Dejargoned: Mutual funds’ haircut2 min read . Updated: 07 Aug 2017, 04:08 AM IST
When a borrower or an underlying security of a debt mutual fund defaults, we hear that the fund took a haircut. Here is what it means
As more debt funds lend money to corporates—and especially those that follow a credit opportunity strategy—what happens if a borrower or an underlying company defaults? In this context, you might have heard the term ‘haircut’. What is it?
In August 2015, two debt schemes of erstwhile JP Morgan Asset Management Co. Ltd sank sharply on the back of a downgrade in Amtek Auto’s credit rating. In February this year, the net asset values of four debt schemes of Taurus Asset Management Co. Ltd fell 7-12% in just one day when one of its underlying investments, Ballarpur Industries, got downgraded.
When companies fail to pay interest, fund houses start writing off part of the asset’s value, starting 180 days after the interest payment due date. The book value is written off, and not just the interest component, because the assumption is when companies default on interest, they may default on principal as well. Thus, the slow and progressive write offs begin. Six months after due date of interest, 10% of asset’s book is written off, 20% after 9 months, another 20% after 12 months, 25% after 15 months and then remaining 25% after 18 months. If there is default of principal payment, the credit rating of the instruments falls to ‘D’ and credit rating agencies write off 25% of the asset’s value and stop providing the daily price to fund houses. At this point, the fund house’s internal valuation norms take over.
Debt funds have to value their underlying debt papers as per prices that two independent rating agencies provide daily. A drop in credit ratings changes the price of such securities. If a security defaults, then its price drops by 25% and that’s the last of it.
When Crisil rated JSPL debt papers to a ‘D’ in March 2016, the valuation committee of Franklin Templeton Asset Management (India) Pvt. Ltd decided to revalue the security at a further 10% mark-down. Soon after, the AMC bought the final tranche at the marked-down value. This difference between the final realised price and the original value is called the haircut.
JP Morgan Asset Management Co. Ltd took a different approach. It split its units into two parts: the so-called bad unit (with only the Amtek Auto scrip in it) and the good unit with all other instruments in it. It froze redemptions on the bad units till the time that it recovered its underlying value. Eventually, the fund realised 85% of the bond’s value. This was passed off to the investors whose money was locked in these side-pocketed units. In short, the 15% value lost was the haircut.
A third approach was what Taurus AMC took. It wrote off the underlying debt papers and decided to write back to the schemes’ NAVs as and when it recovers money from the company. This is a volatile approach as your debt funds’ NAVs could swing wildly.
In banking industry, too haircuts can be seen. Once an asset gets classified as a non-performing asset after an interest or principal repayment remains overdue for more than 90 days, banks start provisioning (setting aside its net worth to cover the loss) for such loans, depending on whether it is to be completely written off or to be classified as ‘doubtful’. Simultaneously, it starts the recovery process. The difference between whatever money—if any—a bank gets as against the loan’s original value is called a haircut.