In a fresh round of bad news for debt fund investors, ICRA has put six debt funds under rating watch. What should you, the investor, make of this rating action and what should be your next course of action? Read on to know what the developments mean for you.
The story so far
ICRA put six debt fund schemes—two from HDFC Mutual Fund, one from Aditya Birla Sun Life Mutual Fund and three from UTI Mutual Fund—on a rating watch with negative implications.
Debt funds downgrade: No reason to panic yet
These funds held bonds of certain special purpose vehicles (SPVs)—Hazaribagh Ranchi Expressway Ltd (HREL), Jorabat Shillong Expressway Ltd (JSEL) and Jharkhand Road Projects Implementation Co. (JRPICL) that have links with IL&FS Group. What triggered the rating action was a communication from the SPVs seeking to stop any future repayments to their bond holders, which included these mutual fund schemes, not because the projects were not able to generate the funds, but on a legal technicality relating to settling the obligations of insolvent IL&FS Group companies.
Subsequently, Crisil downgraded the bonds of JRPICL to BB(SO), indicating moderate risk of default, and India Ratings put the bonds of HREL and JSEL on a rating watch with negative implications, indicating a possibility of further deterioration in the credit quality.
The schemes that have been affected are HDFC Banking and PSU Debt Fund and HDFC Short-term Debt Fund with exposure of 0.29% and 0.55% of their assets under management (AUM), respectively, to HREL; UTI Bond Fund, UTI Dynamic Bond Fund and UTI Banking and PSU Debt Fund with exposure of 5.98%, 6.25% and 6.87% of AUM, respectively, to JSEL; and Aditya Birla Sun Life Short term Opportunities fund with exposure of 1.15% of AUM to JRPICL.
What mutual funds did
For mutual funds with exposure to these bonds, this meant that the obligations, when they arise, are unlikely to be met and they have to address the default. In such situations, mutual funds write down the value of the bonds to reflect the downgrade. Accordingly, all the affected mutual funds valued these bonds at a discount of 20-25% to daily prices taking a hit on their net asset value. For example, a bond that was valued at₹100 earlier will now be valued at ₹70 because this is what the bonds are likely to realise in the current situation. To this devalued value of ₹70, the mutual fund company may choose to give an additional discount, in this case in the range of 20-25%, to be conservative. So, in effect, the value of the bond drops from ₹100 to ₹52.5.
They do this so that the portfolio reflects the risks and is realistic about what the bonds can realise. The extent of impact on the NAV (net asset value) will depend upon how much of the fund’s assets were held in these bonds. The impact on UTI schemes, having greater exposure to downgraded assets, will be more significant compared to funds with a lower holding of these assets.
The option to segregate or side-pocket these assets so that the impact of the downgrade does not lead to panic redemptions is not yet available since the regulations require that the scheme information document be updated to allow such segregation, and there has been no move on this front by fund houses.
Should fund houses have seen the writings on the wall in September when the IL&FS issue broke and exited from all instruments of the parent company and its subsidiaries at that stage? No, say industry experts and point to the cast iron protection that the SPV structure provides to lenders where their claims to cash flows into the escrow account gets precedence over all other claims. According to Lakshmi Iyer, head-fixed income, Kotak Asset Management Co. Ltd, “At the moment, mutual funds are anyway wary of lending to the NBFC segment. However, in this case, the nature of default is very different, and everyone is aware that it is not an interpretation issue. Markets could be more tolerant as compared to what we saw in September last year. If it were a wilful default, the escrow account would not have the money, which it does.”
The SPVs have been servicing their debt obligations on time so far and the escrow accounts, into which the cash flows from the projects accumulates and is then paid out to the bond holders, continue to hold adequate funds to service the debt. “If a resolution does not happen, it may put into question other similar structures and have a negative impact on investor confidence in debt funds,” said Arvind Chari, head-fixed income and alternatives, Quantum Advisors Pvt. Ltd.
What it means for you
“I don’t see this situation having a contagion impact leading to outflows in the asset management industry as a whole. Affected schemes have already marked down the exposure and that reflects in the NAVs,” said Iyer.
To put it in perspective, the HDFC Short Term Debt fund has an AUM of around ₹8,985 crore (as on 31 December 2018) of which the exposure to HREL was 0.55% or ₹49 crore. Similarly, the exposure of Aditya Birla Short Term Opportunities Fund to JRPICL stood at 1.15% of the AUM of ₹3,925 crore (as of 31 December 2018) or ₹45 crore and that of UTI Bond fund to JSEL stood at 5.98% on an AUM of ₹802 crore or ₹47 crore. But however small the impact, the return from the funds will be lower to the extent of the hit the NAV takes due to the event, unless there is a ruling in favour of the lenders going forward and recoveries happen. All the funds have high ratings from agencies tracking and ranking MF schemes, indicating high level of confidence in the quality of the schemes’ portfolios.
The HDFC Short-Term Bond fund is part of the Mint 30 basket and we see no reason to question its eligibility as of now. Investors who are holding the schemes need not consider exiting for now. “Wherever there is an exposure to the IL&FS SPVs, mark down has happened. We are telling clients not to exit in panic. We continue to watch the developments closely. The question is whether the resolution will happen quickly or not,” said Roopali Prabhu, director and head investment products, Sanctum Wealth Management.
New investors should wait and watch how the situation plays out before considering fresh investments into the schemes.