Debt, Stress and the painful fallacy in Mutual funds

A primer on Debt and Bank Loans

Why am I losing my Capital?

Well, this is a question most of the Debt Fund holders are presently asking around in the country – let alone the whole world. Before getting into debt funds, let’s first have a look at well, Debt. Just like any other mutual fund product available, Debt Funds collect money from individual investors like you and me, pool it onto a fund and provide it as a source of capital to corporations. The obvious question to ask as an investor would be – Shouldn’t the banks be doing this? Well, Debt Funds provide an additional financing mechanism to Corporates.

Here’s why companies primarily chose to go for raising finance through debt over availing bank loans:

  • Issuing debt is a much cheaper exercise than getting a bank loan. The rate of interest the Company might end up paying would be way lower than what it would have paid on a loan
  • A bank loan entails a lien/charge on your existing assets (Secured Loans)
  • Alternatively, you may have an unsecured loan (where you need not have a lien/charge on your assets) and end up paying a higher rate of interest

Debt can be issued in various forms of instruments – Bonds, Commercial Paper etc.

The rate of interest in the Debt instrument is generally governed by the credit rating assigned to it. Higher the credit rating, the debt paper would carry a lower interest rate since there is less likelihood of default. (In an earlier article, I had managed to cover the relationship between risk and return in investing in a very lucid manner.) Now, there is no denying that rating agencies do their necessary due diligence before assigning a rating, the ’08 crisis did teach us very expensive lessons.

In India, we live in a trust deficit society. I’ve heard various entrepreneurs from Ankur Warikoo to Kunal Shah speak about this issue. What this means is every transaction, every interaction in India always starts with a sense of mistrust. Building trust over time becomes paramount and difficult at the same time.

The NPA issue has been far on the rise and even though the entire financial system is flush with liquidity, the flow of commercial credit in the economy has almost come down by 95%. While a part of this can be attributed to the reduced level of economic activity which was declining for quite a few quarters the other factor is the sense of mistrust.

Pre-existing stress in the financial system

As per a research paper co-authored by the erstwhile Chief Economic Advisor, Mr. Arvind Subramanian in November 2019 India was already suffering from a Twin Balance Sheet (TBS) Problem which got extended to a Four Balance Sheet problem (FBS). You can read about this in detail here.

Among a host of issues highlighted in the paper, the following warrant a deeper look.

  • Share of Corporate Profits as a % of GDP has come down to 2.7% in 2018 (erstwhile 7.1% in 2007)
  • The share of corporate debt owed by companies unable to service their interest obligations has remained in the range of 40-45%. (Due to further reduction in the economic activity post Covid – 19 this ratio is bound to increase.)
  • The best indicator of stress is the difference between lending rates (i) and the nominal growth of the economy (g), summarized as (i-g). In normal times, revenues and profits of the average corporate will grow at the nominal rate of growth of the economy. If this growth rate exceeds the rate of interest on corporate debt, as it normally does, then corporates will find it easier to service their debt. But if (i-g) is rising, then debt stress is growing.
  • In the second quarter of 2019-20, the weighted average lending rate was 10.4 percent, well above the nominal GDP growth rate of 6.1 percent. As a result, the (i-g) differential reached 4.3 percent, an exceptionally high level. Even the government’s cost of borrowing is above nominal GDP growth, at a time when it is running a large primary deficit, larger than the official numbers show. As a result, the debt situation of both the private sector and the government is bound to deteriorate further.
  • Despite massive bank recapitalization (USD 39 Bn injected in last 5 years in PSB’s), write off of NPA’s of USD 100 Bn in the last 5 years (reduction by 2% of total bank assets) – NPA’s are still at USD 127 Bn (9.5% of total bank assets) which is the highest ratio of any major economy in the world, by far.
  • At the public sector banks, the NPA ratio is even higher, at 12%
  • Another USD 35 Bn in debts (mainly in the power sector) is being negotiated as inter-creditor agreements.
  • In contrast, in the United States, which during the GFC suffered a much larger banking crisis, its largest since the Great Depression, the NPA ratio is now less than 1 percent.
  • IBC resolution has been slow – an average of 409 days against 270 days envisaged in the law
  • Only USD 28 Bn of cases resolved through IBC (recoveries of USD 11 Bn) against actual NPAs of USD 127 Bn
  • Flow of commercial credit has fallen from USD 304 Bn in 2018-19 to USD 14 Bn in H1 2019-20. (This number is again further expected to go down due to the ongoing pandemic.)

Asset allocation of Debt Funds

Source: SEBI

The Debt Fund Industry between Mar ’19 and Mar ’20 has swiftly managed to keep AUM at ~USD 190 Bn. Swift re-allocation has taken place by reducing exposure from Commercial Paper (27% to 17% – ~USD 19 Bn) and parking money with other Money Market Instruments such as CBLO, T-Bills etc.

At USD 57 Bn of Debt exposure to MFs, Corporate Debt still has the highest allocation as an asset class in Debt Funds. The RBI had recently announced a USD 7 Bn special window of borrowings for Mutual Funds to face any unprecedented redemptions, the future would be interesting to watch out for. There is a huge possibility that a fair percentage of the Corporate Debt may not become an NPA and remain Standard, the downside risk cannot be ignored.

Commercial Papers (CPs) – DHFL, Vodafone Idea et all

To understand what Commercial Paper is and how it works, click here.

Mutual Funds are mandated to adhere to strict limits in terms of Asset allocation. For CP, the limits are 25% at an Industry level, 10% at an issuer level and 15% at a Group level. These were a part of big bang reforms introduced by SEBI in Oct’19.

Source: SEBI

While CPs have provided a good vehicle of Short-Term financing to corporates in India, the DHFL episode (barring the Governance issues) was worthy enough to show us how fragile this can end up being if not used carefully. A while back, Mr. Kumar Mangalam Birla of the Aditya Birla Group had publicly stated in a media appearance that he will have no option but to shut shop w.r.t. Vodafone Idea if AGR relief is not provided. Incidentally, Franklin Templeton marked down the value of all it’s CP papers of Vodafone Idea to 0. But more on that later.

The Franklin Templeton (FT) Episode – A personal Account

On April 24, FT announced that it is winding up 6 of it’s Debt Funds. While much has been talked about here and there and the internet is peppered with multiple articles, I shall specifically talk about the Franklin Credit Risk Fund (FCRF). With a view to park some money with Debt Funds, I came across FCRF in October ’19. Impressed by the stellar historic return it had achieved compared to its peers, I went ahead and parked my money.

It was only in January ‘20 I saw a significant correction in the NAV when the Vodafone Idea Paper was marked to 0 by FT after a credit rating revision by CRISIL. This was the first case of side – pocketing (a practice where fund houses isolate risky assets from the rest of their holdings and cap redemption in the segregated assets) in 2020. Seeing this sudden deep correction, I did what any amateur investor does – panic and redeem the entire holding (taking a hit of 3% loss on a weightage of ~5% of my total portfolio).

Once the winding up was announced, a deeper research on the fund made me realize that a “Credit Risk Fund” basically invests in debt instruments that carry a lower credit rating and hence carry a higher risk of default / non – repayment. Again, a classic fallacy ignored by most investors accounting for upside but ignoring the downside. The higher return also comes with a higher risk. It is generally advised to have Credit Risk Funds, if at all interested, as a part of your Satellite portfolio (allied portfolio to your main portfolio).

Now, this is not an account of “I saw it coming.” Past episodes had taught me very expensive lessons about how markets keep giving you signals whenever something big is cooking. I had a hunch – I acted on it. If things would have gone well, I stood with the possibility of recouping my loss and gaining but this time around I decided to ignore my irrational optimism.

Let’s consider a few factors that we as investors should consider before investing.

Default Risk or Credit Risk?

All kinds of investments entail some amount of risk. Credit risk, however, takes the center stage in fixed-income investment. One of the most popular debt instruments is debt funds. Before investing in debt funds, you need to be aware of the manner in which you may entail credit risk.

What is Credit risk in Mutual Funds?

Debt funds make money by way of interest earned on the underlying assets i.e. debentures, bonds, treasury bills, and the likes. Apart from that, the underlying security is obliged to repay the principal upon maturity. Debt funds are exposed to credit risk when a bond/debenture defaults on its interest/principal repayment obligations. So, in a way, investing in debt funds exposes you to credit risk indirectly.

Various rating agencies like CRISIL and ICRA assign credit ratings to debt securities which indicate their extent of creditworthiness. A higher rating indicates a lower probability of default by the issuer which issued the underlying security. These credit ratings are dynamic in nature. The ratings change as per the financial performance of the underlying security. In mutual funds, the fund manager looks at the credit rating of security before investing in it. He/she may go for AAA-rated or below rated security as per the investment mandate of the fund. In the debt funds arena, you may find funds that have no credit risk i.e. GILT funds to funds that have high credit risk.

How does credit risk affect fund NAV?

The Net Asset Value (NAV) of a debt fund is immensely affected by the behavior of the underlying assets. Whenever a rating agency upgrades/downgrades the underlying security, it leads to a change in the market price of the security. This leads to a change in the NAV of the debt fund. A rating downgrade on account of interest/principal repayment default usually decreases the market price of the security. This, in turn, reduces the fund NAV. Ultimately, returns on a debt fund are reflected in its NAV movement over a given time horizon. If a fund continues to experience a fall in the NAV, it means that the fund is losing money.

Debt securities that have low-credit ratings tend to give higher interest on investment. This is to compensate the investors for the undertaking high risk of investment. It is aligned to the principle that higher returns are associated with higher risk. Now, a fund manager would choose security as per the fund’s objective. High return generating debt funds like credit opportunities fund invest in high yield generating AA-rated or below rated securities. Conversely, other debt funds like GILT funds invest only in AAA-credit rated sovereign bonds which yield relatively moderate returns. In a nutshell, the debt fund manager tries to achieve optimal returns by managing risk.

How to manage credit risk during fund selection?

The amount of returns that you take home ultimately depends on your fund selection. While investing you need to ask yourself

What are my investment objectives?

What is my risk appetite?

As higher returns are associated with higher risk, you need to be clear about your risk-taking ability. Additionally, you need to prioritize wealth creation or the safety of capital. If you expect higher returns from your debt fund portfolio, then you may allocate a portion to credit risk funds. But before that don’t forget to analyze its risk-adjusted returns generating ability. A look at the Sharpe ratio of a debt fund, which can be found in the fund’s factsheet, reflects its return potential. A credit risk fund that has a higher Sharpe ratio shows that the fund is generating enough extra returns to compensate for the high risk undertaken by way of low-credit rated securities. Conversely, if the safety of capital is your priority, then look for debt funds that invest in AAA-rated securities.

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This post was made with significant valuable inputs from Mr. Kamal Rampuria, a capital market veteran with 20+ years of experience. He is presently Senior VP at AUM Capital.

Aayush Saraogi has assisted with significant research around various numbers appearing in this article.

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About the author

Saket Mehrotra

Number cruncher, avid reader, coffee connoisseur, book store hopper & Metallica fan. An active follower of Sensex since 2009. CA, CS by profession.

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