The recent spate of negative news in the debt space, with the downgrading of debt papers of some banks and NBFCs, may have caused you to panic.
What’s more, for the first time, the media is covering a lot about debt downgrades as opposed to simply stock price falls. This deluge of information may have left many of you confused on which event is significant enough to act on and which is not.
Here are some broad points that might serve as your playbook on when to act and when not to.
What really matters, in the face of negative news, can be broadly addressed with the following questions:
- Is the risk material? If the risk transpires, will its impact threaten the existence of the company or its financial strength or its growth?
- Is the impact on the stock or on the debt instrument or both?
- Is the holding in your fund significant enough for you to be hurt by it?
- If so, can the fund manager get out of the stock or the debt instrument? In other words, what is the liquidity risk here?
- Will the return expectation from the fund undergo a significant change if the event transpires?
Equity is not a zero-one game
It is important to distinguish between general negative news and news that can hurt. For example: if Larsen & Toubro had bid for a project and failed to bag it, the stock market may be disappointed temporarily and hit the stock. But it does not impact the existence of the company or its finances. It does not also impact the credit worthiness of the company’s bond. An FDA warning for a pharma company may be viewed negatively by the market but a fund manager who thinks there is opportunity may be buying it.
The stock of Zee Entertainment Enterprises fell heavily in end January 2019 only to recover very soon. There was nothing wrong with the stock or the underlying company although plenty had gone wrong with the group.
Now these distinctions are not easy to make but what is easy to understand is this:
- Stocks, especially those picked by fund houses, are mostly liquid. They have a market in the stock exchange.
- A fund manager will exit the stock if things go south or will retain it if he/she feels there is potential. For example, Motilal Oswal Multicap 35 exited Manpasand Beverages on corporate governance issues. But ICICI Pru Value Discovery has held on to Sun Pharma even in the face of plenty of regulatory and even governance issues.
- Equity is not a zero-one law. You don’t lose permanently because the stock suddenly falls. And even if you do (like a company going defunct or the stock price collapsing, like it did with Manpasand Beverages), the exposure is seldom high enough to kill your fund or significantly deteriorate the return expectations. For example, a 30% drop in a stock, which accounts for 3% of your portfolio would mean a 0.9% drop in your equity fund NAV. This impact is insignificant, if not nothing, in an equity portfolio that has a much higher return potential. Just as a stock might fall significantly, a stock can rise too which compensates for stock price falls.
In the above cases, as analysts (or as investors) our job is to see how soon the fund can recover from the fall based on other sound holdings. Or, if the fund continues to hold the impacted stock because it sees potential, then the question is whether the bet pays off in reasonable time. If performance does not speak in time, then we need to move on.
Bottomline: Reacting to stock events is best avoided, when you hold them in equity funds. Instead, focusing on the fund’s strategy and performance would be a better idea. Any slippage in this would call for an exit.
How debt is different
When you read news of downgrades, you ask us if your fund holds say, Bharti Airtel or DHFL or Yes Bank or CanFin Homes and so on. There is a very high chance that your fund holds one of the other of these papers. Does it mean you exit all your funds? Not necessarily.
|Examples of falling asset size and swelling exposure to troubled group papers|
|Mar-19 Holding||Sep-18 Holding|
|Fund||Mar-19 AUM (Rs crore)||Sep-18 AUM (Rs crore)||Fall in AUM||Zee||IL&FS||Reliance ADAG||Zee||IL&FS||Reliance ADAG|
|ABSL Dynamic Bond||4,179||5,651||-26%||14.7%||1.6%||10.7%||1.5%|
|ABSL Medium Term||8,299||10,983||-24%||15.2%||6.6%||11.3%||5.7%|
|Baroda Treasury Advantage||571||1,543||-63%||8.6%||4.9%|
|DHFL Pramerica Short Maturity||357||1,124||-68%||11.9%||6.6%|
|HDFC Dynamic Debt||740||1,028||-28%||4.7%|
|UTI Banking & PSU Debt||266||783||-66%||7.3%|
Exposure matters: For example, DHFL papers are widely held by many funds. The company saw a notch downgrade in its bonds some time ago and in its commercial papers recently. Note that I am not talking of any default here.
If a fund holds, say, 1.5% in this instrument and another fund holds 15%, their risks are significantly different. If the downgrade turns into a default (which it hasn’t thus far), then the fund holding more of the paper gets hit harder.
Exposure often also swells because of redemption pressure. If a fund has high exposure to a risky paper, then it faces redemption, especially by corporate investors who are averse to such risks with their treasury money. This further causes the exposure to that paper to swell. For example, let’s say a fund has Rs 20 crore in a risky paper and its total assets were Rs 200 crore. A fall in assets to Rs 100 crore due to redemption would mean exposure increases to 20% from 10% earlier.
When zero-one law applies: Just as stocks go up and go down in an equity portfolio for various reasons, one of the reasons for variation in a debt instrument’s price (apart from the interest accrual) would be rating downgrades and upgrades. A downgrade by itself does not mean a fund is going to be hit severely. An AAA-rated paper going to AA+ or AA does not make it credit unworthy. There may be a marginal mark-to-market impact but as the accrual comes and principal is repaid the ‘paper loss’ vanishes. Hence, not every downgrade is worrisome. And downgrades happen all the time.
But if a paper is pushed to below investment grade (typically BB+ and below) then that is a clear sign of trouble. If it is further pushed to ‘D’ (default) then your probability of getting money goes to zero (unless, of course, you do get it back later). This is where debt distinctly varies from equity. The equity stock value seldom goes to zero. There is an underlying value and there is a market to value it further and there is a market to exit the stock. In debt, the market is often gone when the paper defaults or when it is pushed to below investment grade.
Impact cost: Now take the debt papers of the IL&FS group or the Essel group. When a paper turns bad, schemes essentially don’t get the money back when it is due. They may try to sell it in the secondary market, if there are any takers. And if by chance somebody wants to buy a defaulted paper, you can imagine the discount at which it will be sold. Hence, apart from the hit to NAV when the mark down happens (or downgrade or default), there could be added loss when a fund house attempts to sell it and cause further erosion to NAV. In the meantime, a redemption pressure may push the fund into selling even some of its good papers at a poor price. Thus, there is a ripple effect or even a contagion effect.
Sometimes a hit in NAV happens even before the news of the risk comes to light since many papers are not listed and news is sparse. In these cases, many of you ask us whether there is a probability of getting the money. There always is.
But the way to assess such situations is thus – if the fund does not get the money back, how long will the fund take to recover the loss through its other assets? Looking at the portfolio yield and the portfolio residual maturity will give us some idea on this. If your holding time frame does not provide the leeway for such recovery, it would be better to exit.
How to act
In equity, it is simple. Let the fund manager handle the mark-to-market moves. Unless you are a direct stock investor, stock specific news should not bother you. It is up to us at research to see if a consistently poor-quality portfolio is impacting performance and make suggestions accordingly.
When it comes to debt, it is not easy for an investor to assess all the above points we mentioned. Looking at exposure, looking at asset size or looking at rating downgrades is not a viable option.
Here’s what you can do if you are invested with us:
- In debt, while not every issue comes to our notice on time, we have managed to sound off risks. In the last 6-8 months alone – while one of our funds were hit too, we alerted you on risks in at least 6 funds and suggested an exit. In all these cases, it was before the NAV took a massive hit. We take such calls based on the extent of the risk, the exposure to various risky papers, redemption pressures, etc.
Our communication to you over mail, our research calls or a call from your advisor are a few things that you need to necessarily keep tab of. This is of course restricted mostly to funds from our research list. With the other funds, when you come for a review, we let you know whether you need to exit particular funds because of looming risks.
- Many funds that have been hurt in the recent debt crisis were funds we have always viewed with caution. These were funds with high yields, high concentration and variable AUMs. We stayed away from those. But many of you picked such funds for high returns. Our suggestion would be that you consult your advisor when it comes to investing in debt or go with our recommended funds. When you go with our recommended funds, you have the benefit of us keeping an eye on them and communicating (through various channels) on action needed, if any.
- As a rule, avoid choosing funds with very high returns in the debt space. They seldom come without credit risk (we are not talking of gilt funds here).
- When faced with a situation of whether you can stay or exit, your decision in debt funds should be based on risk mitigation than return maximisation. There is equity to do the job or maximising returns.
- You may often be told that there is ‘value’ in debt after a fall, like it is with equity market. Do not take that at face value. Most ‘value’ pockets in debt can be value ‘traps’ when it comes to credit risk.