Mutual Funds and NBFCs pledging not to sell the pledged shares of two groups -Essel and the billionaire Anil Ambani’s ADA Group has shaken investors and regulators alike. The steady rise in the flow of savings to income funds since 2015(approximately when RBI started inflation targeting) became a flood in 2017 post demonetisation when returns from banks deposits crashed. The heady increase in investible funds led to a chase for yields leading fund managers to take risky bets such as loans against shares. The risk began to unravel last month when the Essel group shares crashed. Under their covenants , a clutch of funds would have had to sell their pledged shares leading to a further crash in the prices and probably all round losses for the group and for mutual funds and NBFCs. In an unprecedented move the fund managers reached an understanding with Subhash Chandra, the group patriarch, not to sell the pledged shares till September 30, by when the group promised to sell the jewel in its crown- Zee Entertainment- and make good the loans. This sequence was repeated with the ADA group, which now looks close to selling the jewel in its crown, Reliance Nippon. ADAG and Essel are not the only vulnerable assets. Bonds issued by a few other NBFCs who have real estate exposure are also problem assets for mutual funds.
The first question to ask is: will there be an accident? What if either Essel or ADAG or any other promoter is unable to pay up? If this merely results in a marking down of the NAV, this will be an insignificant event. Trouble will be only if such a default sets off a panic reaction among Investors and they start pulling out their money. No fund, however well managed can withstand a run.
What are the chances of an accident? That depends on how much has been lent to promoters. Fund managers say the total for the fund industry may be rs 40,000 crores which only 20 percent may be weak promoters. That means not more than 10,000 crores is at risk for the fund industry. A small speck for a 15 trillion rupees fixed income industry.
Maybe the problem won’t be for all funds but for the Credit Risk plans. These by definition invest 66 percent of their money in paper rated below AA, and such bonds don’t trade. Funds have to hold them to maturity. The worry is that month-to-date, these funds have seen an outflow of nearly 3000 crores according to market sources. It is possible that one or two funds may have run out of AAA and AA rated paper and may hence have a problem honouring investor commitment.
Fund managers put forth several defences: one that some Credit Risk funds like those run by Franklin Templeton have an exit load that gets heavier for early withdrawal and get lighter, the longer an investor stays. This may be a bulwark against panic withdrawal. Second, they claim many credit risk funds have a cap of say 5 crores per unitholder and hence mass withdrawal is unlikely. Likewise, they also have no more than 3 percent in one asset, so the loss in case one borrower defaults is restricted to a few basis points of the NAV Other fund managers also claim that it is not that paper rated below AA can’t be sold.
High Net Worth Individuals(HNIs) and Asset reconstruction companies (ARCS) are willing to buy lower grade paper but only at a much higher yield than the coupon. That is the fund manager will always be able to meet fund outflows, albeit at lower NAVs, Which brings us to the problem of valuation. This appears to be the weakest link. Out of six lakh crore of outstanding bonds, only 18000 cr of bonds are traded in a month.. which means there is no traded rate for over 95 percent of the bonds. These bonds are valued according to a poll done by rating agencies across fund managers.
The question then arises, how will rating agencies rate such peculiar instances of MFs not selling pledged shares backing a bond. It is not immediately clear if all MFs are valuing the paper identically and correctly. If not, savvier investors who are exiting the funds now are getting a higher return. If either Essel or ADAG or any of the vulnerable NBFCs don’t pay up, these valuation questions become real. The entire saga of valuing will remain murky till MFs shift to mark-to-market, which is unforeseeable for now given the state of the bond markets. Yet it has to be said to the credit of the mutual fund and rating industry that they are at least attempting some kind of mark-to-market; the banking and insurance industry (in the absence of IND-AS) are blissfully holding vulnerable loans without any provisions till they actually default.
The even bigger issue about these credit risk funds and indeed several kinds of income and balanced funds is that they are being sold by financial advisors like they are fixed deposits. Most MFs carry a risk meter for each fund on their website, but these do not reflect the nuanced differences between risky and riskier credit funds. More importantly, most financial advisors are either unaware of the risk-meter and/or don’t alert the retail investors. Misselling of such funds to even retirees and widows is rampant.
Fund managers angrily asked me should car makers be blamed if car users don’t wear their seat belt. That’s a cute argument. The RBI holds banks responsible even if money is stolen from a white label ATM. Investors in fixed income funds feel cheated by falling NAVs or worse, a loss of capital, they can set off a run on these funds, and this can be brutal, no matter who is to blame. The regulator will probably not want to push over an already skittish market, but sooner or later it has to write some new rules on the extent of risks MFs can take, whether caps and ratios need to be mandatorily fixed and if rating agencies have indulged in some loose practices to win business. Even more important is the advisor and Investor education. Rather than blow up all its fund in misleading Sahi Hai advertisements, the fund industry needs to use some those funds to educate the financial advisor and the ultimate investor.