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Sometimes AAA yields are compared to lower rated bonds, but note that the drivers of high quality and a credit portfolio are different, says Anurag Mittal, fund manager, IDFC Mutual Fund.
Sometimes AAA yields are compared to lower rated bonds, but note that the drivers of high quality and a credit portfolio are different, says Anurag Mittal, fund manager, IDFC Mutual Fund.

Despite low yields, debt fund managers wary of credit risk

Experts say this is not the right time to take any chances, and the focus should be on preserving capital

Fund managers attending the Mint Money Conversation presented by digibank by DBS on Wednesday took a cautious stance on credit risk, highlighting factors such as low GDP growth and weak corporate balance sheets. The credit risk category has shrunk to about 28,000 crore in August 2018 from its peak of about 80,000 crore in early 2019.

Credit issues came to a head in April 2020 when Franklin Templeton Mutual Fund froze six of its debt schemes but these seem to have quietened down since then with the Reserve Bank of India (RBI) launching various stimulus programmes to support the bond market. Despite the relative calm, fund managers remain wary of the credit space.

Anurag Mittal, fund manager, IDFC Mutual Fund, pointed to unfavourable macroeconomic factors. “Most economists are projecting a 10% decline in GDP. This will be distributed across the government, households and corporates. The K.V. Kamath Committee report has outlined 26 stressed sectors, and that’s only the direct impact. Most sectors are in a state of suspended animation. Many industries are operating at only 60-70% of capacity," he said.

Mittal went on to take an unambiguous stand on credit risk. “This is absolutely not the time to get into credit. This is the time to contain your risk and preserve capital. We really don’t know how long the corporate and financial stress will take to play out. We have impairment in household and corporate balance sheets and, hence, in bank and shadow banking balance sheets, which were not strong even before the covid-19 crisis," he added.

Mittal also warned against comparisons of average yields of AAA papers with lower-rated-but- high-yielding debt. “Sometimes AAA yields are compared to lower rated bonds, but note that the drivers of high quality and a credit portfolio are different. A high quality portfolio works in a period of low growth and low interest rates. Credit portfolio works in a period of stabilizing and then recovering economic growth where impaired balance sheets improve and leverage ratios come down. The two are chalk and cheese. The macro situation does not warrant any kind of risk on the credit side," he added.

According to fund managers, it is too early in the cycle to consider credit. “If the growth momentum and government borrowing is slow, duration will outperform. For credit to do well, you need positive growth momentum and lower cost of money. As of today, only one of the two elements is working. The cost of funds is low but the growth momentum is still plateauing at lower levels. The sensitivity of credit markets would’ve reduced but till the time the yield curve is steep, we expect risk-reward to be more favourable on duration rather than credit," said Saurabh Bhatia, head, fixed income, DSP Mutual Fund.

Duration is a strategy that takes exposure to long-dated bonds, which offer higher yields than their short-dated counterparts. But investors following this strategy can stick to funds investing in long-dated bonds of governments, PSUs or top-rated issuers rather than riskier entities.

“There are enough avenues in duration, I don’t think it is time for credit risk. Investors should buy mutual funds which give a duration play to beat FD returns over a three-year period, given that a mutual fund is more tax-efficient," said Asheesh Jain, senior vice-president and head of investment and forex business at DBS. Mutual funds held for more than three years are taxed at 20% along with the benefit of indexation. Bank FD interest is taxed at the slab rate.

Nitin Singh, CEO at Avendus Wealth, said there are opportunities available in direct debt investing for high net-worth investors. “There are interesting opportunities in market-linked debentures (MLDs) and alternative investment funds (AIFs) from high-quality companies. This also extends to REITs (real estate investment trusts), InVITs (infrastructure investment trusts) and low volatility hedge funds," he said. “If you are a more sophisticated customer who has access to good wealth managers, there are opportunities in the direct fixed income side. Look selectively at a combination of MLDs, direct bonds and AIFs."

MLDs are debt instruments, typically linked to market movements, such as Nifty levels over three-five years. This makes them more a hybrid instrument than pure debt. However, listed MLDs, as other listed bonds, levy a long-term capital gains tax of just 10% if sold after one year. Issuers, typically, make informal promises of buying back MLDs after set periods to give HNIs the tax advantage. These are, however, high-risk instruments and the rating and repayment ability of the issuer (typically NBFCs) is very important. “If you have small sums of money, continue with mutual funds. You won’t necessarily have the capability, expertise or time to find the right instruments," he added.

Be careful about risky instruments in the present scenario.

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