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Investing in lower-rated, higher-yielding bonds appears to be an easy way to enhance yields without
taking much risk. However the relentless rise in non-performing loans at banks and a series of credit
events in mutual funds have raised some concerns about the risk-reward trade-off in lower rated debt.
To be sure the right time to be concerned about weakening credit quality would have been before
these events (see our note from July 2013 on emerging credit risks for example). Today, the question
we are asking is: now what? Are things getting better or worse?
Background
RBI data indicate the scale of the problem. The banking system is groaning under 7.5% gross NPA
levels. The pain is not evenly distributed with nationalized banks seeing nearly 11% of their advances
turning non-performing while private banks have performed relatively better having just under 3%
NPA ratio. The aggregates are skewed towards PSU banks as nationalized banks account for nearly
half of bank loans, and along with the SBI group account for over 70% of the total size of the system.
Note that the RBI data above only goes to FY16. The situation has only worsened in the last year.
The NPA overhang has limited the ability of banks to grow. Provisions have reduced profits and in
many cases led to net losses. Capital requirements have meant that banks have been unable to make
new loans. Here again we see a divergence between nationalized and private banks; and the private
sector has kept its growth rate thanks to better profitability. An interesting divergence can be seen in
the relative performance during the 2008-10 and the current periods. In the previous downturn, all
banks faced a slowdown thanks to weaker macro. This time slow growth is clearly thanks to
differences in NPA performance.
Clearly the time to have worried about the impending credit bust would have been back when the
credit growth was strongest and the macro was getting weaker. We know now how that has played
out. The right question today is whether the cycle is getting worse or if this is the time to start getting
back into credit?
The macro picture of credit
As we did four years ago, we will look at the data to guide us. Once again we turn to RBI which
publishes the aggregate corporate financial performance numbers. The RBI study covers close to
20,000 non-government, non-financial public companies over the past three years. This study paints a
picture in stark contrast to the well-publicized NPA story as explained below.
The first observation we make is that the aggregate operating performance across companies has
improved substantially over the last three years. Remember that oil and other commodity prices fell
substantially during 2014/15. Overall raw materials costs fell relative to sales and was a major
contributor to operating profit margin improvement.
The second big trend of the past couple of years has been the large fall in interest rates, which has
reduced the debt service burden of companies. What we see is a double impact: fall in rates and a
general deleveraging. Thus the amount of debt (relative to equity) has come down and the interest
rate on debt has reduced. These two factors mean that the interest coverage ratio (earnings before
interest and taxes divided by interest costs) has improved markedly in the last two years.
The improvement in operating and financial performance has resulted in an increase of nearly 50% in
net profit margin over the three years.
To summarize, the aggregates from the RBI study suggest the following all of which are supportive of
an improvement in the credit cycle:
Costs under control Operating performance improved Reduction in debt leverage Improved debt service ability Big jump in net profit margin
How does the micro picture look?
The aggregate data support the view that the credit environment has improved. And yet we see the
NPA levels rise. How do we square these views? For one, these gains are not evenly distributed. The
fall in raw materials has resulted in better margins, but what if you are the producer of these raw
materials? Steel companies have suffered, while auto companies have benefited – for example.
Further a presence of some large indebted companies can skew the data.
Unfortunately in this cycle companies with the most stress have been the large indebted companies in
sectors like commodities, infrastructure & power, etc. Thus the apparent credit quality has worsened
even as underlying profit performance has improved. This can be seen in credit rating agency data
released by SEBI earlier this month. The chart shows the credit ratio (the number of upgrades to
downgrades) and the debt weighted credit ratio (the value of upgraded debt to downgrades). In this
chart, values above 1 indicate improvement in credit quality, while values below 1 indicate worsening
of quality. The chart shows the rolling six month trend.
We see two cycles of credit in this chart. The first was between 2012-13 when the early signs of credit
worsening started. During this phase, we see both the number of downgrades and value of
downgrades outpacing upgrades. A second leg down was in 2015-16, when the value of downgrades
has outpaced upgrades, but where we see an improvement in the number of upgrades relative to
downgrades.
This divergence is important. What it says is that while many more companies are getting upgraded,
many heavily indebted or leveraged companies continue to be downgraded. Another way of looking at
this is a quick summary of the last two years:
Upgrades by number relative to downgrades +41% 749 upgrades, 531 downgrades
Downgrades by value relative to upgrades +215% ` 5.5 tr downgrades, ` 1.7 tr upgrades
As an investor (or a fund manager) we are not bound to invest in the highly leveraged and indebted
companies. In fact, the higher pace of upgrades suggests that the universe of investible companies is
potentially expanding.
What about the market?
In fact as an investor today, the spread that we get from investing in lower rated bonds has expanded
relative to AAA bonds. The spread is the extra yield that we get for the higher credit risk.
The chart below shows the spread of A-rated over AAA-rated bonds over the past five years.
Bizarrely, during the period from 2012 to 2014 when credit quality was under stress across the board,
the spread narrowed. That is, the compensation for higher risk was low at a time that risk was
increasing. In more recent times, the spread has widened and today is close to the highest levels for
over five years. As an investor this means that we are getting compensated more for taking the same
level of risk (i.e. for same credit rating).
This is even more interesting because, as compared to the 2012 period, now the weakness in credits
appear to be concentrated and not across-the-board. That is to say the spread is wider even though
the overall credit environment appears to have improved. From a low of about 80 bps, spreads are
now over 200 bps for A-rated debt.
Investment Implications
To summarize, even as backward looking data (bank NPA numbers) seem to suggest that credit
issues continue to be a problem for the financial system, the three alternate sets of data paint a very
interesting picture about investing in lower rated debt.
The RBI study on corporates shows that the profitability of the corporate sector has improved over the
past two years. This has been on account of both better operating performance and a reduction in
leverage.
Ratings data confirms the improvement in credit quality in the last two years. However, heavily
indebted / highly leveraged companies appear to be still in a downgrade cycle. The fact that many
more companies are being upgraded suggests a widening in the investible corporate space.
Finally, the market pricing of credits has improved. Compared to the previous cycle, yield spreads are
wider.
As investors, this presents an investment opportunity where the macro and rating developments are
improving while yield spreads are relatively wide. Thus we have been increasing our allocation to
below-AAA bonds. The ratings and micro level analysis still urges caution. The investment process
needs to be strong with well-developed risk management. That will have to be the subject of another
note, though.
Sources of Data: RBI, SEBI, Bloomberg
This document represents the views of Axis Asset Management Co. Ltd. and must not be taken as the basis for an investment
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