The turbulence in the financial sector, which started as a liquidity crunch in the non-banking finance companies (NBFCs) space, has now spread to the mutual fund industry as well as the banking system.
The most recent casualties are Reliance Capital and PNB Housing Finance. Rating agency ICRA downgraded Reliance Capital’s short-term debt worth Rs 950 crore to A4, while CARE put AAA-rated PNB Housing Finance’s select debt instruments on “credit watch with developing implications”. This was preceded by a repayment crisis in the Essel Group early this year, and a spate of rating downgrades in the housing finance company DHFL last year.
Rating downgrades cast doubt on the debt repayment prospect of companies and tend to create panic among investors. These developments, however, are not surprising. Given the dynamics of the lender-borrower relationship, a change in the repayment prospect inevitably create troubles for the lender. But what could make this into a broader crisis, however, is the collateral damage for a gamut of stakeholders if the default fears materialize. These stakeholders include larger institutions such as insurance companies and mutual funds.
Insurance companies, for instance, are dealing with the possibility of breaching the regulator IRDAI’s investment rules that mandate them to invest at least 95 percent in AA+ rated instruments. A spate of recent rating downgrades has changed the credit composition of the debt portfolio of these companies. Thus, insurance companies have sought regulatory forbearance to comply with the rules.
Mutual fund investors in fixed maturity plans, debt funds, and even hybrid funds have been caught in a fix, owing to the exposure of their schemes to one of these downgraded groups. Kotak Mahindra AMC and HDFC AMC, for instance, deferred a part of the redemption for one of their fixed maturity plans that were due recently. This was because of their exposure to the Essel Group firms where they have entered into a standstill agreement with the latter.
A similar situation is currently playing out in hybrid funds. Three hybrid schemes of Reliance Nippon AMC, for instance, have significant exposures to the Reliance Capital group. As per reports, these three schemes have roughly 5.6 percent exposure or Rs 900 crore of the total scheme assets, which could cause the AMC to book mark-to-market losses.
Then, there is lingering uncertainty over the credit profile of the housing finance company DHFL. A host of rating agencies recently downgraded DHFL’s short-term debt papers on account of liquidity concerns. A fallout of this is that several mutual funds, which have a combined exposure of roughly Rs 6,500 crore to DHFL, stand to face their liquidity issues as investors seek to exit.
How did we get here? The present liquidity crunch in NBFCs is a result of asset-liability mismatch and governance lapses (recall IL&FS). Its impact on the cost of capital has made it difficult for them to refinance loans, maintain margins and asset quality.
Mutual funds, on the other hand, have increasingly been engaged in a yield chasing spree. This is mainly owing to two factors. One, the assets under management of mutual funds have witnessed stupendous growth over the last ten years – from roughly Rs 5 lakh crore in 2008 to Rs 23 lakh crore in 2018. Against this growth in AUM, the amount of AAA-rated firms as a proportion of the total rated universe of companies has remained at a meagre 0.85 percent. Therefore, fund managers had to go down the credit chain to deploy funds and reap returns.
Second, with substantial growth and greater competition for investors’ funds, there has been pressure to deliver high returns. Also, most fund houses lack dedicated teams to monitor credit profiles on a regular basis.
As things stand now, it seems unlikely that the mess created out of governance failures, unhealthy asset-liability balance, and poor management of investors’ funds would be resolved within the next 12-18 months.
Policymakers should, however, tighten the rules governing asset-liability mismatch in NBFCs and harmonize them with those prevailing in the banking sector. They should also review the mutual fund exposure rules, specifically those concerning lending to private, unlisted companies against shares of their listed counterparts.
Harsh Vora is a proprietary investor and trader. Views are personal.