X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2018 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
How IL&FS Rating Downgrade Will Impact Your Mutual Funds... - Outside View by PersonalFN

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

How IL&FS Rating Downgrade Will Impact Your Mutual Funds...
Sep 17, 2018

Casualties are inevitable in "too-big-to-fail" organisations when they find themselves in hot water.

And when mutual fund houses invest in debt instruments issued by such companies, thousands of investors suffer.

Recently, Net Asset Values (NAVs) of several mutual fund schemes took a knock in the range of 0.1% to 1.2%.

Mind you, mutual fund houses incurred these losses effectively in a day. They had to mark down their investments in Infrastructure Leasing & Financial Services (IL&FS) and its group companies owing to credit rating downgrades.

As per data obtained from ACE MF, nearly 14 mutual fund schemes collectively had an exposure of Rs 2,130 crore to IL&FS and its group companies as on August 31, 2018.

Astonishingly, liquid funds and ultra-short term debt funds such as Principal Cash Management Fund and Principal Ultra-Short Term Debt Fund suffered 1.2% and 1.0% loss respectively between September 07 and September 10.

Apart from these, DSP Credit Risk Fund and Invesco India Credit Risk Fund are two funds that have witnessed a substantial fall in the NAV.

Realistically, this is not for the first time the mutual fund industry has taken a hit due to the deteriorating financial condition of the issuer of a debt fund.

And the IL&FS episode raises a question-Are debt funds really safe?

Story in detail...

IL&FS along with its subsidiaries has around Rs 1 lakh crore worth public debt on its books, as reported by Time of India, dated September 07, 2018. Including its subsidiaries, IL&FS has under its belt around 90 entities and Special Purpose Vehicles (SPVs).

And the bad news is, this 'systematically important' company has difficulty repaying loans.

Adding fuel to the fire, it's borrowing heavily to repay loans; running from pillar to post to raise corpus.

It recently sought immediate loan assistance of Rs 3,000 crore from two of its shareholders-SBI and LIC. Coincidently, LIC Mutual Fund too has invested in debt securities issued by IL&FS and its group companies.

IL&FS tried raising Rs 4,500 crore through the rights issue, but its plan met with misfortunes. HDFC, another shareholder, has already communicated its disinterest in subscribing to the rights issue.

It seems HDFC is unsure if IL&FS will be able to successfully exit SPVs or monetise its assets to raise money and par debt.

Recently, the settlement of Commercial Paper (CP) was overdue by two days, which prompted the RBI to prohibit IL&FS from accessing the CP markets until February 28, 2019.

A debt-trap is no different than this.

Taking a serious note of all these developments, several credit rating agencies downgraded its credit rating. Moreover, some important subsidiaries of IL&FS also faced severe downgrades.

In the Indian context, any bond rated 'BBB' and above is fit for investments, while any bond rated 'BB' and below is classified as speculative grade category. In other words, any bond with 'BB' and below ratings has a significantly higher risk of default of interest and principal.

ICRA, an independent credit rating agency, justified its rating action of downgrading IL&FS to speculative category. "The downgrade of ratings takes into account the increase in liquidity pressure at the group level. While the company is in the process to raise Rs. 8,000 crore of funds from the promoter group (through a mix of rights issue and long term line of credit), timely receipt of the same is important to improve the group's overall liquidity profile. Further clarity is awaited on the timing of these inflows and given the sizeable repayment obligations of the group's debt, this remains a key rating sensitivity in the near term. The ratings also consider the company's elevated debt levels owing to the funding commitments towards Group ventures coupled with slow progress on asset monetisation and deterioration in credit profile of key investee companies."

A behemoth or a cripple?

Company Instrument Amount
(Rs in crore)
Rating upgrade/downgrade Outlook
Infrastructure Leasing & Financial Services Limited Non-Convertible Debenture (NCD) 5,225 Downgraded to [ICRA]BB from [ICRA]AA+ Under watch list with developing implications
Commercial Paper 2,500 Downgraded from [ICRA]A1+ to [ICRA] A4 Under watch list with developing implications
Term Loans-Long Term 350 Downgraded to [ICRA]BB from [ICRA]AA+ Under watch list with developing implications
(Source: ICRA)

What led to downgrading of ratings?

  • Liquidity crunch
  • Heavy indebtedness and inadequate capital adequacy
  • Investments in illiquid projects
  • Declining profitability

A deeper analysis of IL&FS and its group companies, which have faced rating actions in the recent past, suggests the problems are deep-seated and can't be addressed by merely raising a few thousand crore Rupees. The possibility is that the group might have invested in several commercially unviable SPVs and perhaps many of them may not be revivable ever.

One of the largest subsidiaries of IL&FS felt the heat...

Company Instrument Amount (Rs in crore) Rating upgrade/downgrade
IL and FS Financial Services Commercial Paper 4,000 Downgraded from [ICRA]A1+ to [ICRA] A4
(Source: ICRA)

What led to downgrading of ratings?

  • Deterioration in the credit profile of the parent company--IL&FS
  • Concentrated exposure to infrastructure and real estate projects
  • Overstretched balance sheet
  • Deteriorating asset quality

Another instance of failed infrastructure projects...

Company Instrument Amount
(Rs in crore)
Rating upgrade/downgrade Outlook
IL&FS Tamil Nadu Power Company Limited Term Loan 6,080 Downgraded to [ICRA]BBB  from [ICRA]BBB+ Revised to negative from stable
Non-Convertible Debenture (NCD) 500 Downgraded to [ICRA]BBB  from [ICRA]A+ Revised to negative from stable
(Source: ICRA)

What led to downgrading of ratings?

    Deteriorating credit profile of the parent company-IL&FS and IL&FS Energy Development Company Limited (IEDCL)

    Lower capacity utilisation and heavy reliance on short term contracts

    Vulnerability to currency risk and coal price fluctuations

    Delay in payments from Tamil Nadu Power Generation & Distribution Company Ltd (TANGEDCO)

    Sizable near-term repayment obligations

Renewable energy dream looks illusive?

Company Instrument Amount (Rs in crore) Rating upgrade/downgrade Outlook
IL&FS Wind Energy Limited Non-Convertible Debenture (NCD) 200 Downgraded to [ICRA]BB+ from [ICRA]A+ Revised to negative from stable
(Source: ICRA)

What led to downgrading of ratings?

  • Deteriorating credit profile of the parent company-IL&FS and IL&FS Energy Development Company Limited (IEDCL)
  • Lack of revenue visibility
  • Sizable near-term repayment obligations
  • Inexperience in handling and forecasting regulatory changes
  • Fragile financial condition of state distribution companies buying power from IL&FS Wind Energy Limited

No Sunshine

Company Instrument Amount
(Rs in crore)
Rating upgrade/downgrade Outlook
IL&FS Solar Power Limited Term Loan 45 Downgraded to [ICRA]BBB from [ICRA]A- Revised to negative from stable
Non-Convertible Debenture (NCD)-I 150 Downgraded to [ICRA]BBB from [ICRA]A- Revised to negative from stable
Non-Convertible Debenture (NCD)-II 210 Downgraded to [ICRA]BBB from [ICRA]A- Revised to negative from stable
(Source: ICRA)

What led to downgrading of ratings?

  • Weakening of financial position of the parent company-IL&FS and IL&FS Energy Development Company Limited (IEDCL)
  • Delays in securing regulatory approvals for the project commencement
  • High indebtedness
  • Inability to repay older debts
  • Inexperience in running solar power generation business

What to expect in future?

If the parent company, i.e. IL&FS, fails to raise money through rights and honour its debt obligations, not only it will affect its rating profile, subsequently even its subsidiaries may lose their 'investment grade' ratings. This would be a catastrophic event for the bond markets.

Marquee promoter profile won't help IL&FS beyond a point. There's a limit to which LIC and SBI can burn taxpayers' money on bailing it out.

Nevertheless it's important to note that, IL&FS hasn't defrauded any creditors.

Mutual fund schemes having exposure to IL&FS and its subsidiaries have taken a knock on the mark-to-market basis. In layman terms, the fall in NAVs continues to reflect notional losses. However, if IL&FS defaults, the losses would not only mount but they will become a real threat.

The fund managers are in a catch-22 situation, especially if they hold long term bonds IL&FS and any of its subsidiaries. Reducing exposure at this point would cost them a pretty penny, but holding onto investments is equally risky as well. Some funds such as DSP Credit Risk Fund, Aditya Birla Credit Risk Fund and Aditya Birla Medium Term Plan hold debt securities that have a maturity in 2019, 2020, or 2021. They might get some more time to negotiate with the debtor.

But funds having exposure to papers nearing the maturity are more vulnerable.

IL&FS is on the ventilator so as mutual fund schemes.

Will LIC and SBI bailout IL&FS this time? But for how long, that's the question.

Some might argue, impact of IL&FS on debt funds is temporary and most of the mutual funds will easily absorb the shocks.

But investors are the real sufferers.

They don't invest in debt funds for maximising returns? Or do they?

If you are one of the investors who looks at the high returns the debt scheme has generated in the past and invest in it expecting it to repeat the performance, you are making a big mistake.

Let's not forget, when fund managers might have invested in IL&FS, the company enjoyed high credit rating of 'AA+'. Debt issued by its subsidiaries was also highly rated.

It seems fund managers are excessively relying on credit ratings.

But independent credit rating agencies can't walk away scot-free.

Many of them revised credit ratings only a day before the debt instruments matured. Aren't they supposed to take timely action? When the credit rating is downgraded several notches abruptly, it's a sign of sluggishness.

IL&FS has been a classic case of what credit risk means to bondholders and why debt funds aren't risk free.

[Read: Another Loose Cannon In The Portfolios Of Debt Mutual Funds...]

Instead of passing the buck, it's important to be extremely vigilant while investing in debt funds.

Going merely by past records isn't comprehensible enough to make a wise financial decision.

Consistency in the risk preferences of the fund managers and fund houses is the key to watch out for.

Editor's note:

There are many funds that are well-known and have become popular over time making it to the portfolios of mutual fund investors.

However there are also some hidden gems that you have probably never heard of, but still carry commendable management qualities and portfolio features and offer superior growth potential to become category outperformers in the long run.

Believe it or not, unusual and lesser-known funds too are capable of generating big gains for, you the investor. Want to know which are these 'Undiscovered' funds? Click here to read more...

Happy Investing!

Author: PersonalFN Content & Research Team

This article first appeared on PersonalFN here.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

Equitymaster requests your view! Post a comment on "How IL&FS Rating Downgrade Will Impact Your Mutual Funds...". Click here!

  

More Views on News

Two Meetings That Nailed the Idea of Owning Brilliant Smallcaps Without Buying Them (The 5 Minute Wrapup)

Mar 22, 2018

Certain blue chips hold the potential of delivering returns comparable to small-cap stocks. With these stocks, you can get the best of both worlds.

What They Forgot to Tell You About Sensex at One Lakh (Profit Hunter)

Nov 29, 2017

Stocks that could beat Sensex returns in the long term.

Overthrow Your Financial Evils This Dussehra (Outside View)

Oct 17, 2018

PersonalFN explains the key things to do to overthrow financial evils and make a new beginning and march ahead to live a healthy financial future this Dussehra.

Why LIC Will Continue to Bailout the Govt This Year as Well (Vivek Kaul's Diary)

Oct 17, 2018

With central GST collections unlikely to meet the target, the government will be desperate for money during the second half of the year.

Work Timings Prevent You From Investing? An Efficient Robo-Advisor Can Help (Outside View)

Oct 17, 2018

PersonalFN explains a robo-advisory platform can save time and can help you manage your investments on-the-go.

More Views on News

Most Popular

Don't Panic in This Falling Market... Do This Instead(The 5 Minute Wrapup)

Oct 5, 2018

Find companies with long term durable moats, which are correcting with the current broader market sell-off.

Taxpayers to pay salaries of CEOs/CIOs of Mutual Funds(The Honest Truth)

Oct 5, 2018

Ajit Dayal on the crisis in the market and in the mutual fund industry.

This Market Crash could be the Biggest Wealth Creating Opportunity Since 2008(Profit Hunter)

Oct 8, 2018

While widespread fear is the friend of a value investor, serving up bargain purchases; personal fear is an investor's biggest enemy.

IPO Market Feels the Heat of the Market Crash(Sector Info)

Oct 12, 2018

The sentiments in primary market have also deteriorated amid the stock market correction. Most listed IPOs of 2018 are trading below their issue price.

Are These Deep Corrections a Buying Signal?(Chart Of The Day)

Oct 5, 2018

The correction has bought many good companies to reasonable valuations. Go against the wisdom of crowd and Buy.

More

Small Investments
BIG Returns

Zero To Millions Guide 2018
Get our special report, Zero To Millions
(2018 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Oct 17, 2018 (Close)

MARKET STATS