Are debt mutual funds losing credibility?

What started with the collapse of IL&FS last year is still having ripple effects in the market.

Getty Images
Transparency, liquidity and prospects of better returns prompted chartered accountant Kuntal Parikh to move a substantial portion of his savings from banks to mutual funds about five years ago. Parikh enjoyed higher returns all these years, but is now moving a portion of his savings back to traditional bank deposits.

A series of defaults on borrowed sums by companies and their promoters, coupled with regulatory changes, eroded returns from mutual fund debt plans, leading investors to question whether risks outweigh the returns.

As recently as last week, UTI Mutual Fund and Reliance Nippon Asset Management sliced off the holdings of Altico Capital bonds after a default and suspended normal subscriptions and redemptions. Kotak Mutual Fund and Aditya Birla Mutual Fund faced similar pressures after some companies such as the Essel Group defaulted.


Debt corporate funds, which more than doubled in size in the past five years, have returned 7.08 per cent on an average in the period, compared with 6.25 per cent yielded now by State Bank of India’s fixed deposits. Bank FDs are taxable, while bond investors get indexation benefits if instruments held for at least three years.

Crisil data showed that some mutual funds schemes from DSP, UTI, DHFL Pramerica and others have lost their entire value in the past one year, when funds wrote down the value of defaulting debt. This led earnings of many years to be eroded with just one or two defaults.

“I have never thought that I would lose my principal amount in debt investments,” said Parikh, a resident of Ahmedabad. “This (value erosion) has changed my perception of debt products. I have shifted back to fixed deposits that would earn me less, but would be safe.”
ADVERTISEMENT

What started with the collapse of Infrastructure Leasing & Financial Services (IL&FS) last year is still having ripple effects in the market. Essel Group of Subhash Chandra, Vikram Thapar’s CG Power, Dewan Housing Finance and Sintex are among prominent defaulters to have hit mutual funds so far.

Events of the past year in debt mutual funds have even irked the markets regulator.

“The safety of investment cannot be compromised for want of higher yields,” said Ajay Tyagi, chairman of the Securities & Exchange Board of India. “While we have taken steps to restrict such investments, the industry as a whole needs to do its own analysis on a regular basis to avoid such situations in future.”

Origins of stress
After years of meagre growth since starting in the mid-90s, mutual funds had a blistering growth as they packaged the advantages of transparency and liquidity. ‘At the click of a button’ was a slogan that traveled well into individual homes and corporate treasuries looking to beat market returns.
ADVERTISEMENT

Debt mutual funds’ assets under management rose 85 per cent in August 2019 to about Rs 13.22 lakh crore from Rs 7.13 lakh crore in August 2014. Credit schemes to liquid schemes to plain vanilla corporate bond funds flourished as savings moved into debt plans.

While debt credit risk funds returned an average of 7.26 per cent in five years, the risk was also building up with indiscriminate borrowing that led to over-leverage. A sudden economic slowdown and halting of payments over disputes led to a credit squeeze, especially for infrastructure firms.
ADVERTISEMENT

“There is a trust deficit among investors,” said Vikram Dalal, managing director at Synergee Capital, a Mumbai-based advisory firm. “Investors are not investing any fresh funds into debt funds, as some NBFCs and mortgage firms have defaulted on their principal/ interest repayment. After the IL&FS episode, rating agencies have become very alert in assigning ratings.”

Companies arbitraging interest rates – borrowing short-term at lower rates and lending long for higher returns – were given the stick by mutual funds. When they declined to roll over credit, funds became scarce. The likes of DHFL and Essel group were hit.

Of course, the funds bled. For example, Aditya Birla Mutual Fund invested Rs 2,220 crore in DHFL group companies as on September 30, 2018 which is worth Rs 55 lakh in August, showed data from Value Research. DSP Mutual Fund invested Rs 126.12 crore on September 30, 2018, in DHFL, which is now worth Rs 40.16 crore in July. Fund houses either marked down losses or exited investments in the secondary market.

“Until about a year ago, the significant growth of the mutual fund industry was one of the most talked about success stories of capital markets in India,” said Sebi’s Tyagi. “The events last year, however, exposed the fault lines in the industry and showed that a credit event in even one issuer/group could have a contagion effect leading to liquidity risk across the market.”

Troubles and solutions
Investors and mutual funds were playing musical chairs. When the music stopped, they did not find an exit door in a market that was shallow and that did not have a proper valuation mechanism for these illiquid papers.

“Much needs to be done on debt infrastructure, governance and accountability,” said Ananth Narayan, professor of finance at SPJIMR. “We need to increase the corporate bond repo market liquidity, increase debt secondary market volumes, improve accountability of rating companies, and strengthen credit departments of mutual funds.”

The corporate debt market has grown to Rs 30.6 lakh crore by June this year from Rs 14.4 lakh crore in 2014, RBI data showed. Of this, the size of structured notes market has grown to Rs 23,000 crore from Rs 878 crore. But the trading volume is less than a crore a day in this segment.

“The secondary market in corporate debt is so illiquid that we can very well say there is no such market,” said BP Kanungo, deputy governor at the central bank.

While mutual funds have their own credit appraisal methods, a lot of it depended on rating companies that were caught napping. Two of the biggest defaults in the past year – IL&FS and Dewan Housing – carried triple A rating almost until they missed payments.

Naresh Thakkar was shown the door by ICRA, a unit of Moody’s Investors Services, for his suspected role in meddling with rating actions. Sebi has come up with a new set of rules like disclosing near-period performance to capture their performance. This has led to quick and often overnight junking of some debt papers.

“The rating transition of some corporate debt, particularly those issued by financial firms, has been phenomenal – from sound credit to junk,” said Kanungo.

While the regulator tightened rules for rating companies, it came up with a bail-out plan for the industry facing such troubles – a concept called ‘side pocketing’ – where a fund can set aside the defaulted paper and redeem units at the net asset value minus the amount stuck with the defaulter.

This led to a sudden drop in the NAV of a scheme which faced a default from a borrower. Although investors may get whatever value the fund realises when a resolution happened, it hit at the very foundation of the mutual fund concept – liquidity at the click of a button with pass through.

“Side pocketing ensures that some investors can get a more-than-fair share of the fund’s real value and some can get a less-than-fair share,’’ says Dhirendra Kumar, founder & CEO, Value Research, a mutual fund research company.

Maturity and rigour
Every financial asset and investments in these instruments through mutual funds carry some risks. However, in India banks are a different class with the assumption of 100 per cent safety, although deposit insurance covers just about Rs 1 lakh of investments.

Given the RBI’s undeclared commitment to protect depositors and nearly three-fourths of the banking system owned by the government, people take the safety of their funds as granted.

Although investors are used to see their NAVs in equity schemes fall dramatically over a period of time, they were unaccustomed to the erosion of value in debt funds.

“We do not have a strong history of bond defaults, which have been happening in the past one year,” said Kumar of Value Research. “This is only a tiny portion when it compares with mammoth bank bad loans. The latest default is like a Delhi winter for a person, who has never experienced winter in true sense.”

While investors get used to the risks associated with debt funds, the faith in the industry is being dented by the quick recourse to side pocketing and deals with defaulters for later payments.

Mutual funds as financial intermediaries have helped companies diversify their risk, reduce their borrowing costs, and help investors earn better returns. But the faith built over the past two decades needs to be maintained by ensuring practices that are transparent as investors digest the risks associated with such investments.

“The tagline often associated with mutual funds is ‘Mutual Funds Sahi Hai’,” said Tyagi. “We ought to remember that it takes years to build trust in an industry and only a single event may erode it. So, there should be a collective effort by all stakeholders, including AMCs, trustees and Sebi to uphold and maintain that trust and faith.”
copy image

Download
The Economic Times Business News App
for the Latest News in Business, Sensex, Stock Market Updates & More.
Download
The Economic Times News App
for Quarterly Results, Latest News in ITR, Business, Share Market, Live Sensex News & More.
READ MORE
ADVERTISEMENT

Top Mutual Funds

3 M(%)
6 M(%)
1 YR(%)
3 YRS(%)

READ MORE:

LOGIN & CLAIM

50 TIMESPOINTS

Related Companies

Save with Tax planning SIP's

More from our Partners

Loading next story
Text Size:AAA
Success
This article has been saved

*

+