverage metrics that are similar or better than ‘AA’ category rated corporates a few years ago. This indicates prudence in capital allocation/capital expenditure (capex) decisions by mid-rated issuers.

3. There has been a positive shift in Loss Given Default (LGD) trends in the Indian context over the past decade. LGD is a measure of loss that lenders or investors incur post default on debt instruments. India is transitioning in terms of LGD, aided by a stronger insolvency and bankruptcy regime. The insolvency process also serves as a deterrent for issuers resorting to wilful default, thereby improving credit discipline among corporates. Although there is still room for improvement in the insolvency process, the improved LGD will boost investor confidence in mid-rated corporate bonds.

4. Market regulator Securities and Exchange Board of India (Sebi) has initiated confidence-building measures by launching the Corporate Debt Market Development Fund (CDMDF) to tackle the issue of liquidity, especially in times of market dislocation. This underlines the government intent to add depth to bond markets with an eye on the collective benefit to the economy, companies and investors.

"Therefore, investment in ‘A’ rated category issues makes a case for intelligent investment, especially in the current market scenario, where mid-rated bonds offer higher risk-adjusted returns compared with the ‘AA’ rated category. For the record, mid-rated ‘A’ category bonds offered 2-3 times higher risk-adjusted returns compared with ‘AA’ category rated bonds over the past three years. These returns are resilient in the backdrop of mid-rated corporates strengthening their balance sheets even as interest rates increased, supporting their case for an investment," noted the study.

In fact, returns outweigh risks, with a higher differential between market yield and required yield for issuers rated in ‘A’ category compared with those rated in ‘AA’ category, as seen in the chart below. 

This is in the backdrop of reducing default rates due to healthy growth and lower leverage amid moderate capex. Currently, risk-adjusted returns on bonds issued by ‘A’ rated category players are 50-60 bps higher compared with the ‘AA’ rated category.