BackCROP funds: a strategic slice
AUM of credit opportunity funds have grown nearly five times in the past five years
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High-yield bonds have held a significant place in the investment spectrum globally for almost half a century now though their size has waxed and waned given the risk investment climate and interest rate scenario.
A study of the past decade shows that the share of high-yield bonds in the US market dipped sharply during the 2008 financial crisis. However, the low interest rate environment that followed saw a spurt in preference for these bonds as investors gravitated towards lower-rated papers to generate higher yields. High-yield bond issuances rose from $96 billion (13% of the total pie of bonds in the country) in 2005 to $260 billion (17%) in 2015, after having fallen to $43 billion (6%) in 2008.
India, too, has seen a progressive increase in sub-AAA bond issuances over a 10-year period, from 24,200 crore (30% of total bond issuances) in financial year (FY) 2006 to 1.5 trillion (35%) in FY15.
Not surprisingly, assets under management (AUM) of credit opportunity (CROP) funds—represented by the weighted average index of Crisil-ranked CROP funds—that invest in low-rated debt securities (below AAA), have grown nearly five times in the past five years. The spurt in such investments can be attributed to the potential for higher returns, though these funds also gain from price appreciation when an underlying bond’s credit rating improves. These two factors give these funds an edge in terms of returns, especially over short maturities.
In 2015, CROP funds had a spread of around 70 basis points (bps) over money market funds (represented by the Crisil-Amfi Money Market Fund Performance Index) and 96 bps over short maturity funds (represented by Crisil-Amfi Short Term Debt Fund Performance Index). One basis point is one-hundredth of a percentage point.
However, the underlying investments in CROP funds carry a higher risk as was again evidenced in a recent corporate bond default. Such examples of corporate defaults reiterate the need for prudent risk management and scrutiny by investors. In August 2015, when default worries first unfolded and now till February 2016, the AUM of CROP funds have declined by 12% from 75,500 crore to 66,200 crore.
The higher returns provided by such funds come with accompanying higher intrinsic risk. Since individual risk appetites are different, it is important to note that these funds are not for conservative investors.
For one, these funds run greater credit risk (implying payment default by borrower) compared with investments in higher-rated paper. Credit risk depends on the probability of default and the exposure to it, both of which may vary within schemes. For instance, exposure to lower-rated papers within CROP funds ranged from 52% to 94% (over a 1-year time frame).
Another thing to keep in mind is that CROP funds are prone to significant liquidity risk on account of lower rating (implying there might be fewer buyers for such bonds at the time of default despite discount), and in stress situations they are susceptible to deeper haircuts (write-down) in comparison to higher-rated bonds. This liquidity pressure on the defaulting bond creates a chain reaction as investors rush to redeem the schemes, which consequently creates liquidity stress on the fund. And, eventually, distress selling creates a contagion effect on other bonds held by the fund in its portfolio, paring down their prices (or higher yield) compared with the market price, thus leading to significant valuation shocks and erosion in net asset value.
Therefore, investors need vigilant portfolio monitoring and must watch out for early signs during the entire investment cycle, unlike the hold-to-maturity investments. While evaluating the credit rating profile, it is also important to distinguish the rating provided by different rating agencies and the vintage of outstanding ratings.
Investor behaviour in lower interest rate regime
Corporate bond markets across the world have developed in low-interest rate ecosystems where investors have to chase yields to bolster returns. In the US, where interest rates are near zero, gross issuance of corporate bonds in FY15 was $1.5 trillion. India is a pygmy in comparison, with issuances of about 4.42 trillion (around $70 billion). Further, India’s share of corporate bonds to total debt securities was also lower at 21.84% compared with 53.37% in the US.
The imperatives of economic growth and the quest for higher yield are expected to deepen India’s corporate bond market. This will improve debt market access, and increasingly companies may also convert their bank loans to bonds. Structured products seeking to minimise investor risk but assuring higher returns will create both opportunities as well as risks.
That is another reason to ensure that avenues such as CROP funds remain open and attractive to investors who are willing to take higher risk. However, there is a need for market segmentation of these funds, better risk management and deeper investor risk education. Investors should also view CROP funds as strategic asset allocation for the long term to diversify across the debt spectrum and earn optimum portfolio returns relative to their risk-return profile.
Moreover, development of these products as interval funds rather than open-ended ones, as they are now, may give asset managers better latitude to manage liquidity and credit risk, while also changing the psyche of the investor to a more long-term holding period.
Manish Jaiswal, business head, Crisil Research.
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