A Lower ‘A’ in the Rating Could Help Debt Investors Succeed in the Yield Game

As the returns of debt mutual fund products that bet on the safest, top-rated bonds fall to their lowest for more than a decade, there may be an opportunity in programs that invest in securities with higher ratings. ratings one notch below the best.

With annual returns from short-term programs such as liquid, overnight and ultra-short-term funds ranging from 3.5% to 4%, fund managers and wealth advisers recommend that investors consider medium duration funds, which bet on a mix of securities, including the highest rated and those below. AAA is the highest credit rating.

Medium-term debt programs, which invest in securities with maturities of between three and four years, are riskier than short-term funds due to some exposure to lower-rated papers. They are also sensitive to changes in interest rates.

However, increased investor aversion to riskier papers has led to better return prospects for many medium-term debt programs, which invest 30-50% of their corpus in papers rated AA and below and the remainder in AAA rated securities. As a result of recent interest rate cuts and a strong investor preference for higher rated securities, the return potential of mid-term programs has improved.

“Due to the flight to safety, the rate transmission occurred more in the extremely short space and in the AAA space. In AA space, transmission remains silent. This anomaly provides an opportunity to invest in an AA corporate bond space that offers capital appreciation and capital appreciation due to spread compression, ”said S Naren, CIO, ICICI Prudential Mutual Fund .

The spreads of securities rated AA and below against the reverse repo rate, which is 4%, amount to 384 basis points. Investors could earn up to 6.5-7% from these mid-term funds, which have generated flows worth 2,700 crore in the past three months.

Investors have been reluctant to invest in riskier debt programs since September 2018, when the IL&FS crisis erupted. A series of crises in the bond markets, including the DHFL default, the closure of all six Franklin Templeton debt programs and Covid-19, have made investors risk-averse, prompting them to look to government bonds and the category of bank debt funds and PSUs. The influx of money into these papers resulted in narrowing spreads and very low yields for the categories that only hold AAA rated papers.

Yields on a three-year AAA-rated paper fell to 5.33% as of September 30 from 6.86% in January. Yields on AA rated papers fell from 7.85% to 8.18% over the same period.

Carol M. Barragan

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