When DSP Mutual Fund received a redemption request from its corporate investors on the debt fund, the real reason was that the client was a tad worried. The fund has a large exposure to the bonds issued by IL&FS, both in the long duration and the short duration. A sharp fall in the NAVs due to a rating downgrade meant that the short term funds started showing losses. That immediately triggered sell orders from treasuries. With a huge redemption request, DSP needed to generate the requisite cash. It could either sell the G-Secs in its portfolio, but that would mean booking losses in a rising yields scenario.
The better option was to book the loss in private debt where there was anyways an element of risk. That is exactly what DSP did when it sold bonds of Dewan Housing at a huge discount. As against the market yield of around 8%, DSP sold the bonds at a yield of 11%. That means, an Rs.100 bond was sold at Rs.82, incurring a large loss in the process. That triggered worries in the equity market that there were similar problems in DHFL too and that is what led to the sharp crash of 60% in DHFL in a single day. Other HFCs like Indiabulls were also not spared as they too relied on the short and medium term bond markets to raise funds on a continuous basis.
How the rating downgrade triggered the panic
The whole problem started when rating agencies downgraded IL&FS drastically the moment the default broke out. The downgrades were swift and very drastic. The long-term ratings of the parent entity IL&FS were downgraded multiple notches from AA+ to BB on September 8 and then to D on September 17. The short-term rating was downgraded from A1+ to A4 on September 8 and then to D on September 17. Similar rating actions were witnessed across debentures and CP on several other group entities – IL&FS Financial Services, IL&FS Tamil Nadu Power Company Limited, IL&FS Energy Development Company Limited, IL&FS Transportation Networks Ltd and IL&FS Education & Technology Services Ltd. The main reason stated was the sharp deterioration in the risk profile of IL&FS. That was the starting of the trickle-down effect. But the big question is whether this story can become much larger than just one DSP MF selling bonds? Or could it become something much larger where there is panic selling in bonds and also equities wherever companies are found to lack in transparency or whether there is a risk of maturity mismatch.
Will it really impact the mutual funds?
It would be naïve to believe that mutual funds in any way could be immune from this series of downgrades that IL&FS has faced. Mutual funds have a major exposure to the bonds issued by IL&FS, which were generally preferred by mutual funds for the higher yields that they offered. And the total exposure that Indian mutual funds have to the IL&FS is nearly Rs.2200 crores, which is not small by any standards. More so because most of these are short term instruments where there are corporate investors with their own internal risk management constraints. Secondly, there are nearly 10 FMPs that are exposed to these IL&FS bond in a big way. A default will mean that the very concept of a Fixed Maturity Plan (FMP) will be diluted as they will not be able to provide quasi assured returns any longer.
The problem may become a lot graver in the coming months for obvious reasons. Some of these exposures were due to mature in September, which were returned due to insufficient funds. Several funds held aggregate exposure in excess of 5% to IL&FS and group companies in their portfolios. Given the Mark to Market (MTM) impact on these bond prices, these funds witnessed a sharp drop in NAV. While upgrades and downgrades are expected to happen, what really hit the mutual funds, as in the case of Amtek Auto earlier, was the swiftness of the downgrade. This resulted in a significant MTM impact on bond prices. In some cases the MTM impact of the first round of downgrades on bond prices was as significant as 25%. That means; a 5% position for the bond in the fund would result in a -1.25% MTM impact, which is huge considering the low returns that these short term funds provide. For the first time, Indian mutual fund investors may see the risks of debt funds in real time. For the real impact, watch out of funds like DSP MF and Aditya Birla; where the exposure to the IL&FS group is in excess of Rs.600 crore each. But DSP and Aditya Birla are much larger in terms of AUM. The real problem could arise for AMCs like BOI AXA, LIC MF, Principal and Tata MF, where the exposure although smaller is a significant proportion of their overall debt exposure.