Debt Note: Why Quality Matters
As we move into a rising interest rate scenario, the focus shifts to high-quality low-volatility investments. Our strategy has been to construct a layered portfolio by locking into high-quality investments at different yields. At this juncture, short-term AAA investments make the most sense. Contact us if you would like to explore debt investment options.
Until now, the key driver for interest rates has been inflation. Other factors such as weakening rupee, crude oil prices, the current account deficit, trade war tensions, rising global interest rates, investment outflows, etc. now determine the interest rate trajectory.
Higher interest rates stress borrowers who don’t have robust balance sheets and solid cash flows. If lenders aren’t selective about who they lend to, they might get stuck with defaulters or delayed repayment schedules.
There’s no way to predict when the next default will happen or who the next defaulter would be. The RBI’s strictness about credit discipline could spell pain in the short-term but will do good for financial stability in the long run. We are clearly in a transition phase.
In debt, one way to evaluate risk-reward is through spreads (the difference between yields).
|Particulars||AAA – GSec||AA – GSec||AA – AAA|
|10 Year spread||0.89%||–||–|
|5 Year spread||0.68%||0.91%||0.23%|
|3 Year spread||0.91%||1.54%||0.63%|
|1 Year spread||1.37%||1.59%||0.22%|
You could earn about 0.9% more from a 5-Year AA Corporate Bond, or 0.7% more from a 5-Year AAA Corporate Bond than a 5-Year Government Bond. There is room for expansion in the AAA/AA spread. AA yields will shortly readjust upward when their re-investment is due. When bond yields rise their prices fall and investors witness a mark-to-market loss. This spike in yields may be more permanent, meaning, it could take much longer to recover losses.
Simply put, credits are not worth the risk, given the upside cap on returns. The way to deal with uncertainty is to stick to quality. By choosing AAA investments, you could hardly go wrong.