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'It was less of a liquidity and more of a confidence crisis'

We speak to Rajeev Radhakrishnan, Head - Fixed Income, SBI Mutual Fund to get a handle on the outcome of recent events affecting debt funds and what investors can expect now

'It was less of a liquidity and more of a confidence crisis'

Debt markets have been in turmoil for the last two-three years. Beginning with the IL&FS episode, there have been several downgrades and defaults in bond-fund portfolios. Recently, the situation was exacerbated by a lack of liquidity in the lower-rated papers, followed by an outflow of capital from credit-risk funds. The country-wide lockdown due to COVID-19 further fractured the economy and its impact on companies' debt-repayment ability will soon be visible. Meanwhile, the government has increased its borrowings to fund relief measures and the RBI has cut interest rates by 40 basis points. We speak to Rajeev Radhakrishnan of SBI Mutual Fund to get a handle on the outcome of these events and what debt-fund investors can expect now.

Debt markets witnessed significant liquidity constraints during the period of lockdown. When do you expect the order to be restored? Are things any better than they were in March or April?
Subsequent to the policy actions announced by the RBI, including TLTROs (Targeted Long Term Repo Operations), liquidity constraints in the market have been significantly alleviated. This has been amply reflected in market levels as well as credit spreads, which have tightened since the stress witnessed in March and April. At the same time, it must be emphasised that the market had been facing less of a liquidity and more of a confidence crisis as risk appetite remains extremely low.

In this context, recent government measures such as the credit guaranteed facility for MSME lending, SPV with government guarantee for purchase of corporate bonds and CPs of NBFCs/ HFCs, and enhancing the coverage of partial credit guarantee scheme by allowing balance-sheet borrowings to be covered under 20 per cent first loss are encouraging steps. The implementation of these programmes with adequate tweaks to maximise the impact remains crucial.

To provide relief to borrowers, the RBI has been asking banks to provide moratoriums on loans, as required. What are the trends in bond markets? Are issuers seeking deferment of payments on their bond issuances as well?
While banks/NBFCs have been provided the flexibility to grant moratorium on loans, the applicability of the same to capital-market borrowings is fraught with other negative implications. Apart from hindering the ability of corporates to access debt markets in the future, this would also have an impact on daily NAVbased products as customer withdrawals have to be honoured without delay. We have not witnessed this trend yet in debt-capital-market instruments of issuers seeking deferment of payments. It is expected that corporate issuers make use of the range of liquidity interventions provided so far by the RBI to ensure that any short-term disruptions in cash flows do not impact the servicing of their capital-market liabilities on time.

What are the likely implications of the higher Centre and state borrowings to support the recently announced stimulus on bond yields and debt-fund returns over the next one-two years?
The extra spending requirements and revenue shortages expected due to the nationwide lockdown have necessitated additional market borrowings by the Centre. It is also expected that most state governments would choose to avail the additional borrowing leeway allowed by the Centre over the rest of the fiscal year. In the absence of supporting measures by the RBI, which could involve direct/indirect absorption of the excess supply and/ or measures to encourage bank SLR buying through hike in HTM (held to maturity) limits, the market absorption of the same would come at the cost of higher market yields. This would be at sharp variance with all the conventional and unconventional measures adopted by the RBI so far and would be inconsistent with the requirements of an economy facing a material growth slowdown with negative GDP growth this financial year. In view of the same, we expect that policy actions would be taken to ensure a non-disruptive conduct of market borrowings. Accordingly, the base-case view remains that there would not be a negative impact on debt-fund investors in the coming year.

Liquidity constraints have been particularly severe for lower-rated papers. Are there signs of stress in the market even for top-rated issuances?
Top-rated issuers continue to benefit from the prevailing market conditions. This is amply demonstrated by the response in the TLTROs. Overall, investors continue to remain discerning with respect to the selection of specific names, which is independent of external ratings.

We are likely to be in a low-interest-rate environment for a considerable amount of time. Do fixed-income investors need to reset their return expectations?
Definitely. In the prevailing circumstances and considering the expected evolution of economic conditions, interest rates are likely to remain 'low for a bit longer'. At the same time, given the movement so far in this rate cycle, investors need to reset their return expectations as compared to the recent history. Overall, all fixed-income investment avenues, including assured-return schemes and bank FDs, have witnessed markdown in interest rates. Debt schemes still provide the ability to capture mark-to-market gains in a declining/lower-interest-rate environment as we expect that the current interest-rate cycle can extend for a longer period.

The conventional role of fixed income in an investor's portfolio has been to provide moderate but steady growth, while it is left to equity to provide a legup to returns. From that perspective, where do high-yield strategies, such as credit-risk funds, fit into an investor's portfolio, more so with the hindsight of the last few months?
The hindsight lesson from the recent experience has been that investors should always follow a simple asset-allocation approach and within the same, debt categories so selected should be in line with their investment duration and more importantly risk tolerance and liquidity requirements. Hence, high-yield strategies may not necessarily be suitable for all classes of investors. Investors with adequate understanding of inherent risks in credit-risk funds and with enough time horizon may consider this category for ongoing allocations.

The industry has witnessed downgrades and writedowns of an unprecedented scale since the IL&FS episode. How much of a role have the valuation norms played in exacerbating the situation for debt funds? Have you undertaken any changes or tweaks in your credit-appraisal or portfolio-management practices in response?
The recent turbulence in certain debt-fund categories has less to do with valuation norms. It's more about the inherent sustainability of strategies in a situation where the underlying secondary-market dynamics haven't developed enough to provide sufficient liquidity and fair pricing for these categories of bonds. At the same time, the participant base is only gradually widening beyond mutual funds, with most banks still reluctant to move beyond AAA bonds in the non-SLR books.

When it comes to valuation norms, especially in the non-liquid space, the pricing becomes less exacting for some securities. However, the valuation norms have adapted to events in the industry and are being refined continuously. In view of the market illiquidity in credit bonds, pricing is largely based on daily polling of a very vast number of individual debt securities. Even with the listed securities, a plethora of terms (secured/unsecured, covenants, management covenants) make it difficult to have a nuanced valuation. This is an unavoidable fact in debt markets with an element of subjectivity that is inherent in the valuation process.

Our credit-appraisal process is completely bottom-up and is continuously adapting to all market events but rarely to valuation norms. Within the portfolio- management templates, there is a renewed emphasis of portfolio- diversification norms as well as portfolio-level liquidity.

Your Short Term Debt Fund has been performing very well and as a result its assets are also steadily rising, even as many others are struggling. Can you elaborate upon some of your rules governing its management? For instance, what can and cannot enter its portfolio? Any upper limits on exposures to AA & below rated papers, issuer-level exposures, liquidity management, etc.?
All our funds are managed within riskbased scheme templates, which govern broadly the extent of interest-rate risks, credit risks in terms of ratings filters as well as liquidity and diversification requirements. These templates have been in existence for more than a decade and were incorporated based on the lessons from the 2008-09 crisis. The templates have been adapted over the years and have governed the overall risk parameters of all portfolios with oversight by the Investment Committee since then.

With respect to the Short Term Debt Fund, the scheme has always had a cap of three years average maturity, which post the SEBI reclassification has been changed to Macaulay Duration based limit of three years. With respect to the credit-based filters, the scheme template restricts exposure to non-AAA rated bonds at 10 per cent of the AUM. Within this range, the scheme has a rating floor of AA- as per the scheme template, with single issuer limit of 3 per cent in non-AAA names. Issuer-level limits, even for AAA names, are tighter than the regulatory norms. Liquidity requirements are assessed periodically and reported to the Investment Committee.

Who should invest in your Short Term Debt Fund versus your Corporate Bond Fund? Both have high-quality bond portfolios and pretty similar yields and average-maturity profiles?
I've already explained the mandate of the Short Term Debt Fund. The Corporate Bond Fund has a template mandate of investing only in AAA rated bonds and government securities, including SDL (state development loans) and bills. With respect to the duration limits, the scheme average maturity is capped at five years. Given the extant credit- market dynamics over the last few years, the Short Term Fund has consciously followed a more conservative mandate than allowed by the templates.

The core scheme mandates as in the templates are not intended to change with changing market dynamics. Accordingly, the Corporate Bond Fund is positioned for investors who are highly conservative with respect to credit allocation. The fund has gained significant traction in recent times, even though it was launched only in January 2019. This indicates the appeal of the strategy among investors in the current market environment.