July 01, 2019

A Most Eventful Month For Debt Funds

To say that the month gone by was extraordinary, would be an understatement.  It shone a whole new light on the riskiness of debt funds.  And for some debt fund investors, it was catastrophic.  While there has been ample media coverage on most of what happened, in this post, I’d like to talk about some of the less-reported stuff that stood out for me.

Let me start with the downgrades.  We all know about DHFL.  We probably know about Sintex as well.  But there were two other companies whose downgrades threw up a few questions for me- Wadhawan Global Capital (WGC) and  Cox & Kings.  There were only a handful of schemes holding debt of these companies, and in all but one of those schemes, investors were not impacted.  Still, these questions are pertinent given how much credit rating agencies influence debt fund returns.

WGC is the parent company of DHFL, and I talked a bit about it in an earlier post.  I had mentioned that its rating was linked to that of DHFL and that it was downgraded along with it between February and May (although with an inconsistent time lag).  I had pointed out that when DHFL was downgraded to ‘default’ on 4 June, WGC wasn’t. After a questionable delay, on 21 June, the new rating for WGC was released.  But guess what?  Its rating wasn’t downgraded to ‘default’.  Instead, in what I consider a sleight of hand, its rating was delinked from DHFL and was independently assessed as BB.  But why the long delay?  This wasn’t a complex company that needed deep evaluation.  Did the delay have anything to do with some stake sales that were to came through (and eventually came through)?  Would the rating have been the same if it had been done right after the DHFL downgrade?  Was such a delay justified?  Was the delinking from DHFL justified?

There’s more: one fund house held around 300 cr of NCDs issued by WGC that were due to mature in 2020 and 2022.  Since WGC was untouched by the DHFL downgrade, its schemes holding these NCDs weren’t impacted either.  Not only that, if reports are to be believed, this fund house managed to sell back its entire WGC holding (or at least a large part of that) to the DHFL promoters, before it eventually got downgraded to BB.  In some quarters, the move was hailed as a masterstroke by the fund manager.  Frankly, I don’t know if it would qualify as skill, luck, or something else.  Regardless, assuming this information to be correct, I’d be curious to know what made the promoters of DHFL fast track this repayment and prioritize it over repayments to other creditors, especially in light of their inability to honour DHFL maturity payments later in the month.

As for Cox & Kings, for those who may not know, the company defaulted on repayment of commercial paper due on 26​ June, to the extent of 150 cr.  Fortunately for mutual fund investors, only one scheme was impacted.  However, what I found intriguing is that just two days before the default, one of the credit rating agencies had reaffirmed the rating of the company’s 2000+ cr CP program as A1+, the highest rating that can be given.  As someone said, it’s getting hard to know what to make of ratings any longer.

On account of the downgrades (mostly DHFL), June was a month of widespread negative returns across debt funds.  By my count, 159 schemes ended up with negative returns.  14 of these fell by 10% or more, of which 4 schemes fell by 40% or more.  If my numbers are correct, the simple average return of all debt funds (including gilt and liquid funds) put together was –0.24%.  To my mind, this hits home the need for quality in diversification across debt funds.  Blindly diversifying oneself wouldn’t have been enough.

If I drill down into individual categories, unsurprisingly, the worst affected category was that of credit risk funds.  Again, if my numbers are correct, this category had an asset-weighted return of  -0.71%.   But this was by no means the only category with a negative asset-weighted return.  There were 3 other categories: low duration (-0.58%), medium duration (-0.58%), and short duration (-0.29%).

Among the schemes that gave negative returns, there were two schemes that particularly grabbed my attention.  The first was BOI Axa Credit Risk Fund which fell by over 44% in June.  It was the subject of a post that I wrote a couple of years ago, where I had called it out for the level of risk it was taking. Sadly, some of my fears about this scheme have come true.  Investors who are in the scheme since its inception (over 4 years ago) are now sitting on a loss of over 30%.  If I am not mistaken, it has been impacted by more downgrades than any single scheme.  What worries me is that the worst may not be over for this scheme.

The other scheme is a somewhat obscure FMP managed by ABSL MF: Series OW (1245 days). It fell by ~6.7% in June.  It was hit by both the DHFL downgrade as well as the IL&FS downgrade.  From what I can see, it also appears to be holding NCDs of one of the Essel group promoter companies.  What caught my eye is that according to Value Research, it has now given negative returns in 5 of the first 6 months of this year.  I haven’t yet investigated this in detail but it certainly adds a new angle to the riskiness of debt funds.

When bond prices fall, yields go up.  So is there an opportunity in this crisis, to capture the accrual from high yields?  That’s a question I’m hearing in some circles.  The June-end portfolio yields are yet to be disclosed.  If the May-end yields and back-of-the-envelope calculations are anything to go by, I will not be surprised if there are a dozen schemes or more with yields in excess of 13%.  Some of the likely high-yield schemes are closed for subscription.  A few others have exit loads.  But the opportunity, wherever it exists, comes with the risk of further downgrades and write-offs.  And if there are too many people seizing the opportunity, there could be a dilution.  Still, it’s something worth thinking about.  In any case, for those of us who are already invested, the yields offer a glimmer of a silver lining in the gloomy cloud of June.  But we also need those side pocket changes, real fast.

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