With the spread between AA and AAA rated securities at the highest in the last 10 years, credit investors can benefit greatly, says R Sivakumar, Head, Fixed Income, Axis Mutual Fund. He also shares his views on how debt funds need to focus on diversification to reduce risks. Excerpts from an interview:

Over the past two years, a spate of corporate bond downgrades and defaults has impacted the performance of some debt mutual funds. What are the factors you consider while managing a debt portfolio?

Most debt funds, barring very few schemes, have given reasonable returns over the past one-two years. In the recent credit events, though, there seem to be a lot of issues, which are actually still relatively smaller in number, for the industry. There are two parts on how you handle the debt mutual funds. First is the selection.

We have a strong selection criteria that weeds out as many weaker credit-rated issues and issuers as possible and own only those in which we have more confidence.

Second is how you do risk management. Regulatory norms limit up to 10 per cent exposure to a single issuer in one scheme.

That does not mean that you should hold 10 per cent in a single issue.

If you run a reasonably diversified portfolio, the impact of credit downgrades would be reduced to that extent. We have more than 50-55 individual issues (approximately) in the portfolio, in most of our debt funds.

In general, we try to maintain the average allocation to a single security around 2 per cent and our highest allocation in the range of 4-5 per cent. Hence, the portfolio is highly diversified and the impact of any one issue or issuer is quite small in the overall portfolio of a fund. So, diversification is extremely important.

What is the optimum number of holdings that you believe make a debt portfolio a diversified one?

Diversification of debt is different from that of equity. In equity, if you want to have a focussed portfolio, you also realise that if you diversify too much you are giving up on performance.

But in debt, if you hold 10 or 50 bonds from different issuers which are AAA rated, the yield is almost the same as long as you hold similar quality papers. Hence, there is no major impact on returns. So, diversification does not reduce the yield on the portfolio except on credit risk, which gets reduced.

As long as you hold a large number of securities in the debt portfolio, fund managers and analysts need to do due diligence, which become much more complex in terms of analysis.

We found that 50-60 securities are an optimal mix, where we have the ability to deep-dive and understand the companies, and thus provide sufficient diversification. Another important point which is easily overlooked is that, Indian debt markets tend to be quite illiquid, which means there is very little secondary market liquidity, especially for non-AAA papers.

So, it is very important to also have portfolios that have very short maturity, so that there is a constant maturity of bonds at all points of time.

For example, if I hold a two-year paper and would like to continue the same issue after it matures at the end of two years, then I can reinvest.

But if there is a change in the financials of the issuer or the macro environment or if some other risk comes up, then I do not have to invest in that company.

But if I bought a 10-year paper of the same issuer and the economic environment has changed at end of two years, then for the remaining eight years, I hold that risk because there is no exit or limited opportunities for exit.

So, it makes sense for us to hold short maturity credits that reduces liquidity risk in the portfolio. So, the portfolios have to be self-liquidating at all points of time.

Is it advisable to invest in credit risk funds at this point of time?

About one-and-a-half years ago, the spread between AA and AAA rated securities was in the range of 50 to 75 basis points. Today, it is between 200-300 basis points because of the concerns about the credit quality.

Buyers are demanding a much higher spread today, compared with the same one-and-a-half years ago.

We see the biggest opportunity for credit investors today. By some metrics, the spread between AA and AAA rated securities is the highest in the last 10 years.

If you go back to the global financial crisis 10 years ago, the environment where some of the biggest banks in the world and in India were under threat, and compare that with today’s environment, they are definitely in a much better position now.

Secondly, the underlying fundamentals are improving a lot.

Let us say, in the period between September 2018 and September 2019, the stress on quality was quite high.

But over the last three months, things are becoming stable and we have not seen any new names coming under stress.

The RBI has infused a lot of liquidity since July 2019, which is again stabilising the money markets and the funding markets to a large extent.

The government has also done a lot in terms of the various programmes supporting NBFCs. I would say it will take a few more months to get fully fortified.

Our expectation is that these stresses are compressing very quickly and they have already compressed a lot from the peak.

So, we think that this is a very good opportunity for investors who are looking at the credit side and those looking to top up their existing investment.