“Historical events occur twice — the first time as tragedy, the second as farce,” quipped Karl Marx. Recent developments in the mutual fund industry have made this quote little more serious than just a wisecrack.
The first ever scheme launched by the mutual fund industry was the debt-based US-64 scheme — a balanced fund that became popular among investors for regularly delivering a high-dividend. However, the stock market rally in the early nineties whetted the risk-appetite of the fund managers, and the equity portion in US-64’s portfolio rose to 64% in the late nineties from a mere 26% at the beginning of the decade, even as investors expected assured returns from the scheme.
As they say the rest is history: the stock market rally came to a screeching halt in 2000 owing to the dotcom bust. US-64 faced heavy redemption pressure. Amid the sharp depreciation in its investments, it became difficult to maintain the liberal dividend policy. Everything that could go wrong, went wrong with US-64. Faulty investments, lack of transparency (US 64 disclosed neither its full portfolio nor its net asset value), and lack of investor awareness about the nature of the beast. US-64 came out of the crisis with a helping hand from the government.
Fourteen years later, the parallels between issues around US-64 and the recent troubles at two debt schemes of a renowned AMC are hard to miss, albeit the scale is far from comparable — after all, at that time Unit Trust of India was almost the entire mutual fund industry, with US-64 being the star fund. Today, debt funds have ₹820,000 crore of assets under management, held across a smorgasbord of categories and less understood products. Even as investors have largely considered debt instruments as “safe”, the Amtek Auto case once again highlights the dangers of such a belief. Fund managers are taking more credit risks to deliver higher yields in what is a highly competitive marketplace. Products such as Credit Opportunities Fund are being floated precisely for this reason. These schemes invest in corporate bonds across all investable grade including double A or lower.
As of FY15, Indian banks had ₹302,000 crore in gross non-performing assets. Averse to the idea of further adding to this number, banks are treading with caution as far as corporate lending is concerned. That avenue restricted, corporates with a weak credit profile are tapping the debt market to raise funds. And that is how your mutual fund is ending up with exposure to double A or lower-rated corporate paper. In an environment where analysts, economists and business media are still debating whether India is on track for an economic recovery, the credit risk in a lower-rated corporate bond can’t be ignored.
House of tinder
Some serious trouble may be brewing. According to data from Value Research, the mutual fund industry has an exposure of more than ₹18,000 crore to the power and steel industry. While mutual funds are no banks, their portfolios have some names which have been a cause of worry for Indian banks.
Falling steel prices amid declining demand and rising imports have put the sector under stress. So much so that analysts argue that some steel companies should be allowed to go bust so that the overcapacity is dealt with to some extent. With 48% of the steel sector having a debt/Ebitda greater than 12X in the first quarter of FY16, and that metric for the entire sector being greater than 6X, analysts worry about their ability to service debt. Besides, the stress in the power sector is expected to continue unless government brings in reforms. Weak demand is a concern even as coal availability is at an all-time high.
In this backdrop, if one takes a look at the gearing of companies that debt fund schemes have exposure to, the credit risk seems acute. Their combined exposure to Adani Power which has a debt-equity ratio of 7.8X stands at ₹1,985 crore. Exposure to Adani Enterprises which has a gearing of 3.2X stands at ₹1,203 crore. For Tata Power, Tata Steel, Jindal Saw and Jindal Steel & Power which all have debt-equity ratio of more than 2X, the exposure stands at ₹5,094 crore. All this only means that default risk is a clear and present danger.
But, the debt fund investor is never explicitly told what he is buying into. “The investment objective of the scheme is to generate regular income and capital appreciation by investing predominantly in corporate debt,” this is how the investment objective of a Credit Opportunity Fund reads. In fact, amid the expected fall in interest rates, there seems little room for taking credit risks for investors. For instance, Gilt-Medium and Long-Term has given returns of 3.19% in the past three months and 13.2% in the past one year. Other debt categories such as Short-Term, Liquid and Credit Opportunities Fund, have given returns of 2.15%, 1.91% and 2.1%, respectively.
Theoretically, there may be a case for debt funds in India that take aggressive credit calls, but there is ambiguity about the market value of these bonds as they are not actively traded. While credit calls can be rewarding, they are also fraught with risks almost similar to equities. Under the current circumstances, Dhirendra Kumar, founder, Value Research, believes that investors should stick to government bond funds and avoid the credit risk prevailing in corporate paper. Investors can take a duration call in government bond funds as with each passing day the clamour for a rate cut is only getting louder.