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'A massive intervention from an outside force is required'

Providing a macro view of the ongoing credit situation, Maneesh Dangi, CIO - Fixed Income, ABSL AMC, discusses its impact on the debt-fund industry

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We caught up with Maneesh Dangi, Chief Investment Officer - Fixed Income, Aditya Birla Sun Life AMC to get his perspective on the current credit situation in the fixed-income space and what lies ahead. Read the excerpts from our conversation below.

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Credit downgrades have zoomed in recent months and they have a direct impact on the returns of debt funds. A lot of debt fund investors are experiencing it for the first time and they are scared. From your perspective, how bad is it?
We need to look beyond the propaganda to see the real situation. Out of the total size of the debt mutual fund industry, which is around Rs 13 lakh crore, the total amount of stressed assets is less than Rs 25,000 crore. Note that this is not a loss, but assets which are stressed. The loss given defaults would be less than 20-40 basis points.

The companies which are said to be under stress are the ones which are in the news all the time, some of them defaulting on their payment obligations or their stock prices falling sharply. This creates the perception of the issue being much bigger.

But how much worse can it get from here? As this is still unfolding, the proportion of stressed assets, which looks relatively small right now, can potentially snowball into something much bigger, can't it?
Such occasional stress and defaults are part of normal functioning of credit markets, but the thick spreads adequately compensate for the risks and occasional volatility. We have seen such stress in the past but things normalise. We believe that the worst part of the stress is likely over due to two reasons: 1) Policy makers are taking cognisance of the stress and responding to it, 2) Market noise of the stress and risk aversion appears to be peaking with even good companies being watched with suspicion. Typically this extreme level of risk aversion is the sign of bottoming out.

Moreover, such periods of crisis and extreme risk aversion also means that credit is priced better and ex ante returns are likely to be better, compared to a prolonged period of tranquillity which begets complacency and some mispricing of credit. Just as a prolonged period of stability makes a system unstable, crises like these are generally followed by long periods of stability and decent returns. We should also remember that with IBC in place, creditors are in a much better position compared to the past, which is possibly not yet being adequately reflected in the current pricing, creating space of higher risk adjusted returns for the investors.

Moreover, despite so much noise, it is not that the complete Rs 25,000 crore of the stressed portfolio has gone down, it is only Dewan Housing Finance, Reliance Commercial Finance, Reliance Home Finance, and IL&FS which have defaulted out of these. If the complete stressed portfolio of Rs 25,000 crore goes down, then maybe the loss will be around Rs 5,000 crore.

Let me put this in perspective. Take the banking industry. With an industrial loan book of ~ Rs 32 lakh crore, it has NPAs of 17.5 per cent, i.e. 5.6 lakh crore. Compare that with the numbers I mentioned for debt funds. A possibility of losing Rs 5,000 crore versus lakhs of crores which have been written down by the banking industry.
I'm making the comparison just so that people get a bit of the perspective of how insignificant the total size of possible loss facing debt mutual funds is.

Look at it from another perspective. In the last three years, a bottom quartile credit risk fund - these are the ones with maximum risk - would have delivered about five per cent per annum. A median credit risk fund would have delivered about seven per cent. So about five to seven per cent is the range of returns in a category which is supposedly under 'super stress', because a bulk of this Rs 25,000 crore I talked about is in this category.

So a median fund has actually delivered substantially better than a fixed deposit. And such performance has come in one of the worst years in the last 20 years from a credit risk point of view.

Our credit risk fund has delivered 9.5 per cent per annum in the last three years, so about seven per cent net of expenses and taxes, which is much better than tax-free bonds and fixed deposits.

Now this is what should be communicated to investors which unfortunately is getting masked owing to unconstructive news doing the rounds.

How big a dent can this small exposure make given the lack of adequate liquidity in debt markets in India. Even a few defaults can lead to a market-wide loss on confidence and squeeze the liquidity further, right?
Things happen in a sequence. First, the sovereign rates boil, affecting access to liquidity as money becomes pricier. People find it difficult to raise money and credit events begin to happen. These are first visible in small-cap companies since they are the first to experience a credit squeeze, leading to a sharp drop in their stock prices, which is precisely what happened in April-June of 2018. It started with small caps, leading to collapse of mid caps and eventually large caps. So there is a cascading effect for any credit event.

Talking specifically of the current situation, the cascading effect has already played out. Implications of the same can be seen in poor auto and home sales, falling real estate prices and so on, leading to economic slowdown.

Unless there is a massive intervention from an outside force such as the government or any regulatory authority like RBI, it can continue to perpetuate. There is no other way to stop it. This continues to be contagious and things worsen incrementally everyday. Falling credit itself convinces risk takers to not take any further risks. Thus, it becomes a self-fulfilling process which can be quite damaging.

On a different note, the recently created 16 categories of debt are far too nuanced. Which among these do you feel are sufficient for a retail investor's fixed income portfolio?
There are many categories, but in reality there are only four.

One is the liquid and overnight fund category which provides for one's very short-term needs and assumes very little risk both in terms of duration and credit.

The next is the ultra-short-duration category which caters to one's savings needs for three to six months. It includes four types of funds - low duration, ultra-short-duration, floater and money market funds. Retail investors don't have to bother much. They are simply looking at 15-20 basis points over and above the liquid fund category, thus, low duration funds are suitable for them. On the other hand, for more evolved investors, floater, money market and ultra-short-duration can also be looked at to earn a little extra.

Then there is a short-duration category which includes banking and PSU funds, corporate bond, short-duration, credit risk and medium duration funds. The duration here oscillates between one to four years and they differ on some counts.

Banking and PSU is a sectoral category with focus on private and PSU banks and companies which makes it a safe category, though you are taking a sectoral bet.

Second is corporate bond funds where large amount of AUM is invested in AAA bonds of good companies. So unlike banking and PSU funds which are sector restricted, these funds are sector agnostic but have rating constraints. It is safer than Banking and PSUs because it's actually taking a bet on the balance sheet and not on the sector.

Then there are short-duration funds which are rating agnostic but typically in our industry no one goes below AA/AA+. Then comes medium-duration funds which have a mid-yield strategy with a little more aggressive duration of up to four years. The fifth category in this space is credit risk funds. With a similar duration, these funds takes on higher risks by investing in below the highest rated instruments.

Essentially, all of these funds in a three year cycle will give you a significant alpha on fixed deposits as well as inflation.

The fourth broad category is the long-duration category, which includes dynamic bonds, medium-long duration, gilt and long duration funds. These four are for investors who want to add some opportunistic duration to their portfolio. These are not for your steady state allocations.

So there are broadly only four categories and a retail investor need not bother about the fourth one.

At a category level, credit risk funds don't appear to have delivered any better than short duration funds even in the last 7-10 year timeframe. What's the case for them if you assume greater credit risk but don't get rewarded?
Comparing credit risk funds vis-a-vis a short-duration funds is not appropriate at this time since credit risk funds are in their worst phase right now while short-duration funds, on the other hand, are experiencing their best time in the last 10 years.

The gross return profile in case of debt should be looked at this way - with inflation at around 4 per cent, fixed deposits can give you about 1 per cent extra, liquid funds about another half a per cent on top of it, a further 1-2 per cent from short duration funds, and another upto 2 per cent from credit risk funds.

Credit funds offer you a certain return profile which may be more appetizing than equity. A 25 per cent equity and 75 per cent high quality debt allocation, so a conservative hybrid allocation, will give you three to four per cent more than fixed deposits. That's precisely the kind of return you can get in a credit risk fund over a long period of time but without the volatility of a conservative hybrid allocation. Because in case of the latter, even a 25 per cent equity allocation makes it fairly volatile.
So credit has actually picked up in the world because of its ability to give you a good diversification vis-a-vis equity.

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