January 21, 2020

The Vodafone Valuation Controversy

The facts are reasonably well known so I’ll only briefly summarize the background. 

For some time now, there has been a cloud over the ability of Vodafone Idea to honor repayment of NCDs issued by it.  This cloud became darker after a Supreme Court order last week.  However, the rating agencies didn’t change their ratings on the company.  For reasons best known to them, the NCDs continue to be rated ‘investment grade’.  Among the fund houses holding these NCDs, most of them marked down their holdings by roughly half or so.  Franklin Templeton went ahead and marked down its holdings completely, sparking a bit of outcry over the resultant NAV fall, and a debate over the wisdom of its actions.

Was Franklin Templeton right in completely marking down the Vodafone Idea NCDs? 

Opinions are clearly divided.  There are those who feel that it was the best way to protect the interests of most investors.  There are others who claim that a complete mark down was neither fair nor warranted, and was a sort of overkill.  What makes it complicated is that only in hindsight will we know if it was necessary or not.   

What is undeniable is that when it comes to mark downs in open end debt funds, no matter what action any fund house takes, there are some investors who will be impacted more than others.  Take this case, for example.  In funds houses that partially marked down their holdings, investors who stay invested are at risk of facing a greater negative impact than those who exit: they most certainly face a greater uncertainty.  In the case of Franklin Templeton, investors who stay invested have no further downside (related to these NCDs) while investors who exit will have to certainly bear the brunt of the mark down (unless, of course, there’s a reversal before they exit).

In short, there was no perfect solution.  Thus, I cannot fault any fund house for the action that they took.  However, I would like to believe that there could have been a win-win scenario had the fund houses explored that and had SEBI agreed to that.  Maybe the fund houses did and, if so, I’d be curious to hear what SEBI’s response was.  But what exactly am I referring to?  I would have liked to have seen the creation of a side pocket.

Sure, there would have been practical difficulties in doing so.  I am also aware that as per the rules, side pocketing a rated security can be effected only in the event of a downgrade below investment grade.  But I submit that side pocketing is too vital a tool to be restricted in the way that the current guidelines do.  It is also too vital to be inextricably linked to what rating agencies perceive to be ‘investment grade’.  Imagine if side pocketing had been allowed to happen in this instance.  I doubt if there would have been much debate or outcry. 

Allowing side pocketing is undoubtedly one of the most important measures instituted by SEBI to protect the interest of debt fund investors.  But there is a good case for expanding the scope of its usage (e.g. currently it doesn’t help investors in Fund of Funds that hold side pocketed debt funds).  There is also a case for giving fund houses more discretion.

I recognize that, going forward, if Vodafone Idea does get downgraded to below investment grade, fund houses can still create a side pocket.  But its effectiveness would depend on the extent of mark down, the date of creation of the side pocket, and the amount of inflows into each fund between the date of mark down and the date of creating the side pocket.  And it would benefit only those who are invested on the date that the side pocket is created.

On the other hand, what if Vodafone Idea is not downgraded?  What if the payments come through on time?  The mark downs can’t continue indefinitely.  And neither can all investors stay invested, waiting for the papers to mature.  Yet, if a side pocket were to have been created, there wouldn’t be a cause for worry.

Still, it is SEBI’s decision to make.  At the very least, I hope that this case makes SEBI consider the value of side pocketing beyond the current letter of the law. 

Open end debt funds are a singularly complex investment option.  As I have noted earlier, though they invest in debt instruments, they distort the very traits of those instruments that make them appealing to investors.  They carry a wide variety of risks but, as I have also previously written, probably the scariest part about them is that there are some risks that are hard to fathom or even give a name to.

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