Bond fund investors face increased credit quality risk

Slowing corporate growth could constrain bond-fund returns as the risk of downgrades loom large

The financial stress on corporates could soon start to show on the credit quality of bond funds. In the past couple of months the risk to lower-rated bond funds has risen as corporate profitability is undergoing severe stress and the risk of downgrades are expected to heighten in the next few months. In such an environment, investors in bond funds should only look at the highest-rated ones, say experts.

Corporate financial performance deteriorated significantly last year and this has continued in the first quarter of this financial year.

Says R Sivakumar, head, fixed income, Axis MF, “There's a substantial deterioration in the financial health of companies and in some cases it’s even worse than the 2008 financial crisis.”

Many companies are finding it difficult to make payments of their debt, reflected in banks’ larger quantum of non-performing assets. For PSU banks, in the June quarter this has risen 16% sequentially (QoQ). A recent Crisil study highlighted that one-third of the firms it rates do not generate sufficient cash to service their debt through internal accruals.

In this current corporate stressed environment, the quality of debt has turned into a major concern. Lower-rated corporate bonds are at a significantly higher risk and are more prone to downgrades in the near future.

Bonds that are downgraded often see a spike in yields and erosion in their values, and funds that hold such bonds take a huge hit to their net asset values. Says Sivakumar, “The downgrade risk is overwhelming, and once you have a downgrade at this juncture, bond values decrease.”

Investors are also not compensated for the higher risk they take in lower-rated bonds. For now, the spread between AAA-rated paper and AA-rated paper is just around 50 basis points, significantly less than what it was a few years ago. Investors shouldn't take additional risk of lower-rated paper for a meaningless increase in  returns. Says Yadnesh Chavan, fund manager, fixed income, Mirae MF, “The incremental returns on lower-rated paper are minimal and it’s not worth taking that risk in this environment.”

Only those bond funds that are near 100% invested in AAA-rated paper might be able to withstand the pressure on the debt market in coming months. Credit quality is becoming a major concern now in the bond market and investors should steer away from lower-rated paper, say experts.

Last month debt funds lost 1.8% and short-term bond funds lost 1% as the yield-spike sent bond prices lower. Long-term gilt funds were the worst hit according to value research, with loses averaging 3.1%.