Why DHFL payment won’t bring any gains for investors soon

A rigid regulator, defensive fund managers, and rattled rating agencies are today caught in a web of rule and fear psychosis that is hurting mutual fund investors.

Even after a company with a ‘D’ or default tag pays interest on its bonds, funds holding the securities are not allowed to mark-up the valuation of the papers. As a result, investors, hit by a huge valuation mark-down following a downgrade, do not see the value of their investments rise.

On Tuesday, the troubled housing finance company DHFL paid Rs 962 crore as interest on some of the debentures it had issued. But, unlike a downgrade (following delay in interest payment that shaved a slice of their investments), Tuesday’s interest payment did not improve the fortunes of investors.

Why? According to the rules, which the fund industry had to accept after it was prodded by Sebi, a default would necessitate a 75 per cent mark-down of valuation for secured papers and 100 per cent for unsecured papers. The somewhat blunt rule, say market insiders, owe its origin to one of the fund houses giving some of the large investors an easy exit last year, just before the IL&FS house of cards collapsed.


The question that crops up is: even though DHFL is not out of the woods and may have to struggle to arrange cash after two months, why can’t the funds mark-up securities and show a higher net asset value (NAV) after the company serviced interest on the bondsRs

Here comes the rating companies wearing two hats: first, assigning rating of debt instruments -- triple-A, or triple B or D, etc; second, estimating valuation of securities based on which funds calculate the respective NAV of schemes which have invested in these securities.

Having been hammered after the IL&FS fiasco, which sparked downgrades by several notches in quick succession, rating companies have turned far more sceptical and are unwilling to upgrade the rating of a bond simply because DHFL has serviced one round of interest payment.

“It is a company under stress. It is constantly under media glare and there are reports of the government issuing look out notices on promoters. Rating companies, whose role has been looked into by SFIO, will think twice before taking DHFL out of the ‘default’ category”, said a senior industry person.

“And, if the rating is not revised upward, the other segment of the rating industry which deals with valuation will not give those papers a higher valuation… so this could mean a long wait before rating, valuation and thereby the NAV of MFs (holding DHFL papers) go up,” said a fund manager.

Once a security is rated ‘D’, agencies wait for three months before evaluating any window for upgrade.

Earlier on June 4, when DHFL did not pay interest on NCDs, fund houses marked down their investments in DHFL by 75 per cent. Subsequently, the net asset values of several debt schemes fell 6 per cent-53 per cent on June 4, reflecting the marked down value of the holdings in DHFL paper. About 22 mutual funds together own DHFL papers worth Rs 5,236 crore across 163 debt schemes as on April 30, 2019, as per data from Value Research.

RBI as well as Sebi have sought data from rating agencies to check whether there have been swift downgrades that left investors unprepared. Under the circumstances, rating companies would upgrade DHFL only after they are adequately convinced that financials have improved. “Unlike IL&FS, rating companies were comparatively more vigilant on DHFL... So, they would argue that they were proved right on DHFL,” said a banker.

What might have complicated the situation -- and could make rating agencies further reluctant to review the ratings – is a freak trade of DHFL bond cut at a yield of more than 60 per cent. Bond prices fall when yields rise and absurdly high yields reflect panic or distress sale. (The buyer, said market sources, was the FPI arm of a British bank while the seller, another FPI, is controlled by a Japanese group.) “It’s a comedy of errors. Each actor is playing a role trying to save its skin. The regulator has introduced harsh, inflexible rules. Fund managers have no say. And, rating agencies are on the backfoot... But a mark-down is not exactly a write-down,” said another person.