Rahul Bhuskute, Head of Structured and Credit Investments at ICICI Prudential Mutual Fund, shared his views at the fixed income panel discussion held at the Morningstar Investment Conference.
End 2015 and early 2016, we saw spreads widen quite significantly. Now they are showing signs of coming back down the curve. What's your assessment?
When yields come down, typically in most markets you would expect credit spreads to come down. Once liquidity is abundant, the environment changes to risk-on. There clearly credit spreads come under pressure and actually tighten. But what has happened in India over the last three years is actually quite surprising.
We analyze credit spreads regularly and we have four papers which we use as totemic of respective parts of credit curve – such as Rural Electrification Corporation (AAA); Tata Motors (AA) etc.
These four papers signify a large part of the credit market. The yields on these papers obviously have come down. Therefore, the common perception is that the spreads have also tightened. But if you actually see, the credit spreads have not tightened beyond 10 bps or so. Now, in an environment where yields have come down by almost 2%, you would expect credit spreads to tighten far more.
I think that's part of the game that's yet to be played out.
Can you expand on that? Why it will play out that way?
My view is that over the next year or two, we will see that spread tightening.
One is because the action seems to be moving from a duration-centric play to a credit-centric or accrual-centric play. You have seen the flows of accrual funds increasing significantly. Last month these funds got Rs 5,000 crores. So, purely, from a demand supply kind of perspective, you are going to see more demand coming and that is going to have an impact on the spreads.
Secondly, a large part of the financial space has been relatively quiet in terms of banks which have not really joined the credit play yet. They are not increasing their books. Some are, but a large part of that space has been quiet.
I think in the next year or two we would see a lot more banks getting back into the balance sheet increasing, chasing quality credit assets kinds of space, and that's going to add to the demand.
That’s why I believe we will see credit spreads tightening significantly in the next year or two. That would obviously mean that values of bonds go up and returns of the funds that hold these kind of papers is going up. So, I don't think credit spreads have tightened. In fact, they have remained the same. But I think over the next year or two, you are going to see that happening.
You spoke about the demand. On the supply side, are you really seeing newer corporates getting into this space vis-à-vis say pure bank lending?
In terms of financing support to corporates, banks are still daddies and control almost 70% of the market, but that has been shrinking at a rapid pace. Look at the amount of credit content in the mutual fund industry - that's gone up significantly in the last three years.
Corporates still consider banks as their regular and faithful friends while capital markets, perhaps rightly so, are considered more fair-weather - you might be here today but not tomorrow when I need you. That perception will change over a period of time as corporate bond markets acquire depth and there is always a ready buyer for corporate paper. To put this into numbers, there are almost 1,300 corporates rated AA- and above but the mutual fund industry has exposure only to about 325 out of those.
Clearly, there is a vast area of that corporate space which has not been tapped by the mutual fund market or capital markets yet. That is going to happen. Over the last six months or so, I have seen a lot of corporate inquires directly coming into the fund house, pointing out that the rates seem to have come to levels where they are borrowing for 3-5-7 years and for AA+ and AAA kind of names even 10 years. Today corporates are willing to come into the market and lock into rates. So we will see more supply that's going to come with a little bit of lag. Demand seems to be moving ahead of supply.
Possibly, there would be a 6-month period where you would see demand outstripping supply and therefore credit spreads coming under a bit of pressure.
Based on your learnings from what happened in the credit market over the last year or so, what sort of positioning did you do in your portfolios?
The first learning is that if you're investing in corporates, you're going to have events. India is a developing country. We keep evolving. Maggi gets banned. Sun TV licenses come under a question mark. Iron ore mines get banned. Coal mines get banned. Public sector banks become A or A- from AAA, AA.
So, as a fund manager or investor, assume that events are going to happen rather than assuming they are not going to.
Second, if events are going to happen, then how are you going to manage that risk? The best way is by managing your exposures. If exposure is relatively small, then that does not have a significant impact on the fund, the fund performance, the franchise value. On the other hand, one event has the ability to actually completely destroy your investor experience if the exposure is large.
In our market, I see that huge concentration risks are taken. Bond funds in developed markets where the assets run into billions (dollars or pounds), the largest exposure typically won't exceed 4%. That's diversify adequately. The largest corporate bond ETF in the world doesn't have more than 1.9% exposure on a single name. I believe in the Indian context that exposure to a single name should be on a promoter, not exposure on one company of a promoter. And that should be monitored very, very rigorously at both the fund level as well as at the AMC level.
Third, it is wrong to assume that an individual who manages duration well will do the same for credit. Within equity funds you have specialists managing large caps and small caps, etc. There are specialists managing G-Sec funds. Perhaps there is a case for the industry to acquire more talent from industries such as banking or NBFCs, people who understand credit and can resolve such kinds of situations, if they do arise.
Lastly, don’t forget management of media. The moment such an event happens there is a veritable media circus around that event. After the Amtek Auto incident, a large business daily ran an article saying all leading mutual funds have exposure to troubled/stress sectors. And ICICI Prudential was mentioned as having a 5% exposure to the troubled power sector. Based on our AUM at that point in time, 5% amounted to Rs 5,000 crores.
We culled out a list of our companies and 70% of that exposure was in four names: NTPC, NHPC, Power Grid, Nuclear Power Corporation. These are not stressed exposures. But imagine what that could do to an investor or adviser who would then want to cut his losses, pay the exit load, pay the tax, and move out, when there is no reason for doing so. The media reported downgrades extensively. But what about upgrades? There have been plenty of upgrades too.
Tell us about the two funds you manage which have slightly divergent trends. In Regular Saving Fund, or RSF, you are moving to slightly more conservative credit. In Corporate Bond Fund, you are reducing your AAA and going more into the AA sort of segment.
We believe that there are two ways to engage with an investor.
Either the investor has done his homework and comes to you with a specific requirement. Or he presents his situation in life and asks for suggestions regarding the right product.
With that logic, we've created two funds – RSF and Corporate Bond. (The third is relatively new.)
The two are based on two different themes. Corporate Bond only invests in AAAs and AAs, RSF goes up to A- rated and selectively does structured deals.
If people want to have the complete accrual experience, they come into RSF and it is our job to manage those risks. So we are credit and risk conscious.
In Corporate Bond, we play a little bit of duration. Just because papers are AAA and AA, we feel comfortable lending to them in the longer term. When you come down the credit curve, you don't want to go long in terms of credit risk exposure.
So in RSF we run a duration of between 1.5 to 2.5., typically it has been about 1.75 to 2.2. In Corporate Bond we don't mind taking slightly larger duration and moving up to 3.5 to 3.75. But at the core, both are accrual funds. And we want consistency of returns. So, we don't want to take calls like dipping into G-Secs or SDLs or trading. If the investor wants a duration experience, he can go to some other fund.