Recently, Net Asset Values (NAVs) of several mutual fund schemes took a knock in the range of 0.1% to 1.2%.

Mind you, mutual fund houses incurred these losses effectively in a day. They had to mark down their investments in Infrastructure Leasing & Financial Services (IL&FS) and its group companies owing to credit rating downgrades.

As per data obtained from ACE MF, nearly 14 mutual fund schemes collectively had an exposure of Rs 2,130 crore to IL&FS and its group companies as on August 31, 2018.

Astonishingly, liquid funds and ultra-short term debt funds such as Principal Cash Management Fund and Principal Ultra-Short Term Debt Fund suffered 1.2% and 1.0% loss respectively between September 07 and September 10.

Apart from these, DSP Credit Risk Fund and Invesco India Credit Risk Fund are two funds that have witnessed a substantial fall in the NAV.

Realistically, this is not for the first time the mutual fund industry has taken a hit due to the deteriorating financial condition of the issuer of a debt fund.

And the IL&FS episode raises a question—Are debt funds really safe?

(Image source: pixabay.com)

Story in detail…

IL&FS along with its subsidiaries has around Rs 1 lakh crore worth public debt on its books, as reported by Time of India, dated September 07, 2018. Including its subsidiaries, IL&FS has under its belt around 90 entities and Special Purpose Vehicles (SPVs).

And the bad news is, this ‘systematically important’ company has difficulty repaying loans.

Adding fuel to the fire, it’s borrowing heavily to repay loans; running from pillar to post to raise corpus.

It recently sought immediate loan assistance of Rs 3,000 crore from two of its shareholders—SBI and LIC. Coincidently, LIC Mutual Fund too has invested in debt securities issued by IL&FS and its group companies.

IL&FS tried raising Rs 4,500 crore through the rights issue, but its plan met with misfortunes. HDFC, another shareholder, has already communicated its disinterest in subscribing to the rights issue.

It seems HDFC is unsure if IL&FS will be able to successfully exit SPVs or monetise its assets to raise money and par debt.

Recently, the settlement of Commercial Paper (CP) was overdue by two days, which prompted the RBI to prohibit IL&FS from accessing the CP markets until February 28, 2019.

A debt-trap is no different than this.

Taking a serious note of all these developments, several credit rating agencies downgraded its credit rating. Moreover, some important subsidiaries of IL&FS also faced severe downgrades.

In the Indian context, any bond rated ‘BBB’ and above is fit for investments, while any bond rated ‘BB’ and below is classified as speculative grade category. In other words, any bond with ‘BB’ and below ratings has a significantly higher risk of default of interest and principal.

ICRA, an independent credit rating agency, justified its rating action of downgrading IL&FS to speculative category. “The downgrade of ratings takes into account the increase in liquidity pressure at the group level. While the company is in the process to raise Rs. 8,000 crore of funds from the promoter group (through a mix of rights issue and long term line of credit), timely receipt of the same is important to improve the group’s overall liquidity profile. Further clarity is awaited on the timing of these inflows and given the sizeable repayment obligations of the group’s debt, this remains a key rating sensitivity in the near term. The ratings also consider the company’s elevated debt levels owing to the funding commitments towards Group ventures coupled with slow progress on asset monetisation and deterioration in credit profile of key investee companies.”

A behemoth or a cripple?

Company	Instrument	Amount (Rs in crore)	Rating upgrade/downgrade	Outlook
Infrastructure Leasing & Financial Services Limited	Non-Convertible Debenture (NCD)	5,225	Downgraded to [ICRA]BB  from [ICRA]AA+	Under watch list with developing implications
	Commercial Paper	2,500	Downgraded from [ICRA]A1+ to [ICRA] A4	Under watch list with developing implications
	Term Loans-Long Term	350	Downgraded to [ICRA]BB  from [ICRA]AA+	Under watch list with developing implications

(Source: ICRA)

What led to downgrading of ratings?

• Liquidity crunch

• Heavy indebtedness and inadequate capital adequacy

• Investments in illiquid projects

• Declining profitability

A deeper analysis of IL&FS and its group companies, which have faced rating actions in the recent past, suggests the problems are deep-seated and can't be addressed by merely raising a few thousand crore Rupees. The possibility is that the group might have invested in several commercially unviable SPVs and perhaps many of them may not be revivable ever.
  One of the largest subsidiaries of IL&FS felt the heat…

Company	Instrument	Amount (Rs in crore)	Rating upgrade/downgrade
IL and FS Financial Services	Commercial Paper	4,000	Downgraded from [ICRA]A1+ to [ICRA] A4

(Source: ICRA)
What led to downgrading of ratings?

• Deterioration in the credit profile of the parent company--IL&FS

• Concentrated exposure to infrastructure and real estate projects

• Overstretched balance sheet

• Deteriorating asset quality

Another instance of failed infrastructure projects…

Company	Instrument	Amount (Rs in crore)	Rating upgrade/downgrade	Outlook
IL&FS Tamil Nadu Power Company Limited	Term Loan	6,080	Downgraded to [ICRA]BBB  from [ICRA]BBB+	Revised to negative from stable
	Non-Convertible Debenture (NCD)	500	Downgraded to [ICRA]BBB  from [ICRA]A+	Revised to negative from stable

(Source: ICRA)
What led to downgrading of ratings?

• Deteriorating credit profile of the parent company—IL&FS and IL&FS Energy Development Company Limited (IEDCL)

• Lower capacity utilisation and heavy reliance on short term contracts

• Vulnerability to currency risk and coal price fluctuations

• Delay in payments from Tamil Nadu Power Generation & Distribution Company Ltd (TANGEDCO)

• Sizable near-term repayment obligations

Renewable energy dream looks illusive?

Company	Instrument	Amount (Rs in crore)	Rating upgrade/downgrade	Outlook
IL&FS Wind Energy Limited	Non-Convertible Debenture (NCD)	200	Downgraded to [ICRA]BB+  from [ICRA]A+	Revised to negative from stable

(Source: ICRA)
What led to downgrading of ratings?

• Deteriorating credit profile of the parent company—IL&FS and IL&FS Energy Development Company Limited (IEDCL)

• Lack of revenue visibility

• Sizable near-term repayment obligations

• Inexperience in handling and forecasting regulatory changes

• Fragile financial condition of state distribution companies buying power from  IL&FS Wind Energy Limited

No Sunshine

Company	Instrument	Amount (Rs in crore)	Rating upgrade/downgrade	Outlook
IL&FS Solar Power Limited	Term Loan	45	Downgraded to [ICRA]BBB  from [ICRA]A-	Revised to negative from stable
	Non-Convertible Debenture (NCD)-I	150	Downgraded to [ICRA]BBB  from [ICRA]A-	Revised to negative from stable
	Non-Convertible Debenture (NCD)-II	210	Downgraded to [ICRA]BBB  from [ICRA]A+	Revised to negative from stable

(Source: ICRA)

What led to downgrading of ratings?

• Weakening of financial position of the parent company—IL&FS and IL&FS Energy Development Company Limited (IEDCL)

• Delays in securing regulatory approvals for the project commencement

• High indebtedness

• Inability to repay older debts

• Inexperience in running solar power generation business

What to expect in future?

If the parent company, i.e. IL&FS, fails to raise money through rights and honour its debt obligations, not only it will affect its rating profile, subsequently even its subsidiaries may lose their ‘investment grade’ ratings. This would be a catastrophic event for the bond markets.

Marquee promoter profile won’t help IL&FS beyond a point. There’s a limit to which LIC and SBI can burn taxpayers’ money on bailing it out.

Nevertheless it’s important to note that, IL&FS hasn’t defrauded any creditors.

Mutual fund schemes having exposure to IL&FS and its subsidiaries have taken a knock on the mark-to-market basis. In layman terms, the fall in NAVs continues to reflect notional losses. However, if IL&FS defaults, the losses would not only mount but they will become a real threat.

The fund managers are in a catch-22 situation, especially if they hold long term bonds IL&FS and any of its subsidiaries. Reducing exposure at this point would cost them a pretty penny, but holding onto investments is equally risky as well. Some funds such as DSP Credit Risk Fund, Aditya Birla Credit Risk Fund and Aditya Birla Medium Term Plan hold debt securities that have a maturity in 2019, 2020, or 2021. They might get some more time to negotiate with the debtor.

But funds having exposure to papers nearing the maturity are more vulnerable.

IL&FS is on the ventilator so as mutual fund schemes.

Will LIC and SBI bailout IL&FS this time? But for how long, that’s the question.

Some might argue, impact of IL&FS on debt funds is temporary and most of the mutual funds will easily absorb the shocks.

But investors are the real sufferers.

They don’t invest in debt funds for maximising returns? Or do they?

If you are one of the investors who looks at the high returns the debt scheme has generated in the past and invest in it expecting it to repeat the performance, you are making a big mistake.

Let’s not forget, when fund managers might have invested in IL&FS, the company enjoyed high credit rating of ‘AA+’. Debt issued by its subsidiaries was also highly rated.

It seems fund managers are excessively relying on credit ratings.

But independent credit rating agencies can’t walk away scot-free.

Many of them revised credit ratings only a days before the debt instruments matured. Aren’t they supposed to take timely action? When the credit rating is downgraded several notches abruptly, it’s a sign of sluggishness.

IL&FS has been a classic case of what credit risk means to bondholders and why debt funds aren’t risk free.

[Read: Another Loose Cannon In The Portfolios Of Debt Mutual Funds…]

Instead of passing the buck, it’s important to be extremely vigilant while investing in debt funds.

Going merely by past records isn’t comprehensible enough to make a wise financial decision.

Consistency in the risk preferences of the fund managers and fund houses is the key to watch out for.

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Comments
gkmboddu@gmail.com Jan 07, 2019 Thank you Sir, for enlightenment to investors in debt mutual funds.
gkmboddu@gmail.com Jan 07, 2019 Thank you Sir, for enlightenment to investors in debt mutual funds.

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