Credit spreads on AAA-rated corporate bonds have fallen sharply from historical levels. Take, for example, 3-year and 5-year bonds. They are currently trading at yields of 6.4% and 6.9% respectively, just 8-9 basis points (bps) higher than similar duration government bonds (g-secs), according to the data. from Bloomberg. Based on the average of the past 10 years, these bonds traded at significantly higher spreads of 82 basis points and 74 basis points, respectively.
Although an expansion of these spreads (higher yields) from now on could imply a negative impact on the market value of debt fund portfolios, the current composition of these funds can help withstand the impact.
Unlike today’s top-rated AAA bonds, many AA-rated bonds and more, most A-rated bonds trade at levels close to or slightly above their historical credit spreads.
All corporate bonds trade at a premium of g-sec. The spread – the difference in yield between any bond and that on g-secs of the same duration – compensates for the relatively higher risk of default associated with the former.
What’s at work
“Spreads have fallen because, on the one hand, AAA corporate bond yields have not risen much, while on the other hand, g-sec yields have risen sharply,” says Joydeep Sen. , corporate trainer and author. the gap or gap between the two has narrowed.
“Unlike in the past, where large issuers such as REC, Power Finance Corporation (PFC) and the National Bank for Agriculture and Rural Development (NABARD) raised large sums through bonds, there is no had no such AAA bonds this year,” says Devang Shah, co-head, fixed income, Axis MF.
Private sector AAA bond issuance has also been tepid, according to Sen, given the deleveraging of corporate balance sheets over the past year. The limited supply of these corporate bonds has therefore limited yields (a lower supply prevents bond prices from falling and their yields from rising too much).
Data from the Securities and Exchange Board of India (Sebi) shows that corporate bond issues through private placement at ₹5.9 trillion in 2021-22 was down 24% from ₹7.7 trillion in 2020-21.
Limited supply, along with good demand from target-maturity funds that invest in such AAA bonds, kept yields in check, according to Shah.
G-sec yields, however, have plummeted due to the government’s large borrowing program, rising inflation and, more recently, hawkish monetary policy.
Implications for investors
Corporate bond issuance is expected to pick up as the investment spending cycle picks up and companies step up fundraising. “This could cause AAA corporate bond yields to rise and spreads to gradually widen over time,” Sen says.
According to Shah, most mutual funds have realigned their portfolios more towards cash, g-secs and SDLs (government bonds) and have smaller allocations towards AAA bonds. So once spreads start to widen and these bonds start trading at higher yields than they do today, debt fund portfolios will not take a significant hit (loss at market price) .
“Most investors have put money into funds with shorter durations, so the negative impact of spread expansion, as it occurs, will not have a negative impact. impact on many,” says Ajay Manglunia, Managing Director and Head, Institutional Fixed Income, JM Financial.
For those investing directly in bonds, Manglunia recommends placing money in bonds with shorter maturities and moving to bonds with longer maturities, once the current inflation environment stabilizes and markets bonds are normalizing.