Mutual Funds eye lower grade paper, but ask for collateral

While chances of default in AA-rated papers are low, same cannot be said for A-rated papers

Easy liquidity and a rising risk appetite has made mutual fund managers take on higher bets on corporate papers with lower ratings backed by bank guarantees and equity collateral.

In the last few months, mutual fund industry officials said that the pursuit for higher yields brought on by expectations of improving corporate earnings had seen a higher incidence of AA-rated and even A-rated papers in the industry.

"Broadly, sentiment in the market itself is positive. The chase for higher yields and a risk-on mood in the market has fewer people worried about defaults. Given the current liquidity, issuers with lower credit-rating also would see good appetite," said Killol Pandya, senior fund manager (debt), LIC Nomura Mutual Fund.

While the chances of default in AA-rated papers are low, the same cannot be said for A-rated papers, said industry analysts. In some corporate bonds, the percentage of AA-rated and A-rated papers together was higher than those of the AAA as well, they added.

In such cases, fund managers resort to hedged structures which help mitigate the risks involved in investing in such papers. Of the many structures employed, the popular ones include investing in low-rated corporate papers of large corporations.

Another structure employed is in the form of a bank guarantee. This is used in case of unlisted entities. While in case of listed entities, mutual funds even take a cover of equity shares where the collateral is 2 to 3 times the exposure taken in debt, said fund managers.

"Credit funds are coming back into vogue. They had lost significance during the crisis period which started in 2008 when some people had taken credit-risk in bond papers of certain corporate which had later defaulted," Dwijendra Srivastava, head - fixed income, Sundaram Mutual.

Fund house officials said that the risk appetite among mutual fund investors was on the rise but fund houses themselves were being cautious about such risk-exposure.

"There are those funds which go in for lower rated papers. In such cases the portfolio maturity will be of a lower tenure, less than a year or just about a year. That way these schemes can take advantage of higher returns but do not take on a lot of risk because of the shorter tenure," said Vidya Bala, head - mutual funds research, Fundsindia.com - an online mutual fund tracker.