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Business News/ Opinion / Use credit spreads to boost fixed income
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Use credit spreads to boost fixed income

Credit opportunities funds have some room to invest down the rating spectrum and earn higher yields

Pradeep Gaur/MintPremium
Pradeep Gaur/Mint

For long, investing in fixed-income mutual funds meant picking either long-term or short-term funds. But of late, a whole new category has emerged, expanding the choice for investors. Say hello to credit opportunities funds, which seek to generate higher returns by investing in non-AAA rated securities (AA and below). Since such securities rank lower on credit quality, they typically offer higher yields compared with higher rated securities.

At present, there are 18 funds that can be categorized as credit opportunities funds. In an indication of their growing popularity, the category closed 2013 with average assets under management (AUM) of 38,043 crore, up 32% year-on-year, compared with a 19% growth of the entire debt funds universe.

These funds are closest to short-term income funds in terms of average maturity but with comparatively higher credit risk due to exposure to non-AAA rated securities. Additionally, most of these funds are aimed at a minimum investment horizon of 180 days (0.5 years) to 730 days (two years), as reflected in the exit loads charged by these funds.

Crisil’s study of the performance of these funds shows that the category outperformed short-term income funds across time frames. Over the one- and two-year time periods, the category outperformed short-term income funds by 0.88%and 0.68%, respectively. As many as 12 out of 17, and 11 out of 16 funds delivered returns higher than the average short-term income fund performance over these time frames.

While these funds have outperformed the short-term category, it is important to understand reasons for outperformance and the potential upside that they hold. A key factor is the spread of lower-rated securities over higher-rated securities. Higher the spread, more attractive is the investment and better positioned are these funds to generate higher returns.

Over the past one year, credit opportunity funds have invested 37% of their assets in a combination of government securities and AAA-rated instruments. More importantly, just over half of the average portfolio exposure has been to securities rated AA or lower, while the remaining 8% is allocated to cash and cash equivalents. Therefore, while these funds have shown outperformance, the limited exposure to lower-rated securities has capped the potential for higher upside over short-term income funds.

This can be best illustrated by means of an example. Today, the average maturity of credit opportunities funds is up to 3.5 years. In view of this, we considered the yields of AAA, AA and A-rated securities with 2.5-3.5 years’ maturity that find place in mutual fund portfolios. The spread between AAA and AA-rated securities ranged from 0.72% to 1.07% for the three months ended 31 December 2013, while the spreads between AAA and A-rated securities ranged from 2.34% to 3.28%. The average spread between AAA and AA-rated securities was 0.88% and between AAA and A-rated securities was 2.82%.

While lower-rated securities have higher spreads, they also carry higher default risk. Based on the Crisil Annual Default and Ratings Transition Study for 2012, the average cumulative default rates of AA and A-rated categories for three-year periods between 2002 and 2012 were nil and 2.47%, respectively.

We created a portfolio with an allocation of 80% to AA and 20% to A-rated securities to gauge the credit risk-adjusted returns, which is a good way of evaluating the impact of higher default risk on returns in non-AAA instruments. The portfolio assumed investments at the average yield of securities under the respective rating category that were a part of mutual fund portfolios between October and December 2013. The portfolio could generate an indicative risk-adjusted return of 10.74% over a three-year period of the analysis—around 1.1% more than a portfolio that invests entirely in AAA-rated securities.

However, a caveat is due here. Actual returns depend on the market yields and spreads prevailing between the rating categories.

For mutual funds, what that means is credit opportunities funds have some room to invest down the rating spectrum and earn higher yields—without impacting the risk-adjusted returns of their funds.

Mukesh Agarwal is president, Crisil Research.

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Published: 27 Feb 2014, 06:59 PM IST
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