March 26, 2016

The Valuation of Junk Bonds

The recent, successive downgrades of securities issued by JSPL, have led me to ponder over the inconsistencies across fund houses in valuing junk bonds. Frankly, valuation of securities is not my forte.  But seeing the exposed fund houses take different approaches to valuing their holdings in JSPL, I felt the need to examine the choices that they made.  In that backdrop, and with some assistance, I have put my observations and thoughts here, as accurately as I could, in the hope that these encourage discussion around improving the fairness of valuations.

On Feb 15, CRISIL downgraded JSPL securities to junk status.  The next day, the schemes of Franklin Templeton MF (FT) and ICICI Prudential MF (I-Pru) holding JSPL securities reported a fall in their NAVs.  It appeared that both these fund houses had applied a discount of 25% to the face value of their holdings right after the downgrade, something that was subsequently confirmed by a reading of their month-end disclosures and FT’s additional disclosure.  However, the schemes of Reliance MF, which also held JSPL securities, did not report a decline in their NAVs after that downgrade. 

According to this news report, a spokesperson of Reliance MF said that the fund house had negligible exposure in the company and that the security that its schemes held had not been downgraded. He/she may have been referring to the exposure relative to the fund house’s total debt AUM because when looked at, relative to the AUM of the individual schemes which held JSPL securities, the exposure was, by no means, small.  In two of these schemes, the exposure to JSPL was in excess of 11% of the portfolio.  In a third, it was over 8%. As to the point about the security they held not having been downgraded, that was, in a way, accurate.  That security had been rated by CARE, and not CRISIL, and CARE had not, till then, downgraded the security.  Reliance MF’s stance, though, was at odds with that of I-Pru, which held the same security in a number of their schemes, and had chosen to mark it down right after CRISIL’s downgrade.  Eventually, on Feb 25, CARE downgraded that security.  The next day, the NAV of the schemes of Reliance MF fell marginally.  Going by the month-end portfolio disclosures, Reliance MF had applied a discount of 2.5% to the face value of its holdings, far less than what FT and I-Pru had applied. 

Then on March 9, CRISIL further downgraded JSPL securities to default status.  FT stated that it had sold off its entire holdings of JSPL, leaving nothing to be valued. This time around, Reliance MF reported a fall in the NAVs of all three debt schemes holding JSPL, ranging from –0.83% to –2.66%.  Unlike the last time, it seemed as if it had accepted CRISIL’s downgrade (CARE’s downgrade happened on March 11).  While the complete facts may take some time to be known, it seems that it marked down the value of the JSPL holdings to about 75% of their face value (i.e. to the level that FT and I-Pru had marked down their holdings in February).  In stark contrast, I-Pru did not report a fall in the NAVs of any of the FMPs that had significant exposure to JSPL.

So why did the NAVs of the schemes of I-Pru not dip?  After all, it would stand to reason that whenever a bond gets downgraded, its price would be expected to fall.  If anything, FT’s sale of JSPL securities (although different from the one held by the FMPs of I-Pru) on March 10, at a further discount to their February-end values, supported such reasoning.  And why did Reliance MF apply a discount in February that was only a fraction of the discount applied by FT and I-Pru?  Why did it refuse to acknowledge CRISIL’s downgrade in February, and then act upon it in March?  And why did it do an apparent volte face, and apply a more significant discount after the March downgrade?  What, indeed, were the reasons for all these inconsistencies in the valuation of this junk bond?

As far as I can make out, the valuation policies of most fund houses do not carry any specific instructions on valuing junk bonds.  These fund houses let the decision be taken by their respective valuation committees.  Even so, it seems that the norm is for junk bonds to be valued at 75% of their face value.  The decisions by FT and I-Pru appear to be in line with that.  Reliance MF, on the other hand, is one of the few fund houses to have explicit guidelines for valuing junk bonds.  According to its valuation policy that was in force in February, junk bonds (that were not NPAs) with more than 182 days to maturity were to be valued at 75% of their face value while those with less than 183 days to maturity were to be valued “after markdown by 2.5% to the Face Value every 2 weeks cumulatively starting from the day of the downgrade.”  In light of this, its valuation of JSPL holdings in February is very understandable: the security that it holds, is due for redemption next month.  However, there appears to be no explanation in their valuation policy for their subsequent decision to apply a cumulative discount of 25% at one go, right after the second downgrade.  There is also no explanation that I have been able to gather for I-Pru not marking down its holdings any further.

Regardless of fund houses sticking to their individual guidelines or the recommendations of their valuation committees, I believe that fund houses should disclose to their investors, in a transparent manner, the rationale behind decisions that may appear questionable.  At the same time, I also believe that SEBI needs to bring about greater uniformity and even conservatism in the valuation of junk bonds.  If you think about it, at the end of February, Reliance MF valued its JSPL holdings 30% higher than what I-Pru had valued its holdings.  By any yardstick, that is a vast difference.  Thankfully, if I may say so, Reliance MF’s holdings of JSPL were all in closed-end schemes.  If these were to have been in open-end schemes, the knowledge of the fund house’s relatively liberal valuation policy could well have triggered an exodus of its investors from those schemes.  Of course, it is entirely possible that someone may have actually exited those schemes based on that knowledge, irrespective of their closed-end structure.

Last but not the least, I would also make the case that SEBI should re-examine how NPAs are defined, and provisioned for.  Most fund houses classify NPAs based upon the definition in the SEBI guidelines.  But that definition ends up excluding securities such as the JSPL NCDs held by I-Pru and Reliance MF even though CRISIL has specifically stated that its downgrade reflected actual delays by JSPL in payment of interest on its term loans.  For a bond to qualify as an NPA under the current mutual fund valuation guidelines, a fund house has to have firsthand experience of the delay.  And it isn’t just the definition: even the provisioning guidelines, to my mind, are way too liberal.  As I see it, fund houses that strictly follow the guidelines, run the same risk that I referred to in the previous paragraph.

On a somewhat related note, an extract from the SID of one of the debt funds still holding JSPL NCDs was brought to my attention.  It reads thus:

“Credit evaluation is a continuous process.  It applies not only for issuers where investments are being evaluated for the first time but also for those where we already have credit exposures.”

I doubt if any fund manager would disagree with the truth in this statement.  Yet, a statement like this also begs these questions: Why would a scheme still be holding a security that has been downgraded to default status?  What does the fund manager of that scheme know that the rating agency does not know?  And as I think about it, there may be one other advantage to having more stricter and conservative guidelines for valuing junk bonds and for provisioning for NPAs: it may well act as an additional deterrent against fund managers buying and holding securities that are junk or borderline junk, without good reason.

Special thanks to Robin Jehangir for his inputs.

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