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Today’s episode, the very first, is about the concern in debt markets and the hit that debt mutual funds are taking. We’ll talk about:
Shray: Hi everyone, we are recording this from our brand new Capitalmind office in HSR layout, it’s Google maps and Swiggy findable. So , anyway Deepak interesting stuff happening in the world as always but this time it is in the space of Debt so what’s happening with Debt Mutual funds they are not going up & some people on the internet are using four letter words like “LOSS”.
Is this really happening?
Deepak: Yeah, Shray I think you know the chickens have come home to roost in a way we had situations where Debt Mutual funds which were considered to be the safe investments but have now getting into this territory where there actually losing money and not really because interest rates are going up but because the underlying bonds that they have bought are actually coming to a point where they can’t return any money. You have seen that happened in I&LFS September where IL&FS was considered to be this Triple A fantastic debt , lot of mutual funds held it lot of companies held it and then IL&FS turned out that to be bankrupt in more ways than one and now any fund that held IL&FS debt, IL&FS bonds is seeing that IL&FS is not returning the money and therefore their investors effectively lose money because their effectively channelling the investor’s money into these IL&FS instruments and some of because if they have a 5 % holding in the IL&FS bond, the IL&FS mutual fund has now lost 5% because IL&FS hasn’t been able to payback anything so far . The situation is weird, it’s strange but it’s evolving it’s also coming to a point where India’s coming to terms of the fact that a lot of debt that has been taken is probably not sustainable & not just have banks have seen the damage now mutual fund investors have seen the damage as well.
Shray: Alright, So let’s just get to the nuts and bolts, How does a Debt mutual fund lose money I mean both now and in general and why this is happening now?
Deepak: Yeah ,so you know Debt mutual funds haven’t always been safe in the sense that you , there is a potential of loss of capital because you put your money into a fund when the fund invest in something and something value can go up or down you have seen that in equity but debt as well can see prices go up sometimes because let us the say the market interest rate falls when they do the bond becomes more expensive it’s an opposite effect so if market interest rate falls bonds become more valuable when bond becomes more valuable you will see an appreciation in the prices of those bonds which will reflect in your mutual fund value. Now, if interest rate were to go up for any reason market interest rates this means that the bond values will fall if the bond values will fall then I if I hold bond and I bought it at a Rs100 for today the buyer in the market is only willing to pay Rs 90. I have a 10 % fall in the bond value that I hold and a mutual fund can hold hundred to two hundred, five hundred different bonds and if some of them start to fall in value, the mutual fund as a whole can actually be seeing a loss that it reflexes is called interest rates risk but the other big problem if it holds 500 bonds for instances may be that a few of these bonds don’t return any money and they won’t return any money, you end up with the situation where that much percentage of your fund which is invested in those bonds is suddenly at risk. So if you lent a Rs100 out to a person who is not giving you back anything that’s Rs100 you is no longer have so your you lose Rs100 out of Rs5000 you invested in the bond. So your bond value falls by 2%. This is Credit risk. So effectively an IL&FS were creditors you gave money to IL&FS but IL&FS didn’t return anything back so until it does return anything back you are literally down how much ever you have invested in IL&FS. IL&FS may return money or may not now this becomes subjective because at some point debt mutual fund has to have some regulations around when it takes losses and when it doesn’t. SEBI prescribes that if your bond is investment grade that’s fine you can use the valuation matrix provided by the Crisil or one of the provider, if it falls below the investment grade that means there are investment grades like AAA, AA, BBB but when it fall below BBB to BB or B or C you end up going down at least 20% in values so the bond was bought it for Rs100 you are supposed to marketed it at 80 the idea here is that something below investment grade you may not recover the full 100 from that investment so you mark it down by 20% .You can mark it down more if you like but you have to mark it down at least by 20%. If the bond goes into default which means it got it’s interest payment due or principal payment due and hasn’t paid anything you have to take a 50% hit. A lot of people did 50% for IL&FS and later they found that IL&FS is not paying back anything and then they took another 50%. So a Tata short term bond for instance or Tata corporate bond a few days back took a 50% hit because earlier it is taken 50 % on whatever it owned in IL&FS it has about 10% of its investments in IL&FS. So that’s again the problem we coming to what’s happened now is that a lot of funds have found themselves you know swimming naked when the tides running out. We thought mutual fund will diversify we don’t buy mutual fund unless it has 50 stocks or 70 stocks so one particular stock falling would not affect it so much. You would assume the same would happen with Debt mutual fund why would you concentrate your risk on one company or two companies owing 15% of your assets but mutual funds have done it they have actually lent something like 5%,10%, 15% to one company or group. In that process what’s happened is your funds have become concentrated you aware of the 15% exposure but their is just a conduit you are the one whose lending effect you are the bank in this case so what’s happened at this point is that because you have 15% concentration in IL&FS if there is a loss like they said they went into default, when they went to default you saw a 50% hit that means if you have 15% of your fund you saw a 7.5% cut in your investment NAV. After they realise they couldn’t get anything back from IL&FS you saw another 7.5%. So it would be 15% hit that has happened to you as a investor because your fund has chosen to concentrate it’s investment in companies like IL&FS Sometimes it’s not the same entities IL&FS .it’s IL&FS investment Managers IL&FS something else multiple companies of the same group the whole group went bankrupt nothing you could have predicted one year back perhaps if would have happened it left a lot of mutual funds too concentrated in a certain set of securities. Happening now again with Zee it’s happening with DHFL a lot of mutual funds concentrated themselves in these bonds a lot more than they would have liked typically i would have send any fund should have 120 different or 100 different say securities. So you are not exposed more than 1% to the same group may be 2% because you have taken two companies but most funds have 4-5% in one single investment and that could provide concentration skill sometimes they’ll have 4% in one 3% in another company of same group .So when the group gets impacted you get impacted big time this is what is happening now and that’s why mutual funds are seen those four letter words and you know even four letter word IL&FS and DHFL and all of the other things start coming to play.
Shray: Why is this happening now ? What’s changed?are we just unlucky?
I think the history is quite interesting people went to mutual funds primarily to save themselves on taxes , fixed deposits were taxed at about 30%on marginal income rate , capital gains tax applies to mutual funds so as a debt mutual funds hold you don’t have to pay any taxes on any gains until you actually exit that fund so a lot of people move d their money to debt mutual funds but at the same time they weren’t really aware the risk is there the fixed deposit if you give a bank a fixed deposit the bank lends that money to somebody else and the somebody else defaults the bank picks the hit your fixed deposit is safe and mutual fund just on lent so which means that if the defaults happens by the end person who is buying the bond whose the bond is given to you are at risk you are the bank. The knowledge of this has not been wide spread and mostly these things are being sold as safe and extremely safe investment. However, what’s also happened is because mutual funds saw so much money coming in they start chasing years. So a lot of yield chasing meant that the companies didn’t deserve to get in me money couldn’t borrow from banks they couldn’t borrow from other sources they have gone and borrowed money from the mutual funds Mutual fund are happy to lent them as long as they were able to return the money and a lot of them borrowed money with these using companies that didn’t have any operations they just borrowed a promoters of the company wanted cash or whatever reason sometimes set up their own venture or how to do some other kind of investments which are not related to the main company by using their own company’s share as collateral but apart from the collateral the mutual funds had nothing else there were no cash flows those businesses which were borrowing money .So there were what would happen was they would borrow the money run for four years there would be no need for cash flow because they got something called Zero Coupon bonds, Zero Coupon Debentures ,where you don’t have to pay any money until the end it’s a cumulative large interest component and at the end you may get the money back but it’s actually a rollover so what happens is they issue a new bonds they use the new money to pay back the old money this a sort of a ponzy but idea is as long as the shares they have as collateral you don’t have to care except in zee’s case you found out the hard way that they do have to care they have 9000 to 12000 Cr share capital has been pledged They can’t even sell 200 Cr worth of shares with dropping a price by 30% that is scary because you have collateral that if try to actually sell hat collateral anywhere close to the value that you have lent and if you don’t get the value you have lent then you are not gone get anything else because the company has no other cash flow. So you end up with the situation where mutual only thinks that the things that the collateral but they really don’t and that situation is compounded there is DHFL has cash flows but you are not sure how they are there is IL&FS not have cash flows and has assets but you can’t sell those assets like you can’t sell a road overnight it’s gonna take you 8 months , 8 months you are not going to get any interest on the investment that you have already made because all they are gonna do is try to payback what they should have paid a year back and these are the complications of debt markets in general you are facing what is called a Credit Risk issue and it’s boomeranging now because IL&FS now has caused a problem mutual funds didn’t rollover debt or didn’t want to rollover debt why? Because the investor saw a losses and when investor see losses in mutual funds debt mutual funds they take the money out and put in the fixed deposits in banks if mutual funds don’t have the money they can’t rollover this mutual funds bond that are borrowed by promoter companies because they don’t have the money they need the money back the promoter companies same time do not have money to pay back in the first place they always expect that they could refinance without refinance available you suddenly have an issue like ZEE, ZEE cannot repay and some other try to sell the share s fall 30%. Suddenly everybody is aware of the problem because their collateral is not worth what they are known is at this point and suddenly and this system tries to break apart.
Shray: Now, that you say this, so let put may be a global context or from a different era, can you share an example of may be when something like this has happened in India or abroad at a different time frame?
Deepak: Yes, credit risk was what started of 2008 price as if you look at 2007 July nobody thinks of that is the beginning but that was when 2 Bear Stearns funds funds which were invested in subprime securities “Broke the buck”. Broke the buck is effective in USA means they took a loss. Now money market funds are funds which invest in very-very short term debt and they lost money. When they did in July you saw whole tumble happened in the space around subprime debt this subprime debt balloon-balloon even further to a point where Bear Stearns collapsed in January 2008, that was 7 months later. Once it collapsed, it was forcefully sold to JP Morgan but that collapse had add problems entreasured system a lot and then create cascading effect downward in all the way point wise lament pass the system of USA is much more lee word of course 30X, massive derivative exposure we don’t have that kind of crisis here yet but the credit crisis triggered this they’re been multiple credit crisis. Credit crisis 1992 in USA called the saving and loan crisis where banks failed or saving non-banking lenders failed and you had a big crisis that required rescue from the FED. In India, we had crisis in 2000. Well, we had multiple layers so you had individual banks are went through a crisis but a credit crisis of some short which there in 2013, Where we saw interest rate spike up to 9-9.5% created problems in 2016 when there was demonetization a lot of micro finance borrowers defaulted on n lot of micro finance NBFCs which meant that had effect on their crisis we seen these in the past. Some of them how potential to bloating out because some firms can be so badly over leverage that if you take away their ability to borrow they are finished. Exactly what happened in Lehman, Lehman was fine until they could rollover loans. The minute they couldn’t rollover loans they were bankrupt. It was literally that one day they couldn’t rollover that they were bankrupt. Enron similar situation, Enron was a fraud but as long he kept rolling loans it was fine when people figured out it was fraud they didn’t rollover loans then it was finished. Lot of Indian banks and Indian NBFCs are potentially on the territory of either people think they are fraud or refusing to rollover loans for any other reasons and if they are not well capitalized they can end up going burst. So, that we are I don’t think it was happen because RBI on this case they are going to truly help change things soon because a systematically important lenders anybody is more than 10000 crores of lending is not going to be allowed to go down without a RBI coming in trying to rescue there.
Shray: So, I mean these are not very reassuring comparisons. So just bring it back to target audience- customer and investors. So investors in these mutual funds and then customer what do we do. How do adopt just new reality?
Deepak: So, I think the reality is that there is risk in mutual funds we have to understand we are the bank and we are lending to mutual funds which are investing in debt. It is our job really to make sure that we understand what kind of risk we can take if we can’t take any risk we shouldn’t be invest in mutual funds. We should also be demanding in the sense that if something called overnight funds. Overnight funds carry very little risk because whatever is invested in the evening and the money comes back to the mutual funds in the morning. So the risk of that because it happened in RBI govt. platform of is relatively low or very low. However risk start appearing in say liquid funds in more ultra-short term funds. We should assume that is zero risk that they will be some risk. Now these are funds called ultra-short bond funds. It’s been a phenomenal performer 9% average 4-5 years but it has had two situation where it lost money in the past and there was a default by Jindal steel which have made in taken 25% hair cut on those bond because he hit to the fund was smaller it was probably less than 1% but the fact is on the day you lost something which was little bit less than 1 % but you did lose money then the fund off course after that it took that hit it was able to recover from remaining set of investments but you are Ok with it but this the best performing ultra- short term funds that has seem credit event hurtled in the past the good thing it was relatively small position so it was 2% position and you lost 25% of the 2% position your hit was only 0.5% . If ILFS was 2% position in most of the mutual funds you would have not been so unhappy. However where is 15% position is too much so your job as an investor also make sure that your investment not only that you understand your own risk profile but the investment that you do in mutual fund those mutual fund should have diversified if they haven’t you need walk away from that investment you need monitor this every month that’s why you should invest in 40 funds because if you do you know we track all of them so invest in few funds and make sure that you understand the diversification within that your job is also to help identified what you need not to diversified for in the sense if have 40% govt. debt I am fine because the govt. is unlikely default if the govt. default we have bigger problem than what we are talking about so I don’t think that is useful diversification to say listen don’t have 40% govt. debt that if you want to go ahead. If you haven’t 40% in any single private company or group or even 20% or in fact even 15%. So, I would say PAT exposure that 5% max and try and ensure that your fund lives up to that promise they have the ability to move things around and from your perspective you should understand that when you as a collective 12,00,000 crores to corporates through mutual funds. It’s very likely that 0.5% and 1% of 8 will go bad. If you see something go bad of the order 1000-2000 Crores but remember 1 % of 12,00,000 crores is about 12000 crores. So we should expect that they will more damage and that’s there is more to come. So, don’t invest assuming things are going to be safe invest assuming that you will get a higher return but only if there is higher risk in this is the way risk is hitting right now.
Shray: Alright, the risk of making a prediction how do you see this panning out in general. I mean going forward.
Deepak: So I, you know interestingly I think markets don’t have a lot have patience in fact many people who invested with safety in mind I going to pool their money out. So what going to happen is going to be discerning investors who left behind who will be able to take this kind of risk on their balance sheet who will be able to give money and say listen even if you have a little bit of default I don’t care because I am going to be in fund another 3 years.
The second part of this equation is that people are going to find difficult or unlikely another going to mutual fund. Give money to mutual fund who invest in these Zero coupon bond by this promoter companies. I think that source of financing for promoters is going to be top is going to be go of whether we like it or not is probably not a great thing for stock market because lot of this money it was borrowed has found is way back into stock markets through some either operator or something others but it is good things because this was not supposed to be how, it is not how market supposed to be used funds borrowed by pledging and go buying more of your own share which is just little too complicated but I don’t think this is right way that promoter company should done this. I don’t think they were going to get be more funding.
The third thing in the bond market is that we have some semi rules and some govt. rules required in any incremental funding to be 1/4th from the bond market. Which means by the middle of this year where going to be lot of issuer may be because 12,00,000 crores were chasing bonds and you didn’t get enough issuers. The mutual fund were attempted to give it to the promoter companies. But the minute you have good companies MRF, CEAT may be L&T borrowing through the bond market more rather than borrowing directly from banks that mean you have more quality issue that available if quality issues are available why would go and take money from L&T . L&T is borrowing cost still 9%. I am happy to lend from L&T at 9% in the bond market except L&T was in bond market. It was there but it was too small issue. Now you end up with more capacity into bond market, mutual fund have more things to subscribe so. The profile of investment will change and the profile of investor will change to get more debt where investor vs debt . You are also get lot of more high quality cashflow based companies issuing debt in the debt market Vs non cash flow based, collateral based bond that is currently available. So, Largely I feel that is good thing for the market as an evolution during that phase we going to see term oil whether I like it or not things are going to look like the end of the world and then things are probably come back. I hope we not as badly leverages it was when Lehman was around perhaps worst one is around those were entity is levered 30x todays is the worst is probably DHFL levered 10X . JM or Edelweiss are levered only 2 or 2.5 times, Piramal is levered less than 2 times. So these are companies tremendous amount of capital. Even you shut the amount of capital market for a short period they are not going to go under because they are leverages substantially lesser. So, I think system is little more resilient was earlier however you do know that disappoint things are in flux so we are going to see someone lender go under simply because they can’t grow some merger and acquisitions and this will actually in good things for bond market. It’s in the end for bond market investor however in short term I say as a mutual fund investor going there look it what you invested in if you don’t like walk away because the risk is there it’s present and you shouldn’t be if you don’t understand the risk and at the same time if you understand the risk stay in. This is the market that will reward you in the long term because as interest rate go down bond market is one where money is going to be made.
Shray: So, that is the actionable advice for these interesting time on that note I think good to wrap up today this show. So, Thanks very much to listener. it will always read more about Deepak shenoy and the rest of our team. Capitalmind .in.
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