imgbd AMC Speak

Caveat Creditor: let the lender beware

R Sivakumar, Head of Fixed Income, Axis MF

5th June 2017

In a nutshell

Sivakumar meticulously stayed away from lower risk corporate credits in recent years - a call that has clearly paid off well - but when news headlines are again filled with high profile downgrades, he is making a clear case for stepping up allocations to lower risk credits rather than running for cover. Sounds odd? Not if you go through this excellent piece from him, where he dissects the credit environment in India with hard data to show exactly where opportunities are getting really attractive and where the nightmare is only getting worse.

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?


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:

  1. Costs under control

  2. Operating performance improved

  3. Reduction in debt leverage

  4. Improved debt service ability

  5. 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 decision. Neither Axis Mutual Fund, Axis Mutual Fund Trustee Limited nor Axis Asset Management Company Limited, its Directors or associates shall be liable for any damages including lost revenue or lost profits that may arise from the use of the information contained herein. No representation or warranty is made as to the accuracy, completeness or fairness of the information and opinions contained herein. The material is prepared for general communication and should not be treated as research report. The data used in this material is obtained by Axis AMC from the sources which it considers reliable. While utmost care has been exercised while preparing this document, Axis AMC does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Investors are requested to consult their financial, tax and other advisors before taking any investment decision(s). The AMC reserves the right to make modifications and alterations to this statement as may be required from time to time.

Axis Mutual Fund has been established as a Trust under the Indian Trusts Act, 1882, sponsored by Axis Bank Ltd. (liability restricted to Rs. 1 Lakh). Trustee: Axis Mutual Fund Trustee Ltd. Investment Manager: Axis Asset Management Co. Ltd. (the AMC) Risk Factors: Axis Bank

Limited is not liable or responsible for any loss or shortfall resulting from the operation of the scheme.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.

Share this article