Debt funds affected by defaults since the Infrastructure Leasing and Financial Services (IL&FS) debacle last year now have some guidance on handling below investment grade paper.
The Association of Mutual Funds in India (Amfi) has issued guidelines to the industry on how fund managers should write down debt and take haircuts once a paper falls below investment grade.
Haircut is mutual funds writing off the principal amount and the interest in case of a default. This then reflects in the net asset value (NAV) of schemes.
Amfi has suggested lower provisioning for secured debt of infrastructure and real estate firms, hotels, hospitals and the contentious so-called loan against share or LAS paper.
According to Securities and Exchange Board of India (Sebi) guidelines, any security which has a rating below BBB- is considered to be below investment grade.
Due to lack of standard practices so far on how to treat below investment grade paper, every asset management company (AMC) and fund manager used to write down or decide on haircut on their own.
“This will bring about uniformity in the valuation of distressed securities across the industry. It also brings about a level of fairness, as the tendency to delay or defer creating provisions in the hope of recovery will be contained," said Mahendra Kumar Jajoo, Head, Fixed Income, Mirae Asset AMC.
This Amfi direction to AMCs comes after a Sebi circular on 22 March. The circular asked Amfi and the valuation agencies – Crisil and Icra Management Consulting Services Limited (IMaCS) -- to develop a valuation methodology for such paper.
The industry body and valuation agencies are yet to finalise the methodology. In the interim, Amfi, after working with the valuation agencies, has issued a circular prescribing haircuts that funds managers should take for such paper.
A copy of the circular has been reviewed by Mint.
“Members are requested to adopt the attached Standard Hair-Cut Matrix for sub-investment grade debt securities till such time the valuation agencies compute the valuation of money market and debt securities classified as below investment grade," said Amfi in the circular issued on Friday.
While devising the haircuts the industry body and valuation agency have taken specific care of sectors.
“In certain kind of debt instruments and sectors the recoveries rates are higher. For instance, we have proposed a lower haircut for secured debt. We have proposed as high as 100% haircut for D-rated instruments of traders and gems and jewellery companies as the recoveries are almost impossible," said an Amfi member who did not wish to be named.
According to R Sivakumar, Head Fixed Income, Axis Mutual Fund, this measure will reduce arbitrariness.
“The new regulations are based on recovery rates in particular sectors and are hence are more scientific. This move by Amfi will bring about greater consistency," he added.
A fund manager with a mid-sized fund house said where the security in question is also traded in the market, the lower of the traded price and the haircut will have to be considered. If there is a subsequent recovery in the paper, the recovered value will get added on the maturity of the paper.
Interestingly Amfi has suggested lower provisioning for the contentious LAS schemes or paper. For secured debt instrument with shares as underlying for a default-rated instrument the proposed haircut is 50%. For unsecured it is 100%.
Recently, LAS schemes have faced criticism following a collective decision by fund managers to not sell shares of Essel Group.
In January the Essel Group companies, to which mutual funds had lent a combined ₹7,000 crore against debt securities, neared a payment default. The funds agreed not to sell the pledged promoter shares until end-September on a promoter’s guarantee. This standstill agreement has affected payouts in fixed maturity plans (FMP) of Kotak Mahindra AMC and HDFC Mutual Fund.
As of March 2019, Zee Media Corporation Ltd has pledged 93.84% of promoter shares. Another group company Dish TV India has pledged 94.60% of promoter shares.
Mutual funds have an exposure of over ₹51,000 crore to these LAS schemes or paper.
Dhawal Dalal of Edelweiss AMC said the Amfi circular is a guidance and not binding and MFs can still take a more aggressive or conservative haircut.
“In the absence of any robust statistics on recovery the guidance on markdown appears to be a stop-gap arrangement rather than a final version," pointed out Dhawal Dalal, CIO, Fixed Income, Edelweiss Asset Management Company.