High Yield funds in India invest in Corporate Bonds that are down the rating scale to deliver returns from a higher portfolio yield. The funds aim to take advantage of higher yields on corporate bonds rated AA or below to create a portfolio that will deliver above average returns. High Yield funds are largely driven by accrual strategy where the fund manager locks in to yields on corporate bonds and does not churn the portfolio to capture any fall in corporate bond yields.
Given the accrual strategy, the average maturity of high yield funds are around 2 to 3 years, depending on the fund positioning. High yield funds usually have high exit loads for redemptions within two or three years as it provides the fund manager the stability of assets required to invest in lower rated corporate bonds.
Characteristics of an High Yield Fund
The characteristics of an High Yield Fund are best understood by an example. Mutual Fund A runs an high yield fund with a mix of corporate bonds rated AA to A-. The fund has an average maturity of 3 years with a weighted average portfolio yield of 10.11%. Table 1 gives the portfolio of the fund.
The expense ratio of the fund is assumed at 150bps. An investor investing in this fund would receive post expense return of 8.61%. This return requires to be compared with returns from a 3 year fixed deposit, from 3 year AAA/AA+ corporate bonds and from short term income fund with average maturity of 3 years. Table 2 gives an indicative comparison of high yield funds against other fixed income asset classes.
The return on the high yield fund is higher than the returns on the other asset classes but credit risk is high and liquidity risk is high. Is the risk & return profile of the high yield fund optimum?
In actual market conditions, high yield funds would have different levels of portfolio yields and that would depend on the fund managers appetite for credit risk and also on the ability of the fund manager to spot and source high yielding corporate bonds.
In India, the assets under management of high yield funds are over Rs 500 billion as the funds are finding favour with retail investors who are willing to take on credit risk and liquidity risk for higher returns.
Risk in High Yield Funds
High yield funds carry two major risks, credit risk and liquidity risk. Credit risk is the risk of increase in probability of default while liquidity risk is the risk of the fund manager not being able to sell the corporate bonds at low impact cost and within a short time frame.
Credit risk can either be in the form of a default where an issuer defaults on payment of interest and principal or in the form of rise in credit spreads. An issuer defaulting on interest or principal will force the fund manager to write down the value of the corporate bond held in the portfolio that will impact the NAV negatively leading to either outright capital loss or lower returns for the investors in the fund.
Credit spreads (Read our Tutorial on Credit Spreads) can rise up or down and that affects the NAV of the fund. Example of credit spread movements affecting portfolio value is given in Table 3 and Table 4. Credit spread risk is taken out if the corporate bond is held till maturity and the issuer pays bond holders fully at the time of redemption. However, when markets are stressed as seen in credit crisis of 2008, sharp rise in credit spreads (credit spreads in 2008 for corporate bonds across categories rose by a whopping 500bps to 3000bps or even higher) chart 1. can lead to large scale withdrawal from high yield funds.
Liquidity risk in an high yield fund is the impact cost of selling bonds from the portfolio. In the example of high yield fund given here, if there is sudden withdrawal from the fund, the fund manager will be forced to sell the corporate bonds to meet the redemption. However, liquidity from corporate bonds is low in India with average traded volumes at just 10% of government bond traded volumes and corporate bond volumes are predominantly (over 90%) concentrated in the AAA to AA+ category of bonds. Corporate bonds rated AA and below have extremely low liquidity and impact cost of selling could be very high.
Impact cost of selling is best understood with an example. Assuming the high yield fund given here faces redemptions of 25% of total assets, the fund manager would be selling bonds upto 50bps or higher over and above valuations. AA bonds are valued at 9.20% and selling the bonds would be at valuations of 9.70% or higher if the fund manager is forced to sell to meet redemptions. Investors would not be able to redeem at the NAV they believe they are getting due to impact cost of selling the illiquid bonds.
The high yield fund would also have an extremely high risk portfolio if the fund manager sells AA bonds to meet redemptions as the portfolio will then have only AA- to A- rated bonds in a 33.33% weight. Existing investors would then have a completely different risk profile of the fund.
When to invest in High Yield Funds?
High yield funds carry high credit and high liquidity risk. Hence investments should be based on outlook for credit spreads. Credit spreads are affected by economic and business environment, domestic and global macros and global risk aversion. If the view is positive on the factors affecting credit spreads, then investments can be considered in high yield funds. View on Presentation on Factors affecting Credit Spreads)
How to look at portfolios of High Yield Funds?
High yields funds carry varying degrees of risk depending on the credits that go into the portfolio of the fund. Hence it is important to look at the portfolios of high yield funds, study the issuer and sector weights in the portfolio before investing. Every issuer will have a credit rating and that rating goes up or down depending on the fundamentals of the issuer. For example Steel Industry is in a downturn and so are many other infrastructure industries. Banking sector NPA levels have grown at over 28% CAGR over the last six years. NPA’s of banks are predominantly from infrastructure, steel and textile industries. Banks are worried about debt of Telecom companies given high license costs and increased competition.
High yield funds carrying corporate bonds of issuers in stressed sectors can face issues if there is further downturn in the sectors. Funds with high concentration of assets in stressed sectors carry extremely high risk and unless returns are commensurate with risks, investments in such funds are not optimal.
Changes in credit spreads affect the portfolio returns
Let us take an example of a typical bond fund portfolio.
The portfolio in Table 1 will yield 7.9% every year if interest rates remain unchanged. The investor will receive the portfolio yield less expenses of around 1.5% to 2%.
Portfolio returns are subject to change in credit spreads. If credit spreads go up then portfolio returns will fall while if credits go down portfolio returns will rise. Taking an example of credit spreads falling or rising by 0.5% while interest rates remain unchanged, the returns will be as follows. In Table 2 and 3. The portfolio has 50% weight in government bonds and 50% weight in corporate bonds.