The story so far: Earlier this month, Kotak Mutual Fund informed investors in its Fixed Maturity Plans (FMPs) that it would not be able to fully redeem investments made in two series of the FMPs. Separately, HDFC Mutual Fund also announced the extension of one of its FMP schemes, which was due for maturity on April 15, by 380 days.
What are FMPs?
Debt mutual funds, unlike equity MFs, invest in debt securities issued by companies (both publicly listed and privately held) and governments. FMPs, in turn, are a class of debt funds that are close-ended: one can only invest in them at the time of a new fund offer and they come with a specified maturity date, much like a fixed deposit (FD). However, in contrast to deposits, FMPs don’t offer a guaranteed return but only pitch an indicative yield that the investor then takes a bet on. What the investor forgoes in terms of liquidity compared with an FD, she hopes to make good via the marginally higher returns that the fund’s investments in higher-yield debt instruments such as commercial paper, corporate bonds and non-convertible debentures (NCDs) could potentially earn it. Additionally, investments in FMPs are more tax-efficient, since there are indexation benefits linked to capital gains, as opposed to tax on interest income in the case of an FD. FMPs, however, like other debt funds come with their own set of risks: the most significant ones are interest rate risk and credit risk.
How did Kotak’s and HDFC’s FMPs end up stuck?
Both the mutual funds’ investment managers had invested (as part of their portfolios) in debt securities issued by some of the Subhash Chandra-promoted Essel Group’s listed and unlisted companies.
Specifically, Kotak had invested in debentures of Konti Infrapower & Multiventures Private Limited, a Mumbai-based provider of accounting and consulting services, and Edisons Utility Works Private Limited, also based in Mumbai and reportedly operating in the construction industry. These debentures, which carried a coupon interest rate of 11.1%, were rated A+(SO) — putting them in the middle of the scale for investment grade ratings and indicating that the issuer had stable financial backing. The debt had also been secured by a pledge of Zee Entertainment Enterprise Limited’s shares.
While the exact purposes for which the borrowed funds were utilised is not known, Mr. Chandra’s group firms did make some investments in infrastructure projects and also sought to acquire Videocon’s D2h business. “In retrospect, disastrous investment decisions,” was how investment advisory services provider Morningstar Inc. described the group’s investments, in an April 12 note on their website.
In November 2018, the Essel Group announced that the promoter group planned to sell up to 50% of its stake in Zee Entertainment. This announcement, coupled with market speculation about financing difficulties at the group, prompted some lenders to start looking for ways to minimise their losses in the eventuality of a ‘credit event’ such as the announcement of a default on repayment of the borrowings.
On January 25, some lenders sold about ₹200 crore worth of Zee Entertainment shares, resulting in a sharp fall in the stock’s price from its previous close of ₹434 on the BSE, to ₹319 per share.
At this point, the remaining lenders including Kotak MF and HDFC MF opted to not convert the notional loss on their holdings into a real one and instead reached a standstill agreement with the Essel Group.
As per the agreement, the creditors agreed to give Mr. Chandra and the Essel Group time up to September 30, 2019, to conclude the strategic stake sale in Zee Entertainment and use the proceeds to repay the borrowings with interest.
Which are the funds affected by Essel woes?
The cumulative amount at stake for FMPs is estimated to be more than ₹1,400 crore with over 40 schemes maturing later this year. More importantly, about 14 schemes, with an exposure of almost ₹475 crore, were set to mature this month.
In the case of Kotak, besides the FMP Series 127 and 183, which matured on April 8 and April 10, respectively, and whose investors did not receive full redemption proceeds on account of the funds’ exposure to the Essel group firms, four other FMPs viz. Series 187, 189, 193 and 194 as well as the Kotak Credit Risk Fund have exposure to the Essel group firms.
According to Morningstar Inc.’s analysis of FMP fund portfolio statements as of December 2018, the cumulative exposure of close-ended funds like FMPs to the Essel group’s debt was pegged at ₹1,670 crore ( see graphic ).
What else is at stake for MF investors?
Kotak’s note to investors from earlier this month is revealing. Besides the Essel group exposure, the fund house has acknowledged that four of the FMPs viz. Series 183, 192, 193 and 194 had also invested, in May 2016, in NCDs issued by the IL&FS Transportation Networks Limited, a unit of the financially distressed IL&FS.
Kotak said it had made a 100% provision by February 12, 2019, for this investment as the recovery would now depend on a resolution plan agreed to by a new board at the beleaguered parent and the National Company Law Tribunal.
Also, the troubles at both the Essel group and IL&FS point to the woeful inadequacy of credit ratings as a means to assess the most crucial element for fixed income investing: credit risk.
A look at Kotak’s own breakdown of the overall portfolio holdings of Assets Under Management (AUM) for its debt schemes reveals that only about 46% of the overall funds are parked either in sovereign (almost 13%) or AAA-rated (22.9%) securities.
The rest of the AUM are spread across fixed income securities rated below AAA, while still invested in investment grade assets.
The industry’s mandatory disclaimer: “Mutual fund investments are subject to market risk”, couldn’t be more germane than in this case.
