Every downgrade doesn’tcall foran exit
Fund investors should check strength of the bond's promoter group and where rating stands after the downgrade before taking a call
Debt fund investors, especially in credit opportunities or credit risk funds, have been on tenterhooks for a while. With a spate of downgrades in the corporate bond market by credit rating agencies due to potential risk of default, mutual fund schemes with exposure to bonds of some companies do face some pressure. Many debt fund investors have been quick to exit such schemes, at times at a loss. And fund houses such as J P Morgan (now taken over by Edelweiss Mutual Fund) and Franklin Templeton Mutual Fund have witnessed outflows. The question is, are all these downgrades worth taking seriously? The answer: No.
On August 10, CRISIL downgraded the non-convertible debentures (NCDs) of Essel Mining and Industries Ltd (EMIL) from AA to AA-. It also put the bond on rating watch with negative implications.
EMIL is an Aditya Birla Group company. It is an operating-cumholding company. It has some mining operations. A subsidiary of this company has investments worth around ~15,000 crore in other Aditya Birla Group companies such as Hindalco, Grasim, Century Textile, and so on. The company also has considerable annual operating cash flow. The bond's downgrade was triggered by a recent Supreme Court (SC) verdict. The SC levied a penalty on the company for an amount that is yet to be finalised. Rating agencies took the view that the bond's credit profile needed to be downgraded.
ICICI Prudential Mutual Fund, when investing in this bond about a year ago, had factored in this development by putting in a clause. “To safeguard investors' interest, we had put in covenants that if the paper is downgraded, it will result in an increase in the rate of interest payable,” says Amit Bhosale, head of risk management, ICICI Prudential Mutual Fund, whose funds have limited exposure to EMIL. The impact of this event on the net asset values (NAVs) of ICICI Prudential's funds has been negligible.
Experts say this rating downgrade doesn’t call for investors to exit the funds that have invested in EMIL’s NCDs. “This is an Aditya Birla Group company. The likelihood of a default, given the strength of the promoter group and the reputation risk that a default carries, is very small,” says Prateek Mehta, cofounder and chief executive officer, Upwardly, a Bengaluru-based wealth advisory and investment platform. In this case, the downgrade is of one and not multiple notches, as has been witnessed in the past. “A small downgrade is acceptable so long as there is no default risk,” says Mumbai-based financial planner Arnav Pandya.
Given the current credit environment, and with the Securities and Exchange Board of India (Sebi) asking credit rating agencies to be more proactive with their rating changes, one can expect more action in this space. Investors need to focus on the larger picture. "They should ideally look at the modified credit ratio. It is the ratio of upgrades to downgrades which stood at 2.7x for ICICI Prudential Mutual Fund's universe of bonds. While the focus is largely on downgrades, what gets ignored are the positive developments in the form of upgrades," says Bhosale. The modified credit ratio stood at 1.27x for CRISIL's universe of bonds for the six months ended March 2017. This means that there were 127 upgrades for every 100 downgrades.
Investors also need to take a closer look at their funds, specifically its concentration risk. If concentration in each paper is high, the impact of a downgrade will be higher. In ICICI Prudential's case, none of the funds had an exposure of more than 2.5 per cent to EMIL's paper.
The level at which the rating stands after the downgrade is important. If the rating comes down to, say, BBB- after a downgrade, investors need to react differently (consider quitting) than if it is at AA-.
Finally, the strength and quality of the promoter-management group is crucial. A strong group can always raise resources to meet the company's debt obligations, and infuse equity capital to bring down the level of leverage.