Nothing fixed about fixed-income funds
Take a step back to appreciate the importance of risk-adjusted returns in fixed income funds
The euphoric surge in assets under management (AUM) of fixed-income funds in recent years may be a reason to rejoice for the industry, but it also heightens the risks for investors.
As of July 2017, the AUM of fixed-income funds stood at Rs10,59,582 crore, compared with Rs524,009 crore in July 2014, and Rs311,900 crore in July 2012—a near-tripling in just 5 years. The run-up mirrors the growth in bond market where the number of issuers has quadrupled from 164 in fiscal 2012 to 671 in fiscal 2017, while the value of these issuances has grown at a compound annual growth rate (CAGR) of about 23% from Rs251,437 crore to Rs706,955 crore. The bulk of the issuances are of papers rated AAA, denoting highest safety and liquidity.
So where is the risk?
Issuances of lower-rated bonds have surged too, and at a much faster clip. While AAA issuances have run up at 16% CAGR in the past 5 years, AA category issuances have logged 34% and A+ or below 48%. Indeed, mutual funds are the largest investors in lower-rated papers, given their whetted appetite due to buoyant inflows—especially in credit opportunities funds. Insurance and pension funds, in comparison, have rating-level limits.
Between July 2014 and July 2017, the AUM of short-term debt funds more than quadrupled from Rs47,500 crore to almost Rs206,900 crore, even as that of credit opportunities funds jumped 2.5 times to Rs121,200 crore.
Today, more than Rs191,170 crore worth of securities issued by sub-AAA issuers are part of fixed-income funds’ portfolio, compared with Rs80,300 crore 3 years back. AA-rated securities form the highest proportion of this at 79%, followed by A-rated (19%) as of July 2017.
This has predictably heightened the risks—of credit, liquidity and concentration.
Risk-adjusted return is a key factor to look out for when investing in fixed-income funds, especially credit opportunities funds. As the credit risk taking is in line with the mandate of these funds, the incremental risk for the higher return is what the investor needs to be wary of. Typically, investors believe risk in fixed income is only because of duration, i.e., interest rate risk. However, credit is a pertinent risk. There can be a few downgrades or defaults, where the risk has to be borne by investors.
While credit opportunities funds generated higher returns (9.92% 3-year CAGR as on 31 July 2017) compared with short-term debt funds (9%), their credit risk was higher with 47.9% allocation in AA, 23.4% in A, and 1% in BBB securities as against paltry 9% allocation to sub-AAA papers by short-term debt funds.
As the value of exposure to lower-rated securities increased, the credit risk has increased correspondingly. The more a fund goes below the credit curve, the higher the yields, and the risk. For example, the maximum spread over G-sec of an A-rated security is 9.31%, but with a higher cumulative default rate of 4.25%.
Further, the risk of rating downgrades is real too, and can impact valuations. For instance, over the last 1 year, a downgrade in AA- securities has led to an average fall of 33 basis points in yields.
Mutual funds are structured as highly liquid investment products, with redemption proceeds getting credited in the investor’s account in a day or two. Hence, majority of the assets of these fixed-income funds need to be in liquid securities to minimise the impact cost. There have been instances in the past where on account of high redemption, funds’ net asset values (NAVs) nosedived due to stress selling. For example, in 2017 a fund gave -5.88% return vis-à-vis the benchmark’s 1.59% in 3 months due to high redemption pressure resulting in a fall in AUM by 95%.
Illiquidity and credit follow each other closely. There are some illiquids even among the highest-rated, and the numbers increase exponentially as you go down the rating curve. More than 93% of the trading is restricted to AAA—which accounted for 75% of the daily trading volume in fiscal 2017—and AA segments. This underscores the fact that bonds rated A+ and below are an accrual and held-to-maturity market, and hence largely illiquid, making up just 6%. Keeping in mind the illiquid nature of low-rated securities, investments in credit opportunities funds should, therefore, be made with a longer-term perspective than as liquidity products.
A larger number of issuers accessing the corporate bond market bodes well for mutual funds from a diversification perspective. For a long time, the supply of low-rated securities was an issue, especially for credit opportunities funds. But this has been alleviated with the total number of AA- and A-rated issuers almost doubling to 354 over the past 3 years. The impact of this can be seen in the higher number of issuers in credit opportunities funds with reduced exposure per issuer.
Concentration risk is still pertinent due to the combination of credit and illiquidity. Increased exposure to a single issuer or sector coupled with credit and illiquidity increases the concentration risk. For instance, a downgrade from AAA to AA for a security that accounts for 10% of the portfolio can shave 57 basis points off the investor’s returns, compared with 11 basis points for a 2% exposure. The surge in assets indicates the mutual fund industry is finally getting the attention it deserves and moving in the right direction.
It is important for investors to understand that there is nothing ‘fixed’ about fixed income. Credit risk can erode capital in the same manner as interest rate movements. Having said that, both credit and rate calls are important for alpha generation. So, identify funds with better risk-adjusted returns. Secondly, with credit now becoming a material part of the fund manager’s strategies for alpha, mutual funds must inculcate strong risk management processes covering aspects such as continuous review of credit positions.
Jiju Vidyadharan, senior director, funds & fixed income, Crisil Research on ELSS
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