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Fund Managers Tune into AA Bonds

With sparkling returns on the back of the bull-run expected to sober down, debt funds now aim to increase their income stream with higher investments to lower-rated debt instruments

Blame it on falling interest rates! Their barb against lower rated bonds in the past notwithstanding, fund managers have stepped up allocation to this segment in order to protect returns on their portfolio. With sparkling returns on the back of the bull-run expected to sober down, debt funds now aim to increase their income stream with higher investments to below AAA debt instruments. Top rated corporate debt and government bonds offer maximum capital appreciation when interest rates go down but returns take a dip as yields stabilise at lower levels. Further, the coupon income from new instruments also goes down. On the other hand, lower rated debt offers higher returns for its inferior credit quality and hence, higher risks.

"A lower rated debt instrument does not necessarily mean a poor quality paper. We have significantly increased our allocation to AA+ credits since these bonds have only marginally higher risk than AAA rated companies. For instance, we have chosen 5-year RPL (AA+) yielding 10.10% over 5-year Reliance Industries (AAA) yielding 9.6% since RPL is also a fundamentally strong company,'' says Vineet Udeshie at Alliance Capital Asset Management Company. Udeshie manages the Rs 1261.36 crore-debt fund, Alliance Income. The fund had a 32 per cent exposure to AA-rated bonds on June 30, 2001, up from 14.5% in March 2001.

The AA tilt: Courting risk for return?
   AA and below exposure as on    Change in  
  March-01  June-01  Exposure *  Size **
Dundee Bond PSU 0.00 18.50 18.50 0.00
Alliance Income Fund 14.51 32.63 18.12 202.50
IDBI PRINCIPAL Income-DHY 4.52 14.24 9.72 83.12
JM Liquid-G 7.56 15.57 8.01 186.02
Templeton India Income 10.29 16.59 6.30 536.36
Grindlays SSI 1.57 7.46 5.89 760.83
"* in %, ** Rs Crore"
Apart from a higher interest income, many such investments provide scope for capital appreciation when they are upgraded on the rating scale. "Reliance Petroleum debentures also have upgrade potential from AA+ to AAA,'' says Udeshie.

The rising exposure also means that fund managers are now attempting to strike a fine balance between interest rate and credit quality risks. So far, an overwhelming majority has stayed glued to triple A bonds with active portfolio management to guard against interest rate volatility. This has also meant a sizeable allocation to sovereign securities, which are an ideal tool to manage portfolio maturity with their high liquidity. The average exposure to government bonds has been around 35% in recent times.

"However, with a surging corpus and limited triple A corporate opportunities, funds have to scout for lower rated bonds since they cannot stretch beyond a point with their investments in government bonds. A higher exposure to gilts increases the risk profile of a debt fund and makes it highly susceptible to interest rate changes,'' says a fund manager.

The increased focus on lower rated bonds could also be attributed to the bull-run percolating to this category. On most occasions, below AAA papers are bereft of liquidity and hardly attract any trading interest. "There has been some buying interest in AA-rated debt securities since yields have dropped to historic lows in gilts and AAA bonds and offer little scope for fresh gains. However, it could be dangerous since the liquidity in lower rated debt could disappear once the positive sentiment ebbs,'' says Akhilesh Gupta at Dundee Mutual Fund.

The higher returns notwithstanding, inferior debt instruments could pose problems for fund managers in a fast deteriorating economy. In case companies default or go belly-up, funds will be left holding worthless papers and hit the NAV of the fund. For instance, consider a fund with a corpus of Rs 1000 crore. Such a fund accrues interest of Rs 27.50 lacs per day (at about 10% p.a.). If there is a credit default of Rs 5 crore, it will take away accrual of about 20 days. In other words, the fund will not earn anything for that number of days.

Recently, term-lending major IDBI was downgraded from AAA to AA+. Even this downgrade from highest to high safety impacted the sentiment and pulled down the NAVs. Arvind Mills is also a case in point, where a large debt fund lost a chunk of its investments since the company defaulted on its repayments.

While all lower rated bonds are not necessarily poor quality investments, fund managers have to exercise extra caution and manage these holdings dexterously. With funds now beginning to lower the credit guard in an attempt to at least maintain returns amidst peer group pressure, investors need to need to thoroughly scan the portfolio. Invest only if you are comfortable with the credit quality of your fund's portfolio!