YES Bank, IL&FS scams keep debt fund investors on edge. What's the way out?

Their tolerance to NAV fluctuations has been tested once too often. Opt for high-quality, low-risk portfolios

“One should develop tolerance to net asset value (NAV) fluctuation. Sticking to fund houses that have seen several cycles and can ride through the marginal ups and downs, including noise levels, would be a good strategy,” says A Balasubramanian, chief executive officer, Birla Sun Life Mutual Fund. And investors’ tolerance to NAV fluctuation has been tested on several occasions in the past 18 months. For example: After the Reserve Bank of India superseded the YES Bank board and decided to write-off additional tier one (AT-1) bonds, five schemes of Nippon India saw their NAVs fall 9 per cent to 25 per cent in a single day. Schemes of other fund houses like Franklin India, IDBI and UTI Asset Management also felt the heat.
 
From September 2018, when the scam at Infrastructure Leasing and Financial Services broke, debt funds investors have been under constant pressure. Since then, many leading companies have either defaulted or delayed their payments to debt mutual fund schemes. These companies include Anil Ambani group, Zee Enterprises, Dewan Housing Finance and others.
 
The main worry is the frequency at which these credit events are happening. In such circumstances, what should debt investors do? Nilesh Shah, managing director, Kotak Mutual Fund has this advice: “Since there is no risk-free return, investors should invest in a debt fund after reading the offer document, fact sheet disclosing monthly portfolio and understanding credit risk, liquidity risk and interest rate risk of the portfolio. Most investors won’t have time for the same and hence should choose an appropriate distributor or advisor for financial planning.”
 
The latest problem with YES bank is a little different. With many of its loans turning bad, the bank needed to raise equity capital to meet regulatory norms. But its management failed to do so, forcing the Reserve Bank of India to step in and issue a moratorium. The draft reconstruction proposal included  State Bank of India’s infusion of  Rs 2,450 crore in lieu of a 49 per cent stake, initially.
 
What’s unique about AT-1 bonds: For debt fund investors, the problems are quite different. Usually, when there is trouble at a company, bondholders get paid off first. Creditors and equity holders get paid off later. But AT-1 bonds are not pure senior secured bonds. Their position lies between debt and equities. They pay a higher coupon than regular senior bonds. If the common equity tier 1 ratio falls below a certain threshold, the value of these AT-1 bonds can be written down completely. Any entity that takes over YES bank would have to take on the bank’s debt. It would be reluctant to do so if the bank’s balance sheet is loaded with debt, which is why RBI has proposed writing down the value of AT-1 bonds completely.

 YES bank has issued Rs 8,500 crore worth of AT-1 bonds of which about Rs 2,700 crore is held by mutual funds. All its other debt securities have also been downgraded to D or default status. Mutual funds hold another about Rs 100 crore of other (non-AT-1) bonds of YES Bank. The value of these bonds does not have to be written down completely. But the value of AT-1 bonds has turned to zero. Fund houses with large investments in YES Bank bonds have side pocketed them. Some bondholders have also approached the court seeking the conversion of debt into equity.  
 
Vidya Bala, co-founder, Primeinvestor.in, says: “Given that Yes Bank was facing issues and AT-1 bonds are riskier than regular corporate bonds, it is perplexing why mutual funds continued to hold on to them.” It is possible that fund managers may have tried to get rid of these bonds but did not succeed. “Once there is trouble at a company, it is difficult for a fund manager to sell the bonds of that company in the secondary market,” says Mahendra Jajoo, head of fixed income, Mirae Asset Global Investments. 
 
Existing investors’ choices: Investors should check how much exposure their fund has to these bonds. “If the exposure is large, and the quality of the remaining portfolio is also poor, then investors should cut their losses and exit the fund. But if exposure to these bonds is just 1-2 per cent, and the quality of the rest of the portfolio is good, investors may continue with the fund,” says Bala.
 
Side pocketing will be advantageous for current investors, like it happened in the Zee Enterprises case, which paid back after a delay.  “Even if you sell your units in the main fund, you will not book a permanent loss. If and when some positive resolution happens, that is, mutual funds are able to recover some money, you could get some value out of these bonds in the segregated portfolio,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India.
 
Strategy for investors: “As a thumb rule, investors who have lower credit risk appetite should invest in lower credit risk funds like dynamic bond fund, gilt fund and PSU debt fund. These funds manage interest rate volatility to generate a return. An investor who has risk appetite for credit can consider credit risk funds, which invest in lower-rated assets to generate returns,” adds Shah.
 
As far as selecting a scheme goes, Balasubramanian says that majority portion of an investor's funds should be in high-quality debt schemes that invest in papers between 6 months and 3-year period. “Given the fact that underlying instruments get reinvested on its maturity, the interest rate gets reset upon such maturity,” he adds. New investors should stick to high-quality portfolios. “The current environment favours high-quality portfolios and not aggressive ones,” says Jajoo. He adds that investors should also avoid funds that hold complex instruments, like structured products and AT-1 bonds.