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Is it time to increase your investments in high-yield debt funds?

An improvement in company finances can result in a pickup in credit offtake in 2021. Credit spreads are attractive too. But don’t go overboard on credit risks.

March 10, 2021 / 11:03 AM IST

Bonds had a stellar 2020. The CRISIL Composite Bond Index (a widely used benchmark for bonds) was up about 12 percent. Yields dropped to multi-year lows in 2020, as the RBI cut policy rates by 115 basis points (bps) in 2020 to an all-time low of 4 percent and supported the economy through a slew of liquidity measures. Bond price gains were made across major debt mutual fund categories. Medium-term duration, long-term and high-quality (AAA) corporate, public sector undertaking (PSU) bond and short-term funds delivered superior returns. Only low-quality corporate bonds had another painful year as the credit environment worsened amid rising defaults and downgrades.

Best of bond returns may be behind us

Since the start of 2021, domestic bond yields have risen given the significant widening of fiscal deficit in the budget and the partial normalisation of some of the COVID-led liquidity measures taken by the RBI. Furthermore, rising global bond yields amid improving global growth and inflation expectations are likely to exert upward pressure on rates.

On the whole, 2021 offers a very different backdrop for fixed income investors, as bond yields are likely to trend higher, albeit slowly. Thus, it is important for debt fund investors to lower their return expectations, as the best of bond returns is possibly behind us. Also, capital appreciation could be muted as cash, government and AAA corporate bond yields are still trading near decadal lows even after accounting for the recent rise. This is likely to drive a search for yield as bond investors move up the risk curve. They may increase exposure to a riskier asset class such as equity or raise allocation to low-quality or long-term bonds.

High-yield (AA) bonds are attractive

In our view, some exposure to high-yield (AA) corporate bonds can improve yields without taking excessive risk. Over and above the favourable macro backdrop, here are some reasons that would likely support high-yield corporate bonds.

First, the credit cycle is on revival mode as domestic and global growth expectations improve. The asset quality trends of financial entities have improved over the last few quarters amid lower credit costs and moderation in non-performing loans. This is likely to support a pick-up in overall credit growth. Further, corporate earnings delivery has positively surprised over the last two quarters. A more broad-based economic recovery and better corporate profitability are likely to result in a reduction in credit default risk.

Second, credit spreads of high-yield bonds are attractive. AAA corporate bonds were the main beneficiaries of the RBI’s liquidity measures, with record issuances in 2020 at low yields, as investors preferred safety amid an elevated credit risk environment.

However, an improving credit cycle and reduction in default risk support a further compression in corporate bond yield premiums. This may especially hold true for AA/A rated corporate instruments, which appear inexpensive on a relative basis, with credit spreads for high-yield bonds trading higher than pre-COVID levels.

Third, measures to deepen the credit market are supportive of high-yield bonds. An institutional framework to provide liquidity to the corporate debt markets by buying investment-grade bonds, both in stressed and normal times, will help deepen the liquidity of the corporate bond market. Further, the government has proposed setting up a new financial institutions to buy stressed bank assets and funding infrastructure projects to aid overall credit flow.

Still, stick to short-term accrual funds

It is important for investors to be wary of the risks. We are still in the early stages of a new cycle, with default risk not yet at comfortable levels. Thus, being selective is key as one moves down the credit quality curve to search for yield. Investors should also be cautious on increasing durations given their higher sensitivity to rising rates. Overall, investors with a time horizon of three years and above could focus on short-term accrual funds holding AAA and AA corporate bonds based on risk/reward trade-offs while trying to target a higher yield-to-maturity.

Vinay Joseph is the Chief Investment Strategist, Standard Chartered Wealth, India
first published: Mar 10, 2021 10:58 am