Case 043Debt fund credit decisionsWarm up
A client asks why a credit risk fund yields 9.1% while a corporate bond fund from the same AMC yields 7.6%. Break the 150 basis point gap into its parts and say what it means for the client.
1The situation
Shubhra Mutual Fund offers a corporate bond fund, mostly AAA-rated paper, yielding 7.6%, and a credit risk fund, mostly AA and A-rated paper, yielding 9.1%. Both have a similar maturity. A client with Rs 20 lakh in the corporate bond fund asks whether he should switch to the higher yield.
The fund's credit team estimates, for planning, that the credit risk fund's issuers default at about 1% a year each, and that it recovers about 40% of face value after a default, so it loses about 60%. The fund holds about 25 issuers at about 4% each. The team puts the rest of the gap down to the paper being harder to sell and to the uncertainty of losses.
2Your task
Split the 150 basis points into expected loss, liquidity and risk premium, and explain what the client is really being paid for.
Quick check
After expected defaults, roughly how much more does the credit risk fund return than the corporate bond fund?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
About 60 basis points of the gap is the defaults the client should expect, about 40 pays for illiquidity and about 50 is a premium for uncertain losses. After expected losses the credit fund is likely to earn about 0.9 points more, not 1.5. And losses arrive in lumps: one default among 25 holdings costs about 2.4% of the fund, more than a year's extra yield. It suits only money that can wait and absorb a bad year.
Step 1What is the higher yield paying for?
A moneylender who charges a riskier borrower 15% instead of 10% does not expect to keep the extra 5%; some borrowers will not pay. A higher yield on riskier bonds is mostly compensation for losses the investor should expect and for illiquidity, not free extra return. Split the gap into three parts. Expected loss is the default rate times the loss on default: 1% times 60% is 0.6 points. Liquidity is the extra the market demands for paper that is hard to sell quickly, here about 0.4. What remains, about 0.5, is the risk premiumExtra return demanded for bearing outcomes that are uncertain, over and above the losses expected on average. for losses that are uncertain and lumpy.
Step 2Why does lumpiness matter more than the average?
Because defaults do not arrive at 0.6 points a year; they arrive one issuer at a time. With 25 holdings of 4% each, one default at a 60% loss costs about 2.4% of the fund in a single month, more than a full year of the extra yield. If each issuer has a 1% chance of default and defaults are independent, the chance of a year with no defaults is about 78%, one default about 20% and two or more about 3%. In practice defaults cluster in bad years, so the chance of a multi-default year is higher than independence suggests.
| Defaults in a year | Chance, if independent | Credit fund return | Against 7.6% |
|---|---|---|---|
| 0 | 77.8% | 9.1% | +1.5 pts |
| 1 | 19.6% | 6.7% | -0.9 pts |
| 2 | 2.4% | 4.3% | -3.3 pts |
Step 3What do you tell the client?
Translate the split into his money. Switching Rs 20 lakh would add about Rs 18,000 a year on average after expected losses, about 0.9 points, but in a year with a default his fund could earn less than the corporate bond fund, and in a stressed market the credit fund may be harder to redeem or may side-pocket a bad bond. He is being paid for taking illiquidity and lumpy losses, which suits money he will not need for several years and a slice of his debt allocation, not all of it. If the Rs 20 lakh is his emergency or near-term money, the 7.6% fund is the right home; the limitation of this split is that the 1% default and 40% recovery are planning assumptions, so revisit them as the portfolio changes.
Where candidates lose it
The common loss is comparing yields as if they were returns and calling the credit fund 1.5 points better. Yield is what the bonds promise; return is what is left after the promises that are not kept.
The second miss is using the average loss and stopping. Credit losses arrive in lumps, and one default in a 25-issuer fund wipes out more than a year of the extra yield; the client needs to hear that before he switches.
What the interviewer asks next
- How would the split change if recoveries fell to 20%?
- Why might the liquidity premium widen sharply in a stress even if no default occurs?
- How many issuers would the fund need for one default to cost less than a year's extra yield?
Company names and figures are illustrative.