Life after Debt Paper Downgrades

What next, after the slew of rating downgrades of debt paper?

A lot of fixed income investors are asking themselves this question while planning their investment strategies.

They know that a rating downgrade signifies deterioration in the quality of the instrument. As compensation for the additional risk that investors take, they demand a premium over the G-Sec yields and hence, the spread (difference) between the yield of G-sec and corporate papers widens.

Here’s what the spreads in the debt market between the triple-A rated corporate bond and the 10yr G-Secs look like between July 2018 and January 2019.

Date

Spread between  AAA-rated papers & G-sec
31-Jul-18

82

30-Aug-18

81

28-Sep-18

77

31-Oct-18

109

30-Nov-18

104

31-Dec-18

115

31-Jan-19

129

Source: Care Ratings

 

It can be seen that the spread has increased since July of last year. Signifying that investors demand a higher reward for the higher risk they are taking.

A quick recap of what happened for those who came in late…

The series of downgrades by credit rating agencies began when CARE Ratings downgraded its rating for IL&FS Financial Services Limited from AAA to D within a span of 1 month. Some of the reasons for the downgrade include a delay in servicing of debt obligations and deterioration in the asset quality and liquidity profile of the company. Apart from mutual funds, IL&FS papers were also held by banks, insurance companies and pension funds. Investors had to face losses due to the fall in prices because of the downgrade.

Another company whose ratings were downgraded recently was Dewan Housing Finance Limited (DHFL). During the last week of January 2019, the media reported that the primary promoters of DHFL were accused of illegally transferring public money through secured and unsecured loans and advances. This led to a sharp reduction in the share price and a rise in bond spreads of DHFL. Subsequently, CARE Ratings dropped the credit rating of DHFL’s Non-Convertible Debentures (NCDs), Fixed Deposits (FDs), Commercial Papers (CPs) and Long Term Bank Facilities, amounting to Rs 1.17 lakh crore from CARE AAA to CARE AA+ on February 03, 2019. Following the downgrade, the price of various DHFL bonds fell by nearly 11% – 48% within a short span of just 1 month.

The sharp fall in the share prices of Zee Entertainment Enterprises (ZEEL) and Dish TV added to debt funds’ woes. The Essel Group was said to have connections with Nityank Infrapower, which was being investigated by the Serious Frauds Investigations Office for allegedly depositing over Rs 3,000 crore, post demonetization. On January 25, shares of ZEEL fell 26% and Dish TV India fell nearly 33%. When share prices fell, the value of the collateral fell too, exposing debt funds to a big risk. But there is no default by the group yet on any of its payments.

So, what now, indeed?

It is a common understanding that debt fund returns are typically more stable (less volatile) than equity fund returns and thus, diversifying via debt funds reduces the overall portfolio risk. The recent events that have taken place in the market have raised questions on this very basic understanding. Investors invest in funds having higher exposure to ‘AAA’ rated instruments, which are top quality papers, and thus assume that their investments are safe. But as credit rating agencies downgraded the ratings of some debt papers in the recent months, without much warning, suddenly funds that were earlier safe now carried some element of risk.

The question that now arises is: Should investors completely avoid or stay away from debt instruments?

Defaults, by a few companies in their repayment, do not make investments in debt a bad option. Investment in debt instruments should be as per the asset allocation strategy that the individual investors adopt. Investors should build their debt portfolio keeping in mind the time horizon, risk profile and the post-tax returns that they wish to earn.

The table below lists the various debt options that are available and their post-tax returns.

 

Investment Options

Post Tax Returns (%)

30% tax

20% tax

NIL tax*

Perpetual Bonds (AAA Rated)

5.8 – 6.6 6.7 – 7.6

8.5 – 9.6

Taxable Bonds (AAA Rated)

5.3 – 6.5 6.1 – 7.5

7.8 – 9.5

Tax-free bonds

6.3 6.3 6.3

RBI Bonds

5.3 6.1

7.8

Debt Mutual Funds (more than 3 yrs)

7.4 – 7.6 7.4 – 7.6

7.4 – 7.6

Fixed Deposit (3 years)

6.0 6.9

8.8

Senior Citizens Savings Scheme

6.0 6.9

8.7

Fixed Maturity Plans (FMPs)

(more than 3 yrs)

7.3

7.3

7.3

Note: As per the recent budget announcement for income less than Rs. 5 lacs tax would be NIL.

The above instruments are different with respect to the risk-reward characteristics. Investors should also note that these returns are nominal returns and that they will be reduced by the amount of inflation which averaged at 4% for the last 5 years.

Like any other form of investing, debt investors should study the instrument in which they will be investing or take expert advice while investing in fixed income products too.

Disclaimer: Ventura Securities Ltd has taken due care and caution in compilation of data for its web blog. The information has been obtained from different sources which it considers reliable. However, Ventura Securities Ltd does not guarantee the accuracy, adequacy or completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. Ventura Securities Ltd especially states that it has no financial liability whatsoever to any user on account of the use of information provided on its web blog. The information provided herein is just for the knowledge purpose and shouldn’t be construed as investment advice under any circumstances.

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