How we have positioned our Managed Portfolios

Morningstar Investment Management Team on how they are navigating the fixed income space.
By Morningstar Analysts |  15-07-20 | 
 

The Indian corporate bond (credit) segment has been under stress post the IL&FS default in September 2018. A chain of defaults and downgrades that followed IL&FS led to a rise in risk- averse sentiment. This, along with banks’ reduced ability and willingness to lend in the sub-AAA segment, led to a liquidity crunch. As a result, credit spreads across the rating profile inched above their long-term historical average. Companies with asset quality concerns and asset-liability mismatch, particularly NBFCs and HFCs, traded at higher yields. The sentiment improved slightly with credit spreads compressing briefly around mid-2019 (largely in the AAA segment) amid improved monetary transmission and liquidity situation.

The spread of the coronavirus (covid-19) created a challenging situation that many of us could not have imagined a few months ago. Market sentiment worsened, reflecting the uncertainty associated with the likelihood of a global recession of unknown depth and length. Money started flowing out of high-risk investments into safe-haven liquid assets.

Exhibit 1 shows 3-year corporate bond and banking/PSU bond spreads over G-sec

Corporate bond spreads too widened, trading significantly above their long-term averages (+2 std. deviation from the historical mean) – reflecting a risk-averse sentiment despite adequate liquidity in the banking system. The risk premia across rating profile, particularly illiquid segment, increased amid weak business outlook and deteriorating willingness to lend to corporate borrowers.

Risk of capital loss increased among high yield/low rated credit funds with looming downgrades & defaults. As a result, such funds saw strong outflows amid investors' flight to safety. This led to further stress in the illiquid segment as mutual funds started selling corporate bonds to honor heavy redemption requests. Yields rose as investors demand greater compensation for the risk they bear.

The generalized sell-off in the corporate bond segment across AA and A segment resulted in a massive yield/spread dislocation with money flowing out of credit risk category and moving into a relatively safer banking & PSU debt category and high credit quality issuers. As a result, spreads compressed massively in the banking & PSU debt segment and for few high-quality issuers, whereas those for the corporate bond segment widened significantly. That said, liquidity support announced by RBI and the government, to an extent, helped in improving the market sentiment.

Exhibit 2 shows monthly estimated flows in credit risk and banking/PSU debt fund categories

How are we looking at the credit segment

Since the launch of managed portfolios (April 2019), our exposure to the short-term debt segment was limited to banking & PSU funds as the outlook for the credit markets looked grim, and the risk- reward didn’t appear to be favorable. Though the time frame is short, the call played out well as the banking and PSU fund category outperformed other categories in the short-term duration bucket as the latter took a hit due to downgrades and defaults.

 “Be fearful when others are greedy and greedy when others are fearful.”

― Warren Buffett

This is a famous quote by Warren Buffett, which typically holds for the equity markets. However, in the current environment, to an extent, it holds for the credit markets as well – Fear of capital loss led to investors pulling out money heavily from the credit markets.

In this scenario, we see an improved opportunity in credit markets where credit spreads offer a decent reward for risk. Based on our valuation-implied return forecasts, the corporate bond segment (3-5 years) looks relatively attractive over the short-term debt (G-sec) segment. The attractiveness of the credit segment relative to the banking & PSU debt segment has also improved with money flowing towards the latter – a recent drop in yields and spread compression in the banking & PSU segment reduces the return expectations.

The AA and A issuers segment could see downgrades and defaults, which needs to be monitored carefully, but the yields on offer are attractive to us. The case for investing in this segment has improved. Of course, risks remain elevated; however, we believe the yields on offer are becoming compelling for long-term investors. In a portfolio context, this means we need to be careful about understanding the underlying risks to assets. For example, corporate bonds and equity markets can behave very differently, yet both are susceptible to an economic shock (damage to corporate earnings could cause equity values to fall, and bond spreads to widen). The message is that we must diversify against fundamental risks to reduce the impact of an economic recession.

With this backdrop, we added exposure to the credit segment as a part of short-term debt bucket in the Active Balanced and Active Growth portfolios. The allocation is funded by banking & PSU debt funds. The key here is to identify a fund that could give us the desired exposure to the credit segment with a strong process and better credit/liquidity risk management. We evaluated several credit risk strategies, both qualitatively and quantitatively. The idea is to identify a fund that provides a balance between reward and risk, rather than focusing only on reward (high yield) or only on risk. A key factor to consider in this segment is the security/issuer level concentration.

Lately, some of the funds saw massive outflows, which led to a further increase in concentration towards lower-rated issuers/securities, increasing the yield on offer along with the increased risk of capital loss.

In this unique economic situation, we are actively reviewing our views across asset classes and portfolio positioning.

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