October 13, 2019

Dead Weight In Debt Fund Portfolios

As if monitoring debt fund portfolios wasn’t already hard enough, there is now one more thing that investors need to watch out for.  It’s what I call portfolio ‘dead weight’:  investments that have matured but continue to be shown in the portfolio as having some value.  If that sounds cryptic or baffling, or if you’re just wondering why that should matter, read on while I explain.

Let me take the mutual fund investments in DHFL as an example.  You may remember that DHFL NCDs were downgraded to ‘default’ status in June on account of a delay in interest payments.  Most fund houses marked down their holdings of DHFL NCDs by 75%, regardless of when the NCDs were going to mature.  The idea was that when the money was repaid, the fund houses would write back the amount they had marked down.

But what if the payments don’t come through, or are just inordinately delayed?  As it happens, mutual funds holding DHFL NCDs that matured over the past two months, haven’t got their money back.  And going by the early cut of the ‘resolution plan’ submitted by DHFL, the money is going to take a very long time coming.  Until recently, if something like this happened, all fund houses would have completely marked down the value of these investments.  Not this time around.  In the case of DHFL NCDs (and who knows what else), most fund houses have taken the view to keep the value of these investments unchanged. 

Now think about what that means.

Apart from the fact that no income can be accrued from these NCDs, whatever chances of offloading them in the market were there, stand vanished (or considerably diminished) after the maturity date passed.  So, in effect, by being shown to have some value, these investments are inflating the NAV and the AUM of the schemes. 

To look at it differently, the good news is that for now, the investors in these schemes have been spared from seeing a further fall in the NAV (on account of these NCDs).  The not-so-good news is that until the amount gets repaid, there will be the looming threat that this amount may be written off, anytime, without giving any notice.  If and when that happens, the scheme NAV will take a fall.  Since many of these are open-end schemes, they carry the additional risk of the AUM potentially shrinking.  The more the AUM shrinks, the more will be the fall- if and when it happens.  And that’s what investors need to really watch out for. 

In the latest portfolio disclosures, I noticed schemes where the current DHFL ‘dead weight’ is over 10% (in one instance, I estimate it to be ~17%).  If the AUM of these schemes shrink, those numbers could jump up significantly.  Remember, this excludes NCDs which are yet to mature (which, if the DHFL draft resolution plan can be relied upon, are additional ‘dead weight’ in the making).

How can you know if a portfolio is holding securities that are past their maturity?

There is no industry-wide ‘dead weight’ database, so to speak.  Hence, this information can only be gathered from individual fund house/ scheme portfolios.  Even so, you have to hunt for this information.  I can’t yet say about the fact sheets but in the more detailed monthly portfolio disclosures (available on fund house websites as Excel workbooks), these investments may or may not be listed alongside the other investments of the portfolios.  If they aren’t, then the cumulative value of these investments (and their contribution to a scheme’s AUM) will have been added up and hidden under the bigger head of ‘Net Current Assets’ or ‘Net Receivables’ or something similar. 

However, if you scroll down any scheme sheet, you may see these investments listed/ referenced in the footnotes to the scheme’s portfolio.  There is no uniformity in the way this information has been disclosed, and some fund houses have presented this information a lot more clearly than others.  Bear in mind, though, I have come across at least one instance where a fund house has not yet disclosed this information in any shape or form. 

I think this is a very important disclosure and if SEBI supports the existence of such ‘dead weight’, it should take a close, hard look at how to ensure compliance, clarity, and uniformity.  I am aware that in a recent circular, SEBI specifically asked all fund houses to provide this information.  From what I gather, there appears to be some confusion among fund houses over the format and whether this should be a part of the monthly portfolio disclosures or only the half-yearly portfolio disclosures.  It would be truly useful if this information is provided on a monthly basis, and is clearly presented in all portfolio disclosures, including in the fact sheet. 

I must point out that the DHFL example stands out because at the time that the downgrade happened, most fund houses had not put in place a mechanism for creating so-called side-pockets (or segregated folios).  In the event of a bond being downgraded to ‘default’ status, the creation of a side-pocket is arguably the best way to protect investor interests and avoid the occurrence of ‘dead weight’.

Clarification: On reflection, I feel that my assertion that at least one fund house has not disclosed its exposure to 'dead weight' securities in the latest monthly portfolio, could have been much better phrased.  This assertion is related to a single fund house. It is based on information from sources that I consider to be reliable, and is not contradicted by my observations of the latest monthly portfolio disclosure.  I expect this to be confirmed once the half-yearly portfolios are available, upon which, I will update this post.

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