Scient Capital Credit Pricing and Risk Management Policy for Intermediate Yield Debt Portfolio

Transcription

1 Scient Capital Credit Pricing and Risk Management Policy for Intermediate Yield Debt Portfolio This document defines the general framework used by Scient Capital for understanding and managing investment risk across the PMS investments specifically in the intermediate yield debt portfolios. INVESTMENT OBJECTIVE Scient Capital s PMS focussing on intermediate yield credit will invest in fixed income securities with rating between AA and BB and other equivalent assets/securities. This space covers the fixed income assets in-between the two extremes - the relatively safe but low-yield sovereign/aaa debt on one hand and the unrated/b-rated real estate backed NCDs on the other. We at Scient Capital believe that a mid-yield debt strategy focusing on suitably chosen debt assets can offer significant risk-adjusted returns over Indian G-Sec investments in the next 3-5 years. This is because several of these assets are undervalued in relation to their credit risk. INVESTMENT STRATEGY Non-bank lenders as well as direct access to underlying loans make up a range of interesting intermediate yield opportunities. Many of these are priced incorrectly owing to lower liquidity, limited understanding of the product and outdated credit pricing. The portfolio will invest in a mix of securities issued by the following: 1. Non-bank finance companies - Several financiers focused on consumer and small businesses a. Housing finance b. Small businesses c. Retail and commercial vehicle loans d. Loans against properties e. Other loans 2. Microfinance companies - Indian MFIs have stellar track record in terms of low NPA, high growth and good governance a. Listed and unlisted MFIs b. PTCs, senior debt, sub-ordinated debt, CRPS 3. Pools of retail and small business loans - Some NBFCs and MFIs create and sell asset backed securities built from their loanbook a. Prudent regulations keep originators skin in the game b. Minimum aging norms help investors 4. Subordinate debt of large lenders - Large banks have started issuing additional tier 1 capital and tier 2 capital. Owing to limited understanding of these structures, they are priced quite attractively 5. Bank dis-intermediation - Some borrowers are exploring non-bank alternatives to reduce borrowing cost a. Lease rental discounting b. Business working capital loans

2 CREDIT EVALUATION AND PRICING METHODOLOGY (SCAPFe - Scient Credit Assessment and Pricing Framework) SCAPFe summarizes our internal credit evaluation and pricing methodology for fixed income securities. We feel it s important to perform credit analysis through different lenses qualitative and quantitative, as well as fundamental and market-driven. SCAPFe is based on the following structure of pricing credit: Yield on a Security = Sovereign Debt Yield for the same maturity + Credit Spread Credit Spread The credit spread is arrived at using an internal credit score. For this, a formal credit rating from a rating agency offers a good starting point. The rating agencies have the necessary expertise to determine the appropriate final credit rating through in-depth research on the company, the industry, company cash flow forecasting, performing scenario analysis and other quantitative checks. Apart from these company and industry specific research, we have the following modifiers to arrive at an internal credit score: 1. Industry Modifier: Observed default rates in the industry Industry performance vis-à-vis broad index in the equity markets Macro assessment of the outlook for the industry Example ITNL (IL&FS Transportation Networks Ltd) rated A IL&FS Transportation is one of the largest BOT road asset owner in India and a market leader in the Transport Infrastructure Sector with presence also in Metro Rail, City Bus Services and

3 Border Check-posts. With the current government focus on investment and development of road infrastructure in India, we are bullish on this sector. Hence the industry modifier will increase the credit score for ITNL. 2. Company Modifier: Company s track record of a default event, if any Financials of the company like EBITDA, net profit/loss, debt equity ratio, capital adequacy, Gross NPAs etc Example Andhra Bank Perpetual Bond rated AA- Andhra Bank is one of the PSU banks that is currently profitable. The financial strength of the bank is reflected in lower gross NPAs and higher capital adequacy which results in an increase in the credit score. 3. Equity Market Inputs (for listed issuers): Equity market valuation (P/B or P/E) vis-à-vis the industry Stock price movement vis-à-vis the benchmark index movement Example Oriental Bank of Commerce Perpetual Bond rated A- We have analysed the trend in the equity price movement of OBC (alpha generated by the stock price vis-à-vis the PSU Bank Index). The stock price has been volatile and is currently at the same level as it was six months back, however the YTM of the perpetual bond is much higher for the same period which gives it some scope for correction in the bond price. This improves our credit score. 4. Balance Maturity Modifier: Change in default rates over time for each rating level A CRISIL Default Study shows that the lower rated papers do not add considerable risk at lower tenors. It is only when the tenors go up that their risk goes up sharply. Hence as the credit quality moves away from sovereign, we reduce the score for a lower rated security with a longer outstanding maturity Example Ashirvad Microfinance rated A- The NCDs with an outstanding maturity of 1 year and 3 years offer a YTM of 12.2% and 12.4% respectively. As per the CRISIL default study, average number of months to default for A rated security is 46. Hence a three-year security will be more prone to default than a one-year security. The credit score will be adjusted accordingly. 5. Instrument Specific Factors: Instrument selection must be optimized in terms of lower tax incidence, transaction structure in terms of mortgage available, credit enhancement if any etc. Example India Bulls Housing Finance rated AA The NCD (non-convertible debenture) is yielding 9.07% which is taxable at marginal rate. Hence the post-tax yield is ~6%. The CRPS (cumulative redeemable preference share) offered is yielding 7.6%. This is a pre-tax equivalent of 11.5%. Hence for the same company a different structure helps optimize the return. However, in case of CRPS, dividends will be paid only if

4 the company is sufficiently profitable. Hence one must compare the tax arbitrage with the risk and accordingly the credit score will be decided. Based on the above modifiers, we arrive at a credit score which translates into the credit spread. Some examples of the link between credit score and credit spread are as follows: Internal Credit Score Credit Spread Security 100 0% All sovereign and 0-10-Yrs AAA rated securities % 1-Yr to 2-Yrs AA rated or 15-Yrs AAA rated securities % 1-Yr A rated or 3-Yrs AA rated securities % 1-Yr BBB rated or 2-Yrs A rated or 8-Yrs AA rated securities % 2-Yrs BBB rated or 1-Yr BB rated securities like CRPS, NCD, PTCs of good quality loans % 2-Yrs BB rated securities like CRPS and unsecured loans of midsized firms % PTCs of unsecured small loans % Real Estate Developer debt; unsecured debt to small companies etc % Mezzanine debt with unproven company % Distress debt 0 N/A i.e. infinite Defaulted or near-default papers Once the pricing is determined as above, the actual yield of the security is juxtaposed with the target price. That results in buy, hold and sell recommendations in each security

5 RISK MANAGEMENT IN PORTFOLIO CONSTRUCTION The portfolio is constructed keeping in mind the incremental risk and return of each security in comparison with the risk-free securities. Following are the guiding factors: 1. Sectoral allocation across the following a. Banks b. HFCs c. NBFCs d. MFIs and securitized debt in MF sector e. Securitized debt in other sectors f. Non-financial corporate bonds (subject to availability) While the allocation starts with equal split across the above categories, the size of the universe in each domain will modify the allocation (e.g. corporate bonds may have very few choices). Overall credit risk score of portfolio derived from credit score of each segment will also revise allocations. A crucial input to portfolio level risk calculation is the extent of correlations in the businesses underlying each of the categories. Since we rely on broad estimates of these correlations, we use the output of such optimization only directionally. The availability of buy rated papers in each domain is also important. 2. Credit risk based allocations Most of the above sectors occupy multiple slots in the credit risk spectrum. Hence it is important to maintain control over allocations by credit risk level, in parallel to 1 above. We believe that conventional ratings do not fully describe credit risk of a security. Hence we follow a detailed risk assessment and pricing framework to assign credit risk scores to each security. These range from 100 for Government debt to 20 for (conventionally) B-rated securities. The following split is envisaged in terms of our credit risk scores. a. Credit risk score corresponding to 3-year AA rated papers or better: 20% - 30% b. Credit risk score corresponding to 3-year A rated papers: 30% - 40% c. Credit risk score corresponding to 2-year BBB-rated papers: 30% - 40% d. Credit risk score corresponding to 1-year BB and B rated papers: 5% - 20% It is possible that investors feel a bit more comfortable with conventional rating based limits as well. The following are such limits. a. Rated AA or above by a rating agency: 20% - 40% b. Rated A: 20% - 50% c. Rated BBB: 20% - 50% d. Rated BB or below: 5% - 20% 3. Split across liquid and buy-to-hold papers While liquidity will drive whether a security is bought to trade or hold, the general preference is to buy in secondary markets the higher rated papers with moderate to good levels of liquidity and to structure in primary markets the lower rated papers with assumption of zero liquidity. The former (liquid and higher rated) papers can have balance maturities beyond 3 years. The latter (not liquid and lower rated) papers will have balance maturity of no longer than remaining fund life (3 years or lower).

6 There is no exogenous constraint on liquid vs illiquid papers. The portfolio split across ratings will drive the effective liquid/illiquid split. Expected level of liquid papers in the portfolio is ~25% to 50%. The rest are likely to be bought-to-hold. 4. Modified duration Part of whole of the liquid portion of the portfolio may be targeted at credit spread compression play. We believe that credit spreads will narrow with a lag to fall in G-Sec yields. To that end, the liquid portion of the portfolio may contain securities with somewhat longer tenor than the life of the fund. Since this is not the primary investment hypothesis, we will limit exposure to duration. The duration-exposed part of the portfolio (securities with modified duration above 5 years) will be below 30% of total value. Additionally, the modified duration of the overall fund will remain always below 5 years. 5. Intra-sector security selection This is more specific to each sector. In general, the idea is to avoid as much as possible the obvious correlations in terms of underlying business, geography and exposure to macro-factors. a. Banks since the intra-sector correlation amongst banks is high, there is a limited scope for diversification within the sector. We attempt to diversify exposure to private sector in addition to PSU banks. b. HFCs there are nuanced differences in target segments of customers amongst HFCs. In some cases, there is also geographical concentration. c. NBFCs this sector lends itself to greater diversification. NBFCs have different underlying borrower segments (auto, commercial vehicles, small businesses, gold loans etc.) and often different geographical focus areas. d. MFIs most microfinance institutions run a very similar lending and funding business model and hence diversification is harder. Unlike banks however, there is geographical focus for most MFIs, which allows some diversity. e. Securitized debt this sector too allows a wider diversification. There are diverse underlying loan-pools and originators to choose from. f. Non-financial corporate bonds this sector allows widest diversification. Unfortunately, there are very few options currently available in this space. However, given the government s push for making the corporate debt markets more liquid, we expect a few corporate bond issues in Timing the inflow and primary issuances We will make multiple closes of the AIF. Hence there will be a broad matching of expected inflows and our security buying in secondary markets. We will use drawdown mechanism to get a finer match between our inflows and primary issuances (i.e. those that are structured for investment by the fund directly).

7 INVESTMENT COMMITTEE AND RISK MANAGEMENT TEAM Scient follows an Investment Committee approach for portfolio management. The Investment Committee will evaluate and approve investment proposals relating to acquisition, sale or disposition of Portfolio Investments. At the investment stage, all securities (primarily sourced or available in the secondary market) shall be discussed and finally approved by the Investment Committee. Post investment, the portfolio management process covers a regular monitoring of various aspects of each investment by a dedicated team member responsible for the same. Advisory Board Scient will also constitute an Advisory Board for the portfolio. The Advisory Board will be comprised of not less than 4 members and will include members of the Investment Committee and certain other members of key anchor investors as selected by the Investment Manager as well as independent members who are experts in the relevant sectors. The Advisory Board shall provide advice and counsel as requested by the Investment Committee in connection with potential investments. INVESTMENT PROCESS Security Origination Once the sector is decided, the specific security pricing is sourced from various providers to compare and achieve the best price in the market. In case of primary transactions, the origination of the debt investments will be carried out by an experienced team who will work with issuers directly and some intermediaries to originate transactions in fixed income instruments with a variety of issuers across sectors. The demand for structured debt solutions is tremendous, especially so with mid-sized companies whose access to debt financing is largely restricted to traditional bank funding. The key members of the Origination Team are Chhavi Moodgal and Palak Nanjani who come with significant experience ranging from years in the Indian market with reputed financial institutions, bringing together significant client relationships and security origination skills to the team. Through a combination of direct and indirect sourcing the PMS will benefit by having differentiated and enhanced access to high quality credit risk across the country s middle market corporate segment. All securities are screened by the Origination Team before processing for detailed due diligence. Initial name clearance, indicative pricing and main covenants are discussed internally and communicated to the investee company so as to ensure that broad terms of pricing are acceptable right at the outset. This ensures precious processing time and resources are not spent on a security that may not get executed. Security Assessment The security selection process is an intensive process run by Swapnil Pawar & Palak Nanjani, with guidance from the board members of Scient. This is a very important aspect of the team organization as it creates a maker-checker mechanism and ensures a strong control mechanism. The Security assessment process consists of the analysis & feasibility in line with SCAPFe described above. Information sources cover not only the formal, reported and published information sources but more importantly, also informal sources embedded in long standing relationships. Transaction Management & Execution Post approval from the Investment Committee, the transaction is executed by the internal team responsible for the same in conjunction with internal operations, internal legal and external counsel.

8 Appropriate legal opinions and confirmations are taken from the counsel for the transaction. The Investment Manager has created standardized program documentation for all its debt investments thereby bringing down the costs of issuance and streamlining the entire process of execution and risk management. Post Investment Management Post investment, the portfolio management process covers a regular monitoring of various aspects of each investment. There is a real-time monitoring of company news, information, ratings and other disclosures. Any such information is analysed and filed for future reference. There is also a periodic review of the company s financials and cash flows. There is a comprehensive security tracker both detailed and abridged, which also tracks the investments at a portfolio level for cash flow monitoring. Legal, Regulatory & Tax In case of all fixed income securities sourced in the secondary market, the structure will be optimized in terms of lower tax incidence, transaction structure in terms of mortgage available, credit enhancement if any etc. Primarily sourced securities are structured to ensure compliance of the security structure with all relevant laws and regulations. There is an entire range of regulations and approvals pertaining to fixed income securities as well as other regulations pertaining to Companies Act, debt issuances etc. that need to be considered and adhered to, while issuance of these instruments. Appropriate advice from counsel is taken for the same and incorporated to create a robust security structure. KEY RISKS & RISK MITIGATION PROCESS The central step in the investment process is detailed analysis and due diligence of various risks of the debt investment proposal. Following table shows the key risks that each sector is subject to at varying levels: Risk / Sector PSU Asset Backed HFCs NBFCs MFIs Banks Securities Growth H M H L M Capital Adequacy H M M L Real Estate L H M L M Gold L L M L L Inflation and Interest rates L M H L L Regulation L L M H M Execution/Operations L L M H L Risk Mitigation: Portfolio Diversification The PMS will endeavour to have a fair degree of diversification in its investments by sector or geographic region or asset type with varying exit horizons such that poor performance by even a few of these investments might not lead to adverse effects on the returns received. The table below shows that the correlation within each sector is low. Sector PSU Banks HFCs NBFCs MFIs PSU Banks HFCs Moderate NBFCs Moderate Moderate MFIs Low Low Low ABS Low Low Moderate Low

9 Concentration limit The portfolio will keep sectoral exposures within stipulated limits at all times. Also, single issuer concentration will be limited by policy (in the target portfolio; at the beginning the portfolios will remain concentrated and become diversified through rebalancing regularly. Correlation within each sector is also low. Sector PSU Banks HFCs NBFCs MFIs ABS Correlation across companies within sector High High Moderate Low Low Remarks Most PSU Banks have similar problems and similar likely solutions. HFCs are exposed to similar macro factors. Operational variations are relatively less important. NBFC businesses are diverse. They also operate in individual niches. MFIs most significant risk is execution related which is highly idiosyncratic. The underlying loan-pools are very diverse and behave quite differently from each other. Company Business The analysis covers in detail an understanding of the recent financials of the company so as to gain insight into the financial health of the company and the associate businesses. Financial analysis covers all important aspects pertaining to revenues and profitability, reported and off balance sheet leverage and working capital needs of the business. Regular Monitoring done after Investment Post investment, there is a real-time monitoring of company news, information, ratings and other disclosures. Any such information is analysed and filed for future reference. There is also a periodic review of the company s financials and cash flows.