The downgrade in credit ratings of debt securities of DHFL to default grade threw up multiple issues for debt funds to grapple with, and protecting investors’ interest was principal among them. How have fund houses responded to this and have they done enough?
Mutual fund schemes that held DHFL bonds in the portfolio had to write down the value of the holding when the company defaulted on its obligations that were due on 4 June 2019. The standard haircut or write-down that funds have to take on investments that have become sub-investment grade due to a credit event is laid down by valuation agencies. Some funds wrote down 75% of the exposure as prescribed, while others wrote down 100% of the exposure to be on the conservative side.
For investors, this meant that the schemes’ net asset value (NAV) plunged, depending on the extent to exposure.
But writing down meant the units were now fairly and realistically valued. If there is any recovery from DHFL, then the schemes will be credited as and when there are actual receipts. But to benefit from any recovery from DHFL, investors have to stay with the schemes. Many schemes saw investors exit as NAVs fell. One consequence of this is that funds may have to sell the liquid and good quality investments to meet the redemptions, leading to a poorer quality portfolio. This is a risk for investors who choose to remain invested.
The write-down in the value of DHFL investments that was necessitated by the downgrade and the fall in the NAV hit existing investors. But it has brought bargain hunters into the picture. Buying units of the schemes that have seen a write-off at lower NAVs to benefit from recovery of any dues from DHFL and the consequent rise in NAV is the strategy that these investors are pursuing. However, this will dilute the benefit of the recovery for the earlier investors whose investments actually took the fall initially as they will have to share the payment received from DHFL, if any, with new investors.
To prevent this inequity, some fund houses, including DSP Investment Managers and BNP Paribas Asset management India Pvt. Ltd, have suspended subscription into these schemes.
Another measure that has been taken to prevent speculative transactions in these schemes that will hurt existing investors is to use exit loads to deter those who are looking at a short-term investment into the scheme to benefit from appreciation in NAV after any recovery from DHFL.
Fund houses like UTI Asset Management Co. Ltd have imposed exit loads on affected schemes to discourage bargain hunting and protect the portfolio from the early redemption by such investors who come in for short-term gains. The combined impact of exit loads and short-term capital gains may make such speculative transactions unprofitable.
Another measure for investors has been segregation.
In December 2018, the Securities and Exchange Board of India (Sebi) allowed fund houses to adopt the mechanism of segregating distressed assets to limit the impact on the rest of the portfolio. The DHFL issue was a textbook case for segregation, given the large exposure that many schemes had to these instruments and the significant impact the write-down could have on investors.
Tata Asset Management Ltd is the only fund house so far to notify the creation of segregated portfolios in affected schemes. The affected securities will be moved to the separate portfolio and investors in the scheme will be allotted equal number of units in the segregated portfolio as they hold in the main portfolio. The NAV of the main portfolio on the date of segregation will come down to the extent of the value of securities moved out but this will be made up by the NAV of the segregated portfolio. Investors can continue buying and selling units at the relevant NAV without any restrictions. As for the segregated portfolio, no fresh units will be allotted in it, ensuring that any recovery in dues will only be for the benefit of the investors at the time of creation of the side-pocket.
Any recoveries from DHFL will be paid out to investors in proportion to their unit holding. Investors cannot redeem the units of the segregated portfolio, but the units will be listed and investors who want to exit can sell on the stock exchange.
Investors affected by the downgrade will be looking for measures that will allow them to redeem at least some portion of their investments if they need liquidity, that will give them a shot at recovering the written down portion if the borrower pays up and ensure there is no encroachment on their entitlements.
Srikanth Meenakshi, co-founder and chief operating officer, FundsIndia.com, said side-pocketing is the most beneficial route for existing as well as future investors. “It provides a cleaner solution since it segregates bad assets so that existing investors have a chance to recover something when the repayment happens and new investors are kept from trying to take advantage of the situation," he said. However, he sees some of the provisions of the regulations to create side pockets as onerous, particularly the requirement that segregating should be deemed as a change in the fundamental attributes of the scheme. “This makes fund houses take the simpler route of suspending subscriptions and imposing exit loads," he said. “The option to segregate should be made a part of the SID (scheme information document) for all debt schemes," he added.
Segregation or creating a side-pocket appears to be the option that ticks all the boxes.