The sorry shape of IL&FS has one set of people particularly worried. The CEOs of mutual funds, who are collectively holding INR3,000 crore worth of IL&FS debt, and are getting ready to mark the value down on their books.
After the equity sell-off in mid-caps and even large-caps, this is now another punch to the gut of these funds.
The bulk of the INR90,000 crore debt of IL&FS is on the books of insurance companies and banks, which failed to figure out the cracks in the balance sheet of the company for years.
The manner in which fund managers overlooked IL&FS’s debt is a cautionary tale about how debt markets in India aren’t as good as equity markets (which too are bad, but relatively speaking) at transmitting distress signals to investors.
Debt and equity markets are different
While the wisdom of the crowd works in the equity markets because there are all kinds of investors present in the market with equal and opposite views, pricing equity — especially large-cap equity — becomes easier. Large companies are liquid and are traded everyday on the stock market.
“Debt markets are not liquid. So, while I agree that there are no equal and opposite views in the debt market, we should look at debt like mid-caps which lack liquidity,” says R Sivakumar, head of fixed income at Axis Mutual Fund.
This lack of liquidity leads to one-sided opinions. For instance, a big opinion maker gets the largest say in the movement of a mid-cap stock. This could be a big fund manager or for that matter a broking firm which released the first report on the stock. The investors who buy the stock then look for information that confirms their action, leading to a confirmation bias and no opposite view being encouraged.
“In terms of inflows and outflows into mutual funds, the investor behaviour tends to be homogenous when there is negative sentiment. The issue of rollover and refinancing gets amplified with bad news,” says Arvind Chari, head – fixed income and alternatives, Quantum Advisors.
More than normal debt funds, he feels that credit funds need to analyse debt with a lot of rigour and forecast credit reports. Small- and mid-cap equity managers are good at making forecasts based on different scenarios.
Mid-cap stocks are story stocks where investors tend to look at the vision of the promoters and not at the underlying numbers. Fund managers who have done well in this segment are those who go on the ground, talk to dealers and suppliers to find out the real numbers of a mid-cap stock that are not readily available in the balance sheet. Within a few months of the research, the manager is able to see through the company’s spin and ideally change the view of the market.
Rating agencies are like 1970s police
In the case of IL&FS, the fund managers did buy the story of IL&FS and the importance of infrastructure to India. But they failed to go on the ground to talk to the subsidiaries of the company — both the customers and suppliers. And why should they have? What they had bought was not equity but debt. Debt which was rated AAA till the end of August this year.
Or so thought the rating agencies, entities that have been known to let their believers down more often than Shikhar Dhawan.
The other puzzling phenomenon is the rise of the high-grade debt in spite of troubles in infrastructure and other debt-powered sectors.
According to data available on the website of the Securities and Exchange Board of India (Sebi), in FY12 there were 3,182 issues by Indian companies which were worth INR9 lakh crore. Of this, 58% of the issues were of non-investment grade. In value terms, it was 5%.
In 2016-17, the total debt issued and rated was INR17 lakh crore through 1,204 issues. The non-investment grade debt was at 10% in terms of the number of issues rated. The amount for the same worked out to 0.75%.
In general, 80% of the total corporate debt issued is rated AAA. In 2011, this number was at 60%. This rise in AAA-rated debt is because companies are now more diligent in keeping their balance-sheet ratios profitable to get higher ratings or there is a chance that rating agencies are not very strict at analysing the companies. Most funds which invested in such a company thought that the reporting structure of the borrowers had improved, and nothing could go wrong with these companies.
Now they find it unbelievable that a company with the backing of LIC, UTI, HDFC, and Orix Corporation can default on its debt. LIC owns 25% of the company. “It was like a company with the backing of the government. But what investors fail to see is that LIC doesn’t own 100% of IL&FS. If LIC Housing defaults, then LIC will come and rescue it. It won’t do the same with IL&FS,” says a fund manager.
Aditya Birla Mutual Fund and DSP Fund held close to 50% of the INR2,283 crore debt held by the mutual-fund industry as on August 31, 2018, according to data sourced from Morningstar.
Some of these funds had concentrated their risk in IL&FS and its subsidiaries, with their holding as high as 9% of the total portfolio.
Yields were sending a signal“The IL&FS debt, which includes its subsidiaries, was always traded at higher yields compared to other AAA-rated paper. That itself was a clear indicator for a lot of questions. But then there were no comparative benchmarks,” says a debt-fund manager who had always found the company difficult to classify.
“What will you compare IL&FS Transport Networks with or for that matter the parent company with?” he asks.
IL&FS has a twin model — the company owns infrastructure and also finances it. At best, fund managers compare it with Srei Infrastructure. Others say that one can ideally look at a combination of IDFC Bank and Larsen & Toubro, but the comparison is difficult.
In such a situation, the only way to look at these companies is through the eyes of the rating agencies. Besides, most of the mutual funds were investing in shorter-duration paper and they thought there was no need to do too much analysis. But this attitude itself is wrong.
The quality of promoters was impeccable, but there was no one with any serious skin in the game. Besides, the consolidated balance sheet of IL&FS was available publicly from 2014, which showed that the company was eroding its net worth. Hemindra Hazari, a banking analyst, in an article has mentioned that IL&FS had been insolvent since 2014.
“Intangible assets which need to be written off from shareholder funds are the culprit, and the significant rise in such assets, which in all likelihood are the losses incurred in the company’s subsidiaries, clearly reveals the problem,” he wrote in his article.
The debt equity of the company was at 12:1 and the short-term debt was rising at a faster rate than any other finance or NBFC company. Nobody has any answers to why and how the rating agencies missed these basic aspects in the balance sheet. As of now, the rating agencies do not want to discuss this issue with the media.
But even if we assume that the rating agencies erred, why is it that the fund managers took the ratings as the gospel truth? Rating is only the first level of check and fund managers need to do their due diligence. But those who invested in the paper do not want to talk about it.
“On the debt side, the rating agencies dominate the opinions of the entire market just like foreign brokerages dominate the opinion of equity markets. If these companies give the best rating to any company for debt, or, for that matter, equity, then the entire market follows. Brokers are equivalent to AAA-rating agencies. And both of them have reasons to be biased, as the business is fee-based,” says an equity fund manager. And this happens to be the biggest problem in the financial market community.
So, what is the way out?
The answer is diversification. Portfolio construction works on a simple idea of diversification. But funds that did not diversify or took a concentrated bet on IL&FS have been badly hit.
Invesco India Credit Risk Fund has 7.73% of IL&FS Transportation Networks debt in its corporate-bond fund. Similar is the case with BOI Axa, which held 6% of IL&FS debt through commercial paper. These funds are now writing off the IL&FS debt in its entirety.
The net asset value or NAV of BOI AXA is down by 6.69% over the last month and the same is 7.88% for Principal Cash Management Fund.
While we can forgive all the funds for relying too much on rating agencies and not doing their own due diligence, can we forgive them for taking concentrated positions on the debt of a single company?
As a mid-cap fund manager sees the size of his fund grow, he doesn’t take concentrated positions in the stocks that he likes. He simply increases the number of stocks to invest in. The best mid-cap funds have closer to 100 stocks as the size of the fund increases.
In most cases, mid-cap fund managers do not take more money when they realise that they cannot manage the liquidity of the fund. They know that they deal in a one-sided market and in case the market falls, a lack of liquidity will lead to a serious fall, from which recovery will be difficult.
Sivakumar of Axis Mutual Fund likes to keep his investment philosophy simple. He avoids things that he doesn’t understand and keeps his portfolios well diversified.
This was also the reason why he decided to stay away from any debt issued by IL&FS. “It is a complicated balance sheet with a lot of subsidiaries. We found it difficult to analyse,” he says. He had tried to understand the balance sheet of the company a few years ago and realised that he had more questions than answers.
That is a pattern more fund managers better keep in mind if they don’t want to lose their investors’ money.
via Why Indian mutual funds took a big bet on IL&FS’s (good) bad debt – ET Prime
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