The wait for troubles to end in debt schemes seems to be getting longer with each passing day. Various categories of debt funds such as Credit Risk Funds, Medium Duration Fund, and Low Duration Fund, etc. witnessed strong outflows in April on Franklin Templeton Mutual Fund shock leading to significant erosion in assets.

In another blow, NAVs of certain schemes of HSBC Mutual Fund and Principal Mutual Fund plunged after they decided to write off their exposure to DHFL.

HSBC Mutual Fund and Principal Mutual Fund completely wrote off their exposure to matured NCDs of the beleaguered Dewan Housing Finance Corporation (DHFL) on May 08 and April 30, respectively.

HSBC marked down the exposure in two of its debt schemes – HSBC Low Duration Fund and HSBC Short Duration Fund.

Principal Mutual Fund wrote down the exposure in its multiple schemes. Among debt schemes, it was undertaken for Principal Low Duration Fund, Principal Short Term Debt Fund, Principal Credit risk Fund, and Principal Dynamic Bond Fund along with two hybrid schemes – Principal Hybrid Equity Fund and Principal Balanced Advantage Fund.

Following this, the NAVs of the affected HSBC scheme declined in the range of 9 to 10%, whereas the NAV of Principal MF’s debt schemes took a knock in the range of 4-6%. The impact on PMF’s hybrid schemes was negligible due to low exposure to the security as a percentage of scheme corpus.

Notably DHFL had defaulted in making various interest and principal payment due to which rating agencies had downgraded its papers to ‘Default’ rating. Consequently, both fund houses applied a standard haircut of 75% as per the norms applicable for investment in below-investment grade securities.

Now both fund houses have further marked down the papers from 75% to 100%, meaning the NCDs will be valued at zero with effect from the date of write off.

Table: Impact of mark down on affected funds

Scheme	AUM as on March 31 (Rs Crore)	Impact on AUM (Rs Crore)	Impact on NAV (%)
HSBC Mutual Fund
HSBC Low Duration Fund	128.30	17.41	-9.74
HSBC Short Duration Fund	324.67	9.33	-9.00
Principal Mutual Fund
Principal Low Duration Fund	116.70	6.06	-5.72
Principal Short Term Debt Fund	134.02	6.62	-5.69
Principal Credit risk Fund	31.90	1.96	-6.29
Principal Dynamic Bond Fund	29.06	1.25	-4.22

Impact on NAV calculated as on the day of announcement of write off of the respective fund house
(Source: HSBC Mutual Fund, Principal Mutual Fund, AMFI)

Reason for write off

DHFL has defaulted on various debt obligations as it was facing severe cash crunch and huge pile up of loans. Following this, the company’s credit rating was downgraded from ‘AAA’ to ‘D’ last year. The company was then forced to sell its non-core assets to pay off its debt and manage liquidity. It is currently undergoing an insolvency resolution process initiated by RBI.

In the interest of investors PMF and HSBC MF decided to completely mark down exposure to DHFL for the following reasons:

1. Financial markets are rife with high volatility and uncertainty due to the outbreak of COVID-19 leading to heightened redemptions. The liquidity conditions in debt market have tightened since March due to high redemption pressure, especially for lower rated securities
2. Fund houses expect continued dislocation of businesses and erosion in value of the residual business of DHFL due to lockdown
3. The lockdown could also delay the insolvency and bankruptcy proceedings against the company, which means the resolution is likely to be deferred
4. Continued redemptions in debt funds is expected go on for a prolonged period. Hence the risk of rising concentration of stressed assets like DHFL in the portfolio is high as these cannot be offloaded
5. There are trading/settlement restrictions applicable on matured NCDs

Credit risk has amplified due to COVID-19 induced lockdown. Numerous borrowers are facing a cash flow crunch due to halt in business operations and low demand. Hence, there is a strong likelihood of delay in repayment of principal and interest.

The moratorium provided to borrowers by RBI can delay the good loans from turning into bad. However, if even after the moratorium if lenders are not able to recover the amount, banking and finance sector may become overwhelmed with the financial stress.

[Read: How an Extended Lockdown Has Amplified Credit Risk]

In such a scenario, risk aversion by lenders has risen and they are taking necessary steps to prevent pile up bad loans. Write off of securities is one such step.

In the coming days we may witness other fund houses with exposure to stressed assets such as DHFL marking down their exposure.

However, the write off does not mean that fund houses will not make any attempt to recover the amount. Any future receipt of cash flows from the securities will be credited back to the respective funds.

What should investors do?

Debt mutual fund investors are not feeling as confident after previous incidents of exposure to toxic papers. The recent collapse of debt schemes of Franklin Templeton MF could make them even more wary about their investment in debt schemes. As a consequence, there may be some panic selling in other debt schemes by investors worried about their funds getting locked.

However, instead of taking any hasty decisions, it would be a great idea to check your funds for the quality of assets it holds.

In this market environment, it would be preferable to invest in instruments issued by government and public sector enterprises, and stay away from those having high exposure to private issuers.

Choose a fund house that follows prudent investment process and stringent risk-management system. In these uncertain times, it would be wise to stick to liquid funds and overnight funds for the fixed-income part of your portfolio because they have more liquidity and carry lower risk. Alternatively, if you prefer safety of capital, invest in Bank fixed deposits.

Before investing in debt funds understand the various risks involved and invest in schemes where the portfolio risk aligns with your own risk appetite and financial objective.

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This article first appeared on PersonalFN here