It all began with DSP selling a chunk of Dewan Housing Finance Ltd (DHFL) bonds at an inordinately high yield of 11%. That is roughly 3% above the normal yields that these bond quote at. That means the Rs.100 bond was actually sold at around Rs.82, incurring a loss of Rs.18 in the process. That raised the serious question, why would a large reputed fund sell bonds at such a huge discount. It immediately raised the spectre of a potential default by DHFL and soon it spilled over to the equity markets with the stock losing nearly 60% in a single day. Nearly a month later, despite all the clarifications from DSP and from DHFL, the stock still trades at a huge discount to its pre-crisis levels.
It all began with a corporate redemption request in the bond fund
When DSP MF received a redemption request from its corporate investors on the debt fund, the real reason was that the client was worried. DSP MF has a large exposure to the bonds issued by IL&FS to the tune of over Rs.600 crore, 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 triggered sell orders from treasuries. Such huge redemption requests are not normal and hence DSP MF needed to generate the requisite liquidity for the redemption. It could sell the G-Secs in its portfolio, but that would imply booking losses some bond market yields had gone up sharply. DSP settled for the other option to book the loss in private debt where there was anyways an element of risk. That is what DSP did when it sold bonds of Dewan Housing at a huge discount. This loss sale 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. It was not just about DHFL but other HFCs like Indiabulls and even LIC Housing were not spared. Typically, HFCs rely on the short and medium term bond markets to raise funds on a continuous basis.
IL&FS rating downgrade was the reason
The whole problem started when rating agencies downgraded IL&FS drastically the moment the default broke out. 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/or CP of 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. This was an outcome of the sharp deterioration in the risk profile of IL&FS.
Will the selling contagion spread to other mutual funds?
To begin with, other mutual funds will not be immune from this series of downgrades that IL&FS has faced. Mutual funds have a major exposure to IL&FS bonds, which were generally preferred by mutual funds for the higher yields that they offered. Total exposure that mutual funds have to the IL&FS is nearly Rs.2200 crores, which is not small by any standards. There are nearly 10 Fixed Maturity Plans (FMPs) exposed to IL&FS bonds in a big way. A default will mean that FMPs will not be able to provide quasi assured returns.
Will it impact other funds in the days ahead
Surprisingly, the mutual funds have shown a lot of resilience. Despite redemptions of nearly Rs.3 trillion from liquid and income funds last month, bond markets were fairly stable barring the occasional spurt in the bond yields. However, the problem could become more serious. Some 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. The Mark to Market (MTM) impact will lead to a sharp drop in NAVs. What really hit the mutual funds, as in the case of Amtek Auto roiling JP Morgan Fund, was the suddenness 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%.
For the first time, Indian mutual fund investors may see the risks of debt funds. Keep an eye on 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. As we write BOI AXA has written off its entire exposure of Rs.100 crore exposures to IL&FS this month. Now the action could get more intense!