Exposure to Essel and IL&FS has hit fixed maturity plans. Here is all that you wanted to know about the crisis
19-Jun-2019 •Aarati Krishnan
How can a 'fixed' maturity plan (FMP) ask me to be flexible about the maturity date? Can mutual funds lend to promoters? Was I wrong to invest in FMPs instead of good, old bank deposits?
Many such questions are swirling around in the minds of mutual fund investors after it has come to light that several fund houses are seeking to defer part of the returns or looking to roll over some of their FMPs after delays in repayments from their borrowers.
Before we get to how you can deal with this issue, let's understand how the FMP crisis came about.
I saw the note from Kotak AMC to their investors saying that they will pay back only 99.6 per cent of the original capital on one of their FMPs (Series 183) on maturity date. On another FMP (Series 127), they've paid back just 109.1 per cent. They've indicated that more returns may be shared later. How come the maturity amount be so low?
The two FMPs had bonds from two Essel group companies - Konti Infrapower and Edisons Utility - in their portfolios. These bonds were due to mature on April 8, 2019. If the Essel companies had repaid on time, the FMPs would have received their principal, along with 11.1 per cent interest for the entire period of investment. But because the Essel group couldn't make the repayment, the fund has given them more time until September 30 to come good. As these FMPs matured earlier, they've repaid capital and promised to share some of the returns later, assuming the Essel group repays its dues by September 30. Kotak has said that four other FMPs (Series 187, 189, 193 and 194) also hold Essel group bonds and are likely to face similar issues at redemption.
I read that HDFC Mutual Fund also held Essel bonds in its FMP 1168D Feb 2016 series that was maturing. It has asked for its investors okay to roll over the scheme by another 380 days. What about investors who put money in the FMP thinking they'll get it back this year?
They could have chosen to redeem on April 15 by not giving their written consent to the roll-over. HDFC Mutual Fund gave its investors the option of either opting for the roll-over or redeeming their investment on the due date. But if they redeemed on the due date, the fund would not have received its repayments from the Essel companies and therefore may have repaid less than their original capital. The two Essel companies - Sprit Infrapower and Edisons Infrapower - accounted for 9.6 and 9.9 per cent, respectively, of this scheme's portfolio. HDFC Mutual Fund has also listed out over 20 other FMPs with maturity dates falling between April 2019 and July 2021 that have some holdings in the Essel group.
But when these AMCs knew fully well that their FMPs were going to mature earlier, why did they give the Essel group promoters extra time to repay?
The truth is that they had no choice. The AMC's loans to the Essel group companies were secured against the promoters' equity shares in group companies such as Zee Entertainment and Dish TV. The loan agreements had clauses saying that the value of shares held as security against the bonds always had to be 1.5 to 1.75 times the outstanding loans. In January, it became clear that the Essel promoters were cash-strapped and would find it difficult to repay all their obligations. A couple of lenders sold the Zee shares pledged with them to realise their money. But the selling of just 0.6 per cent of Zee's equity shares in the market led to the share tanking by 26 per cent. This made the seven AMCs holding the Essel bonds wary of invoking the collateral and selling their equity shares as that would have seen the bottom drop out of the share price, denting their own realisation. Instead they jointly negotiated a 'standstill' agreement with the promoter on not selling the shares. They also signed an agreement in April, when the bonds became due, to grant the promoter extra time until September 30 to repay the loan.
So what happens if this repayment doesn't happen?
Essel group promoters are presently in talks to sell stakes in companies such as Zee Entertainment and Dish TV, which have sound fundamentals and may find buyers. If they manage to do so before September, they can repay the AMCs. The AMCs have also worked out an arrangement to get an extra share of profits from the Essel promoters as compensation for the delay if the deal happens. But there's no certainty that the deals will happen before September. If they don't and the group defaults, the AMCs may have to sell the shares they hold as collateral and realise whatever they can. The proceeds that will be distributed to FMP investors will depend on which of the two scenarios plays out.
Hopefully, these are stray cases and that will be the end of the FMP fiasco!
Unfortunately, they aren't. While Kotak and HDFC have been the first AMCs to invite the wrath of investors with their disclosures because their FMPs were first in the line for redemption, data digging by Value Research tells us that bonds from the Essel group are widely held over dozens of schemes across seven AMCs. There are 56 FMPs with exposure to Essel entities, while some credit-risk funds, medium-, short- and low-duration funds also hold them.
The list of AMCs holding Essel group exposures includes Aditya Birla Sun Life (Rs 2,762 crore), Baroda Mutual Fund (Rs 118 crore), Franklin Templeton India (Rs 641 crore), ICICI Prudential (Rs 745 crore), Reliance Nippon (Rs 409 crore), SBI (Rs 258 crore) and UTI (Rs 95 crore). This is apart from Kotak (Rs 452 crore) and HDFC (Rs 1,154 crore). You can check out the list of schemes with Essel exposures in the table accompanying this article. Overall, the debt-fund industry's exposure to Essel companies based on March-end portfolios, totalled Rs 6,638 crore.
Gosh, so this may just be the beginning! But why are mutual funds getting into this risky business of giving promoter loans? Aren't there banks to do it?
Promoter loans by mutual funds usually deliver yields that are 2 to 4 percentage points higher than what high-quality bonds in the market offer. In the past, such loans have seen practically no instance of defaults. For the last 10-15 years, Indian mutual funds have been extending loans to promoters by subscribing to their bonds. The bonds, typically with an 18- to 24-month term, take two forms. Sometimes the bonds are unsecured if the funds are very confident about the promoters' ability to repay, such as in the case of Tata Sons. Most are secured against the promoters' equity shares in listed companies, with the value of the shares usually amounting to 1.5-2 times of the loan value. There are two things that usually deter promoters from defaulting on these loans. One, equity shares usually make up the lion's share of promoter wealth and promoters hate to lose control over their companies. Two, banks in India do not lend to promoters against their equity shares and promoters are therefore heavily dependent on NBFCs and mutual funds for their borrowing needs to fund equity infusions or new business forays. They wouldn't like to spoil these relationships through defaults.
But recent events have shown that having equity shares as collateral is not so useful, isn't it? What's the use of collateral if you can't actually liquidate it?
That's quite right. Mutual funds have never had to actually invoke their collateral in promoter loans against shares in the past and perhaps that had made them complacent. Had they tracked the total quantity of shares pledged by the Essel group, they would have known that it was too large a quantity to be sold in the market, given the daily trading volumes in the stock. AMCs have now said that they will look to cap total promoter leverage when they get into such deals in the future.
Don't tell me they will continue to give out promoter loans.
They probably will, but perhaps with stricter clauses on collateral and the total extent of promoter leverage.
Clearly, promoter loans are a high-risk proposition. So are funds right to be buying such bonds in their FMPs, which I thought were low-risk products?
Not all FMPs are mandated to be low-risk funds. Most of the FMPs which had Essel group exposures stated in their scheme document that they would be taking exposure to AA and lower-rated securities. The Essel bonds were incidentally rated A (SO) when they were bought by the funds. Recent events such as the IL&FS default have, however, shown us that even AAA ratings aren't foolproof.
It is all very good for AMCs to tell us that defaults like the ones from IL&FS or Essel group are the market risks they warned us about in debt funds. But I am surprised that the exposure to one group going wrong can have such a big impact on FMP returns! How is it that this one default is enough to wipe out all the returns earned by some FMPs over three years?
You've hit the nail on the head there. The key reason why FMP returns are taking such a big battering from the Essel default is that many fund houses hold fairly concentrated exposures in individual bonds in their FMPs. Many of the FMPs owning the Essel exposures have a 9-11 per cent exposure in a single security. Some FMPs also own more than one Essel group bond in the same scheme.
Don't SEBI rules say that debt schemes cannot own more than 10 per cent in one security?
That applies only at the time of investment. Plus, a scheme can hold 10 per cent in multiple entities from the same group. Since FMPs are closed-end schemes, the AMCs probably saw no risk of breaching regulatory limits due to inflows or outflows from these schemes. In the case of open-end schemes holding Essel bonds, you will find that the weights allocated to Essel bonds were much lower. The 'credit-risk' funds of HDFC and Kotak, for instance, held less than a 1 per cent weight in Essel bonds.
Also, why didn't the default show up in the NAVs of the schemes earlier? Then we would not have had nasty surprises at the redemption time.
That's because the Essel group bonds were technically speaking 'restructured' and didn't involve an actual default. AMCs did not have to write down the value of these holdings in their NAVs, as per SEBI rules. Even in cases of actual default, AMCs do have leeway on the extent of write-down they take because there's no standard practice across the industry on how valuations of non-investment-grade bonds can be done. The problem with most corporate bonds rated below AAA or A1 in India is that they are not actively traded. So, AMCs do not have a standard benchmark like a quoted price on the basis of which they can do a mark-to-market valuation. SEBI has, however, recently come up with a new set of rules to standardise the valuation of low-grade bonds and hopefully this loophole will get plugged.
I hope the AMCs are making some changes in their promoter loan deals after this. But what can investors in FMPs do?
If you own any FMP in your portfolio, do run a check on its portfolio. Apart from exposures to the Essel group, exposures to IL&FS entities may also entail risks to your final maturity proceeds. As you know, after its default last year, IL&FS is now being managed by a government-appointed board, which is monetising its assets on a piecemeal basis. You can refer the accompanying table for debt funds with exposure to IL&FS. You also cannot rule out risks from other NBFC holdings, given the ongoing liquidity crisis in NBFCs. But unfortunately, while checking on the portfolio may help you prepare for poor returns on redemption, there's not much you can do about it as FMPs do not allow premature exit under any circumstances.
After all this, I am wondering if FMPs are worth investing in at all, compared to bank deposits or open-end debt schemes?
These events certainly underline that FMPs can be as vulnerable to market risks as any other kind of debt funds. In fact, given that they often own concentrated portfolios, they may be riskier than open-end funds. You can reduce credit risk in FMPs by checking out the statutory disclosures on the rating composition in their scheme information documents before investing in them. But that does not foolproof you against risk because even AAA and AA rated entities have been known to default at times in India, as credit-rating agencies have been quite tardy with their downgrades.
So, do not think of FMPs as bank-deposit substitutes and avoid them if capital protection is an absolute priority. If you are an aggressive return-seeking investor, then open-end credit-risk schemes, which are more upfront about their portfolio choices and are better at diversification may be a better bet despite their higher costs. For other investors, only seeking the tax efficiency of debt funds, liquid or short-term funds with high-quality portfolios remains the best bet.