DHFL crisis and the impact on the mutual fund industry

How the DHFL bonds impacted the evergreen debt mutual fund industry in India?

All hell broke loose in the debt mutual fund industry when DHFL failed to make interest payments. This led the mutual fund house which had exposure to DHFL commerical papers to write down their assets.


Impact on Mutual Funds


The DHFL default is due to a delay in payment of interest, rather than an outright default. Rating agencies, like, CRISIL and ICRA downgraded DHFL's commercial paper to "default" grade, notches lower from the earlier A4+. Ratings agencies maintain that the reason for the DHFL downgrade is the firm's inadequate liquidity position. As many as 165 schemes are exposed to DHFL (as of 30th April 2019) with a cumulative exposure of ₹5336 crore across 24 AMCs.


Following the incident, several debt funds have taken a hard knock, witnessing huge single day NAV declines on June 4th. As per valuation norms, mutual funds need to write down the holding in case of defaults (in this case, non-payment of interest) on bonds. Most mutual funds holding these bonds have already marked down the holding by 75% given that the instruments were secured. The write down would have been 100% if they were unsecured. This explains the drop in NAVs.


But, to explain the magnitude of decline in NAVs, one needs to note that every time a bond's rating is downgraded, investors tend to redeem units, and debt mutual funds have seen massive redemptions over the 8 to 10 months. As a result, the exposure of mutual funds to bad bonds has kept on rising, and the DHFL event has caused a great decline in the NAV of such funds.


Mutual funds have been exploring a few alternatives, one of which is the option of side pocketing. Some AMCs have also decided to take this approach. Side pocketing is a process where mutual funds separate the bad holdings from the good ones. While they continue allowing buying and selling of the good portion of the portfolio, the bad part is set aside in hopes of recovery for investors. Recently, Sundaram Mutual Fund has withdrawn the proposal to side-pocket its ₹52-crore investment in the debt papers issued by distressed Dewan Housing Finance Corporation (DHFL). The other alternative is to wait and watch as to how the DHFL saga unfolds - that is, whether they will be able to make the interest payment within the stipulated time and whether there will be further defaults as expected by the rating agencies.


The Road Ahead


DHFL is now classified as an SMA 2 (special mention account 2) exposure, meaning loans where the payment of interest is delayed for more than 60 days but less than 90 days. That means the account is still not classified as nonperforming.


A resolution plan for the mortgage lender is being prepared based on the 7 June circular of the Reserve Bank of India (RBI). Lenders to Dewan Housing Finance (DHFLNSE 2.26 %) have agreed on a three-level resolution plan that includes conversion of debt to equity and issuance of nonconvertible debentures, steps that will give creditors majority stake in the embattled financier and help resume stalled credit lines. The plan that lending banks have broadly agreed upon involves conversion of some debt into equity. This is a small portion, may be 1 per cent.


The majority part of the equity conversion will come from the haircut banks take on the wholesale loans of the company, at a nominal price of Rs 1 per share, which will give banks a majority share in the company. Banks have a collective Rs 35,000-crore exposure to DHFL through loans, and the lenders also hold debentures. Bond holders, which include mutual funds, insurance companies and pension funds, also have a Rs 45,000-crore exposure, which effectively means that the company owes its creditors about Rs 80,000 crore.


The restructuring plan being worked out by lenders also includes conversion of some loans into non-convertible debentures, instruments that will be longer-term in nature and give the company some breathing space on repayments.


Mutual funds that have exposure to the company have also been granted permission to sign an inter-creditor agreement (ICA) with lenders to join the resolution process by the Securities and Exchange Board of India (SEBI). The tale is yet to tell itself, and every investor has a nail-biting moment in front of her. Only time, and the government and regulator’s quick insightful steps can deviate the saga from its expected conclusion. It’s all to see, how this unfolds.

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