Low interest rates on fixed deposits are making investors consider investments in bonds offering high-interest rates. Recently Edelweiss Financial Services and Muthoottu Mini Financiers with a credit rating below AA have approached the general public to raise money through public issue of non-convertible debentures offering up to 10 percent return.
However, most investors ignore that such bonds come with high credit risk. Bonds carrying ratings less than AA+ indicate higher credit risk than the credit risk associated with AAA-rated bonds and government securities. Here is what you should keep in mind while buying them.
Why higher interest rates?
When you see a fixed deposit or bond offering you higher than the rate of interest offered by a nationalised bank or a sovereign-backed instrument such as a postal deposit, you are being asked to take a higher risk. Such fixed-income investments with a higher rate of interest could be carrying higher credit risk. Other things remaining the same, higher credit risk calls for the higher rate of interest.
How to measure credit risk?
Depending on various factors including quality of the business, the strength and weakness of the company, profitability of the business, existing debt on the balance sheet, and the firm’s ability to service it, the credit rating agency issues a credit rating to the issuer of the bond. AAA is the highest rating one can get and connotes adequate safety for investors. As we go down the safety we see ratings such as AA, A, and BBB, and so on. Each of these connotes higher credit risk. While assessing the credit rating for the firm, do check the short-term and long-term ratings. Sometimes many firms which enjoy the highest (A1+) ratings for short-term debt obligation, do not get highest (AAA) rating for long-term debt.
Are credit ratings trustworthy?
Credit ratings are given to firms at a given moment of time. Over a period of time as the business environment changes and the issuers go for more debt or repay existing debt their credit profile changes. The credit rating agencies also change the ratings accordingly. There is no assurance that an issuer with an AAA rating won’t default in the future. Entities such as Infrastructure Leasing &Financial Services and Dewan Housing Finance also had AAA ratings. In less than one year these ratings became D as the bonds defaulted.
Rating transition studies give a good idea to the investor about these changes. For example, according to CRISIL's long-term credit rating transition study between fiscal 2011 and fiscal 2021, 98.6 percent of CRISIL AAA ratings remained in the same category at the end of one year and 1.4 percent were downgraded to AA. In a tough business environment, this ratio becomes larger.
Credit ratings of the issuer can be upgraded as well. For example, over the same period, 96.3 percent of the CRISIL AA ratings remained in that category at the end of the one year, 1.3 percent were upgraded to CRISIL AAA and 2.4 percent were downgraded to CRISIL A category or lower.
How do that changes in ratings affect your investment?
Joydeep Sen, Corporate Trainer- Debt, says, “A credit rating downgrade pulls down the prices of the bonds. Since low rated bonds are more susceptible to downgrades, compared to AAA rated bonds, the yield spikes can be sharp.” It also works the other way round. An upward revision in credit rating push up the prices of bonds in the secondary market. Less credit risk ask for low yield and in turn high price. If such a bond is held by a bond fund then the net asset value (NAV) changes accordingly.
Does low ratings impact liquidity?
Lower-rated bonds are also less liquid.
A study by IDFC Mutual Fund in 2018, made it clear that 98 percent of the AAA-rated issuers traded at least once in a period of three months of the observation window. Only 62 percent of AA-rated bonds and 23 percent of A-rated bonds traded over the same period of time.
When you invest in a low-rated bond you have to be prepared to hold it till maturity. If you are keen to exit before maturity, then you may have to exit at a steep discount to fair value. Franklin Templeton mutual fund’s bond schemes investing in low-rated bonds for higher accrual could not handle redemption pressure beyond a point and were closed down in March 2020.
Abhishek Gupta, Founder and chief financial planner, Moat Wealth Advisors says, “If you are looking for a bit higher yield, consider long duration funds which bring in interest rate risk.” If you have a long enough time frame you can still make money. But credit risk is best avoided, worse avoid taking both credit risk and interest rate risk together, he adds.
What about bond funds investing in low-rated bonds? Credit risk funds invest at least 65 percent of the money in bonds rated below AA+. After the scheme closures of Franklin Templeton Mutual Funds, most fund houses are focusing on AA-rated bonds and maintaining fairly liquid portfolios in their credit schemes. As the macroeconomic situation improves in a high liquidity environment, even low-rated (AA) issuers are getting funds at relatively lower rates. This has spruced up returns of many credit risk funds. On average, credit risk funds paid 8.31 percent returns over the last year ended August 18, 2021, according to Value Research.
“If you are keen on investing in low rated bonds, despite high credit risk, then consider investments through credit risk funds, as you get to diversify across issuers,” says Gupta.
Even if you are investing in bond funds other than credit risk funds, do check the risk matrix of the fund and the actual portfolios. Within the limits prescribed, the fund manager may be taking credit risk. Stay with large schemes with a good track record.
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