IL&FS Default – Exposure in MFs and Impact

Its Back!

Right when the memories of JSPL were about to fade a new name is back. IL&FS that was on a ventilator from some time now has defaulted on Rs. 10 billion loan from SIDBI last week. It also defaulted on its short term borrowing which was later paid on August 31st. Following this ICRA and Moody has called for caution in Indian money markets which is expected to experience panic in the coming week. 

ICRA has downgraded IL&FS by nine notches to BB from AA+ citing extreme liquidity pressures. As per media reports the company is in process to raise Rs. 8,000 crore and is seeking immediate help from LIC and SBI who are existing stakeholder in the company. This could be a ray of hope for investors. 

Exposure in MFs:

As on August end 2018 following AMCs had exposure to IL&FS and its subsidiaries:

The MF industry has more than Rs. 2,700 crore exposure to IL&FS and its subsidiaries and while the parent has defualted and is downgraded there is  a risk of subsequent downgrades of its subsidiaries – IL&FS Transportation, IL&FS Tamilnadu Power, IL&FS Energy Development, IL&FS Security Services and IF&FS Financial Services. 

How does a downgrade or default impact the MF investors?

Such instances impact the NAV of the scheme. The impact on NAV can be on two occasions – Downgrade and Default.

In case of Downgrade: The impact of downgrade gets reflected in NAV immediately as post downgrade the bond yields are marked up and prices fall. 

Eg: XYZ company bond was AA+ rated and was trading at 10.5% as this bond gets downgraded to BB the yield will shot up to match the increased credit risk and will now trade at a much higher level. As yields go higher bond prices fall and this will reflect in the NAV of the scheme which hold this bond.

In case of Default: SEBI has laid down accounting practice for provisioning non-performing assets by MF schemes.

An asset will be classified as NPA if the interest and/or principal amount have not been received or remained outstanding for one quarter from the day such income/or installment was due. Also if interest is due beyond one quarter it is not included in the accrual income while calculating NAV of the scheme. Such NPA is marked down and written-off in phased manner by the MF.

Eg: XYZ bond’s interest payment is due on half-yearly basis on 30.06.2015 and the interest is not received till 1st quarter after the due date. The provisioning will be as follows:

As seen in the table within one and half years past the due date of the income the asset will be written off completely. If the company pay the due amount this can be added back to the NAV and this can give sudden gain in the NAV. AMCs can write-off more if they want to be conservative. 

For deep discount bond however, bonds can be classified as NPAs immediately if the rating of the bond comes down to BB and below. 

SEBI Chief recently cautioned MFs on their debt investments, he said, “Issue is in their books when they hold these debt instruments, either long term or short term, they have to be cautious of credit risk and how to value that on their books.”

What Should investors do with schemes that have exposure to IL&FS ?

Barring investors who are in liquid funds, retail investors in credit risk funds and other bond funds can remain invested if the AMC communicates ability to recover the principal and interest income. However, if recovery looks difficult investors can exit the scheme where exposures are very high and which will be ultimately written-off if the company defaults. Investors in schemes where exposure is over 4% and above are at risk of losing more and may take a call to exit such schemes. 

Schemes that have exposure to IL&FS subsidiaries may also come under pressure as these may also get downgraded soon as the rating was based on the guarantee from IL&FS. Take a wise call to exit them before these bonds are downgraded.

A detailed communication from such AMCs having exposure to IL&FS and its sunsidiaries shall help investor take appropriate call. 

Secret: The most efficiently run bank also has a NPA of over 1.25%, how can MFs live without NPAs on a lending book of over 12 lakh crore? Beware!