Debt funds primarily run two risks —the interest rates and the credit risk. Interest risk suggests that market value of tradable securities held in a debt fund drops when the interest rates in the economy rise. As a result, the Net Asset Value (NAV) of a fund drops. Since securities are redeemed at par value on maturity, those who can hold out until maturity don’t suffer much, but speculators do.
The credit risk or risk of default is a much bigger concern for debt fund houses. This is because, if the company issuing securities goes belly up, debt funds incur losses that can’t be recovered easily.
You’re probably aware that Indian banks, especially, the Public Sector Banks (PSBs) are facing a serious problem on the asset quality front. Big ticket industrial loans sanctioned in the previous economic boom phase are now turning bad, and this provisioning has dented the profitability of banks. The list of companies facing troubles includes some eminent business groups. Raising funds from the banks isn’t the only step but they have resorted to many other funding options. Mutual Fund Houses have invested in many such companies in search of higher yields on investments. But now, it looks like fund houses that have invested in securities of stressed companies were keener on the profile of business groups rather than assessing their financial condition.
The story in detail…
A case in point is Reliance Communications (RCom). Recently, it missed the repayment obligation of its debt. This hasn’t gone down well with its creditors and the independent credit rating agencies. As a result, more than 10 banks that have credit exposure to RCom are under tremendous pressure. Fitch, an internationally reputed credit rating agency, has raised a red flag calling this loan default a "real possibility."
In a detailed report, it said, "Fitch Ratings has downgraded India-based Reliance Communications Limited's Long-Term Foreign and Local-Currency Issuer Default Ratings (IDRs) to 'CCC' from 'B+'.” Further, it warned investors saying, "The rating action reflects Fitch's assessment that short -term liquidity has deteriorated to a position where credit risk is very high." The most worrisome part of its commentary has been this—“Its capital structure is unsustainable and it has excessive refinancing risk given that we expect cash generation may decline."
Interestingly ICRA, another independent rating agency downgraded RCom from 'BB' to ‘D'. The difference in the rating of two reputed companies is startling. According to Economic Times dated May 29, 2017, RCom had an outstanding debt of Rs 42,000 due at the end of March 2017.
Meanwhile, the company (RCom) has reinstated its commitment, calling for an extended repayment time until September 30, 2017. Responding to media queries, RCom said, "Post signing of binding documents for the Aircel and Brookfield transactions, RCom has formally advised all its lenders that it will be making repayment of an aggregate amount of Rs 25,000 crore from the proceeds of these two transactions, on or before Sept 30, 2017. The said amount will cover not only all scheduled repayments, but also include substantial pre-payments to all lenders on a pro-rata basis."
Keen to know which mutual fund has exposure?
It’s shocking, but Franklin Templeton Mutual Fund seems to have become a habitual risk-taker. This fund house has solely taken exposure to RCom, which that stands at Rs 600 crore collectively through its 5 schemes.
Do you recall the glaring losses it had suffered when Jindal Steel & Power (JSPL) had faced rating downgrades following the debt servicing issues it faced last year. But it seems the fund house has remained as cool as ice cream. Responding to the media queries, the fund house said, “Our fixed income schemes only have exposure to the entity, Reliance Communications Enterprises, which is a holding company of Reliance ADAG."
The positive aspect is that the fund house holds a collateral of shares in 3 ADAG (Anil Dhirubhai Ambani Group) companies—RCom, Reliance Capital and Reliance Infrastructure. The worth of this collateral was more than 2.2 times on June 02, 2017. Although this gives the fund house a cushion against any default, the share prices can fall like a house of cards. We have already seen this happening in the case of a defaulting Indian airline company. That being said, as of now, there’s no need to hit the panic button and creditors have no option but to wait until September 30, 2017. Hopefully, RCom will honour its payment this time.
The moral of the story is:
Debt funds are not as safe as you might consider them to be. As a smart investor, be wary of debt funds that invest in low-quality debt as the credit risk is the biggest risk involved in fixed income investing. And, this can potentially ruin your investments. Moreover, you should consider your risk appetite and time horizon before investing in a debt fund and avoid allocating more than 20% of your fixed income investments in long-term debt fund.
If you are undecided about which funds you can reliably invest in, subscribe to Debt Select —an unbiased research report service offered by PersonalFN.
