Should debt fund investors be worried about credit quality hitting a six-year low?

Source: CARE Ratings

Source: CARE Ratings

Though 67 per cent ratings were reaffirmed in the first quarter this year, the number stood at 75 per cent for the previous year. This number connotes stability in credit quality for the ratings issued in that period. The share of downgrades in total rating actions more than doubled from 12 per cent a year ago to 26 per cent in the first quarter of current financial year, while the share of upgrades declined from 13 per cent to 7 per cent.

Small and mid-sized firms most affected 

The CARE Ratings report mentions that the downgrades were more in small and medium enterprises. Also, the downgrades were more prominent in the ‘below investment grade’ (with below ‘BBB’ rating) issuers. Though the MCR for CARE Ratings stands at a six-year low, experts advise using the information with utmost care.

Dwijendra Srivastava, chief investment officer-debt, Sundaram Asset Management Company said, “The MCR can indicate  bottoming out of the credit cycle, which means that stability in MCR could be seen and after some lead time we could see the MCR rising. On a different note it could mean a stagnating MCR with a downward bias if the below-investment-grade companies keep on facing liquidity pressures, declining profit margins, declining scale of operations etc.” He makes it clear that MCR is open to multiple interpretations and investors must use other factors such as economic performance of India, global economic conditions and other data points or indicators to arrive at an investment decision in addition to the MCR.

While underlining the limitation of MCR, Joydeep Sen, founder of Mumbai based wiseinvestor.in said, “The MCR includes SMEs as well, whereas fixed income investments tapped by mutual funds and investors are mostly in large enterprises.” He is of the opinion that MCR at six-year low does indicate concerns for fixed income investors, but the situation is not as scary as to run away from investments.

Use the ratio with the context

You would be better off looking at MCR in the light of events in the recent past.

“In last one year, we have seen factors such as weakness in Indian currency against the greenback, rising crude oil prices, the Infrastructure Leasing & Finance Services (IL&FS) debacle, NBFC funding crisis and some amount of uncertainty pertaining to political stability ahead of elections affecting sentiments,” says Devang Shah, deputy head-fixed income, Axis Asset Management Company. These issues choked some of the SME funding due to want of liquidity and affected business margins in some cases. Devang foresees the macro situation improving over next three to six months, given the strong political mandate at the centre, infusion of liquidity and public sector banks restarting lending activities on the back of re-capitalisation. The Union Budget earmarked a capital infusion of Rs 70000 for public sector banks.

There are concerns with defaults and late payments from corporate borrowers, which are far more serious in nature than just rating downgrades. Though one may want to run for safety, there may not be easy solutions any more. Prior to the IL&FS debacle, a bond with AAA rating was the safest option. However, investors have now become wary of taking investment decisions based on the ratings alone. A drastic fall in credit ratings of some companies over just a few days following a default or credit event has eroded the faith in credit ratings in the past year or so.

But there’s hope. Dwijendra says, “As mandated by the regulator, the slew of disclosures to be made by the rating agencies will definitely make ratings more credible. But, it makes sense to keep other risk measures in mind while making an investment decision in fixed income assets.” He advises that investors understand their risk-return appetite. High returns come with high risk.

Market regulator Securities Exchange Board of India (SEBI) asked the rating agencies to improve their processes. The regulator asked the rating agencies to start disclosing the probability of default for the issuers they rate. SEBI has also asked the credit rating agencies to disclose the factors that may impact the rating of the instruments. The regulator also issued guidelines pertaining to the calculation of cumulative default rates for the credit ratings issued. This will bring in more transparency in the rating process and make it more useful.

What should you do?

If you are keen to avoid risk there are pockets of relative safety. Joydeep recommends investing in Banking & PSU Bond and Corporate Bond funds, as these two have better credit quality portfolios. According to Value Research, these categories delivered 9.65 per cent and 4.63  per cent returns, respectively over past one year.

Devang prefers well-diversified short-term bond and credit-risk funds. “Portfolios comprising AA-rated bonds are offering at least 200 to 250 basis points more returns than their AAA rated counterparts. Investments in such well diversified credit risk funds should offer attractive returns for investors over next three to four years,” adds Devang . However he is quick to add a caveat – the macro situation should improve in India provided the risk of global recession does not materialise.

Investors should avoid having a concentrated portfolios and instead make diversified investments across product baskets—short-term bond, corporate bond and credit risk funds—after factoring in their risk taking capacity and their financial goals.

Apart from ascertaining how much risk you are comfortable taking, ask yourself when you would require your money back. Match your investment time horizon with a fund that’s meant to cater to that tenure—a very important key to make money out of your debt funds.