The equity markets can be volatile, especially during economic downturns, and possess the power to wipe out investors’ wealth in one day. Take the COVID-19 lockdown-induced sell-off in 2020, for instance. Investing in debt instruments can mitigate the risk to a large extent. They offer moderate to high returns depending on whether they are listed or high-yield debt instruments. They have relatively lower risk than equity products, protecting your portfolio from negative market reactions.
This article will explore the risks associated with high-yield debt instruments and how you can manage them.
Risks of High-Yield Debt Instruments
High-yield debt instruments are popular because they offer higher returns and diversification benefits.
According to CRISIL, bonds with a long-term credit rating between AAA and BBB are considered investment-grade bonds, and ratings between BB+ and D are non-investment-grade bonds. The higher the credit rating, the lower the returns in general.
Debt investment instruments can be broadly:
- Listed and rated by an external credit rating firm.
- Unlisted rated by an external credit rating firm or unrated
Let’s understand them and the risks associated with them.
| Grade | India Research Ratings | ICRA | CRISIL |
| Investment grade bonds | IND AAA | Aaa | AAA |
| Investment grade bonds | IND AA | Aa1 | AA+ |
| Investment grade bonds | IND A | Aa2 | AA |
| Investment grade bonds | IND BBB | Aa3 | AA- |
| Investment grade bonds | IND A1 | A1 | A+ |
| Investment grade bonds | IND A2 | A2 | A |
| Investment grade bonds | IND A3 | A3 | A- |
| Investment grade bonds | IND AAA (SO) | Baa1 | BBB+ |
| Investment grade bonds | IND AA (SO) | Baa2 | BBB |
| Investment grade bonds | IND A (SO) | Baa3 | BBB- |
| Non-investment grade bonds | IND A4 | Ba1 | BB+ |
| Non-investment grade bonds | IND BB | Ba2 | BB |
| Non-investment grade bonds | IND BB(SO) | Ba3 | BB- |
| Non-investment grade bonds | IND B (SO) | B1 | B+ |
| Non-investment grade bonds | IND C (SO) | B2 | B |
| Non-investment grade bonds | IND D (SO) | B3 | B- |
| Non-investment grade bonds | IND A4 (SO) | Caa | CCC |
| Non-investment grade bonds | IND C | Ca | CC |
| Non-investment grade bonds | IND D | C | C |
| Non-investment grade bonds | D |
Listed and Rated Debt Instruments
Listed and rated debt instruments are publicly traded financial securities, like bonds, issued by governments and corporations to raise capital. They are listed on capital exchanges, providing possible liquidity to investors. External credit rating agencies, such as CRISIL, ICRA, CARE, and Fitch, assess the issuer’s creditworthiness and assign a credit rating to the debt instrument, allowing it to be traded in the secondary market.
Listed bonds can be secured by underlying collateral or unsecured. However, all unlisted bonds are secured by the underlying collateral.
Similarly, listed bonds mandatorily have to be rated while unlisted bonds can be rated or not.
Some of the listed and rated debt securities include government bonds, corporate bonds, Sovereign Gold Bonds, and Structured Debt Instruments.
Risks of Listed and Rated Debt Instruments
- Interest Rate Risk
This occurs when the market interest rate changes after the investor buys the corporate bond. Long-term bonds are particularly sensitive to rate changes than short-term bonds.
For example, imagine you have bought a bond worth ₹1,000 with a 3% interest rate. A year later, the market interest rate rose to 4%. This will make your bond less valuable and drive its market price down. It will also pay lesser returns than the new series of bonds.
In a reverse situation, the market interest rate falls after you have invested, and you stand to gain. Your bond becomes more valuable as you lock in a higher interest rate.
- Credit Risk
To determine credit risk, investors must assess a corporation’s creditworthiness, financial health, economic cycles, and industry conditions. As a rule of thumb, higher-rated companies have lower credit risk. These companies are more creditworthy because they have strong balance sheets. Sovereign-backed government bonds (T-Bills, G-Secs) are very low risk.
- Liquidity Risk
There could be a possibility that fluctuations in a bond’s price may make it difficult to buy or sell it. Bonds with lower liquidity would witness a wider bid-ask spread. In such cases, the corporate bond may have to be sold at a value lower than its intrinsic value.
- Inflation Risk
Inflation reduces bond investors’ real return by reducing the purchasing power of future interest and principal payments. If inflation exceeds expectations, fixed interest payments may not keep pace with rising living costs.
Unlisted Debt Instruments
Unlisted but rated debt instruments are high-yield debt instruments with credit ratings by external credit rating agencies. They are not traded on public exchanges. They are usually curated/traded in private markets or over-the-counter (OTC) platforms.
Some examples of unlisted and rated debt instruments include corporate bonds issued by mid- to large private companies across sectors, including Non-Banking Financial Companies (NBFCs), manufacturing, e-commerce, fashion, consumer goods, real estate, and power. Sometimes, these private entities are subsidiaries of large public-listed parent companies.
Unlisted and unrated debt instruments are high-yield debt instruments not traded on public exchanges. They do not carry an external credit rating from credit rating agencies. They are curated via private transactions and sold via over-the-counter (OTC) online platforms or via offline transactions.
Some of the unlisted and externally not rated debt instruments include venture debt (start-ups), small corporates, real estate, and structured debt products.
Risks of Unlisted Debt Instruments
- Liquidity Risks
These debt instruments are not listed on exchanges. Thus making it difficult for investors to sell or liquidate their holdings.
- Default Credit Risk
There is always the risk of default by the issuer, which essentially is the borrower’s inability to make some or all the promised payments. The potential loss for the investor is in terms of both principal and interest payments. The absence of an external credit rating increases the risk as an external independent credit firm does not review and rate the instrument.
- Valuation Uncertainty
Unlisted debt may contain limited information compared to listed debt securities, making it challenging for investors to determine the fair market value of their investments.
- Interest Rate Risk
Changes in market interest rates can affect the value of non-listed debt instruments, particularly those with fixed interest rates, potentially resulting in opportunity costs for investors.
How to Manage Risks
As a first step, investors must understand their goals and risk appetite. Debt instruments that deliver higher returns generally carry higher risk, and vice versa.
The second step is to narrow down the investment opportunities that align with one’s goals and risk appetite.
Furthermore, investors must conduct their due diligence by analysing the information about the company’s financial health, business model, and management team. This will help narrow down the list further.
The fourth step is to define an investment allocation (for example, allocate 10-20% of your overall investment portfolio).
Lastly, diversify and invest in selected high-yield debt Instruments that you have narrowed down. By diversifying your portfolio across different debt investment opportunities across sectors, risk ratings, high/low yields, and tenure, you can earn a good risk-adjusted portfolio return.
Conclusion
High-yield debt investments are an increasingly popular option for investors looking to boost their returns and diversify their portfolios. These investments offer higher yields than traditional fixed-income securities but also come with higher risk.
The key is to balance risk and reward. These opportunities can add value to your investment portfolio, delivering good risk-adjusted returns and generally carrying lower risk than stocks and/or equity-based mutual funds.
The alternative debt space is rapidly developing in India, thus increasing investment opportunities for individual investors. If you’ve considered adding high-yield debt investments to your portfolio, now is the time!
