Credit risk

Should You Consider Investing In Credit Risk Funds Now?

Response from Divya Menon, Vice President – Products, IDFC AMC

The return generated by a debt portfolio has two main components, carry gains / losses (accumulated income) and mark-to-market (MTM).

In a low interest rate environment, when one is not satisfied with the carry of existing products, it is very likely that he will be seduced by debt funds with higher yields. To get a higher carry, you can consider moving up the yield curve (increasing duration risk) or switching to a different yield curve (increasing credit risk).

To learn more, let’s take a look at the yield curve. The yield curve is very steep today, especially in the short to intermediate term. Thus, without diluting the quality of the portfolio, we could gain relatively higher carry simply by moving up the yield curve, ie. by marginally increasing the duration of the portfolio.

Here is an example of a rise in the sovereign yield curve, from 2 years to 3 years for a higher carry – the yield on the 2 year GSec at December 31 was 4.74% and if you look at the 3 year GSec, the yield there was 5.27%, which gives you a 53 basis point spread (spread) by simply moving up the yield curve a year. (Source: Bloomberg).

As mentioned above, another way to get higher carry could be to switch from one (sovereign) yield curve to another (corporate bond yield curve). Here, the point that deserves to be emphasized is that one has now changed his risk profile and has taken on a higher credit risk.

When looking to switch to a higher credit risk strategy, it is also important to analyze the evolution of historical spreads between these two instruments.

Let’s compare 5-year AAA corporate bonds with the 5-year GSec and understand where the spreads are today compared to the average of historical spreads. Today, the difference between the 5-year AAA (yield on December 31, 2021 – 6.22%) and the 5-year Gsec (yield on December 31, 2021 – 5.79%) is only 43 pb. Compare that to an average spread of 85 bps pre-covid, i.e. during the period 2017 to 2019.

This means that today spreads have tightened considerably and therefore there is a decent probability that in the future, as yields increase and spreads also start to widen, the carry more high obtained via credit exposure could prove to be a limited buffer as the corporate bond curve will have to face MTM loss resulting from both events, viz. interest rates rise and spreads widen. (Source: Bloomberg)

While the carry is a significant contributor to the performance of the debt portfolio, it should not be assumed that the carry is an approximation of future returns. As has also been observed previously, the carry return on entry and the experience of hold period returns could be very different. This can be largely attributed to changing yield curves, widening / compressing credit spreads or dynamic portfolio management, where portfolios may undergo changes due to a change in the view of interest rates. ‘interest / credit. Even with high carry, there may be opportunities for capital drawdown through an MTM loss or credit loss.

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