June 13, 2019

Unravelling The DHFL Mess

For those who need a quick recap, on 4 June, DHFL fell behind on its interest payment to NCD holders to the extent of 900 odd crore.  They cited the trust deed to say that they had 7 days to make good on that (for it to not be considered as a ‘default’), and they assured investors (and everyone else) that they would do so.  Apparently, the credit rating agencies had a difference of opinion.  With what I think was an uncharacteristic swiftness, they downgraded the company to ‘default’ status.  Taking a cue from that, all fund houses holding any NCDs of DHFL marked down their holdings by 75-100%. 

Fast forward to 11 June.  In an exchange filing, DHFL confirmed making good on all interest payments.  In itself, that should have made all the NCD holders happy, and to look forward to the next interest payment (or maturity payment).  For the investors in the debt funds that held DHFL NCDs, there was little to cheer about.  Over this period, their total wealth was eroded by an estimated 3000 crore, and there is no clear picture as to when this will be recovered.  For some investors, there will be no recovery. 

So how did this come about?

Let me start with the credit rating agencies.  For many years, DHFL was rated AAA by all of them.  Not just that, until a few months ago, its NCDs were also a part of the CRISIL AAA Medium Term Bond Index.  With such credentials, I find the manner in which DHFL was rapidly downgraded to be rather odd.  And as I hinted above, I also wonder about the promptness with which they downgraded DHFL to default status.  It’s not a decision that can be reversed right away.  Couldn’t they have waited for the 7 day period to expire, before taking that decision?  I am no expert and when I spoke to those who are, they told me that the credit rating agencies were simply acting by the letter of the law.  Still, none of them could give me a satisfying explanation for the apparent flexibility shown in other recent instances or even in the rating of the parent company of DHFL, Wadhawan Global Capital Ltd (WGC).

Without getting too technical, WGC had issued NCDs whose rating was inextricably linked to that of DHFL.  Thus, when DHFL enjoyed a AAA rating, WGC had a AAA (SO) rating.  When DHFL was downgraded from AAA to AA, then to A, and then to BBB, so was WGC.  However, there was a noticeable inconsistency in the time lag between the downgrades of the two companies.  On one occasion, the downgrade happened on the same day whereas on others there was a lag of 3-10 days.  And for whatever it is worth, as at the time of writing, unlike DHFL, WGC has not been downgraded to ‘default’ (nor is there any other update to the rating).  In that backdrop, it is hard for me to believe that rating agencies cannot exercise flexibility.

Let me then move on to the role of AMFI.  It recently came out with “standard” guidelines for how sub-investment grade securities should be valued by mutual fund schemes.  Prior to this, it was up to each fund house’s valuation committee to decide and there wasn’t much by way of industry-wide consistency.  From that perspective, AMFI’s guidelines should have been a welcome move.  Unfortunately, not enough thought went into the details.  The result was a blunt tool about which, the less said the better.  Among other things, it recommended that securities be marked down uniformly, regardless of their maturity.  It is a mystery to me as to why AMFI didn’t simply opt for scrip level valuation for these securities, something which has been talked about for a long time.  In any case, in the present instance, I expected fund houses to apply some discretion rather than blindly follow the guidelines.

I have a bigger issue with the fund houses, though, on a different count.  It had been a long standing demand of fund houses that they have the ability to create ‘side pockets’ (or segregated portfolios, as they are formally called) of securities that are significantly downgraded.  In the event of a default, a side pocket protects the interest of investors who exit after the default but before the money is recovered. It also helps investors who stay put by protecting them from the impact of ongoing sales and redemptions.  Yet, despite the fact that SEBI approved the use of side pockets over 5 months ago, barring one exception, fund houses have not yet initiated the process. 

But the biggest peeve I have with fund houses isn’t specific to DHFL- it is about understanding and communicating the real nature of debt funds and their risks.  Fund houses will not admit it, but most of their salespeople and advisors don’t understand this fact: debt funds are an incredibly complicated investment option.

On the face of it, a mutual fund is a means to invest into an asset class, without some of the attendant risks.  Thus, an equity fund is a means to invest in equity shares, and a debt fund is a means to invest into debt instruments.  In reality, though, things are much more twisted.  While the characteristics of equity funds roughly mirror those of their underlying investments, debt funds have attributes that are markedly different from their underlying investments.  Unlike debt instruments, debt funds don’t assure any return and, other than FMPs, don’t have a fixed tenure.  One could argue that debt funds distort the very trait of debt instruments that makes them regarded as safe, and appealing to investors.  It’s worth asking why should they even be called ‘fixed income’ funds.  Furthermore, compared to equity funds, debt funds carry a larger variety of significant risks.  The scariest part, though, is that, as we have seen, there are some risks that are hard to fathom or even give a name to. 

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