The IL&FS knot and the effect on debt mutual funds

Over the last few days, there has been a lot of news and some noise over the 11th-hour downgrade of debt securities issued by some IL&FS group companies. One of the fallouts is that around ₹ 2,300 crore of holdings sitting in debt and hybrid mutual fund portfolios (August 2018) are now looking unstable.  

Roughly, ₹ 1,300 crore of total exposure in IL&FS securities was reflecting in short duration funds, including liquid funds that held around  ₹ 400 crore. After the latest credit downgrade to a rating of D, mutual funds have now had to write off half the value of these securities held across various schemes. And this is where it starts to get murky. After all, aren’t liquid funds the ideal alternative to your savings bank account with daily liquidity being one of its best features. Such a large write-off in the value of a security can lead to a negative return. As an investor, if I see even a single-day negative return from the fund to whom I entrust my emergency and contingency money, I will panic.  

Several comments around this issue on social media and in published columns focus on where the blame lies. Asset managers, advisors, credit rating agencies or even the regulator? Are the prescribed guidelines for valuing downgraded bonds enough when such cases appear? Should the regulator counter question the asset manager or the rating agencies?  

No one likes to take the blame for unforeseen outcomes and perhaps that’s why something like this is often termed as an accident. Unlike listed equity where investing outcomes as graded, in debt investments you will either get your money or you won’t—this binary nature exaggerates the immediate pain to an even greater degree. But rather than asking where the blame lies, let’s focus on where the change should lie. 

It is easy to say, in hindsight, that investors should stay away from funds that invest in such risky securities. But it is unreasonable to think that an average debt or liquid fund investor will be able to prematurely identify default risk. Advisors too aren’t analysts—what they can do prudently is check portfolio credit rating quality and concentration level. On credit quality, IL&FS group’s debt securities looked good till a month and a half ago. The rating rationale for IL&FS Financial Services Ltd was reaffirmed A1+ (top most rating—highest probability of repayment). However, as on 17 September, IL&FS Financial Services was downgraded to D. Securities issued by some other group companies were already under watch and some got further downgraded to below investment grade. Pre-empting this kind of quick ratings turnaround is understandably beyond the skill set of a financial planner or advisor. Moreover, barring some fixed maturity plans and credit funds, the exposure to IL&FS group securities was below 5% for most schemes.  

Can the onus be shifted to the asset manager who seems to have added more risk than needed? After all, shouldn’t an asset manager have internal risk analysis, regardless of the credit rating? Credit risk analysis is a relatively recent area of expertise within fund management; most credit risk funds have come up in the last five to six years. In the absence of a defined qualification, perhaps experience is what matters most here. 

Capital markets regulator Securities and Exchange Board of India (Sebi) has already prescribed the maturity limit and credit grade for different categories in debt mutual funds. If a scheme is not stepping outside of this and there is no fraud, one can only find fault in competence. Nevertheless, some responsibility lies with the asset manager. 

The severe balance sheet weakness, in this case, should have showed up in asset management companies’ own internal credit analysis; taking this risk in short duration funds and liquid funds is unforgivable—no matter what the official rating was. More so because collaterals and guarantees behind such deals can easily collapse in a negative environment. Active management is about the ability to identify individual investment opportunities, simply relying on what an outside agency says without verifying internally, is perhaps being lazy. In credit funds, this risk is acceptable and, to an extent, expected (it’s another matter, though, that till recently IL&FS Financial Services was a top-rated security, making it somewhat a misfit in a credit opportunities fund).  

This brings us to the rating agencies and the regulator. From top-rated to bottom-rated in a matter of weeks is a surely debatable rating change. One must question why the A1+ rating was reaffirmed in August 2018. Enhanced regulatory monitoring of credit rating agencies and their published ratings, maybe, is the biggest takeaway from what has happened. 

Plus, regulations don’t deny funds like liquid and short-term from taking on corporate bonds and credit risk, maybe that too is a gap that needs some filling, at least for the perceivably safe-and-stable-return funds.  

Eventually, market forces will take over and punish the incapable fund manager. In the meantime, don’t panic if you hold any of these schemes. Rely on the consistency of the fund manager and the asset manager. Just like you don’t expect equity fund managers to be right all the time, debt managers too get it wrong sometimes. Stay invested if their previous records show the ability to select good quality securities and consistency in performance. There could be interim pain but staying invested will be relatively better given that this is a single security issue; accrual income and gains from the rest of the portfolio will accumulate over time. Hopefully, capable fund managers won’t add more risk to portfolios simply to make up for lost returns.

Lisa Pallavi Barbora is a consultant with Mint