Amid defaults and downgrades, the association of mutual funds in India (AMFI) has come to the rescue of mutual fund houses in handling such a situation. AMFI recently issued guidelines on how fund managers should write down a debt paper and take haircuts once it falls below investment grade. A credit rating below BBB- is considered as below investment grade, according to Securities Exchange Board of India.
Currently, fund houses employ in-house methods for writing-off a debt paper whenever a default occurs. This leads to different revised valuations for the same underlying security. This means, two mutual fund schemes exposed to the same debt, in the same percentage, write off it differently in event of default. To avoid this, AMFI has suggested standardising the write offs for such debt, factoring in its type, the sector it belonged to and other important details.
AMFI suggested that the value of a debt paper backed by shares should require lower provisioning compared to unsecured debt, in event of default. Secured debt of hotels, real estate and infrastructure firms and hospitals will also require lower provisioning, it suggested.
The extent of write-offs is based on the extent of recovery possible on selling the underlying security. In the case of unsecured debt, which has no underlying security, a 100% write off is recommended. Even secured debt of certain businesses like jewellery and gem companies should be written off entirely.
In MFs, writing off means reducing the Net Asset Value (NAV) of the scheme due to revaluation of a particular security held, in case of defaults or credit downgrade. The revised value is supposed to indicate the fair market value of such a debt, if were to be sold immediately.
Since August 2018, the Indian corporate landscape saw many companies edge toward financial fragility and some eventually defaulted. Mutual funds that had lent to these companies were stuck holding this bad debt, and had to revalue it constantly to match its market worth. In the absence of immediate information supplied by credit rating agencies on such debt and its new value, mutual funds used their own in-house methods. This led to widely different valuations for the same security, causing difference in the losses eventually borne by investors.
Post adoption of new revaluation methodology by fund houses, the extent of losses seen in mutual fund schemes will become more predictable due to standardisation. These guidelines are to be used until credit rating agencies give out their fair view of such below investment grade debt.