Qu’AAA’lity, Qu’AA’lity or Qu’A’lity? – An Update on Credit Markets
The credit default/sharp downgrades faced by IL&FS & its group entities have had a knock-on effect on the credit markets in recent months, thereby resulting in heightened investor concerns regarding select issuers and sectors. This concern and fear among investors has manifested itself in the form of increased redemptions in the credit fund category, clearly denoting flight to quality.
This leads us to the question – Is there value in credit fund category today? While value is starting to emerge in select segments of the credit markets, we still believe it may not be an opportune time to enter the segment.
Spreads – The Guiding Light
As highlighted in our note (Value Investing - The AAA Way Part 2), spreads of AA rated bonds (over AAA) witnessed massive compression in FY18, thus signaling a better risk-reward trade-off in the AAA rated bonds. However, this trend has started to reverse for AA rated bonds. Over the last few months, in order to fund redemptions, credit-oriented funds have had to resort to selling some of their relatively better rated bonds (primarily AA and above rated bonds). This selling pressure, in an otherwise illiquid market has thereby led to widening of spreads in AA rated bonds.
On the other hand, ‘A category’[1] bonds continue to be sparsely traded, thereby not transmitting the full extent of stress witnessed in the credit markets. This has resulted in continued spread compression for ‘A category’ bonds. This divergence is especially bewildering given the overall risk aversion amongst market participants and general tightening of financial conditions.
Price Discovery – Mirror on the Wall
The true valuation of any security can be ascertained from its traded value. Securities which don’t get traded in the market can continue to be at unrealistic valuations. The same can clearly be seen in the tables below. As can be seen from a sample of trade data, Credit bonds (AA category and below) which have traded over the last few months have witnessed a yield increase of over 100 basis points (reflective of stress in the credit market), whereas the non-traded bonds’ yields have moved up only by 30 basis points. In our view, this divergence in spread can be attributed primarily to illiquidity and not necessarily any change in credit profile.
This, then, brings us to the rating split of bonds that have been traded (primary or secondary) recently. The credit-risk and credit-oriented funds[2] invest primarily in securities in AA category and below. Analysis of trades[3] since 1st Sep, 2018 clearly contrasts the illiquidity in lower rated (‘A category’ and below) bonds as compared to better rated bonds (AA category and above). As can be seen from the graph, over 60% of the AA category issuers in the underlying universe have witnessed a trade in their bonds since September 1st, whereas only 23% of ‘A category’ issuers therein witnessed a trade in the same period. This clearly points towards better liquidity & price discovery in AA bucket, relative to its lower rated peers. Needless to say, AAA rated bonds have seen near 100% trades.
2 Universe of credit oriented funds is as per Crisil classification of “Credit Opportunities Fund” prior to March 2018
3 Source for trade data is from Corporate Bond Reporting and Integrated Clearing System (CBRICS). Inter-scheme trades and trades below Rs. 5 crores have been excluded. An issuer is considered as “traded” if any one of its securities has witnessed a trade since 1st September 2018. CBRICS is not necessarily exhaustive, but is reasonably representative of primary/secondary market trades.
(Source: CBRICS, ICRA MFI Explorer)
Another interesting takeaway from the above graph is the sparse trading witnessed in the AAA(SO) segment, in spite of its high credit rating. These bonds provide an illusion of higher safety but suffer from similar illiquidity and price discovery as witnessed in lower rated bonds.
Relook at Credit Funds?
From a macro perspective, financial conditions have tightened and will only get further accentuated with the recent wobble in NBFC / HFCs. The resulting slowdown in aggregate lending could adversely impact overall growth and therefore is negative for credit markets. From a flow perspective, recent redemptions witnessed in credit-oriented funds have been sizeable and was last witnessed only in December, 2015. If such level of redemptions were to continue, they can have serious ramifications for spreads across the credit curve. Moreover, a lot of the lower rated issuers may face refinancing risk in a tightening liquidity scenario (see Annexure 1).
(Source: ICRA MFI Explorer)
Key Takeaways
- Spreads in AA rated bonds have started to recover. However, this has not been the case for ‘A category’ bonds due to lack of liquidity. As a result, spreads between A and AA bonds have fallen from over 2% to almost 1%.
- Limited trading in ‘A category’ and below bonds results in limited price discovery relative to the rest of the market. As a result, bond valuations do not fully capture stress in credit markets and therefore lead to illusion of better performance in an otherwise weakening market..
- Better liquidity and price discovery in AA category relative to lower rated credits provide a better risk-reward trade-off for investors.
- Overall tightening of financial conditions is negative for the credit markets. This, coupled with adverse fund flows into credit oriented funds calls for caution from investors’ stand-point
Annexure 1: Large upcoming LAS (Loan Against Shares) maturities
Source- ICRA MFI Explorer
A segment of the market which heavily relies on refinancing is loan against shares (LAS), given the absence of significant operating cash-flows at the issuer level. Over the last few years, LAS structures have gained prominence given their higher yields amidst the strong flows in credit oriented funds. The next few quarters could witness sizeable bunching up of maturities as seen in the chart above. This wall of maturities could be a source of credit risk for the weaker/lower rated issuers in light of slowing flows into credit oriented funds and decelerated pace of growth in NBFC credit.
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