The liquidity crisis faced by non-banking financial companies (NBFCs) is an isolated event and does not pose any systemic threat, Nimesh Shah, chief executive officer of ICICI Prudential Mutual Fund said. India’s ₹25.93 trillion mutual fund industry which has lent to NBFCs has received particular attention in the crisis, with questions being raised on the safety of ₹13.24 trillion of assets under management (AUM) of debt funds. According to Shah, the biggest outcome of the crisis is the focus on risk management and diversification. Edited excerpts from an interview:
The debt mutual fund story has taken a hit in the past one year after the IL&FS crisis, where funds have been questioned on credit risk and valuation. How do you view the current loss of credibility?
We are of the view that NBFC crisis is an isolated, individual company event and does not pose any systemic risk. It is important to note that the concerns pertaining to each of the debt papers under question is confined/limited to specific schemes within select fund houses and are not at an industry-wide level, as it is being largely perceived. This can also be gauged from the fact that financial index as on 13 June has delivered 16.26% and has outperformed the benchmark index Nifty, which generated 9.74% over the last one year. We have always believed that credit rating is one of the inputs in investment decision, but not the sole determinant.
Two key tenets of our credit decision-making have been the focus on client selection and avoiding concentration. This discipline has helped us not to overly rely on credit rating and has helped us avoid potential problems, considering that, till recently, many of the credits currently under stress, carried the highest safety rating.
What is your view on the recent credit events, downgrades, defaults and delays in repayments by NBFCs?
If we look at some of the recent credit events, they had the following broad characteristics:
• Borrowers had relied upon short-term market borrowings to finance long-term use of funds which resulted in liquidity mismatch, thereby exposing them to increased refinancing risk. Increasingly, the borrowers are taking measures to address these issues through diversification of their liability mix and reducing excessive reliance on shorter term sources of funding.
• Credit spreads on the bonds issued by some of the issuers were significantly higher than similar rated papers. This was clearly pointing towards the growing divergence between the credit standing as suggested by the ratings provided by the rating agencies and the market perception. Thanks to the rating downgrade, some of these anomalies have got addressed.
• Lack of transparency and/or adequate disclosure for groups with complex group structures created challenges in assessment of credit profile of the issuers.
Do you think these credit events have settled down now? How have mutual funds adapted to these? And what sort of an impact the so-called NBFC crisis has had on debt funds?
We have seen that systemically, some of the credit issues have been addressed or (are) under the process of being addressed. We believe the panic phase has run its course. Most of the headlines have been negative around debt mutual funds and so the sentiment around investing into debt mutual funds has turned negative.
The biggest outcome of these developments has been the focus on risk management and portfolio diversification in debt funds. These events have also highlighted that just as volatility is an integral part of equity investments, rating upgrades and downgrades are part and parcel of credit investments. There is a need to differentiate between various ratings downgrades. A downgrade in credit rating from “AAA" to “AA" has entirely different connotation than that from “BBB" to “BB". We need to appreciate that despite the downgrade, a AA rated credit continues to belong to relatively high safety grade.
While the asset (investment) side of the mutual funds has been under scrutiny thanks to recent events, what is important is to maintain granularity in liability side e.g. in ICICI Prudential Credit Risk Fund, we have a limit of ₹100 crore stipulated on investment from single investor.
Focus needs to be on ensuring adequate diversification. This ensures that even under the event wherein liquidity of a particular instrument gets adversely impacted, the overall scheme level liquidity does not come under stress. There has been a flight to better managed funds. As can be seen from the monthly data, investors have moved on to funds with better risk management practices.
Do you think that mutual funds are highly exposed to papers of NBFCs and should the slant change? If yes why? If not, why?
NBFCs are an important part of the financial ecosystem. Within the NBFC space, there is a wide variety of companies operating in this space, of which some of them are backed by a strong corporate group or a bank. For example: There are companies which operate in two, three and four wheeler space, housing finance, infrastructure finance, gold loan etc. Each of these companies possesses a unique business model.
Within these companies, there are specific pockets which are under stress while for others, it is business as usual. What is important here is to distinguish which of them possess a strong liability franchise.
We believe the current crisis should not be a deterrent when it comes to investing into well-managed NBFC papers. At ICICI Prudential AMC, we have increased our exposure to NBFC names which are backed by banks or strong corporate groups.
How has the debt fund strategies changed in the wake of these back-to-back setbacks?
At ICICI Prudential AMC, our risk management processes followed has held us in good stead till date. But, as an industry, the current debt market situation has sharply brought into focus the importance of robust risk management practices. Our credit due diligence considers both qualitative and quantitative factors, which has helped us navigate the credit ecosystem soundly. The risk management team is independent of the investment team and does not have any return targets.
The biggest puzzle was on valuation of debt funds. Association of Mutual Funds in India (Amfi) has come out with a valuation methodology; is this binding or optional?
The valuation methodology put out by Amfi provides uniformity in the manner in which the valuation of a debt fund is carried out by all fund houses. Despite the bond market being highly illiquid, the valuation practices followed by the MF industry is one of the best. Within various industries, the MF industry is the only one where valuations are done on MTM (mark to market) basis and with inputs from valuation agencies; an investor should derive comfort from this fact.
Sebi is working on a radical thought of having an SLR mechanism for debt funds to ensure liquidity buffer for investors. Your thoughts on this?
The SLR mechanism is a step forward to insulate retail investors from losses in case any of the debt paper held by liquid funds comes under stress. We believe this is a positive development in the interest of investors. The processes followed by ICICI Prudential AMC ensure that there is sufficient liquidity for all its investments.
At a time when credit risk funds have been shrouded in negatives, why do you have a buy call on this category? What is your investment rationale?
Currently, credit risk category of funds is facing reduced inflows owing to negative sentiments (NBFC liquidity crunch), but valuations are attractive at current levels given the elevated yields. We are of the view that the risk-reward benefit has turned favourable and it’s a good time to earn the carry with high credit spreads available in the corporate bond space.