BackHow do debt funds analyse credit risks?
Credit risk analysis of a corporate bond is not just about looking at the rating agencies' grading scale
Premium
The 10-year government security (G-sec) yield at 7.75% (down from 8.5% a year ago) seems to have priced in the current turn in the rate cycle and debt fund managers have now shifted focus away from duration to high yield.
Duration strategy in debt funds refers to portfolios with exposure to very long maturity bonds, which stand to gain the most if interest rates fall; in the Indian context this usually means buying long dated government securities. This gain is in the form of capital gain which enhances returns sharply.
High yield, on the other hand, refers to investing in securities that have a higher coupon commensurate with the credit rating of the securities. Typically, corporate bonds rated AA and below offer coupons or yields that are at least 1.5-2% higher. This enhances the overall portfolio yield if you simply buy and hold the security till maturity.
As the opportunity from duration strategy shrinks, exposure to lower-rated higher-yield corporate bonds is increasing in a number of debt fund portfolios. At least eight credit opportunities funds were launched in the past year and their assets under management has increased about 55% over this period.
Risk attached to such a strategy is different from the interest rate and market risk for duration funds. It’s the risk of non-payment and default that high-yield bonds are perceived to carry which turns away many investors. This requires intense credit analysis and risk assessment within the mutual fund house.
Credit check
The bond market in India isn’t liquid enough to absorb secondary market trades instantly, which means if you want to sell a bond before it matures you may not find a buyer. Especially for lower-rated lesser known corporate bonds, selling in the secondary market means finding a buyer and negotiating a price, rather than settling a trade through exchange. Given that the corporate bond market is still evolving, there isn’t a comfortable buy-and-exit-anytime model for fund managers to rely on. This means credit risk continues till the security matures.
Credit risk refers to the risk of default or non-payment of financial obligations. Rating agencies qualify this risk through a system where a AAA-rated security is considered to have negligible risk of non-payment. As you move down the credit curve—AA, A, BBB and so on—the risk of default increases in a linear manner.
“Given that the liquidity in the Indian bond market is restricted to very high grade (credit quality) names, one has to be very cognizant of credit risk in lower grade issuers as access to liquidity in these names will predominantly be through contractual maturity. In this context, how much and for how long, a credit exposure should be taken, becomes very important in our fiduciary business," said Pankaj Sharma, executive vice-president and head-business development and risk management, DSP BlackRock Investment Management Pvt. Ltd.
Credit analysis itself can include a number of activities such as doing a due diligence of the company’s financial statements, meeting the management, assessing 3-5-year cash flows and understanding the industry and economic environment a company operates in.
“Although there are accredited rating agencies, we have to do our own due diligence. We don’t want to completely rely on credit assessment made by rating agencies," said Sharma. Essentially, fund managers try to assess whether a company has sustainable cash flows for the next 3-5 years or at least through the period for which they are buying the bond.
Management check
The typical pecking order is to first understand the financials of a company, and then management quality—both at a group level and of an individual company. Once that’s done, the security and collateral to be attached to each deal is decided. Collateral essentially refers to the assets that a borrower offers as security against a structured payment or a loan.
Santosh Kamath, managing director, local asset management, fixed income, Franklin Templeton Investments, India, said, “It’s only after multiple meetings with the management that you get a sense of whether you want to do business with the Group. Ideally, we want to fund a company that has decent cash flows. After all this assessment is done, we look at collateral and how much we need."
Sharma agrees that assessing management quality is paramount; the transparency of operations and the consistency of management commentary are also critical he added.
Unlike equity, where the market price of a share can be affected by a number of factors, the risk in debt is more defined. In buying a non-convertible debenture (NCD) and holding till maturity, you either get the payments on time and the money back or it’s a default. Hence, the initial stages of analysis are important. This also makes the value of the collateral important as it’s the first line of security in case of a default.
Collateral check
Having collateral is more a deterrent or preventive measure that should be in place. “Typically, the company has some collateral which it offers, and we ascertain whether the collateral works sufficiently to secure the structured debt. We need to look for sufficient cover that pays principal plus interest," said R. Sivakumar, head–fixed income, Axis Asset Management Co. Ltd.
The type of collateral normally depends on the industry to which the company belongs. For example, for a manufacturing company, fixed assets such as plant and machinery are common sources of collateral. The charge for lenders is usually at par with all creditors rather than a specific charge for one lender.
Where the security or collateral is a financial asset, like equity shares, it’s important to consider whether the company is listed or unlisted. With listed shares, value can be deciphered simply but for unlisted companies, an inhouse assessment has to be made or a third-party valuation used. “We keep away from unlisted equity as collateral since it’s illiquid and ascertaining its value can be tricky," said Sivakumar.
Others choose more collateral. “In case of unlisted shares, the collateral cover we seek is relatively higher," said Kamath.
There could be unsecured bonds in a debt fund’s portfolio. In such cases, the credibility of the promoter group comes into focus. Your fund manager should be able to assess risk and take adequate cover.
There are many other factors that influence how the collateral can protect investor interest. Dhawal Dalal, EVP and head-fixed income, DSP BlackRock Investment Management, said, “It’s important to have tight monitoring mechanism. If the collateral value is dynamic then regular checking is needed, and for illiquid collateral a third-party valuation along with site visits are critical. The language and covenants used in the term sheet is also crucial." At DSP BlackRock, their risk assessment team that is independent of the investment management team does assessment of credit and collateral. Dalal said, “It’s important to have dedicated staff independent of fund management; with multiple offers coming for such deals analysis can get done with sufficient focus."
While each fund house can have a different process, in-depth credit analysis, especially for lower rated, illiquid securities is essential. In most fund houses, this is done by the investment management team itself, but there is also a separate compliance team that looks into the nuances of such deals.
What this means for you
It’s not easy to grasp the details of credit analysis. Investments in high yield-oriented funds have increased significantly in the past few months. While it’s unreasonable to think that retail investors will be able to discern details of security and terms, it helps if the fund house has a process to analyse these deals.
High yield funds give returns higher than those with only AAA-rated bonds, but have higher risk. How the risk is managed determines how your investment performs in worst-case scenarios.
Retail investors should be aware of these risks and the processes followed by the fund house whose scheme they wish to invest in before picking a fund that invests in high yield corporate bonds.
Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!
