By: Rahul Bhuskute
It is now time to focus on opportunities in debt with the credit profiles of companies improving and debt markets doing better due to the interest rate cut by the Reserve Bank of India (RBI).
If there’s anything investors should worry about in the debt market, it is to get sufficient exposure to the right debt funds. Over the past few months, investors have been somewhat apprehensive of the credit profile of the debt market, or whether companies could keep up with re-payments of their debts. The truth, however, is that corporate credit risk profiles are only getting healthier.
One glance at the credit ratios (the ratio of upgrades to downgrades) published by the ratings agencies gives us a clear picture of the improving credit environment. Over the past few years, there have been more upgrades in credit ratings than downgrades. The upgrade-to-downgrade ratio published by Crisil currently stands at 2.10. In other words, there have been nearly twice as many rating upgrades as downgrades in the past year, and that’s heartening.
In debt funds, too, there has been a sharp improvement in the credit ratio. This shows that the economic recovery cycle is well underway, and that the credit market is robust and sound.
The debt markets have also been able to benefit from the interest rate reduction in the economy. Once the economic recovery cycle progresses, corporate India’s credit profile will further improve as interest costs come down. The interest coverage ratios of companies are set to improve in the coming quarters.
Having said that, there is risk in debt markets as in any other asset class. The risks, however, can be mitigated and reduced by following proper risk-assessment and evaluation models. This entails doing one’s own extensive and rigorous bottom up analysis on corporate balance sheets apart from taking inputs from external research.
The performance of credit funds depends largely on managing three types of risk – credit risk, liquidity risk and concentration risk. Evaluating credit risk is the function of a separate credit team. They must evaluate each investment of corporate bonds closely for credit risk, before adding the debt paper to a portfolio.
Hence, keeping a close watch on the credit profile, doing a bottom-up analysis on individual corporate performance, evaluating the industry performance, can go a long way in assessing the credit risk of debt paper. Liquidity risk is another factor that can affect returns. Corporate bonds have lower liquidity than government securities, and hence, they have to be closely tracked on a regular basis. Among other things, one must carefully limit the exposure to corporate groups. The concentration risk needs to be limited to particular groups or sectors so that the impact of any adverse movement in credit ratings can be mitigated.
The credit situation is not as bad as made out to be. With due care in portfolio construction, diversification, liquidity and credit profiles, risks in a credit fund can be contained. Any investment in financial assets has its fair share of risks, but with proper controls, the risk-reward ratio can be shifted to benefit investors.
On a more positive note, the credit market is much healthier than a few years ago as the Indian economy undergoes a rate cut cycle. Lower interest rates not only benefit corporates but also investors in debt funds. Across the spectrum of debt funds, there is an opportunity for investors.
The investors should be guided by rationale while making an investment decision in debt funds. We believe there’s a long way to go for the debt market, and the good times are just beginning.
(The writer is the head of credit and structured investments, ICICI Prudential Mutual Fund)