Rating Changes and Debt Mutual Funds
What are the lessons for investors and the regulator in debt mutual funds from the recent downgrades of Amtek Auto and Jindal Steel? 
 
Debt mutual fund investors focus mainly on returns and often ignore the risk. Over the past few months investors have woken up to the credit risk of mutual fund schemes. In August 2015, schemes of JP Morgan Mutual Fund suffered a sharp decline in their net asset value (NAV) as they had a high allocation to the debt paper of Amtek Auto. The credit rating of Amtek Auto was downgraded and soon investors begun withdrawing their assets from the scheme. In February 2016, debt investors faced a déjà vu. The credit rating of Jindal Steel and Power Ltd (JSPL) was downgraded and this affected the schemes of ICICI Prudential Mutual Fund and Franklin Templeton Mutual Fund. The NAVs reported sharp declines thanks to steep downgrades.
 
Downgrade of a credit rating is normal. Yes, it is sometimes a shock when the credit rating is notched down by three or four steps at one go. It essentially makes us think about whether the rating agencies were asleep? I can understand ratings getting ‘withdrawn’ because a company does not give information. Not giving information is something that an agency can ‘smell’, so long as it has a good surveillance mechanism in place. If they take monthly or quarterly information, they should be able to smell trouble the first time there is a problem.
 
CRISIL recently downgraded JSPL from BBB+ to BB+. This is a three-notch downgrade. The hierarchy is BBB+, BBB, BBB- and then BB+. The divide between BBB and BB is huge. Debt papers up to BBB- are considered ‘investment’ grade and anything below is considered ‘speculative’ or ‘junk’ grade. A move from BBB to the BB is not an unusual one, given the sector the company operates in and its leverage. What I question is the wisdom of the reputed fund houses in taking such huge exposures on something that was already a borderline investment grade. If you are a hedge fund or a speculative investor, such high yield papers are fodder for you. But mutual funds have to be more careful.
 
CRISIL says that the earlier rating of BBB+ had factored in the sale of a unit in Bolivia and the receipt of the proceeds before March 31, 2016. They have not waited for the date, but have fairly concluded that it is not happening and pulled the trigger. In a sense, we can debate whether the earlier rating should have anticipated this inflow and if it was such a crucial thing, could the rating have been BBB minus? Not being privy to all the facts that they would have had, I respect their view. I have been part of the organisation nearly 22 years ago and still trust the checks and balances in place. What I can say from my knowledge is that when I buy a ‘BBB’ paper, my risk of losing money is very high. And let me tell you, no rating agency is immune to a structured fraud. 
 
I differ with rating agencies on one aspect of rating - “Structured Debt”. At the time I was working in the agency, I was at the forefront of developing it. However, over time I see more and more complex structures that a rating cannot really bind together. But commercial interests prevail. Securitisation is merely a paper exercise of ‘selling’. In reality, if an originator of loan sells the loan to an investor or a trust, I do not see how they can really collect on it. 
 
The rating agencies have the power to downgrade, suspend or withdraw a rating. If there is high quality surveillance, I do not see a reason for an abrupt downgrade by two or three notches, unless it is the result of a corporate action, where there is some merger or acquisition or the company has suppressed some facts, which came to light later on. Not giving information as agreed is a serious issue and should lead to rating getting withdrawn.
 
The recent downgrades of a couple of papers, its impact on the mutual funds that invested in those have been the subject of an acrimonious debate. Here I blame the agencies as well as the fund houses. Fund houses should be using the rating as an additional input and not as a primary input. They should be having the skills to evaluate credit. Yes, a rated paper can help you to find companies you have to shortlist. Beyond that, there has to be an internal analysis that approves the paper. Often, the analysis is cursory and we do not see a single ‘debt’ research report. Hopefully, the analysts read the “rating rationale” that accompanies every rating.
 
The impact of the downgrade on a paper is dependent on the extent of exposure a scheme has, to such paper. A 3% exposure of a scheme in to the paper of JSPL, impacted the NAV of the scheme by nearly half a percent. In a sense, if an income scheme has a carrying yield of 7%, nearly 14 days of interest accruals on the entire scheme has gone! And the mark to market to junk, would mean that the fund is unlikely to fetch the marked price in any sale, as no one would immediately buy the paper. So, the actual impact could be higher! 
 
When MFs are handling retail money, in an environment that is thriving on mis-selling, we need to see some reforms in the industry. Maybe the regulators could consider:
 
 i) Allow retail money to be invested only in those schemes where no paper has a rating lower than AA. Not even AA minus, at the point of inception. There should be a clear mandate that if any paper is downgraded, it should be offloaded within 15 days. That would minimise the retail risk somewhat;
 
ii) Schemes that have lower rated papers, should be RED labelled and the minimum investment amount could be hiked to Rs50 lakh kind of threshold. That implies that those with this kind of surplus understand risks better. 
 
iii) Multiplicity of rating agencies has been an issue. Regulations say that ratings from any ‘recognised’ rating agency is acceptable. Unfortunately, the quality of the rating agencies differs. I will not name the culprits, but every debt fund manager knows about it. Maybe the trustees can insist on two ratings as a minimum requirement. Even in the debt market, companies with the same rating do not enjoy the same pricing. Markets do make a distinction.
Valuation of debt papers is always a contentious issue. Some papers cannot be traded unless offered at a discount to comparable paper. 
 
The retail investors, coming into debt mutual funds, come in for capital protection as well as a perceived tax advantage. Many of the small investors who put in a few thousands, are outside the tax bracket. These are the investors who need regulators to offer protection. We have seen how miserably the regulators have failed when it comes to insurance company products. Will mutual funds also go the same way? 
 
There are some folks who say that so long as everything is ‘disclosed’ in the offer document, the investor should not mind. I have yet to meet any average investor who is even aware what such a document contains. At the time of NFO, a four pager is all that is sometimes given. Of course, everything is ‘available’ online. Why cannot SEBI design a simple one pager that goes with every scheme- on the web page, on the application form and with the account statement? I will be glad to help design it.
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    COMMENTS

    Ramesh Poapt

    5 years ago

    ML-discussion on the topic proceeded nicely. You have knowledgeable readers. Good one indeed!Request more such goood articles!

    Avinash

    5 years ago

    Agree with most of points made in the article. However, instead of placing restrictions on retail participation in debt markets, which would hurt the efforts of broadbasing capital markets, I have a few suggestions:

    1. Credit funds which invest in papers rated lower than an acceptable benchmark (say, AA) should be demarcated with a separate risk rating
    2. Risk-Return indicators like Sharpe ratio, sortino ratio and standard deviation (ofcourse, in a language that a novice would understand) must be mentioned for (a) the scheme, (b) aggregate of similar schemes of the fund house, (c) category average across industry. A legend should accompany this disclosure to help investors interpret the numbers
    3. An abridged version of the Mutual Funds SID must accompany all application forms (if physical) and should be displayed prior to concluding the transaction (if electronic). This one-page document must at-the-least contain the risk rating, risk-return indicators, Fund manager, benchmark index etc.
    4. Efforts on curbing mis-selling must continue unabashed.

    Fixing responsibility on rating agencies and ensuring their 'skin-in-the-game' needs to be handled separately as ratings are used by institutional investors and retail investors alike.

    Gupta

    5 years ago

    After the Amtek fiasco, CRISIL proudly released a press release with nice looking statistics that none of its investment grade rating (BBB- or better) has been downgraded by more than 1 notch and hence the quality and stability of CRISIL ratings is much better than others. While I don't disagree with that claim (on a relative basis given the weaker quality of other rating agencies and not because CRISIL is a holy cow), CRISIL may have wanted to be more circumspect. JSPL is a much larger company with much larger debt and should have had stronger surveillance. CRISIL has been found sleeping at the wheel (or with JSPL because JSPL pays for the rating) with this 3 notch downgrade. Any banker or MF fund manager who understand JSPL can say that Bolivia was an irrelevant chapter in JSPL's history and certainly can't be the reason for even a 1 notch downgrade, forget 3. CRISIL is simply hiding behind it to cover up for being cosy with its "customer" for too long. It is once again proven that rating agencies always downgrade after the event and predictive ability of credit ratings is ZERO. While stock prices have nothing to do with credit ratings, they are far better tools to predict what is going on with the "credit". The conflict of interest between borrowers and rating agencies is deep and since rating agencies only give opinions and don't have to lend on their own ratings, the problem will never be solved. Worth considering if RBI would mandate rating agencies to invest their rating fee in the debt of the issuer for a period of 12 months and if there is a downgrade of more than 1 notch, then pay a penalty of 10 times that fee to a consumer protection fund. Radical thought it may be, but we need something to resolve the conflict of interest. RBI did something very similar with Asset Reconstruction Companies few years ago by banning 100% SR buyouts and forcing a cash component.

    REPLY

    R Balakrishnan

    In Reply to Gupta 5 years ago

    Fully agree. Name recognition seems to have played a bigger role..

    Nilesh KAMERKAR

    5 years ago

    Those who cannot stomach few basis points of volatility, for them mutual funds is not the place to be. For absolute Capital protection there are Bank Fixed Deposits.

    Selling debt paper within 15 days of it being downgraded is a sure way of losing capital.

    Even with the most noble intentions some debt papers will still deteriorate in quality. In this deterioration lies risk as well as opportunity.


    REPLY

    R Balakrishnan

    In Reply to Nilesh KAMERKAR 5 years ago

    The only solution, Nilesh, is to forget the NAV impact and hold to maturity? That would be a cross subsidisation and lead to gaming by big punters

    Nilesh KAMERKAR

    In Reply to R Balakrishnan 5 years ago

    Dear Sir,

    Please do consider the foll:

    1) The scope for gaming the system shall be far higher if funds are forced to liquidate debt instruments within 15 days of being downgraded, resulting in substantial losses as not much can be salvaged in such situations.

    2)Sir you shall agree when investors jump the scheme immediately after NAV is impacted, they turn notional losses into real losses.

    3)Investors would do themselves a great favour if they wait to exit, till such time that their returns from the income fund is say 1% better than FD rates, then purpose of investing in debt mf would have been served .

    4)For 3 above to happen investors ought to worry about NAV linked returns rather than scrutinize the portfolio. - That is best left to the professional fund manager

    5) Debt downgrades and defaults have happened in the past too. And investors in open ended debt funds,(& not FMPs) who chose to continue have come out unscathed with reasonable returns to boot.

    R Balakrishnan

    In Reply to Nilesh KAMERKAR 5 years ago

    You are right, Nilesh. But you underestimate the idiots in the world. logically, I do not see the need for this instrument to exist at all. Equities and liquid funds good enough for me. Maybe a savings account . Bond funds is for those who build a bridge to nowhere.

    Nilesh KAMERKAR

    In Reply to R Balakrishnan 5 years ago

    Very well said sir, couldn't agree more . . .



    Prasad

    In Reply to R Balakrishnan 5 years ago

    >> I do not see the need for this instrument to exist at all. Equities and liquid funds good enough for me.

    Sir, can you elaborate why ? Debt funds sit in a sweet spot (medium-term) that equity cannot fill. For a mid-term (2-4) years, I found a 1% to 1.5% difference between liquid funds and short-term debt funds. Do you think they are not worth the risk ?

    R Balakrishnan

    In Reply to Nilesh KAMERKAR 5 years ago

    Any downgrade will have a loss of capital. Whether u sell it today or after one year. Problem is if we have a discipline or a rule book, we should play by it, when retail money is involved. Retail who come in from the FD markets

    R Balakrishnan

    In Reply to Nilesh KAMERKAR 5 years ago

    Yes, Nilesh. You understand. I too understand. A few out there who do not. Bulk of investors are like that.

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