Yield vs. Return

An investor reached out to me with questions related to a certain floating rate fund.  The fund had reported its May-end net portfolio yield (i.e. after expenses) to be ~6.5% p.a..  How was it then, he asked me, that over the month of June, it had shown an annualized return of ~23% p.a.?  If it was, as he suspected, somewhat linked to the last round of rate cuts by RBI, then why was it that other funds that had relatively higher yields as well as higher duration, hadn’t gained as much as this fund?

His suspicion was not without merit.  Such a difference in return over yield is usually seen at times when RBI cuts interest rates.  It’s just that, this time around, bond yields have been taking their time to adjust to the cuts.  While RBI cut rates in March and May, some of the expected fall in yields played out only over June. 

However, there are a couple of things that the investor overlooked.

Firstly, the fall in yields in June wasn’t uniformly across the yield curve, or issuers, and there were some striking differences in returns across funds and fund categories.  For instance, the category that gave the best return was that of corporate bond funds yet the best performing fund across categories was a credit risk fund.  While the categories of short and medium duration funds did better than ultra short and low duration funds, gilt funds, despite their much longer duration, gave lesser return than all these categories.  In a nutshell, it boiled down to the individual securities that a fund was holding. 

In that light, if I look at the May-end portfolio of the aforementioned floating rating fund, some part of its extraordinary gains in June would have been driven by a ~100 bps fall in yields of two AAA bonds, with 3-4 years left to their maturity, and which made up ~10% of the portfolio.  In addition, some gains would have resulted from a 30 to 55 bps fall in the yields of perpetual bonds that the scheme was holding, and which made up ~18% of the portfolio.  In the aftermath of what happened with Yes Bank, across-the-board, yields of perpetual bonds shot up and have remained high ever since.  Only in June did those yields show signs of softening.

I must point out that all that I said just now assumes that those securities continue to be held in the fund’s portfolio.  We will know for sure, once the June-end portfolio is disclosed.

Secondly, at a more conceptual level, while the portfolio yield of a debt fund is the single most important indicator that an investor should examine and track, it has its own limitations.  Yes, it can give clues as to the level of credit risk in a fund, as well as roughly indicate what might be the immediate return that one could expect.  However, yields change daily whereas fund houses disclose the yields only at the end of each month.  Thus, in a period of sharp changes in yields, the last month-end yield will be of limited use.

In addition, if a fund holds illiquid or thinly traded securities, then the fund’s yield may not be a true measure of how the market may value its portfolio.  Selling those securities can well bring about gains or losses to their portfolio values.

To illustrate this point, I’d like to take the example of a fund whose reported net yield as of May-end was ~12% p.a. but which ended up giving a negative return over June, and not because of any markdown or default.

This scheme held a certain security that alone made up almost a third of the portfolio, and which was valued at an estimated yield of ~16% p.a..  For some reason, the fund manager chose to sell some of that security in June.  As it happens, the sale was made at a yield of 28% p.a..  In other words, the fund got a lot less money than what the security had been valued at.  That led to the NAV falling by ~1.5% that day, and that alone was enough to wipe out whatever gains the reported yield would have brought about over the entire month.

To be fair, this may be an extreme example.  Still, it should help drive home the perils of blindly relying on a  fund’s portfolio yield.

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.

When Scheme Differences Are Erased

SEBI’s decision to create clearly defined scheme categories (and to limit fund houses to one scheme per category) was a big step towards empowering investors to make better scheme choices.  It’s been a year since that came into effect and for the most part, it’s been a success.  Unfortunately, some funds houses have found (or are finding) ways to wipe out the differences between schemes across different categories.  While there is a need for SEBI to step in, investors also need to be vigilant, else we could end up holding a scheme that is quite different from what we expected it to be. 

In this post, I want to share a few examples of the variety of ways in which fund houses have attempted to blur the differences between schemes in different categories.  I have presented these in the form of a short quiz.  There is a link to the answers at the end of the post.

Q1: Deceptive Descriptions

Given below are the descriptions of two open-end equity funds managed by a certain fund house.  These descriptions have been taken from the fund house website.  One of the schemes is classified as a ‘Mid Cap’ fund.  Based on these descriptions, can you identify which one of these is the real ‘Mid Cap’ fund?

Fund A:

An open ended equity scheme predominately investing in mid cap stocks

Fund B:

…is primarily a Mid-cap fund which gives investors the opportunity to participate in the growth story of today's relatively medium sized but emerging companies which have the potential to be well-established tomorrow.

Q2: Deceptive Advertising

Given below are masked banner ads for two equity schemes managed by a single fund house.  One of these schemes is classified as a ‘Focused’ fund, while the other is classified as a ‘Multi Cap’ fund.  If you had been able to read the detailed descriptions (which are in smaller print), you might have been able to know which ad is for which scheme.  But since these are website ads, which many will have seen (or will see) on mobile devices, the headlines become all the more important.  Based on the headlines, can you identify which of these is the actual ‘Focused’ fund?

Fund C:

Fund D:

Q3: Deceptive Allocations

Going by SEBI’s definition, in the so-called ‘Balanced Advantage’ funds, the equity/ debt allocation is required to be managed “dynamically”.  While some may consider that term to be all-encompassing, from what I have gathered, the purpose of having this category is to group those funds where the equity/ debt mix will be decided through a process of tactical asset allocation.  As it happens, at least one fund house either has an extraordinarily restrictive interpretation of what ‘dynamic’ means or has chosen not to make tactical calls.  The equity allocation of its ‘Balanced Advantage’ fund has remained in a remarkably narrow band and has had little resemblance to that of any other ‘Balanced Advantage’ fund.  But it has had more than a passing resemblance to the equity allocation of the ‘Aggressive Hybrid’ fund managed by the same fund house.  Given below is the unhedged equity allocation for the last 12 months for the two schemes.  Based on this information, can you identify which of these is the ‘Aggressive Hybrid’ fund and which is the ‘Balanced Advantage’ fund?

Q4: Deceptive Risk Profile

‘Credit Risk’ Funds are required to have at least 65% of their portfolio in securities that are rated AA or lower.  It is generally expected that these funds will carry a higher credit risk than any other class of debt funds.  Given below is the latest rating profile, yield, and maturity of the portfolios of three debt funds, managed by a single fund house.  Based on this information, can you identify which of these is the ‘Credit Risk’ fund?

	Fund G	Fund H	Fund I
Portfolio Composition by Rating
Sovereign/ AAA/ Cash	16%	15%	12%
AA+	9%	9%	11%
AA and lower	75%	76%	77%
Average Maturity (years)	3.1	3.4	2.9
Portfolio Yield	11.7%	11.4%	11.7%

If you’d like to see the answers, click here.

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.

Thoughts On The FMP Fiasco

This is only my second post in the last nine months, and while I’d like to believe that there hasn’t been much to write about all this while, the truth is that ongoing priorities have kept me away, not just from writing, but from closely tracking the fund industry as well.  Still, thanks to the evolving FMP crisis (which I couldn’t ignore) and the incessant cajoling of my collaborators, for whatever it is worth, here it is. 

Anyone who has been following the coverage of the crisis in the media (mainstream and social), would have noted that much of the attention has been on Kotak MF, and on the so-called “safety” of FMPs.  In this post, I’d like to move that spotlight a bit.  The way I see it, firstly, the risks in investing in FMPs are, more or less, the same as they have been over the last several years.  It’s just that many investors, advisors, and fund houses, have been in denial over the fact that portfolio concentration is a bigger risk than credit quality in itself.  While I’ve talked at length about this previously, in this post, I want to talk about the questionable choices made by fund houses this time around, once this risk became a likely reality.  Secondly, I feel that looking at the FMP fiasco from the lens of the decisions of HDFC MF (rather than Kotak MF) offers a better picture of what has happened.  Investors in Kotak FMPs may have been the first to be visibly impacted, but it was HDFC MF that was the first to make the choices that brought us to where we are.

Let me start by flipping back to a month ago.  By my count, there were 6 NCDs issued by three Essel group companies that were due to mature in March.   HDFC MF had investments in two of these companies (across 5 NCDs).  Most of these investments were held in FMP portfolios.  These are the details of those NCDs:

Name of company	ISIN	Date of Maturity
Edisons Utility Works Pvt. Ltd.^	INE097P07047	22 March 2019
	INE097P07062	22 March 2019
	INE097P07096	20 March 2019
Sprit Textiles Pvt. Ltd.#	INE069R07091	22 March 2019
	INE069R07109	20 March 2019

^ Since renamed as Edisons Infrapower & Multiventures Pvt. Ltd.
# Since renamed as Sprit Infrapower & Multiventures Pvt. Ltd.
NCDs whose ISIN is shaded are zero coupon bonds

As you will note from the table, all of these NCDs were slated to mature between 20-22 March 2019.  The reason I mention this is because, in the portfolio disclosure made by HDFC MF, all of these investments were shown to be held in the portfolios of its schemes as on 31 March 2019, more than a week after they were supposed to have matured.  It begs the question- what happened?  If the fund house got back its money on the date of maturity, then why were these investments shown in the scheme books as on 31 March?  And if the fund house didn’t get back its money, shouldn’t these investments have been written off? 

When I first saw the portfolios, I couldn’t figure out what exactly had happened.  Since then, it has come to light that the maturity date of these investments was “revised” to 30 September 2019.  But how did something like that come about?  Surely, an issuer can’t unilaterally revise the date of maturity.  Was this the outcome of the much talked about agreement between the lenders and the Essel group back in January? 

Regardless, in my opinion, there can be no excuse for treating non-payment on the original due date as anything but a default.  What I find especially remarkable is that three of the NCDs above were zero coupon bonds and accounted for over 61% of the value of these NCDs.  To put it differently, these are investments on which the fund house would not have received a single rupee of interest or principal over the last 3 years or so. 

It appears that Kotak MF took a similar stance as HDFC MF in respect of the NCDs it held (which matured on 8 April).  In its case, it appears that all the NCDs that matured were zero coupon bonds.  Personally, I believe that all these investments should have been written off completely.

But coming back to the revision of maturity date, there are two other aspects about this that bother me.  The first relates to investment norms for FMPs.  As per SEBI regulations, a FMP can invest only into securities which mature before the date of maturity of the scheme.  Of the 8 HDFC FMPs that held the aforesaid NCDs, one is maturing on 30 September (i.e. on the revised maturity date).  All the other FMPs (including one that has been decided to be rolled over) were/ are maturing not later than 1 July 2019.  Going by that, revising the maturity date would appear to be in violation of the SEBI MF regulations.

The second issue that bothers me is the role of the rating agency.  In December, last year, the rating agency had put the abovementioned companies/ NCDs on “credit rating watch”.  On 31 January, soon after the debacle related to the sale of shares of ZEEL, the rating agency put out a note, stating that the rating remained unchanged.  What puzzled me about that note was that the rating agency seemed to base its view more on the stated intent of the lenders and the borrowers, than anything else.  Importantly, there was no mention of any change in the date of maturity of the NCDs.

Then on 18 February, it downgraded the ratings by one notch to A, while maintaining the “credit rating watch”.  But there was still no mention of the maturity of the NCDs being revised.  Its next communication was only on 10 April i.e. three weeks after the original maturity date of these NCDs had passed.  It was here that it noted the revised maturity date of the NCDs.  From what I could gather, and strangely to me, the rating agency didn’t seem to see this as an issue of any significance.  Personally, I think there was a good case for the rating to be downgraded to D.

Looking at this all together, throws up a number of questions.  Why did the fund houses not mark down these investments?   Was it a coincidence that both Kotak MF and HDFC MF decided the same course of action?  Was it a coincidence that the rating agency took a similar view?  Or that the rating agency put out its note only after the NCDs held by Kotak MF had matured? 

One industry insider, whom I spoke to, offered this explanation for the action of the fund houses: “It’s all about the NAV.  They can’t risk showing a low NAV.”  That may well be, and there may be other reasons as well.  One thing appears certain to me: both these fund houses (and perhaps others as well) appear to be desperate to project an illusion of safety around FMPs.  What is worse is that these fund houses are attempting to manipulate investors by playing on their behavioural biases. 

Take for instance, the decision by HDFC MF to roll over one of its FMPs.  Like some others, I hold the view that the officially stated purpose behind doing so, is a preposterous and sanctimonious assertion meant to camouflage the fact that the scheme has ~20% of its portfolio in Essel group companies.  But in terms of their relationship with investors, the roll over strikes me as a way to delude the investors into believing that they never risked losing money. 

Similarly, I noted a very careful choice of words by one of the spokespersons of Kotak MF, which also struck me as intended to delude investors.  To paraphrase the comment: “The impact is primarily on the returns, not on principal”.  To which I am tempted to retort: “Have you ever heard of time value of money?”  Even more bizarre was another statement by that person: “I tend to disagree that it is a call gone wrong”.

For anyone still wondering about what the fund houses were thinking, I present this (hopefully accurate) observation from the latest HDFC MF and Kotak MF portfolio disclosures.  While most of the NCDs of Essel group companies were held in FMP portfolios, there were only two open-end debt funds that also held these NCDs.  These were HDFC Credit Risk Debt Fund and Kotak Credit Risk Fund.  Need I say anything more?