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Jindal Steel and Power Downgraded to Default, A 39,000 Cr. Debt Problem as Franklin MF Takes 25% Haircut

Franklin-Exposure.png

Jindal Steel and Power Limited has been downgraded to “default” (D) by Crisil. The rationale is simple: 

The rating downgrade reflects delays by JSPL in payment of interest on its term loans; the delays were due to weakened liquidity. Liquidity deteriorated significantly as the steep fall in steel realisations coincided with high debt repayment obligations. Pressure on liquidity intensified further due to delays in materialisation of asset monetisation plans and refinancing of debt.  

JSPL’s steel business remains vulnerable to volatility in demand and in prices of metal, while its power business is susceptible to demand and price volatility in the merchant market and lack of raw material integration. The group is also exposed to risks related to regulatory changes in the mining sector. However, it has a healthy market position in the steel industry, value-added product profile, and proximity to raw material sources. Successful debt refinancing and asset monetisation will be critical for the group and will assist in tiding over the current liquidity constraint.

Means: they have to roll over loans, and they have to sell assets. Apparently, the problem isn’t just local. JSPL has also, it seems, defaulted on a $25 million loan from a Japanese bank. This has prompted other lenders to do an “early recall” of other loans to JSPL that, if it happens, will require JSPL to pay up $550 million.

JSPL

This is not yet a bank default, perhaps

Banks get to wait 90 days before calling a loan an NPA. And currently, only that bank which has seen an actual default takes the hit after 90 days; while other banks should technically be sharing information and also marking down provisions for a JSPL loan. If JSPL can default with Bank X, it can also default with Bank Y. 

Bankers have traditionally been very lax about such events. They prefer to wait until the shit hits the fan and then claim helplessness. At this point, this is no longer acceptable. They waited with Mallya (and continue to not take over his 1700 cr. holdings of UB, for inexplicable reasons). But JSPL has over 39,000 cr. in loans – it’s 5x Mallya. (The Kingfisher Airlines default was 7,500 cr.)

The right thing to do now, would be to immediately work with Jindal on taking over management control and/or selling assets forcibly to cut exposure; the process is going to take over a year. But we believe banks will somehow give JSPL money through a restructuring or a 5/25 scheme to push the problem further down the line.

The hit on Debt Funds: Franklin Halves Exposure But Still Hit; Takes 25% Haircut

We wrote last month (The Risk in Debt Funds Surfaces as JSPL gets Downgraded) that JSPL is a massive default if it occurs, and in mutual funds, Franklin MF had the biggest exposure. While they have cut their exposure to half in February, here’s the situation as of Feb 29:Franklin MF exposure to JSPL

(This doesn’t include Jindal Power, which will likely be affected only when it is downgraded as well)

For Franklin, even though their holdings may not have defaulted, the downgrade to “D” by Crisil itself will mean they have to downgrade the bond values substantially. The mark down will be visible by the end-day NAVs today. 

And, it seems, they sold some of these bonds at a 25% loss, according to a report in the Economic Times. A 25% haircut is big but there are two reasons why they would have taken this loss:

  • Some of these funds are “short term” funds that see redemptions quite often; and a scare like this will make them exit some more. Remember in September 2015, after the Amtek Auto default and the hit on JP Morgan MF, Franklin MF saw its debt AUM fall 23%. They will need the cash to pay out the redemptions, and perhaps they thought even a 25% hit is okay for them to reduce exposure or keep cash on the books.
  • They believe the JSPL default is serious enough to not receive money for a significant time. Even if there is a recovery process (such as assets provided as collateral) the process of going to a court for resolution can take a lot of time, and the recovery rate may not be greater than 75% anyhow, so a fund could decide to take that 75% hit today rather than later.

We don’t know which of these (or both) impacted the decision to take a large haircut but it gives you an idea of how complex the situation is for bond funds; for them, a default is immediate, and they don’t get 90 days to call something an “NPA”. They have to act really fast.

The other player who has exposure is the portfolio of ICICI (we haven’t got their portfolios for Feb, and here’s the portfolio from @NagpalManoj ):

ICICI JSPL

(As of Jan 2016)

FMPs are more complex. You can’t exit, as an investor in the FMP. The maturity is fixed, so investors will only see the loss – the fund, here, has no redemption pressure. However, look at the size of the exposure here – 14% of one fund! And in Feb, the last downgrade was just a couple notches – this time, it’s a full downgrade to default, so the hit will be higher. 

Note: According to value research, the Series 77 Plan M fund saw a drop to 10% in terms of JSPL as a % assets.

Should We Sell All These Funds?

You can’t do anything if you own the FMPs. You just have to wait.

If you own the Franklin or ICICI funds, the hit will be taken today. Even if you do exit now, you will take that hit. At best you will save yourself further damage.

Franklin MFs are known to have less-than-pristine debt on their books. That’s how they even got some fancy returns. We even wrote about other companies that haven’t defaulted but have very little owned cash flows, whose debt is owned by Franklin Templeton MF. Many advisors know this. And that’s fair to take a higher risk for a higher return. But many such funds don’t give you the impression it’s higher risk (like a “low duration” fund, or a “short term income” fund) and while advisors should tell you that about this risk, they either choose not to, or simply don’t know. 

I have been on record saying the exposure to such debt funds should be reduced to a much smaller exposure, so much that you are okay if there are a few such defaults (where the time for recovery is longer). If you can’t stomach any risk, then you shouldn’t even be i
n such funds (or, for that matter, in most corporate bond funds). 

The JSPL situation will see some action soon. Either banks will give it more money and push the problem forward, or they will become an NPA in bank books. The fact that it’s a 39,000 cr. loan default will ensure that banks fight to the end to not have to call it an NPA. But a default in two places – a foreign loan and a local loan – indicates big trouble. Even with minimum import prices and increase in steel duties in India, a global player like JSPL can’t really compete internationally. This is a warning bell for all steel companies and the banks or funds that lend to them.

  • DJ says:

    Three points:
    1) I’m glad that this time your view is more balanced as opposed to the last time we had an argument over this. In particular, I’d glad that you have said that: “Many advisors know this. And that’s fair to take a higher risk for a higher return.” I think your last few paras are very sound advice.
    2) “But many such funds don’t give you the impression it’s higher risk” – this I don’t quite agree with. Again, to repeat, the valueresearchonline fund portfolio will show how many bonds of which credit rating are held and the very simple, easy-to-check style box diagram will show you that these funds have a portfolio that is categorized as “low credit quality” (bottom 3rd of the credit quality spectrum). I believe this is good enough as a warning. But, to make this better, you could have funds include the words – high yield or speculative credit, to make it even more obvious..
    3) Also, note that high yield bonds in the US have outperformed stocks over the last 20-30 years with an average 4% default rate. Yes, there are caveats – its been an interest declining environment (so bonds in general have done well as compared to stocks), US has a better bankruptcy process with higher recovery rates, defaults have been lumpy in certain years and so on. But, the point is, when holding a high yield bond fund, one should expect something like 4% default rate on average (and higher in some years when defaults are lumpy) and still expect outperformance relative to govt bonds and at times, even equity. Defaults alone does not mean that the fund does not have the ability to ride the storm over the longer term. Some of the higher yield does cushion against such a loss. Caveats apply though, as we have lower recovery rates in India, so drawdowns and the overall performance could be worse as compared to a market like the US.

    • Agree on 3). In fact, right now, tehre is SRTRANSFIN credit available at 11.5% pre-tax. This is high yield. I don’t know if SRTRANSFIN will default but it’s good to have a few such pieces in the portfolio to juice up yield even with a default risk. But you have to take care that the portfolio is diversified (so too much real estate can mean a slump gives you not 4% but 20% defaults). Also that recovery is easy – which it is not in India (can take years). The bankruptcy bill is a good step forward for this.
      Great points in 1 and 2 as well, cheers

  • DJ says:

    Oh and just to preempt some of the usual nonsensical – did not expect this from Franklin Templeton, etc: Please note that Franklin Templeton has all kinds of bond funds – some with lower credit risk, some with higher (which are these). Some with only gilts where you have no risk to company defaults, some with a mix of gilts and bonds of varying credit quality and some only with company debt. So, within Franklin Templeton, you can choose relatively safer or riskier debt funds. There is no alternative for doing the due diligence and taking responsibility for which FT debt fund you choose to go for. Disclosure: I do not work for any MF or FT or any company in the finance industry for that matter.

  • Rajendran says:

    Deepak,
    Thanks for the detailed review. I quickly checked the Credit quality in Valueresearchonline for the impacted Franklin Funds and for all of them now it’s “LOW” I don’t know whether it was changed after this story broke out. Will credit quality be moved from HIGH to Medium and then to LOW or will happen all of a sudden? I do have some exposure to DEBT funds for all them it’s Credit quality now is HIGH and their top exposed papers are marked with mostly A1+ or AAA rating so can I be sure that I am relatively safe.

    • DJ says:

      For at least two of the schemes (low duration and short term income plan), the credit quality has been “low” for the last year. As far as I can make out, the portfolio stats are updated at the end of the month, so I wouldn’t expect any changes in the interim. It is also unlikely that the portfolio quality as a whole will oscillate wildly from month to month, unless the scheme has a changing mandate, which is possible with new schemes or schemes with small AUM, but it would happen rarely (and gradually) for larger, well-established schemes with fixed mandates. Note that some of these “low” quality schemes have a mandate to invest in low quality debt. If the scheme can get 3% extra yield for 2% more defaults it will still be a good trade off. As a retail investor, we need to evaluate whether we are comfortable with that kind of a trade-off and whether we feel confident that the defaults won’t be more than the gain in yield.
      “High” quality schemes can of course also be affected by credit quality deterioration. For example, if a AAA bond gets downgraded, the scheme would have to get rid of it to maintain its high quality mandate and in doing so, it will have to sell at some loss, as the bonds will be worth lesser in the market. So, there will be some loss, but it is unlikely to be hit by losses due to default and sudden liquidation (usually, AAA paper will get a downgrade or two before defaulting, giving the scheme some time to get rid of it), unless we have 2008-type liquidity problems in the market as a whole. Sometimes a downgrade can cost a lot, as much as in a default. For example, if a good company (like lets say a HDFC or a TATA) gets a downgraded from AAA, you can expect the loss to be quite large. But, then, in those circumstances, there won’t be any place to hide except short term gilts. And, one would expect enough warning time before something like that happens to a AAA name.

  • Paddy says:

    Quating from Livemint.com
    ““JSPL is going through some tough times because of external factors like Chinese slowdown and the failed auction of coal blocks. It did not default on any payments to Templeton. Today’s sell off, therefore, seems to be a panic reaction by Templeton,” the above fund manager said.
    According to Manoj Nagpal, chief executive officer, Outlook Asia Capital: “The bad news on their fixed income side was getting spilled over on their equity funds too as there was a fear—from what I gather—of inflows slowing down in their equity funds as well because of all this. Hence, it was most probably a strategic move to sell off JSPL and get out.”

  • Viral says:

    And, which are the major banks mostly involved in loans to JSPL… ??