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Tackling debt funds when bonds get downgraded

LiveMint logoLiveMint 06-06-2017 Lisa Pallavi Barbora

When rating agencies downgraded IDBI’s short- and long-term bonds on 23 May 2017, there was a flutter among investors. These bonds are held by institutional and individual investors either directly or through mutual funds. While ICRA Ltd has downgraded the long term bond to just above junk rating at BBB–, Crisil Ltd has downgraded it to BBB+ and both have kept it on a negative outlook on a ratings watch.

Bond downgrades cause bond prices to fall, leading to capital loss for investors. Capital loss is a result of adjusting the price of a security to the new market price. These are unrealised losses, also known as marked-to-market losses. A downgrade accompanied by a ratings watch says that the security is not out of danger and a further downgrade or even default may happen in future. In IDBI’s case, a further downgrade will send the bond to junk category and that can result in another marked-to-market loss and heightened danger of default.

Investors in debt and hybrid funds shudder when such downgrades happen because the ‘safe’ part of their portfolio suddenly sees a fall in value. While this particular downgrade was not very sharp and hence the price impact was not harsh, such incidents do cause interim volatility in a fund’s value and also warn towards a possible losses if the company defaults.

When such events occur, how does an investor judge whether to remain with the mutual fund scheme or exit?

Vipul Sharma/Mint

There are two kinds of exposures that mutual funds have in IDBI debt securities. One part comprises short-term certificates of deposit (CDs) and the other comprises long-term bonds, including the additional tier 1 issued by the bank. Out of the total mutual fund exposure to IDBI, a debt of Rs7,400 crore, around Rs1,200 crore are in long-term bonds and the rest in CDs.

There is less cause of worry when it comes to the CD exposure, as tenure is only a few months. Here, risk of non-payment is low and owing to near-term maturity, a single notch downgrade might move the yield up by 40-50 basis points, which impacts the security price by a few paise. One basis point is one-hundredth of a percentage point.

The long-term bond exposure is riskier, and successive quarterly results will need to be watched to analyse whether the bank can oblige its financial payments. Moreover, thanks to the long tenure of bonds, the fall in bond price is higher.

According to Ritesh Nambiar, senior vice president and fund manager, UTI Asset Management Co. Ltd, “Even though bulk of the exposure we hold is in CDs, we reacted to the news quickly and were able to sell around Rs1,000 crore in CDs. While the price impact for CDs was around Rs0.10-0.15 paise, for tier 1 bonds it was around Rs 4-5 on the bond price.”

The consensus, among fund managers we spoke to, is that it would be a big risk for the government and the RBI to allow default from a bank that is this large. Recently, RBI’s adjustment to the rules for interest payment on AT1 bonds came at an opportune time for Indian Overseas Bank, which was seen to be in stress to make the payments. The market sentiment too would suffer, which could mar the ability of PSU banks to raise long-term capital from bond markets.

Nikhil Johri, founder and chief investment officer, Trivantage Capital Management India Pvt. Ltd, does not believe that there is a high danger of default. “The downgrade is around a technical factor. The bank meets its common equity tier (CET) 1 capital ratio of 5.5% as per Basel III norms, where it falls short is on the capital conservation buffer. As per specific RBI regulations if the CET1 is above 5.8125% then only 80% of profits are conserved in a year and rest can be distributed. IDBI bank can easily cross that level before the next coupon date in August. ” An analysis of different parts of RBI regulations suggest that the capital buffer is to be built in good periods and can get utilized in periods of stress, he added.

Although most market experts are reasonably certain that the government will step in to help in case of a dire situation, with IDBI’s ability to finance long-term interest payments, one will have to wait and watch for a couple of months till the next interest is due. A ratings watch signifies that the agencies are looking for an adequate response from the bank around its ability to pay long-term debt obligations.

Recently Reliance Communication’s debt got downgraded to default rating by CARE rating and ICRA. Such downgrades impact mutual fund net asset values (NAVs) of schemes that own them.

While institutional investors will take a more informed decision, given their access to information and fund managers, retail investors must err on the side of caution. Here are three aspects that can be analysed towards a decision.

One, if you are invested in a scheme that holds securities facing downgrade risks or have seen a downgrade, check the portfolio to see if it is short-term CD/CP exposure or long-term bonds. If it is the former, you may have little cause for concern as maturity is likely to be a month or two away.

Two, if the exposure is to long-term bonds, you have to see the portfolio and look for the percentage of the fund assets invested in the bond. This can be seen in the monthly fact sheets or online portfolio disclosures. A high percentage exposure, say 10-12%, can be risky as the marked-to-market impact in case of further downgrade will be sharp and if there is a default, the loss to the scheme will be relatively higher.

Three, public sector bonds despite a downgrade carry a very low default risk due to government ownership. This gives them a slight edge over similar private sector issued bonds. But even in PSU bonds, there is a pricing and illiquidity risk that investors will face as a result of downgrade. These add to interim loss in value for the portfolio and if you are completely averse to frequent ups and downs in daily NAVs then it is best to keep away from schemes with high exposure to long-term bonds.

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