Over the past week, IL&FS and its group companies have been in the news, not for the right reasons, but because its long-term debt and Commercial Paper (CP) witnessed sharp downgrades in ratings. The downgrades were swift and very drastic.
The long-term ratings of the parent entity IL&FS were downgraded multiple notches from AA+ to BB on September 8 and then to D on September 17. The short-term rating was downgraded from A1+ to A4 on September 8 and then to D on September 17. Similar rating actions were witnessed across debentures and/or CP of several other group entities – IL&FS Financial Services, IL&FS Tamil Nadu Power Company Limited, IL&FS Energy Development Company Limited, IL&FS Transportation Networks Ltd and IL&FS Education & Technology Services Ltd.
The primary reason for the downgrade was deterioration in the overall financial risk profile of the parent company - IL&FS was seen weakening on account of the group’s elevated leverage levels and moderation in credit profile of key business verticals and a default in the repayment of maturities of an Intercorporate Deposit due in early September. This then had a trickledown effect to the other group companies, which were accorded a rating with comfort on the parent entity.
While IL&FS is in talks with its shareholders for infusion of capital and liquidity through a mix of rights issue and long-term line of credit, which should take away some of these issues, there is currently a huge overhang on the company and its prospects with the capital raising talks yet to fructify meaningfully.
The impact on mutual funds
A total of 12 AMCs across 32 funds (including 9 FMPs, credit risk funds, duration funds, liquid funds) held an aggregate exposure of Rs 2,283 crores to IL&FS and its group companies as on August 31, 2018. Some of these exposures were due to mature early September, which seems to have been returned, but there are several maturities lined up over the next few months, including the latter half of September and will be watched with keen interest.
Several funds held aggregate exposure in excess of 5% to IL&FS and group companies in their portfolios. Given the Mark to Market (MTM) impact on these bond prices, these funds witnessed a sharp drop in NAV. While upgrades and downgrades are expected to happen, what stands out in this case is the swiftness and the quantum of downgrades. This resulted in a significant MTM impact on the bond prices. Sources say that in some cases the MTM impact of the first series of downgrades on bond prices was as significant as 25%. Thus a 5% position for the bond in the fund would result in a -1.25% MTM performance attribution due to the bond holding.
While the capital raising developments will be closely watched between IL&FS and its stakeholders, it is important to note that these are notional losses, as these are downgrades and not an actual default yet.
What should investors do?
The MTM impact of the downgrades is already reflected in the individual bond prices and thus the NAV of the funds. Investors would be best advised to stay invested in these funds, as any redemption in this point would result in actual booking of losses. With IL&FS looking to raise capital, any positive moves around this should help alleviate the concerns around default and liquidity issues. We recommend investors to continue holding on to their positions in the current scenario and wait and watch for the situation to unfold.
This incident though brings out two very important aspects – further highlights the fact that credit risk is something fixed income investors should be cognizant of. Investors should not purely pick funds on past returns, they need to understand the inherent risks that are a part of the strategy in delivering those returns. Although in this case, the instruments were largely well rated until before the swift and drastic downgrade. Which brings to question, the second aspect, the actions of the ratings agencies and the fact that asset managers should not purely rely on external ratings, rather have their own mechanisms in place to assess and track credits.
Aditya BSL Medium Term
- Category: Medium Duration
- Star Rating: 5 stars
This fund takes measured credit exposure with an overall portfolio duration between 3 to 4 years. Aditya Birla Sun Life Mutual Fund has a strong credit research process and team in place and lays a lot of emphasis on carrying out their own credit analysis along with structuring of trades. The fund currently holds three bonds which are due to mature in 2020 and 2021. This gives them a cushion in terms of the overall maturity time frame for a resolution to take place.
DSP Credit Risk Fund
- Category: Credit Risk
- Star Rating: 4 stars
The mandate of the fund is to invest 65% of the portfolio in instruments rated AA and below. The fund has invested in bonds of IL&FS Energy Development Company Limited and IL&FS Transportation Networks Ltd which are due to mature in 2019, starting from Mar-19. The investments were in line with the fund’s mandate. But given the 6.5% exposure to these bonds, the fund had a fairly large MTM impact on its performance. Since the maturities are at least 6 months away, there is some breathing space for a resolution to take place.
