Interest rates in India have likely hit a peak in this cycle. This makes it a good time for investors to lock into the attractive yields available in the bond markets today for the medium to long term. If you have a three- to five-year horizon, ICICI Pru Corporate Bond Fund, an open-end debt fund, is a good option to consider. This fund offers the unusual combination of high portfolio yield with low credit risk.
Why corporate bonds
As interest rates in India have moved up, yields on corporate bonds have moved up more sharply than those on government bonds. Between April 2022 and April 2023, while the yield on the five-year government security (g-sec) moved up from 6.4 per cent to 7.1 per cent, that on AAA-rated corporate bonds shot up from 6.5 per cent to about 7.7 per cent.
This has resulted in the spreads (extra yield) that high-quality corporate bonds offer over g-secs widening. AAA bonds have seen their spreads expand from 10-20 basis points to 50-60 basis points. The extra return on highly rated bonds present an opportunity for investors to improve portfolio returns without taking on credit risks. Corporate bond funds, which invest only in AAA and AA plus bonds thus make for a good investment.
Why this fund
Three features of ICICI Pru Corporate Bond Fund make it a good choice relative to peers in this category.
High portfolio quality: A high portfolio yield for a debt fund usually goes hand-in-hand with exposure to risky bonds. But ICICI Pru Corporate Bond Fund combines high yields with low credit risk. There have been times in the last couple of years when government bonds have offered a better risk-reward equation than corporate bonds. This fund has used this trend to its advantage. The latest portfolio in end-March 2023, featured a 20.5 per cent allocation to long term g-secs and 5.8 per cent to short-term g-secs, with the result that over a fourth of the portfolio is parked in risk-free g-secs. Another 65 per cent was parked in AAA-rated corporate bonds, with holdings such as NABARD, SIDBI, Reliance Industries, LIC Housing and HDFC carrying the highest weights. The fund did not own any bond rated below AAA. Despite this ultra-conservative stance on credit risk, the fund’s portfolio yield-to-maturity (YTM) at 7.98 per cent was among the best in its category.
Tactical use of floaters: The high portfolio YTM has come partly from the fund’s tactical use of Government of India Floating Rate bonds, which have seen a sharp uptick in yields with the rise in market interest rates. GOI floating rate bonds maturing in 2028, 2033 and 2034 made up almost a fourth of the fund’s portfolio in March. These bonds have their coupon rates pegged to the yield of 182-day treasury bills. In recent times, the significant run-up in t-bill yields has seen the coupon on these GOI bonds rise to very attractive levels of 7.8-8.5 per cent. Should a further rise in rates lead to a fall in corporate bond prices, these floaters could cushion the fall in the fund’s NAV.
Portfolio maturity: When market yields are high, it makes sense to extend the duration of one’s debt investments lock into higher returns for longer. ICICI Pru Corporate Bond Fund had an average portfolio maturity of 4.16 years, as of March 2023, compared to less than three years for the category. The fund’s portfolio is more diversified than its peers, with over 90 securities. The large asset size helps reduce concentration risk, both on investors and holdings.
Minuses
While the fund’s 25 per cent exposure to floating rate bonds has been a plus at a time of rising rates, they could weigh on returns, should short-term interest rates begin to decline. In such an event, however, the fund may exit or reduce weights in floaters to switch to fixed rate bonds. The fund’s expense ratio for the regular plan at 0.53 per cent is at the lower end of the category, while direct plan expenses are on par with peers at 0.32 per cent.
The recently changed taxation of debt funds, which make even long-term returns for investors taxable at their slab rate, makes this fund less competitive with high-quality FDs. But investors who seek anytime liquidity with diversification can still opt for this fund.