Is Another Bout Of Volatility Brewing For Debt Funds?

India’s debt funds are having a déjà vu moment as two large corporate groups teetering on the verge of a default threaten to upend the non-banking finance industry. Again.

Domestic funds, within a week of the events at the Essel group, are facing rising concerns on their exposure to Dewan Housing Finance Corporation Ltd., Credit Suisse analysts said in a recent note.

DHFL’s stock and commercial paper tumbled after investigative news website Cobrapost alleged that the housing finance company “siphoned off” more than Rs 31,000 crore of bank loans through a network of shell companies. That was when the NBFC sector was already hit hard by a liquidity squeeze triggered by payment defaults at Infrastructure Leasing and Financial Services. A sale of DHFL debt securities by a mutual fund at a significant discount sparked panic about its operations, leaving it with virtually no access to market funding. That forced them to curtail fresh lending and generate liquidity to repay existing dues.

Mutual funds had to write down the value of investments in IL&FS group entities after they were downgraded to default. Now, their exposure to DHFL’s debt is what concerns the analysts. “DHFL is among the larger borrowers from mutual funds and their aggregate exposure is 0.7 percent of the debt assets under management,” Credit Suisse’s note said. “Exposure for some fund houses is larger, at 2-10 percent of their total debt asset under management, with some schemes having up to 30 percent of the AUM to DHFL.”

These schemes took a heavy-hit when the DHFL allegations broke, leading to overnight mark-to-market losses as its debt was repriced at higher yields.

The risk is not just limited to debt funds. Banks, too, have an exposure to DHFL through loans and bonds. As of June 2018, individual banks’ exposure to the non-banking lender was around 1.5 percent. Among the banks with highest exposure were Yes Bank Ltd., Bank of Baroda Ltd., IDFC Bank Ltd. and Bank of India Ltd.

DHFL’s blow-up happened merely a week after Zee Group stocks crashed following a report that said controlling shareholder Essel Group’s name emerged in a probe linked to large deposits made after demonetisation.

The deterioration in Subash Chandra-led Essel Group’s financial position led it to reaching an agreement with lenders, mainly NBFCs and mutual funds, for an eight-month breather. The group now has time till Sept. 30 to find a strategic partner and deleverage its Rs 13,500 crore debt burden—Rs 11,000 crore of which is from mutual funds and NBFCs.

A potential default by Zee Group promoters will force fund houses to mark down these investments as well, impacting their net asset value unless they resort to side-pocketing—separation of stressed assets—as allowed by the market regulator.

Crisis In The Making?

Credit Suisse estimates that nearly a third of the mutual fund debt assets under management are in non-bank lenders. And rising scrutiny of credit risk in debt funds is likely to keep flows to them volatile. This will also constrain NBFC funding which relies on mutual funds for 10-30 percent of their borrowings.

Yet, it won’t have a “cataclysmic” impact, Neelkanth Mishra, Credit Suisse’s India economist and strategist, told BloombergQuint. “This is not as big a systemic problem as some of the earlier issues,” he said. “This is primary a confidence and liquidity problem.”

Mishra said it could hurt economic growth to some extent as a sizeable amount of credit in the system is given by non-banking lenders. Some regulatory action, he said, should be expected in the next few weeks without which “economic momentum will continue to weaken”.