Debt paper issued by ‘investment’ companies form a significant part of the portfolio of many institutional investors.
In a way, these investments are banking more on faith than on cash flows. Many of the investment firms are in the nature of holding companies which have no cash flows other than dividends received.
Repayment is possible only if:
The investment company sells some shares in order to repay the debt; or
It keeps replacing one debt with another.
In the real world, the first is a rare happening. And when it is forced upon by the lenders, it leaves behind a wave of destruction of value.
The first time it happens in a big way and selling started, there have been questionable deals by mutual fund companies and the promoters.
Whether it is Zee or ADAG, it has become not only a problem for the mutual funds but also for the shareholders. ADAG went to court against the selling of shares by Edelweiss and caused legal costs and pain to Edelweiss.
And once this level of selling happens in a concentrated dose, the traders get wind and the stock price simply collapses, leading to compounding of misery.
The other thing is that promoters may escape disclosing these as ‘pledged’ shares. Often the agreements could be private lending arrangements like in some intercorporate loans.
When a loan is created by pledging of the shares, repayment rarely happens unless the promoter sells off some asset or the other. If so, why not sell off that asset in the first place? A promoter may say that he is waiting for a better price. If so, why cannot his need also wait?
It would be best if Mutual Funds are prohibited from investing in to paper issued by “Investment Companies”.
In general, these borrowers are unlisted and have limited access to capital markets. And there is no control or transparency in end-use. They are used for various ‘corporate’ purposes through a maze of onward lending.
Of course, someone will say that there are ‘good’ promoters and not so good promoters.
However, mutual funds start increasing their risk while chasing higher yields.
To me it is a big caution and warning to mutual fund investors. In an equity fund, if there is loss of three to 10 per cent of the NAV, it is not a shock to an investor. Market moves and stock selection can cause this and the equity investor is ‘prepared’ or not shocked by such falls. Most people at the personal level, approach Income Funds as an alternative to Fixed Deposits with Banks or Companies.
Some also think that the Income funds will give higher returns. So far, we have not seen any bad debt crisis in Income Funds.
Suddenly, there is a bunch of mishaps that are hitting the mutual fund investors — IL&FS, DHFL, ADAG, Zee Group etc..
When there is a permanent loss of capital in a fixed income fund, it hurts. There is generally no upside. Apart from paying very high costs for investors, the least that a fixed income fund investor expects is that Credit Risk is eliminated (or minimised) by sticking to high quality debt instruments of creditworthy entities.
Lending to a promoter is like Loan Against Shares to an individual. A promoter wraps his shareholding in an Investment Company, giving it the façade of a Corporate Debt Paper.
From the Investor perspective, these kind of risks are a deterrent to investing in Fixed Income Funds. If I check out the returns for the last three years — the top 10 medium to long term funds have given returns between 6.7 to 8.1 per cent per annum. Hardly any better than Bank Fixed Deposits. And if there is some bad debt that takes away even five per cent of the corpus, the return will be below the savings bank rates. Is it worth taking this risk? I would keep away from all fixed income funds except the Liquid Funds, which invest only in prime short term paper.
Even in short term paper, I would like to see a cap of ten per cent on finance segment. Today, the portfolios are packed with debt paper and structured instruments from investment companies.
And another important thing I would like to see is the fund manager paying attention to the quality of the Rating Agency.
Laying the blame on ‘ratings’ in general is highly irresponsible. Every player in the industry knows about credit rating agencies. Not all of them are equally trustworthy. A simple ‘recognition’ from Sebi means nothing.
As an investor, I do not mind equity mutual funds — where my first preference is for an ETF on the index. As regards Fixed Income Funds, I think I am happy with Bank Deposits, Company Deposits. Of course, I will go by my judgement of credit rather than depend on credit rating agencies. If I cannot find anything good, I am happy with bank deposits.
(The writer is a veteran investment adviser. He can contacted at balakrishnanr@gmail.com)
