As returns from debt mutual fund products that bet on the safest top-rated bonds shrink to the lowest in over a decade, there might be an opportunity in schemes that invest in securities with ratings a notch below the best.
With annual returns from short-term schemes like liquid, overnight and ultra-short-term at 3.5%-4%, fund managers and wealth advisors are recommending investors to consider medium-duration funds, which bet on a mix of the securities including the top-rated and the ones below that. AAA is the highest credit rating.
Medium-term debt schemes, which invest in securities that mature between three and four years, are riskier than short-duration funds because of some exposure to lower-rated papers. They are also susceptible to changes in interest rates.
However, the heightened aversion to riskier papers among investors has resulted in better returns prospects for many medium-term debt schemes, which invest 30-50% of their corpus in AA-rated papers and below and the rest in AAA-rated securities. Following the recent cuts in interest rates and investors’ strong bias towards top-rated securities, the returns potential of medium-duration schemes has improved.
“Due to flight to safety, the transmission of rates happened more in the extremely short and in the AAA space. In the AA space, the transmission remains muted. This anomaly provides an opportunity to invest in AA corporate bond space which provides higher accrual and capital appreciation due to spread compression,” said S Naren, CIO, ICICI Prudential Mutual Fund.
The spreads for AA- and lower-rated papers over the repo rate, which is 4%, are as high as 384 basis points. Investors could earn as much as 6.5-7% from these medium duration funds, which have got flows worth ₹2,700 crore in the past three months.
Investors have been wary of putting money in riskier debt schemes since September 2018 when the IL&FS crisis broke out. A series of crises in the bond markets including the DHFL default, shuttering of the six Franklin Templeton debt schemes and Covid-19 made investors risk-averse, prompting them to move to government bonds and the banking and PSU debt fund category. More money crowding to these papers has led to spreads shrinking and resulting in very low returns from categories which hold only AAA-rated paper.
Yields on a three-year AAA-rated paper have moved down to 5.33% as on September 30 from 6.86% in January. Yields on AA-rated paper have moved up from 7.85% to 8.18% in the same period.