Higher risk need not mean higher returns

Yields on highly rated bonds are the same as lower rated bonds' due to tight liquidity conditions

Risk is directly proportionate to reward. The higher the risk you are willing to take on your investments, the higher will be the return. That is why equities, which offer high returns, are advised only for those with the ability to withstand the vagaries of the market. Unlike equity, debt as an asset class is safer and also offers lower returns.

Even in debt, if you invest in a low-rated bond, you can expect higher yields compared with a bond with high ratings. But due to the tight liquidity, the difference between the yields of a highly rated paper (say 'AAA' rated) and a lower-rated one (say 'AA'), or spread, has narrowed.

In such a situation, does it make sense to take on higher risk? No, say experts.

According to a recent report by Axis Mutual Fund, lower-rated companies are more likely to default than 'AAA'-rated companies and investors must pay attention to credit quality of debt portfolios. Lower-rated debt may offer higher yields, but those high yields could themselves be contributing to the financial difficulties of the borrowers.

“We believe current spreads do not justify the risks presented by lower-rated papers,'' says the report.

R Sivakumar, head, fixed income, says it is alright to invest in lower-rated papers if you are getting higher returns. But this makes sense only if the credit environment is improving and the spreads are wide. Conversely, if the credit environment is under stress and spreads are narrow (which is how it is now), it is better to stick to high-rated papers.

 

The situation is similar to 2010, when the spreads had narrowed. But in 2010, when the credit cycle recovered, the 'AA'-rated bonds saw an improvement, due to which the yields fell and bond prices increased.

However, this time, the credit cycle could take one to two years to improve. Hence, investors should look at debt funds that have a higher proportion of G-Sec and 'AAA'-rated papers, Sivakumar advises. This data is available in the factsheets of mutual funds.

Another problem is that lower-rated papers are relatively illiquid. Even if the fund manager wants to exit an investment, it may not be possible to sell lower-rated bonds. “Currently, spreads are relatively low and the underlying credit trend is poor. In sum, we believe as investors we are not being adequately rewarded for investing in lower-rated papers at this time," the report says.

 

Sanjay Shah, head, fixed income, HSBC Global Asset Management, India agrees investors should look at the portfolio of debt mutual funds and the stance of the fund house before investing. One can look at short-term funds that invest in high-quality paper at the shorter end and offer high accrual returns or, alternately, one can look at high-quality fixed maturity plans. Even bonds of 'AA'-rated companies (up to threeyear maturity) are offering only 10.50-11 per cent, while papers of similar maturity of certain 'AAA'-rated companies are offering 10.25-10.30 per cent because of the tight liquidity conditions. The shorter end of the interest rate yield curve has moved higher and short-term instruments like bank CDs (of maturity less than one year) are offering yields in the range of 11 per cent. Therefore, one should look at high-quality papers at the shorter end because yields are equally high in those papers,'' says Shah .