Slowing flows into Credit oriented funds
It is well known that lower rated credits have low/negligible liquidity in the bond market. This has been further exacerbated in recent months wherein debt markets have seen deteriorating liquidity for even AAA rated corporates. Nevertheless, illiquidity concerns in the lower rated credit space have seldom been at the forefront for credit fund investors due to the near secular inflows into the category. As a result, many perceive these bonds as “Held to Maturity” without needing to worry about associated liquidity to fund redemptions/ price discovery.
However, this illusion of utopia, despite relative illiquidity in the credit markets could be set to change with slowing flows into credit oriented funds. The chart below highlights the sharp reduction in flows to credit oriented funds in recent months after several prior months of strong growth. In fact, in May 2018, net monthly flows into credit oriented funds were at its lowest since February 2016.
(Source: CBRICS, ICRA MFI Explorer)
Time to refocus on liquidity in credit markets
We have always believed that liquidity plays an important role even in the credit markets as discussed in our earlier note (Liquidity in Credit Markets, 07 July 2017). To recap, we had highlighted the significance of liquidity not just in helping meet redemptions, but more importantly in price discovery of securities. Price discovery ensures better accuracy in daily NAV of funds, thus providing a fair entry/exit for investors.
In light of slowing flows towards credit oriented funds, we have refreshed our analysis on portfolio liquidity across various segments in the credit market as seen below. Here, we calculate the LiquidityScore – defined as the percentage of issuers in a fund’s AUM, whose bonds/debentures have witnessed a trade at least once since 1st April 2018, for each fund in the category. Higher the LiquidityScore better is the presumed liquidity in a fund and vice-versa.
In the above chart, a AAA oriented fund like IDFC Corporate Bond Fund has a LiquidityScore of 100% (rounded off to nearest whole number) which means its portfolio consists almost entirely of issuers whose securities have witnessed a trade in the market at least once in the past three months. In the case of IDFC Credit Risk Fund, 87% of the fund’s underlying issuers have had their respective securities traded at least once in the past three months. As seen in the chart above, the LiquidityScore of IDFC Credit Risk Fund is superior to peer funds in the credit category. Moreover, LiquidityScore tends to wane as the portfolio skew increases towards lower rated credit papers (“High Yield” funds have the lowest LiquidityScore).
In this context, it is important to note that credit spreads have, in fact, benefitted from this shallow liquidity amidst the sharp sell-off in AAA bonds witnessed over the last few months (highlighted in our note, Value Investing - The AAA Way Part 1 & 2). Consequently, higher yielding funds with low underlying liquidity have outperformed the broader market, benefitting from this anomaly. However, this could be transient in case flows towards credit oriented funds were to continue to trend lower or even turn negative for a sustained period of time. In such a scenario, lower rated securities having weaker liquidity will possibly see a sharper re-pricing (widening of credit spreads), thereby reversing this recent outperformance.
Further, we reiterate our view that investors benefit from investing in funds wherein the underlying securities are reasonably liquid. This ensures better price discovery for such securities and thereby improves the accuracy of the daily NAV, thus providing a fair entry/exit for investors.
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