Should you consider investing in credit risk funds now?

The return generated by a debt portfolio has two main components, carry (income accrued) and mark-to-market (MTM) gains/loss.

In a low rate environment, when one is not satisfied by the carry earned by existing products, it is very likely to be enticed by debt funds showcasing higher yields. To earn higher carry, you could look at moving up the yield curve (increase duration risk) or shift to a different yield curve (increase credit risk).

To elaborate on this further, let’s look at the yield curve. The yield curve today is very steep, especially in the short-to-intermediated duration. So, without diluting the portfolio quality one could earn relatively higher carry simply by moving up the yield curve ie. by increasing duration of the portfolio marginally.

Here’s an example of moving up the sovereign yield curve, from 2 year to 3 year for higher carry – 2-year GSec yield as on December 31 was at 4.74% and if you look at the 3-year GSec, the yield there was 5.27%, earning you a difference (spread) of 53 bps by just moving up one year on the yield curve. (Source: Bloomberg).

As mentioned above, another way to earn higher carry could be to shift from one yield curve (sovereign) to another (corporate bond yield curve). Here, the point worth highlighting is that one has now changed his/her risk profile and has taken higher credit risk.

When looking to move to a higher credit risk strategy, it is also important to analyze how the historical spreads have been between these two instruments.

Let’s compare 5-year AAA Corporate bond with 5-year GSec and understand where the spreads are today, versus how the average historical spreads were. Today the spread between 5-year AAA (yield as on December 31, 2021 – 6.22%) and 5-year Gsec (yield as on December 31, 2021 – 5.79%) is only 43bps. Compare this to an average spread of 85 bps pre-covid, ie. during the period 2017 to 2019.

This means that today the spreads have compressed meaningfully and therefore there is a decent probability that in future as yields rise and as spreads also begin to widen, the higher carry earned via credit exposure could prove of limited buffer as corporate bond curve will have to face MTM loss arising out of both the events, ie. interest rate moving up and spreads widening. (Source: Bloomberg)

While carry is an important contributor towards debt portfolio return, one must not assume carry to be a proxy for future returns. As has been observed previously too, carry yield at the time of entry and the holding period returns experience could be very different. This can largely be attributed to the shift in yield curve, credit spread widening/compressing or dynamic portfolio management, where portfolios may undergo changes due to change in interest rate/credit view. Even with high carry, there could be occasions of principal drawdown either via MTM loss or credit loss.