As a close watcher of the personal finance and mutual fund industry and as a journalist who is very passionate about middle class India’s dream of wealth creation, the events of the last few days leave me somewhat troubled, and perhaps even saddened.In the 15-odd years that I’ve tracked the financial markets, the only time the words ‘credit’ and ‘default’ crept up in news reporting was during the 2008 global financial meltdown. Now that was an unbelievable, indescribable,
rarest-of-rare event. And it was happening across foreign shores far away from India. We were still a calm island of safety. Nothing could touch our robust financial system. We were secure, prudent and so well preserved by our regulators and our healthy financial system. Or so we thought.
Exactly a decade later on a fine September afternoon in 2018, the word default rang loud once again. And this time it wasn’t a foreign headline, it was something happening right here at home. One of India’s biggest infrastructure financing institutions was going under. Days after the IL&FS default, DSP Mutual Fund decided to sell some of its holdings of DHFL paper in the already nervous fixed income market. The storm had begun. The nervousness was palpable and the screen was flashing red. In the 9 months that followed, India, its markets and its investors have struggled to come to terms with the reality of credit market stress, unpaid dues, the collapse of corporate entities and the fear of contagion – the domino effect of a debt default that can spread like wildfire through fixed income and equity markets.
DHFL’s non-convertible debenture (NCD) default last week is perhaps a culmination and climax of all these fears. It’s the market’s worst nightmare come true.
Let’s simplify things. Entities like DHFL have gotten stressed in the last few months due to what is called an ALM or asset-liability management mismatch. Simply put, this happens when you borrow money from the market for the short term and lend it out for the long term to borrowers, say in the need of a housing loan which is repaid over the course of 15 or 20 years. When credit markets grow tight, this mismatch can lead to liquidity issues, and once the market knows you are stressed for funds, getting fresh money from banks or other lenders becomes even more difficult.
On June 4, DHFL ran out of money. It missed paying interest amounting to Rs 1,100 crore on NCDs. Rating agencies swung into action, took note of the default and downgraded the company’s debentures, bonds, commercial paper and other credit instruments to ‘D’. And that’s how the dominos started falling. A rating downgrade meant that mutual funds who were holding these instruments also had to mark down the value of their investment. Regulatory norms require a mark down of 75 percent corresponding with a ‘D’ rating. Some like UTI MF went a step further and marked down the entire value of the DHFL securities they were holding, by a full 100 percent. The UTI press release had an eerie, ominous ring to it. “UTI MF anticipates that there would be enhanced pressure and legal action on DHFL from all creditors, including exercise of early redemption clause and legal options by various lenders. This is expected to further delay the recovery efforts of the company in disposal of its assets in an orderly manner. Furthermore, there is no secondary market for such securities in the current scenario. Considering the high level of uncertainty as to recovery timelines and value, UTI MF has increased the markdown to DHFL debt securities from 75 percent to 100 percent,” the press statement reads.
Well advised caution and a moralistic high stance to take, but perhaps it was too little too late. The damage was done.
What next after the default?
As NCD subscribers and MF investors find themselves staring at losses, many are wondering what will happen next. DHFL has promised to pay up the money within the seven-day grace period. According to a fund manager with exposure to the company’s debt, securitisation deals and a strategic stake sale should go through over the next couple of weeks which means the company won’t falter on its future commitments. Proceeds from its sale of the affordable housing business and the education financing arm Avanse Financial should help it tide over upcoming payments and also make good past dues. But this doesn’t change much for investors already burnt by the downgrade and default.
According to industry watchers, even if DHFL repays some or all of the interest it missed paying on June 4, the rating on its debt won’t immediately be restored. Rating agencies take atleast 90 days if not more to reinstate original ratings. This means that raising fresh funds will remain a challenge. The question then is what are the options before investors hit by the DHFL storm?
To put it in one line, DHFL’s current investors don’t have too many options. “NCD investors can’t redeem units anyway. Plus there is no liquidity for these instruments in the secondary market. And even if there was a buyer, there’s little point in selling now at a steep loss,” says personal finance expert Harsh Roongta. “It is best to stay put and one should hopefully see the losses reduce by the time of maturity,” he added.
Now that’s a view on DHFL’s non-convertible debentures. What about all the 140-odd mutual fund schemes that have exposure to DHFL and have been hit by the downgrades? Feroze Azeez, the deputy CEO of Anand Rathi Private Wealth, says one should remain invested in the fund if the scheme’s total exposure to DHFL is less than 8 percent of AUM. “At that level, most of the value has already been eroded so there is no point in exiting at a loss,” says Azeez. However, if the exposure is in excess of 8 percent, one needs to take a call depending on the maturity date, he opined. “If maturity is beyond 2019, it would be a good idea to exit the fund as the probability of DHFL paying up longer maturity commitments is fairly low.”
There are some mutual funds which are creating a so–called side pocket to
The side-pocket attempt
ring-fence the rest of the fund holdings away from the DHFL stress. Take for example Tata Mutual Fund. This AMC is segregating all its DHFL exposure into a side pocket and will give an equal number of units to investors in the main fund as well as the segregated portion. Investors who chose to redeem their investment will get proceeds depending on the NAV of the main portfolio but will have to keep holding the side-pocketed DHFL units. The fund house plans to list units of the segregated portfolio on the stock exchange and will wait for DHFL to pay back the money. As and when that happens, unit holders will be repaid dues proportionately.
The lessons to be learnt
It’s anyone’s guess how the DHFL crisis ultimately plays out. What it has been is a stark wake-up call for fund managers, investors and financial intermediary community. Retail investors find themselves lost without adequate understanding of what exactly transpired. But the question is how many of them took the effort to understand what they were signing up for in the first place? Fixed income, in no way, is equal to fixed returns. Mutual Fund distributors and financial advisors need to place a hand on their heart and ask themselves the question – while aggressively advising retail investors to switch from fixed deposits to debt funds, did they do enough to educate these first timers about the risks associated with such investment? Boom-and-bust cycles are a part of any market and losses must be digested along with gains. But was this basic principle of investing explained while credit funds were being sold aggressively over the last few years?
That brings me to another important point. The problem, as the DHFL episode teaches us, isn’t restricted to just credit risk funds alone. These funds have a total AUM of Rs 76,643 crore out of a total fixed income industry AUM of 10,88,349 crore. That’s about 7 percent of the total pie. Not so bad you’d think. Well it is. Because corporate debt is not just restricted to credit risk funds. DHFL’s debt is spread across 140-odd MF schemes spanning many different types of fund categories beyond credit risk -- Tata Bond Fund, DHFL Pramerica Low Duration Fund, Baroda Dynamic Bond fund, BNP Paribas Corp Bond Fund and Edelweiss Low Duration Fund, to name a few.
So staying away from credit risk funds alone won’t ensure you don’t suffer losses in a debt fund. So what’s the way forward? Like every cloud has a silver lining, this one will hopefully motivate investors to measure their risk appetite and ask more questions before signing the cheque. In an era of digital payments and online investing, this crisis takes us back to the basics – the importance of being aware about your money and investing in simple, easy to understand products.
The DHFL lesson will hopefully lead to more transparency and better industry practices which ensure that debt funds can become a stable part of any investors’ portfolio. Fixed income funds still come with a great tax advantage for those willing to invest for three years. They can offer better returns than the humble fixed deposit only if one understands their risk profile and is willing to take it in his stride.
There is no free lunch in life and there is no high return without a proportionate element of risk. It is this reminder of a basic fundamental principle of investing that will perhaps go down as the most positive takeaway from the DHFL saga.