The RA-RE event hits debt mutual funds


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ICRA, the credit rating agency, yesterday made rating downgrades to two NBFCs, Piramal Housing Finance and Edelweiss Group companies. The reason cited is that they have a significant exposure to real estate sector.

The last 1 year has witnessed several rating downgrades. ILFS, DHFL, Reliance Capital and now Piramal and Edelweiss.

That is our RA – RE event. Rating Agencies – Real Estate.

Real Estate exposures are responsible for this stress at most companies, NBFCs and Banks.

Any rating downgrade for a company impacts its ability to raise / service short term or long financing. Usually, if the rating is downgraded, the risk perception goes up and the cost of fresh funds increases, which, in turn, adds more pressure to the company. Double whammy!

There is bigger fallout elsewhere too.

Mutual Funds take a hit because of rating downgrades

It is common knowledge now that several debt mutual funds have exposure to such NBFCs or Real Estate Lenders.

As per SEBI norms, if there is a downgrade in one of the debt instruments held by a fund, it is required to write off the value (in line with a predefined scheme). A Default rating means 100% write down of value, immediately. The fund’s NAV reflects that too.

A recent episode pertains to downgrading of DHFL bonds to Default rating, thus forcing all mutual fund schemes holding this bond to write it off 100%. Earlier in June 2019, about 10% of the NAV in UTI Treasury Advantage was written off. Any gains for one to two years were wiped off. Some of the recent investments were even looking at a loss of capital.

With the rating downgrades Piramal and Edelweiss, the schemes holding bonds from these companies are taking a hit too. The bonds are currently held by several AMCs – Franklin, UTI, Reliance, Axis, etc.

As of now, the rating downgrade is just a notch, say from AA+ to AA or AA-, and so the funds are taking a very small hit. If for any reason, there are further downgrades, there will be more write offs, which will decreasing the value of your investment in the fund.

What should mutual fund investors in schemes that hold these bonds do?

When investing in a bond fund / debt fund, I expect at least my principal investment will remain intact with a reasonable return. This is specially true for the short term variety – liquid, ultra short, low duration, etc.

The only way to do it is to be with funds that invest only in Govt bonds – short term or long term.

If there is any attempt to look for a higher return, the fund manager will step outside and add risk with corporate bonds. In fact, another category, Credit Risk Funds, as the name suggests, knowingly adds risk to the portfolio for higher returns.

So, then you ask – why do fund managers, with all the fees they charge, not do a proper assessment before letting any bond enter the portfolio? Fair question.

Well, my view is that good fund managers do their homework. Yet, they can make mistakes. The idea is to find out who is a repeat offender and stay away from them.

Of course, no one escapes the impact of a rating downgrade, even when the fund manager’s assessment may show that the money is coming back. As a market linked instrument, the write-off rules apply.

Will Piramal and Edelweiss repay the bonds and any interest on those they have issued?

If it serves any purpose, DHFL, despite the downgrade to Default rating, has been repaying its obligations in tranches. Will it be able to pay it all? We don’t know.

Let me say this. As investors, we are into rough waters. To redeem your investments now may be a knee jerk reaction.

What you should care about is the fund scheme you are invested in and your primary investment objective.

A bad scheme (if you are in one) deserves no chance. Get out while you can.

If your primary objective is capital protection and not higher returns, then you should not leave the money in a fund which seeks to generate a higher return (such as a credit risk fund). Take it out now. There might be a capital gains tax but you still get out before there is a bigger hit.

Put the money back into liquid funds that hold only sovereign bonds or use your good old fashioned Fixed Deposit.

However, if you are willing to stay put for the next 12 months or so with the right fund, it will may turn out to be a little rough but you are likely to get to the other side.

The post The RA-RE event hits debt mutual funds appeared first on Unovest.

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