News Analysis

At the altar of higher yields, funds sacrifice ratings

Dhuraivel Gunasekaran Updated on December 17, 2018

Assets of ‘AA and below’ rated bonds have grown 10% in last one year

In their quest to strike a balance between high ratings and better returns, mutual funds seem to be increasingly gravitating towards the latter, a trend that seems to have taken roots in the last few years: for instance, over the last one year, the total assets under management (AUM) of ‘AA and below’ rated bonds have grown by 10 per cent to ₹1.96 lakh crore. On the other hand, the AUM of the highest rated ‘AAA & AA+’ bonds has fallen by 6 per cent to ₹3.76 lakh crore. Bonds rated ‘AA and AA-’, ‘A’ and ‘BBB and below’ account for 67 per cent, 30 per cent and 2 per cent of the total AUMs of ‘AA and below’ rated bonds.

The share of such ‘AA and below’ rated bonds in the overall AUM of debt funds has inched up by one percentage point to 16 per cent over the same period.

The ‘AAA and AA+’ rated bonds that are considered to be of highest credit quality still form a large chunk of the overall debt funds AUM. But, their share has fallen by 3 percentage points — to 30 per cent.

Hunt for higher yields

Debt funds allocate a certain portion of their assets in ‘AA and below’ rated debt papers to earn a higher yield.

Lower-rated papers carry higher coupon rates than higher-rated papers. The accrual strategy with lower-rated bonds scores over the pure duration play. In duration funds, the fund manager tries to capitalise on the 50-100 bps spread over and above the yields of 10-year government securities by shifting the maturities of ‘AAA/AA+’ corporate bonds. But in accrual play, with lower-rated bonds, the fund manager can get 100-200 bps extra, which is the spread between the 10-year government securities and the ‘AA and below’ rated corporate bonds.

Fund managers also hold the lower-rated bonds, as these bonds may be upgraded in future, which will increase the bond’s value, and by extension, the returns.

Downgrades and defaults

This hunt for higher yields weighs on debt funds since instruments offering higher rates are mostly the ones that carry a relatively higher probability of default.

Over the past three years, there have been five instances of sharp rating downgrades and defaults in the bonds including those of Amtek Auto and IL&FS that resulted in huge erosion in the NAV of some mutual funds.

Also, our analysis shows that there were 37 single-notch rating upgrades and 34 single-notch downgrades (plus five downgrades by many notches) that happened in the bonds held by mutual fund schemes over the last one year. A rating downgrade by a single notch (for instance, from ‘AA to AA-’) results in the bond yield increasing by 20-30 bps and vice versa.

Growing exposure

Our analysis shows that one-third of the debt schemes belonging to the low-risk categories invested at least 20 per cent of their assets in lower-rated bonds (as of November 2018). Over the last one year, the exposure to lower-rated bonds has been increased in categories, including medium duration, ultra-short duration, short duration and conservative hybrid.

For our analysis, we have bifurcated the rating universe into ‘AAA & AA+’ and ‘AA and below’, in line with SEBI’s new categorisation norms that allow credit risk funds to invest primarily in ‘AA and below’ rated bonds.

 

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