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On defaults and downgrades: interview with Arvind Chari

The recent downgrades of some corporate bonds has created much confusion. Arvind Chari of Quantum Advisors explains what's going on

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Why is the debt-fund industry seeing a sudden surge in defaults? How could funds have handled the recent credit events better? Should SEBI step in to curb mutual funds funding their promoter firms? Arvind Chari, Head, Fixed Income & Alternatives, Quantum Advisors Private Limited, takes such tough questions head on in this frank chat with Value Research.

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Why have we seen so many default and downgrade events crop up with debt funds lately?
If you see the pattern of credit events in the Indian market, it was banking which felt the first major impact. From 2012 to 2017, the banking system faced fairly bad credit outcomes. Now, we are seeing this playing out more selectively in the case of NBFCs and debt mutual funds as they have increased their share of lending to lower-rated corporates.

You need to see these events in the backdrop of the subdued economic environment that has hurt corporate earnings in recent years. Lower and volatile commodity prices have had a negative impact on material and resource companies. Infrastructure companies have struggled on account of policy logjams impacting cash flows. Leverage levels have risen across corporate India and still remain very high. The profitability of companies has been neither consistent nor good in recent years and Sensex earnings have been flat over four years. Any risk-taking in this environment is likely to lead to credit events. This is contributing to more credit events.

Promoter lending by mutual funds is not a new phenomenon and debt funds in India have been doing it for over a decade. So, what went wrong with such deals this time around?
It was NBFCs which used to be quite active in promoter lending earlier and mutual funds have come in at a later stage. Such deals typically work well in bull markets as they deliver high yields with rising value of collateral for the lenders. Typically, in extending promoter loans, lenders try to figure out the end-use of that money. They evaluate whether the promoter would use the money to invest in new projects or needs it to repay old debt. In the ordinary course, loan against shares is a pretty simple product. You extend a loan and ensure that you have two or 2.5 times cover in terms of promoter shares pledged with you. Compared to other forms of collateral, equity shares are quite liquid and the collateral can be easily liquidated. The shares are available in an escrow where the trustees and lenders have access to them.

But the recent episodes like Essel highlight that tracking the total extent of leverage taken on by the promoter is also important. After all, the basic point in holding any security/collateral is to use it when things go wrong. Therefore, any credit assessment of promoter loans has to factor in the value and volume of shares traded in the market, and your ability to sell the pledged shares without severely impacting the price if there's a default or when you sense trouble. You need to track the total leverage metrics of the promoter. If that is not a happy number, then you essentially end up relying a lot on the promoter's intent to repay the loan. This is a very subjective call.

In the Zee case, the lenders realised that they could not enforce the collateral because a very high proportion was pledged. Maybe their call to reach a standstill agreement was the best course in the circumstances. In investments, your calls can go wrong and we should not demonise mistakes. But the incident does bring to question many issues on investment due diligence and, from an investor's perspective, suitability, fairness and the need for clearer communication.

To what extent should fund managers go by the credit ratings?
You have to do your own due diligence and treat credit ratings as supplementary information. This is similar to equity-fund managers not relying wholly on brokers' research and having to do their own assessment of the companies and managements they buy into.

But IL&FS so far has been the only example I have seen of an AAA entity defaulting and turning non-investment grade. Companies like Amtek Auto and Ballarpur Industries were slightly lower rated to begin with. In the Indian debt markets, most (long-term) investors are hold-to-maturity investors and do not bother about an AAA going to AA and the spread widening. No one envisaged before IL&FS that an AAA rated entity could go straight to D! I do feel that you cannot fault fund managers for holding IL&FS, though you can always point out that the higher yields on its bonds were always a signal of it not being an 'AAA' rated company.

But from a mutual fund perspective, one ground reality that we need to live with is that, once corporate paper is in trouble in India, there is literally no exit. Liquidity in corporate bonds, across the board, is poor. At the time of trouble, liquidity completely dries up and there is practically no buyer. The Indian debt market also tends to be very homogenous. When there is a credit event, everybody is on the sell side - investors, investment managers, banks.

Because of this nature of the Indian bond market, any lower-rated paper essentially becomes a hold-to-maturity call. Therefore, when buying a non-AAA corporate bond, you need to have the confidence that you will be able to hold it to maturity and that the borrower will honour it. Rating agencies can change their mind any time after you buy a bond. So, it is up to you as a debt-fund manager to ensure that extra layer of due diligence with corporate bonds. It is no use saying that rating agencies messed up!

Do credit calls pay off? Do the higher yields compensate for the default risks?
No, I would caution there that duration calls can also be quite risky. If you look at 10-year returns on duration funds, they have earned around 7-7.5 per cent return. That's roughly the long-term average yield on the 10-year government bond. But you also face quite a lot of volatility along the way. In the earlier cycle, interest rates swung between 4.5 and 9 per cent and this cycle saw rates rise from 6 to 8 per cent. Until about three years ago, I would say debt-fund investors suffered more from volatility in returns arising from duration than they did from credit risks. If you remember the taper-tantrum episode of 2013, many funds lost their entire year's returns. That was the first occasion when investors realised that bond funds can also make losses. Much of the debt-fund assets were also parked in duration products until 2014.

In the last three years, however, the allocation to credit-risk funds as well as allocations by debt-fund managers to credit strategies in their normal funds have risen sharply. I believe that too much money is now possibly chasing lower-rated paper. There is possibly over-allocation to private-sector AA and below bonds. That's why you are seeing so many more episodes crop up - be it Amtek Auto, Ballarpur or the recent Essel episodes.

I think there is also a mismatch between the amount of assets allocated to credit strategies and the available opportunities. Today, secondary market trading volumes in less than AAA rated corporate bonds are a fraction of the outstanding bonds and that makes for very poor liquidity.

Yes, the rising allocation to lower-rated bonds could be a sign of bond-market development in India. And when you are in the initial phases of the development, there will inevitably be some hiccups and disasters along. The regulator, industry and investors will have to evolve on how they prepare for and handle the impact of credit risks.

Despite SEBI's exposure norms clearly saying that debt funds should not have more than 10 per cent exposure to a single issuer, how is it that many FMPs and other debt funds end up with such high concentrations of 15-25 per cent in the Essel companies or IL&FS?
SEBI's concentration norms apply at the time of the original investment. Fund houses usually have internal prudential norms that monitor their portfolios on an ongoing basis based on market value. But the problem is that, even if a fund has such prudential norms, it can end up with concentrated exposures if faced with redemption pressures. I do think though there needs to be a stronger regulatory limit on whether AMCs can invest in their own group companies and fund their own promoters. There are similar norms for banks and there need to be for mutual funds. I would be very surprised if SEBI doesn't look at this!

We recently saw instances of open-end debt funds ending up with very concentrated exposure in DHFL because, as they faced redemptions, they had to sell their most liquid bonds which could still be sold at a good price. This happens in equity funds also. When there's redemption pressure, you would sell your most liquid, large-cap names and not your small caps. That leaves you with a high concentration of small caps or lower-rated bonds in your portfolio. Does the fund manager have a way out? Not that I can see. We have seen few instances of equity funds stopping inflows as the size increases but this hasn't happened in credit funds. The industry has to look into the aspect of fund-size capacity with respect to the underlying liquidity. In good times, 'hot' funds get large inflows and as the tide turns, those funds/strategies are faced with crippling outflows, with underlying investments which cannot be liquidated.

There also seems to be a lack of standard practices on marking down the NAVs of funds after defaults or downgrades in their portfolios. We saw that the NAVs of the affected FMPs didn't immediately take a hit when there were 'standstill' arrangements with the promoters.
Yes, it is my personal view that it would have been the best practice to write down the NAV when there was a restructuring of loans. Banks do make some provisions when they officially restructure their corporate loans and reflect this in their books. Mutual funds too should follow this practice. If the call to extend the time for repayment is taken in good faith, there's no harm in admitting it and reflecting it in the NAV. If recovery follows and you realise something extra, you can always pay back the investors.

Should FMPs refrain from credit risks and should they not feature promoter lending at all?
No, if FMPs have communicated to their investors that they will be taking on lower-rated bonds, I think investors have to brace for such risks. In FMPs, there is a requirement of not disclosing your portfolio upfront, so funds cannot really talk about promoter loans and so on. But it is about how the communication happens on portfolio quality. Once you have communicated it, investors also need to accept that credit calls may be taken and can sometimes go wrong.

After all this, if a very risk-averse investor, say your mom, asks you if she should invest in a debt fund, what would you tell her?
Quantum AMC recently released a note on how to invest in debt funds and laid down five tenets to follow before investing in a debt fund. I think they hold good here.

  • Debt funds are not wealth-generating products. Don't expect double-digit returns from them.
  • Debt funds are only alternatives to your existing fixed-income exposures like FDs, small savings, PF/PPF and endowment insurance. Most investors need more equity exposure than debt exposure.
  • Debt funds are not fixed deposits. There is no guarantee of returns.
  • Debt funds carry interest-rates, credit, default and liquidity risks.
  • Debt funds may also need longer holding periods to ride out a cycle.

So for someone like my mom, I would say, 'No, you are better off investing in fixed deposits.' I remember making some of these points in my earlier interview too. But debt funds do have their pluses. One, you are effectively taking on interest-rate risk even in a bank FD. If rates go up after you invest, you lose the opportunity to earn that higher yield. But if you invest in liquid funds, your returns improve with rising market rates. That's a big plus.

Two, in bank deposits and small-savings schemes, you have a lock-in and pay a penalty for withdrawing your money when you need, but in most debt funds you can withdraw at any time of your choice without exit loads. Three, there is a tax advantage in debt funds when you hold for three years or more.

Four, I do see retail investors going in for high-yielding NCDs in public issues. These are often far riskier than debt funds that take on credit risk. In debt funds, your risk is diversified. In NCDs you are taking on the risk of a single issuer.

Finally, I think, to navigate both credit and interest-rate risks in debt schemes, investors have to be prepared at the outset to hold their investments for longer than they intended. If rates rise after they invest, they may need to wait for the cycle to turn. If there's a credit event, it may take time for the rest of the portfolio to recoup that loss.

Personally, I see a lot of merit for retail investors to invest in liquid funds.

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