Fixed Income: Should You Hold On To Debt Funds With Exposure to IL&FS?

By Joydeep Sen

By now it is well known that multiple mutual funds with exposure to IL&FS or its group entities have fully written off their exposure. Consequently, the hit, i.e., negative impact on returns has happened in the respective funds. Depending on the extent of exposure to IL&FS / group companies (2% of portfolio or 10% of portfolio), it has taken away a few months of accrual of the fund to more than one year of accrual of the fund.

In other words, as on date, returns from these funds are negative over last few months to more than one year. At this juncture, the question in the minds of investors is whether to stay put or exit because the performance is poor.

Events at the AMCs
Let us understand what is happening. When an exposure in a debt fund turns non-performing, as per Sebi rules, the fund has up to 18 months to write it off. However, they can do it earlier also, on their own discretion, if they think that is prudent. In all these instances of write-off, the AMCs have taken a decision that subsequent to a maturity default or coupon default, instead of lingering it on, it is better to write it off and ‘clean’ the portfolio. The fact that a defaulting entity is there in the portfolio impacts business prospects of the fund, and they would like to move on.

It may be argued here, why pass on the negative impact on existing investors, in the interest of getting fresh business. Exposure to a defaulting entity anyways dents the business prospects of the fund/AMC, due to sentimental reaction of investors, and it takes time to recover.

In the immediate aftermath of the full write-off, most AMCs stopped fresh purchases, as the NAV was available at a discount, assuming IL&FS will pay back something in future. Gradually, these funds are opening up for fresh purchases. Even now, these funds are not getting much of fresh investments, as sentiments have been impacted. Arguably, the time period of 18 months allowed by law is too long and needs to be cut short.

Sebi has allowed segregation of bad assets in a fund, by its circular dated December 28, 2018. Though it does not say in so many words that the circular is applicable with prospective effect, it says that segregation of assets, i.e., side-pocketing should be mentioned in the Scheme Information Document (SID). This means that AMCs will amend the SIDs of funds where they may potentially resort to side-pocketing. It effectively means, in cases where the IL&FS incidents have already occurred, they cannot implement side-pocketing.

Why hold on
The extent of write-off done by the fund does not represent the probability of recovery from IL&FS. If a fund writes off only 25% of the defaulting exposure as initial reaction, it does not mean chance of recovery is 75%. Similarly, 100% write-off does not mean chance of recovery is nil. The AMC will continue the dialogue with the issuer on the recovery prospects. Given the new managing board in place and its efforts to resurrect the IL&FS Group by sale of assets / sale of stake, restructuring etc., hopefully, something will come out of it in future for the investors who have suffered the impact of write-off.

If you exit, you are giving up your chances of recovery after suffering the negative impact. Assuming something will come by in future, it makes sense to hold on and wait. To be noted, as and when the AMCs are opening up for fresh purchases, new investors who are coming in will also get the benefit of recovery, as the recovery proceeds will be credited to the NAV.


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