A Whole New Level of Risk

In the quest for generating higher returns on debt funds, some fund houses have been pushing the limits of prudent and acceptable credit risk.  For most, it has been in the extent of their exposure to low-grade securities.  For some, such as Taurus MF and the erstwhile JPMorgan MF, it has also involved adding concentration risk to the mix.  As I noted in an older post, at one time, the top 2 holdings of the erstwhile JPMI Short Term Income Fund accounted for 34% of the portfolio (with Amtek Auto alone accounting for 18%).  More recently, Taurus Ultra Short Term Bond Fund and Taurus Short Term Income Fund each had, at one point, over 20% of their portfolio in CPs of BILT and its subsidiary, BGPPL.  But the endeavours of these fund houses pale in comparison with the risks taken by a certain other fund house in managing one of its debt funds.  For the purpose of this post, I will refer to this fund as ‘Rainbow Fund’.

To me, the fund house behind this fund has never inspired enough confidence to examine its schemes, let alone invest in them.  Rainbow Fund was brought to my attention a couple of days ago, thanks to a friend who is also a long-time industry observer.  Apparently, it had been the subject of some talk because of the fact that despite significant exposure to lowly-rated securities, it was highly rated by Value Research (VR).  Since I am familiar with the VR rating methodology, I don’t see this as a contradiction.  If anything, I am amused by the fact that according to VR, Rainbow Fund carries “below average risk”.  But when my friend mentioned that its portfolio yield was as high as 11% pa, that piqued my curiosity and I decided to take a closer look. 

It turned out that a month ago, the yield was 11.61% pa while a year ago it was 12.46% pa.  Of course, such yields are a reflection of the exposure to low-grade securities.  Sure enough, I saw that as per the latest disclosure, 43% of Rainbow Fund’s portfolio was in securities rated A+ or lower.  But then there was an additional 25% in unrated securities.  And as scary as those numbers are, here’s what really stunned me: as per the disclosure, all the unrated securities were zero coupon bonds that were scheduled to mature between Jan 2019 and Nov 2021.  As far as I could make out, most of them did not have any put option and those that did, were only in 2019 or later.

In case the importance of that eludes you, it means that over and above the risks of investing 43% of the portfolio in lowly-rated securities, by investing in unrated zero coupon securities the fund house had risked not just its principal but the entire interest that it stood to earn as well.  By my estimate, if any of these securities were to default, the impact on an investor would be around one and a half times of what it would have been in the event of a default of a regular return security of similar yield.  But what is most alarming to me is that an investor can simply get out of the fund before any of these securities mature and in the process, pass the entire risk on to the remaining investors. That has the potential to create chaos.  While the fund has put in stiff exit loads as a deterrent, their usefulness is a matter of debate. As I see it, all it would take is a certain number of investors to exit for the remaining investors to realize the pointlessness of staying in the fund.

Some years ago, a wise man shared with me his thoughts about those who take risks.  “There are those who play with fire,” he said, “And then there are some who dance with fire.”  Looking at the portfolio of Rainbow Fund, this fund house seems to be doing a tango.

More Rating Mystery

After my earlier post, about two weeks ago, I was not expecting to have something to write about fund ratings this soon.  It seems I was wrong.

On Thursday, CRISIL announced that it had placed its rating of JPMorgan India Treasury Fund under “Notice of Withdrawal” based on a request by the fund house.  By itself, this would seem to be a straightforward development.  After all, no fund house, in its right mind, would want to use a BBBmfs rating.  But the release didn’t stop at that.  For reasons best known to CRISIL, in this release, it also chose to explain its current rating, updating its explanation in the last release with a reference to the segregation of the Amtek Auto investment.  This is what triggered this post.  I reproduce below a section of the release that I am unable to make sense of. 

On September 28, 2015, JPMAMIPL had allowed redemption in the scheme, following segregation of the specified security in the
scheme’s portfolio upon receipt of unit holders’ approval. This resulted in intensified redemption pressure in the scheme, and therefore, an increased weightage of the specified security. The downgrade in the scheme’s rating reflects the expected increase in the weighted average credit score for the portfolio.

The rating remains on ‘Watch with Negative Implications’ as CRISIL expects the redemption pressure on this fund may remain elevated. Should the redemption pressure exceed current expectation, the weightage of the specified security in the portfolio will increase significantly, further weakening the scheme’s credit quality.

As far as I have been able to make out, these are the facts of the segregation:

• As soon as the segregation was approved, the NAV of the scheme fell to reflect the segregation of the said security.
• Investors in the scheme on the date of the segregation took a hit on the value of their investments.  Investors who invest after that date will remain unaffected by the segregation. 
• If the value of the segregated security is recovered, only the investors who were there on the date of the segregation have a claim on that value. 

What this means is that there is no further downside on account of that security to existing as well as new investors.  To put it differently, an investor who is going to buy into the scheme, in effect, will not be buying into that security.

Thus, if a rating has to be given on the portfolio now, why would this security have any bearing on that rating, no matter how much the portfolio shrinks?

Rated AAAmfs

The recent downgrades of JPMorgan India Treasury Fund by CRISIL have left me wondering about the usefulness of its ratings for bond funds.  As CRISIL puts it, its rating of a scheme reflects “the likelihood of timely receipt of payments from the investments” made by it.  Schemes with a AAAmfs are considered to have “the highest degree of safety regarding timely receipt of payments from the investments that they have made”.  According to CRISIL, its ratings “serve as a tool to investors for selecting funds with a suitable risk-return criterion.”  These also provide “an independent opinion” on the credit risk associated with a fund’s portfolio.

All of this matches with my own expectations from a fund’s rating.  My issues begin when I look beyond the letter, and into the spirit of what a fund’s rating implies.  The core of my dilemma is this: when it comes to an individual bond, I recognize the possibility of a highly rated bond being significantly downgraded overnight.  But when it comes to a portfolio of bonds, I find it difficult to accept that there can be compelling reasons for a major downgrade overnight. In this post, I try to make my case.

Let me start by giving below the month-by-month share of lower rated securities (i.e. other than Sovereign/AAA/A1+) held by JPMI Treasury Fund:

	AA+	AA	AA-	C	Unrated
Jan	7%	16%	3%	0%	6%
Feb	6%	10%	3%	0%	0%
Mar	5%	19%	13%	0%	0%
Apr	0%	13%	6%	0%	0%
May	0%	7%	12%	0%	0%
Jun	0%	7%	12%	0%	0%
Jul	0%	6%	10%	0%	0%
Aug	0%	3%	7%	6%	0%

JPMI Treasury Fund enjoyed a AAAmfs rating from before the start of the year, and this was reaffirmed in May.  It enjoyed this rating despite having around 37% of its March-end portfolio in securities rated lower than AAA.

Then, on September 1, CRISIL downgraded the fund to A+mfs (it subsequently dropped this to BBBmfs).  Going by its rating rationale for the September 1 downgrade, CRISIL did not have the latest portfolio composition at the time of taking that decision.  If, therefore, one had to go by the July portfolio and speculate what the August portfolio would have looked like (after the Amtek Auto downgrade), this is what my guess would have been:

	AA+	AA	AA-	C	Unrated
Aug	0%	6%	5%	5%	0%

Frankly, I find it difficult to reconcile the rating profile of the securities in the fund with CRISIL’s rating of the fund.  CRISIL’s process may well be, as they claim, “derived scientifically”.  But to me, as an investor, there is a contradiction with my perception of what fund ratings imply, at least in spirit.  I expect a portfolio rating to warrant a major downgrade only if a large portion of the portfolio has been significantly downgraded or is likely to be so downgraded.

CRISIL explains the September 1 downgrade, saying that this was “on account of significant weakening in the credit risk profile of an underlying security.”   It goes on to say this: “Earlier, the scheme’s credit score had cushion to absorb some deterioration in the credit risk profile of the said underlying security. However, with the recent sharp weakening in the credit risk profile of the security, the credit score for the portfolio has been adversely impacted.”

I don’t dispute any of this.  But if the downgrade of a single security can cause such a significant downgrade in an entire portfolio’s rating, then it would seem to me that the risk of a concentrated holding in a single security was not factored in determining the rating.  In my view, it should have been a factor.  Put differently, if the downgrade of a single security can push the rating of a fund down by several notches, then I am not sure if a fund’s rating can be of much use to an investor.

More on the JPMorgan Episode

This post is further to my earlier post on this topic.  It is based on some newly observed information, that was missed earlier.  It does not contradict the key points in that post: it sheds more light.

It appears that JPMorgan Mutual Fund has been exceptionally transparent in disclosing its scheme portfolios, month after month.  As far as I can make out, each month, there are three sets of documents released on their website related to disclosure of scheme portfolios.  There is the fact sheet which, among other things, carries details of the portfolios of all their schemes.  Then, there is a series of one pagers with a brief snapshot of each scheme’s portfolio.  Both of these documents are, more or less, in line with industry-wide disclosures.  In addition, there is a third document that is more detailed, and which, to the best of my information, most fund houses do not disclose on their websites.  This is a portfolio disclosure on the lines of the mandatory half-yearly portfolio disclosures, and it specifically marks out the illiquid securities in each scheme’s portfolio (see here).

What this means is that the precise information on the nature and extent of illiquid securities was available on the fund house’s website, month after month.  Sure, just as I missed seeing this, so could have anyone else.  But it begs the question of the responsibility of those who recommended JPMI Short Term Income Fund- both advisors and researchers- to be familiar with such publicly disclosed information.  At the very least, it would seem to me that if someone had missed this information yet made enquiries of the fund house (based on the evidence of concentration risk from the more common portfolio disclosures), the fund house would have likely been open in sharing that information.

To be clear: my observation in the earlier post that the fund house was playing with fire, remains.  This information gives me even less reason to feel for DIY investors who stayed put in JPMI Short Term Income Fund.  It also makes me question, even more strongly, the credentials of advisors and researchers who recommended this scheme.

Reflections on the JPMorgan Episode

Note: A clarification has been added at the end of this post, after its original publication.

With the din over JPMorgan Mutual Fund’s investments in Amtek Auto somewhat fading away, I thought it would be a good time to pen my thoughts and takeaways.

First, a disclosure: I lack the competence to comment on the fundamental merits of any individual holding in a fund.  As an investor, I start with specific expectations as to the level of credit risk, concentration risk and interest rate risk in a debt fund’s portfolio. Fund manager credentials aside, I am most comfortable with funds where the levels of those risks are kept within my preferred limits.  Further, I expect an open-end fund to honour redemptions to the fullest extent possible. I look at liquidity risk as a result of conscious choices made by a fund house.

In this backdrop, therefore, I do not contest the decision of JPMorgan Mutual Fund to invest in the bonds of Amtek Auto per se.  But the extent to which this security formed a part of JPMI Short Term Income Fund does make me question both the collective wisdom within the fund house as also the diligence of investors in the scheme, and those recommending the scheme.  This security was first bought in JPMI Treasury Fund in January, this year.  Then, in February, apparently two-thirds of this investment was transferred to JPMI Short Term Income Fund, and it stood at 14% of the portfolio at the end of that month.  In fact, with this inclusion, the top 2 holdings of this fund accounted for over 25% of the portfolio value. A month later, the share of Amtek Auto had risen to over 18% of the portfolio, and the top 2 holdings now accounted for 34% of the portfolio. 

As I see it, the fund house was playing with fire.  Did the fund house truly understand the possible consequences of the risks they were taking?  If, for any reason, even one of these holdings were to become a NPA, were they clear on the impact that this would have on the NAV, on their ability to honour redemptions, and, in effect, on their credibility as a fund house?  Did they have a Plan B or were they simply acting recklessly? Irrespective, I find it difficult to sympathize with DIY investors who stayed put in the fund.  I believe that anyone who took more than just a cursory glance at the portfolio, at the very least, would have had reason to investigate further.

But what of the fund house’s decision to restrict redemptions in the aftermath of the downgrade?  The fund house claims that doing so was “in the general interest of the unit holders.”  There are also a few industry insiders whom I spoke to, who suggested that such a restriction would prevent a “run,” as they put it, on the fund.  While I wouldn’t want to speculate on what may have happened, I recognize the possibility of what they suggest.  I also understand the complexity of the situation and the absence of a perfect solution.  But I can’t help thinking that had the fund house not taken on the levels of concentration risk that it had, it wouldn’t have had to take such a step.  It was an action that one could argue was doomed, at some point or another.  It could have well been the case that seeing the huge concentration risk, investors may have attempted to leave the fund in droves, months ago.

Through all of this, though, there seeps an uncomfortable question: how much did the illiquidity of the remaining part of the portfolio contribute to the decision to restrict redemptions? If the last half-yearly portfolio disclosure is any indication, 86% of the portfolio of JPMI Short Term Income Fund was in illiquid securities.  I don’t have any evidence yet to question their valuations, but even if guidelines were adhered to, with the NAV calculations making adjustments for illiquidity, I am not sure if the NAV can really reflect the true realizable value of the underlying investments, as SEBI Regulations require it to.  Since this is something that could apply to bond funds across fund houses, this episode should give the industry something to think about.  For instance, credit lines notwithstanding, should such funds be available in an open-end structure?  If yes, then what other precautions can be taken?  To me, probably the single most sacred right of an investor in an open-end fund is to be able to redeem his/her investments at fair value, and at will.  Restricted redemptions are a violation of the trust that investors put into the open-end structure.  

Finally, I’d like to close this post with an observation, offered without comment.

It pertains to an entity which had JPMI Short Term Income Fund as one of their recommended funds.  In an explanation of their methodology some time ago, they had said that their recommendations were based on a mix of quantitative and qualitative parameters.  In their words, “we run our qualitative checks such as a study of portfolio strategies, how fund managers manage the schemes, pedigree and performance in rising and falling markets to be able to cull out a list of schemes that we feel are best suited to perform hereon.”  In a review of their list in July 2015, they continued to include this scheme.  In the aftermath of the Amtek Auto downgrade, the scheme was no longer recommended.  This is an extract of what they had to say: “At the time of its inclusion, this is what (the fund manager) had told us: “The fund caters to the more risk-averse investor, who looks for a sort of assured return. The attempt is to graduate the fixed maturity plan type of investor, but also protect her downside risk.” For a fund that aimed to protect downside risk, it has ended doing just the opposite. We retained the fund in our July 2015 audit as the said debt was due for maturity very soon and there was no change in the credit rating. Clearly this is a fund that has gone off the mandate.”

Clarification (added on September 27, 2015): The reference to the last half-yearly portfolio disclosure was based on the fact that this is the most reliable source for quickly knowing the extent of illiquid securities in a scheme’s portfolio.  A subsequent look at the disclosed portfolio of JPMI Short Term Income Fund as on August 31, 2015 showed that 67% of the portfolio was in “CBLO/ Repo” which would imply that to this extent, the portfolio was liquid.  Thus, the illiquidity of the portfolio may not have been a significant factor behind the continued restrictions on redemptions.  On the other hand, one could say that the implied level of liquidity makes the decision to restrict redemptions look more questionable.  Probably a clearer picture will emerge with the disclosure of the portfolio at the end of this month.  Nonetheless, the high levels of illiquidity in bond funds across fund houses should, as mentioned in the post, give the industry something to think about.