Following the market mayhem, Housing Finance Companies (HFCs) and a few other Non-Banking Financial Companies (NBFCs), have been in the news.  The downturn resumed on Monday morning as well.

HFCs are in the firing line

Company	1-day loss	1-day volatility
DHFL	-42.6%	123.9%
Reliance Home Finance	-12.8%	27.4%
Repco Home Finance	-9.0%	14.9%
Indiabulls Housing Finance	-8.4%	55.3%
Can Fin Homes	-5.3%	18.6%
LIC Housing Finance	-4.7%	18.1%
PNB Housing Finance	-3.6%	17.6%
GIC Housing Finance	-1.6%	12.8%
HDFC	0.5%	5.2%
GRUH  Finance	2.2%	26.2%

Data as on September 21, 2018
(Source: NSE, PersonalFN Research)

Are these astronomical figures of one-day loss?

Some experts have predicted that Friday's news is just the beginning of big trouble.

While others believe that it was just a case of panic selling triggered by unrelated factors.

Naturally, the bigger question investors are asking---‘What will happen to my mutual fund investments?'

While tracking the progress of your mutual fund investments every day isn't an intelligent idea, not taking stock of what's happening in the market regularly is equally unintelligent.

As on August 31, 2018, the weight of the financial services sector in Nifty was 36.13%. Therefore, what happens to banking and financial sector is extremely crucial for the overall market direction.

Is Indian banking sector, especially, NBFCs and HFCs, in trouble?

(Image source: pixabay.com)

Well, any balloon needs just a tiny needle to explode.

Similarly, any market bubble just needs an excuse to burst.

At PersonalFN, we have been saying for quite a while now, market valuations aren't cheap, more so those in the banking and NBFC space.

With Public Sector Banks (PSBs) under immense pressure, investors have been banking on private sector lenders and NBFCs.

Many banking and NBFC companies have been trading at 5 times, 7 times, and 10 times of the price-to-book (PB) ratio. While it's wrong to paint the whole sector with one brush, it's important to note that, the markets didn't factor in many potential negatives until Friday.

On the first sight of tangible trouble, the sector has witnessed heavy selling and extreme choppiness.

What bothers investors about financial stocks at this juncture?

The entire media focus has been on the fall in DHFL, hardly anybody's talking about the potential worries of investors.

The media narrative is something similar to this:

IL&FS defaulted on one of their commercial papers, which affected many banks and mutual funds.

As we approach the end of September, the advance tax related outflows have created a redemption pressure on mutual funds. However, this scenario is seasonal in nature. Amidst tight liquidity conditions, IL&FS' default proved to be a double whammy for mutual funds.

DSP Mutual Fund sold “AAA” rated DHFL paper worth Rs 300 crore at 11% yield. DSP Mutual Fund's exposure to IL&FS commercial Paper (CP) was over Rs 600 crore.

Market experts believe that under normal circumstances the securities sold by the DSP Mutual Fund would have traded at 10.0% to 10.25% yield. In plain English, DSP Mutual Fund sold securities enjoying the highest credit rating at a steep discount. This sent the wrong signal to the market. Bond yields and bond prices share an inverse co-relation.

Recently, the credit rating agencies reduced IL&FS' rating several notches from ‘AAA' to ‘D' over a few weeks.

DSP Mutual Fund selling DHFL paper at a high yield was indicative of ‘some trouble'.

This led the markets to go into panic-mode, dragging other NBFC and HFC stocks along with it.

Later, managements of most HFCs including that of DHFL and Indiabulls Housing Finance issued statements assuring investors about their preparedness to honour their debt obligations.

DSP Mutual Fund issued a clarification too, “Recent sales are a reflection of our interest rate view and not a credit view on any specific issuer.” That suggests it didn't perceive any credit risk to DHFL's ‘AAA' bonds it sold lately.

But markets aren't convinced, purely going by the relentless falls in share prices.

The RBI and SEBI have assured debt markets that they will intervene in the market and are ready to take appropriate actions, if necessary. It seems that wasn't enough to address the worries of investors.

There's no smoke without fire…

Debt market conditions are definitely getting tougher and financial institutions depending on heavy market borrowings and those with higher Asset Liability Mismatches (ALM) may suffer the most. No wonder, HFCs found themselves on the wrong footing on Friday. Many of them borrow short-term and lend long-term, which creates a greater mismatch. If the housing sector NPAs rise, some HFCs might be in trouble.

If you look at the list of Friday's winners and losers, those with weak corporate governance received terrible blows. However, banks and NBFCs with unblemished track record fell less or even witnessed buying.  

Read between the lines

IL&FS has borrowed nearly Rs 93,000 crore from the banks and debt markets. Some of its subsidiaries have been prohibited from accessing CP market until the end of February 2019. Nearly Rs 25,000 crore IL&FS' debt will mature in next 1 year. With marquee shareholders such as LIC, SBI and HDFC giving the cold shoulder to IL&FS, there are very few options left for IL&FS to honour its obligations. Who will put money on the table?

At present, the deviation between overnight borrowing rates and repo rates isn't significant. This indicates, while the situation isn't alarming yet, credit is getting expensive across maturities and credit qualities. The potential default of IL&FS worth Rs 25,000 crore would further accentuate the hardening of yields. If RBI hikes policy rate in coming bi-monthly monetary policy reviews, the pressure on credit markets will mount significantly.

[Read: Bond Yields Have Hardened! Here's A Strategy To Invest In Debt Mutual Funds Now]

Under such circumstances, valuations of banks and NBFCs, especially with ordinary and week corporate governance, will look insanely expensive.

Ironically, investors might chase financial companies backed by better quality managements, making them even more expensive.

Days of cheaper borrowing and high growth seem to be over for Banks and NBFCs.

What happened on Friday might very well be just a hint of what's in store. Even today (September 24, 2018, Monday) NBFC and banking set the dark clouds of gloom. 

So, don't get carried away by any sharp upswings in banking and NBCF sector, in the near future, after the downswing. And at no cost, you should invest in sector funds focused on the banking and financial sector thinking that it will generate fantastic returns for you.

[Read: Why you should not invest in sector funds?]

There's something more to the story than meets the eye…

Until recently, many market experts and veterans touted that in terms of asset quality issues of the financial sector, the worst is already behind us. The IL&FS episode has plugged even the last hiding place for all of them.

IL&FS has bitten more than it could chew. The contagion of IL&FS' trouble is threating to implode the financial system (at least in the short run) exposing the fragility of business models of NBFCs.

Will LIC and SBI offer IL&FS Rs 25,000 crore?

What if somebody drags IL&FS to NCLT? It would be the end of the road for creditors because all activities will cease.

At some point, albeit unwillingly, SBI and LIC will have to offer a lifeline to IL&FS; but wouldn't that set a dangerous precedent?

And more than that, who will foot the bill, the taxpayers?

The elephant in the room

The RBI's disapproval to Mr Rana Kapoor continuing as the CEO of Yes Bank beyond January 2019 shell shocked Yes Bank shareholders. But more than the RBI's disapproval, it was the reasons for the denial that caused the damage.   

As per the media reports, the RBI has cited these three reasons—"Weak compliance culture in Yes Bank", "Weak Governance In Yes Bank", and "Wrong asset Qualification".

And interesting part is the timing of this decision...

Yes Bank has a credit exposure of Rs 18,720 crore to IL&FS Transportation Network, which is approximately 0.9% of its loan book as on March 31, 2018 and 7.3% of its net worth.

So, a question that crops up: Is there any connection between “Weak Governance” and Wrong asset Qualification” at Yes Bank and the on-going episode of IL&FS default?

The RBI had recently rejected the 3-year extension to Axis Bank's CEO despite board's approval. Could this  be an event in isolation too?

In conclusion…

So far, private sector lenders were flaunting their “credit discipline” and investors were offering them “rich valuations” for their so-called “quality”. A combination of IL&FS drama, DHFL saga and mysterious story of Yes Bank has given a clarion call to investors.

Friday's market fall and the continued selling-spree this Monday could mean bigger trouble is in the making.

A message for mutual fund investors…

Almost all diversified equity mutual fund schemes, with a rare exception, have a dominant exposure to private sector lenders and NBFCs including HFCs. Mutual fund industry collectively has an exposure of Rs 2.47 lakh crore to private banks and NBFCs including HFCs.

Investment of mutual funds in HFCs…

Company	Exposure as on August 31, 2018 (Rs crore)
HDFC	24,300
GRUH Finance	2,330
Indiabulls Housing Finance	1,905
LIC Housing Finance	1,357
DHFL	1,317
Repco Home Finance	436

Data as on August 31, 2018
(Source: ACE MF, PersonalFN Research)

Mutual funds won't be immune to potential negatives. And unless normalcy resumes in credit markets, stock markets are unlikely to stabilise. It is feared that HFCs are at a bigger risk, as there is a possibility that they have lent to builders; and some of them may have big Loan Against Property (LAP) portfolios, which are inherently risky in nature.

Needless to say, fund managers of process-driven fund houses will take a prudent call on investment in every individual company.

However, fund houses depending excessively on their fund managers for the performance of their schemes will be at the mercy of how their fund managers read the situation.

This is why it's imperative for you to invest in mutual fund schemes that come from fund houses that follow sound investment processes and systems.

Besides, before investing in a particular scheme, you must take into account the track record of a scheme over various timeframes and under different market phases.

Watch this video to know how to select a mutual fund wisely

And, you shouldn't be afraid of investing in lesser-known funds just because you haven't heard enough about them.

Given the dominance of the banking and finance sector in India's leading indices, what happens to the sector may quickly transmit into other sectors as well.

On the first sight of tighter credit conditions, consumer durable companies and automobile companies have also borne the brunt. Are we going to witness a widespread fall?

No.

We await more clarity on this.

India's macroeconomic conditions are deteriorating and stock markets have realised it. They will disappoint you in the foreseeable future unless you have realistic return expectations.

Systematic Investment Plan (SIP) is the way to go.

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Happy Investing!

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