September 16, 2018

The IL&FS Debacle

It began around a week ago with the steep downgrade of IL&FS and some of its subsidiaries by three credit rating agencies.  That, in varying degree, impacted investors in an estimated 32 schemes across 11 fund houses.  Then late last week, IL&FS failed to honour a mere 50 crore maturity of its commercial paper (CP).  From what I can make out, within the next 10 days, 175 crore of the IL&FS group’s CPs held by mutual funds are due to mature.  It is anybody’s guess if they will honour those obligations. Regardless of what happens, and whether a fund house invested in the group’s securities or not, this debacle should give all fund houses, as well as SEBI, a lot to mull over.  There is also plenty of food for thought for investors.

Can credit rating agencies be trusted?
From A1+ to A4: I can’t remember the last time that a company was downgraded overnight this sharply.  One day, it had the highest rating possible, and the next, it was rated as being on the brink of default.  The rating agencies may claim that they had given indications in August that a downgrade could be on the cards.  But it seems to me that there were grounds for multiple, smaller downgrades, much before that.

The biggest fallout of this could be a loss of trust in credit ratings.  Will we ever be able to look at a AAA/ A1+ rated company and believe with confidence that our money is safe?  How is an investor to then trust the credit quality of a debt fund?  While the rating agencies may have tarnished their own credibility, their actions could impact the growth of debt mutual funds.  

Didn’t fund managers know what was going on?
While there is good reason to blame the rating agencies, I find it hard to believe any fund manager who pleads ignorance about how bad things were.  If nothing else, the yields on the instruments certainly suggested that something wasn’t right.  Here’s one example. 

On 28 August, a certain fund house bought a CP of IL&FS with a residual maturity of 62 days at a yield of 9.25%.  On the same day, that fund house also bought a A1+ rated CP of Indiabulls Commercial Credit with a maturity of 59 days.  The yield: 7.85%. 

Looking at those specific transactions also made me wonder if it was a coincidence that the Indiabulls investment was bought by that fund house in its liquid fund while the IL&FS investment was bought in its credit risk fund.

Let’s talk about concentration risk
About three weeks ago, on a certain online investment forum, someone asked investors on the forum about the things that they considered in selecting a liquid fund.  Most responses dwelled on the credit quality of the portfolio and expense ratio as the key factors.  But there was one reply that was markedly different.  According to that person, the thing that mattered to him most was “concentration risk of non-sovereign holdings”.

It was the mix of credit risk and concentrated holdings that was at the heart of the JPMorgan-Amtek Auto and Taurus-Ballarpur fiascos.   Despite that, the risk of having large positions in individual companies is still not widely well-understood- by investors, or even by fund managers.  I’d say that the IL&FS debacle makes the case that having a concentrated position in a single company can be a bigger risk than credit risk.  Based on August-end data, at least 4 schemes (including one liquid fund and one ultra short term fund) had near double-digit percentage exposures to IL&FS and its worst-hit subsidiaries, with several more close behind.  If I go back a month, I can add more schemes to that list.

For investors, monitoring the exposure of a scheme to a single company, particularly in debt funds, is not easy.  Unlike equity funds, debt funds often have multiple instruments of a single company.  I think it would help if SEBI made it mandatory for schemes to disclose the maximum percentage holding of any single company/ group of companies whose ratings are interlinked.  Personally, I would like SEBI to go one step further and bring down the single-company exposure limits for debt funds, perhaps more so for liquid and ultra short term funds.  The way I see it, investors in debt funds are generally less prepared for the risks of funds holding concentrated positions than, say, investors in equity funds. 

How should junk bonds be valued?
The IL&FS downgrade has once again brought to the forefront the challenges associated with valuing junk bonds.  As I have written in the past (see here and here), this is a contentious issue on which there is no industry-wide consensus.  By and large, fund houses mark down junk bonds by 25%, but not necessarily so.  It can become especially problematic if the instruments have a very short residual maturity, as was the case this time around.  Let me explain with an example.

As on 31 August, Principal Cash Management Fund (a liquid fund) had 9.8% of its portfolio in CPs issued by IL&FS Financial Services.  4.4% was in a CP that matured on 10 September while 5.4% was in a CP that will mature on 24 September.  On Saturday, 8 September, ICRA downgraded these instruments to junk status.  Being a liquid fund, the next NAV to be declared was for Sunday, 9 September.  The question before the fund house now was of how to value its IL&FS investments for the purpose of that NAV.

From what I have gathered, notwithstanding the downgrade, the fund house was confident of getting back its money, some of which was due just one day later.  So from that point of view, some might argue that there was no need to mark down the investments.  Yet SEBI regulations stipulate that each day’s NAV has to reflect the realizable value of the underlying investments.  In that light, a mark down was unavoidable.

Eventually, the fund house decided to mark down its IL&FS investments by 25%.  As a result, the NAV on 9 September fell by 2.3%.  The very next day, on 10 September, when they got back the first tranche of their money as expected, the NAV jumped up by 1.2%.  Unfortunately, those gains were not available to anyone who had exited based on the NAV of 9 September. 

Before you jump to any conclusion, here are a couple of points worth noting.  One is that the fall in the NAV of  Principal Cash Management Fund was in no small measure linked to the percentage exposure taken by the scheme to the IL&FS securities.  If its percentage exposure had been less, the fall would have been less.  The second relates to a scheme managed by another fund house which held a CP of IL&FS that matured last week.  After the downgrade, this fund house decided to mark down its holding to a lesser degree, compared to what Principal MF did.  As it turned out, it did not receive its money back from IL&FS on the due date and had to mark down its holding further.  In effect, the brunt of the fall was borne by investors who stayed invested in the scheme. The saving grace, if I may call it that, was that its exposure to that CP was less than 3%.

I can’t see a perfect solution to this problem.  But I think it would help if SEBI enforces more consistency in the process of valuing junk bonds.  If I understand correctly, currently CRISIL and ICRA provide scrip level valuation for investment grade securities with residual maturity of over 60 days.  There is a case to extend this to all debt securities, including junk bonds.

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