Corporate Bond Funds: A Prudent ‘Risk Reward Analysis’
Santosh Das Kamath, MD & CIO- India Fixed Income, Franklin Templeton Asset Management India Pvt. Ltd. writes about how corporate bond funds have gained traction and if it is the right time to invest in them.
Indians are intrinsically savers and consequently India as a nation has one of the highest domestic savings rate in the world (~30%). Due to concerns over high inflation rates and predominantly negative real returns, a significant amount of these savings, 58% in 2014-15, is parked in physical assets. However, we are now seeing a visible shift towards financial assets, perpetuated by high real interest rates, demonetization and the government’s focus on financial inclusion.
The lion’s share of financial savings has historically been parked in bank deposits. In FY15-16, bank deposits accounted for around 41.3% of total financial savings. Other major investments in financial assets that have attracted investments are life insurance funds (18%) and provident & pension funds (14%). The allocation to shares & debentures, which includes mutual funds, has appreciably increased from 1.8% in FY12 to 6.6% in FY16.
Slow and steady: Savings are moving into financial assets
Retail investors are increasingly taking the mutual fund route to invest their financial savings be it equity or fixed income. Duration-led and Accrual-led are two major investment strategies adopted when it comes to investing in fixed income funds. While duration-led funds focus on long dated securities issued by the government as well as corporates, these funds are highly interest rate sensitive. For Accrual-led funds the emphasis is on constructing portfolios especially comprising relatively higher yielding corporate bonds.
Investors need to ensure that their fixed income portfolio are robust and well diversified in order to strike a balance between various risks emanating from interest rate movements, issuer credit profile and reinvestment options amongst others.
Corporate bond funds (CBFs) have gained traction amongst investors in the last decade or so, primarily due to relatively stable performance profile over the long term. The shorter maturity profile of these funds endeavor to limit the volatility arising from interest rate timing along with diversification benefits.
CBFs typically follow an accrual strategy in the short-to-medium term duration with focus on high yielding corporate bonds. The focus is on maintaining stable average maturity in the short-to-medium term while regularly scouting for fixed income securities offering better spreads. The return profile of a CBF is relatively stable as there is lower impact due to interest rate movements thus complementing duration-led fixed income funds. However in event of credit default there maybe heightened volatility in short term for these funds. The other prominent reasons which make CBFs appealing to investors are:
Adding consistency to the fixed income portfolio: Regardless of interest rate levels, there is always scope for finding mispriced opportunities in the corporate bond segment, thereby ensuring the continued attractiveness of CBFs. Historically, the “consistency” feature of the accrual strategy has complemented the “variability” of the duration strategy and thus offers an ideal combination to any fixed income portfolio.
Alleviating reinvestment risk: In an easing interest rate economy, any reinvestment of coupons/maturing bonds at lower interest rates increases the reinvestment risk. However, in the CBF segment yields are driven more by the prevailing gap due to demand & supply of securities and the availability of mispriced investment opportunities. Thus, the reinvestment of coupons can materialize at better spreads, thereby lowering the reinvestment risk. Following the hold-to-maturity strategy, the portfolio of CBFs may be less exposed to reinvestment risks arising out of frequent portfolio changes.
Enduring appeal of corporate bond funds: These funds focus on identifying securities within the short-to-medium term duration space, aiming to generate higher accrual income across market scenarios. The segment enjoys multiple sources of returns including coupon, riding the yield curve, riding the spread curve along with the potential for capital gains in a falling interest rate scenario. In a raising interest rate scenario, it is a good investment option as the reinvestment is done at a higher coupon rate.
Understand risks associated with investing in CBFs
Liquidity risk. Liquidity risk refers to the investor’s ability to sell a bond quickly and easily, as reflected in the size of the bid-ask spread. That spread is usually quite small for large, actively traded bond issues, reflecting ample liquidity. A wider spread indicates, among other things, greater liquidity risk. High-yield bonds may be less liquid, depending on the issuer and the market conditions at any given time.
Credit risk. Credit risk is the potential for loss resulting from an actual or perceived deterioration in the financial health of the issuing company. Two subcategories of credit risk are default risk and downgrade risk. There could be varying reasons for these risks which may be failure to anticipate shifts in the company’s markets, rising costs of raw materials, regulation, new competition, poor management and changes in management.
CBFs mitigating key risks to endeavour stable returns
Liquidity risk mitigation: The ability to manage the liquidity of the overall portfolio is at the heart of managing an open-ended corporate bond fund. Liquidity management is necessary not just to protect interests of all the investors, but also to ensure that alpha can be generated over long investment horizons. This is more relevant in corporate bond funds due to lack of meaningful secondary market in this segment. Liquidity for the end investors is managed through several layers of measures at the liability (i.e. investors in the fund) as well as the asset (i.e. where the fund is invested) end.
Credit risk mitigation: Corporate bond fund investing is first, and foremost about risk control. Default risk is the dominant risk factor, and all portfolio investments must meet stringent and quantifiable minimum “margin-of-safety” requirements.
The Business and its cycles: one needs to identify businesses with operational as well as financial strength to withstand transitions in economic cycles.
Management and Promoters: The risk appetite, commitment and vision of the management, specifically the promoters, are some of the qualitative aspects of security evaluation.
Financial Strength and Cash flows: One needs to look beyond the publicly available credit ratings and look at the business’ ability to generate cash flows and service obligations.
Deal structure: Even with all the diligence, provisions should be made to ensure that investor interest is safeguarded in case of adverse developments. For e.g.: Shorter tenures, stringent financial covenants, exit clauses through put option, rating downgrade events, covenants linked to promoter shareholding and management control etc.
While fundamental factors may remain stable over the medium-to-long term, the credit rating for a security can be contingent to unforeseen factors that may impact short term cash flows (cash flow mismatch, temporary operational challenges etc.). These short term challenges may lead to a rating downgrade and therefore may impact the valuation of the security. However, it may not impact the interest payment and/or principal repayment to the lender who holds the security till maturity.
Is it the right time to invest in CBFs?
CBFs by their very nature are less exposed towards the risks arising from interest rate movements and that makes them a suitable investment option across interest rate cycles. Moreover, the demonetization drive saw banks getting flushed with funds. This coupled with low credit offtake has led to reduction in term deposits rates. The median rate for term deposits in Dec ’14 was at ~8%*, which is currently hovering at around 6-6.25%**. The investors who were happy with traditional avenues providing higher interest rates are starting to look at avenues which can offer a better return profile. CBFs are currently offering reasonable portfolio yields due to their focus on identifying securities with better spreads which mostly follow hold to maturity strategy.
Further, owing to the issues around burgeoning non-performing assets and capital deficiency across public sector banks over last 1-2 years, the banks’ lending rates have not come down which has led to many new corporates accessing the capital markets for their borrowings. The increased issuances of such fixed income instruments is resulting into a larger universe for investment as well as helping in liquidity risk mitigation.
We believe that going forward, an overall improvement in economic scenario is expected to help businesses do better. This may lead to a higher requirement of borrowings by corporates. Further, these corporates are moving away from being solely dependent on banks for their borrowing needs to accessing capital markets as well. This bodes well for corporate bond funds. These funds have exhibited consistent, long stable performance track records. Regulatory framework ensures the portfolios are well diversified.
Lastly, the recent improvement in credit environment (upgrade to downgrade ratio) bodes well for corporate bond market segment. From an investment perspective, this makes a prudent case for investing in corporate bond funds which may provide higher risk adjusted return. Investors should appreciate that while the returns for corporate bond funds are higher than other funds it is on account of higher credit risk.