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AAA Corporate Bond sell-off         
Corporate bond yields have witnessed a substantial rise in the past few months, as can be seen in the chart below. The reasons for this have been articulated through various notes in the past.
What happened in the non-AAA corporate bond space?
Having witnessed such a rise in AAA corporate bond yields, it is worthwhile to examine whether the same has percolated to the lower rated corporate bonds as well. The corresponding move in lower-rated corporate bonds attains more importance in light of limited liquidity for such bonds thereby resulting in sub-optimal price discovery (as highlighted in our note 'Liquidity in Credit Markets, July 2017).
The efficiency (or lack of it!) in the pricing of lower-rated corporate bonds can be gauged by looking at Yield-to-Maturity (YTM) differential of various credit funds vis-à-vis the IDFC Corporate Bond Fund (Since inception, the Scheme has invested entire corpus in AAA rated instruments).
As can be seen from the charts above, there has been a significant compression in credit spreads. Importantly, in the past few months, this spread compression is attributable primarily to the sell-off in AAA segment rather than any meaningful improvement in the underlying credit cycle. Also, credit spreads in the 'mid yield' segment have not narrowed as sharply as the 'high yielding' segments due to relatively better liquidity and price discovery.
Takeaway for fixed-income investors
The sharp rise in AAA corporate bond yields and the credit spread compression have important implications for fixed income investing decisions. In a way, the 'AA & below' segment yields not having kept pace with the AAA yields also implies that investors are not being sufficiently compensated for taking the same amount of credit risk as they were in the past. Therefore, from a risk-return standpoint, there is a case for incremental fixed-income allocation towards AAA bond funds given the compressed credit spreads and value buying opportunity in AAA bonds.


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