The Indian bond market, which has been behaving like a cat on a hot tin roof since the IL&FS default last year, has been given a new reason for nervousness in the last couple of weeks. It is being spooked by the possibility that sharp swings in the stock prices of listed companies will set off a string of loan defaults by the promoters of such companies.

Given that mutual funds have been active in loans against shares to promoters, investor forums are rife with questions about whether some of the debt mutual funds will now go belly up. Such exaggerated worries however, are triggered by an incomplete understanding of how promoter lending by mutual funds works.

Why promoter loans

In most developed markets, when promoters of successful ventures need equity capital to invest in their existing business or start a new one, they borrow from banks, offering their personal equity shares as collateral.

In India though, the RBI has traditionally frowned upon banks extending loans against shares to promoters. The promoters of India Inc therefore rely heavily on non-bank participants such as NBFCs and mutual funds to raise money. It is not just promoters who are neck-deep in debt who pledge their shares with MFs or NBFCs to raise capital, reputed promoters of cash-rich firms take this route too.

NBFCs and mutual funds on their part are quite enthusiastic about promoter loans because they offer substantially higher yields (up to 3 to 4 percentage points more) than plain-vanilla bonds. Using equity shares as collateral is risky from a price perspective. But in the event of distress, shares offer quick liquidity while property or infrastructure assets can be impossible to encash.

Debt mutual funds deciding to extend promoter loans usually buy bonds issued by the investment company controlled by the promoter. These bonds are structured as zero-coupon bonds repayable after 18 or 24 months. Repayment is secured against equity shares belonging to the promoter or in some cases, operational assets. To shield themselves against swings in the market value, mutual funds typically ensure that that the collateral value is at least 1.5-2 times the loan amount.

In some cases though, funds do extend unsecured promoter loans based on the ‘comfort’ they derive from the promoters’ reputation and net worth. The borrower in such deals may sign an agreement (covenant) with the fund that its total loans will not exceed a mutually agreed limit.

In case a steep stock price fall erodes the collateral, promoters are required to pledge more shares, bring in cash or offer new securities (such as FDs or liquid funds). Failing this, the fund liquidates the collateral towards repayment.

What has changed

While domestic fund houses have been using such structures to extend promoter loans to companies such as Tata Sons for the last two decades, recent developments in the debt market have made promoter loans a riskier proposition.

For one, tight bond market liquidity after the IL&FS debacle has dried up funds for promoters looking to raise quick money. This has prompted many promoters to pledge an inordinately high proportion of their equity holdings with lenders.

Two, the proliferation of NBFCs and their aggressive pursuit of growth in the last couple of years has led to frenetic competition in the loan-against-shares business. Many of the structured bond deals with promoters now feature many participants instead of just a few. Smaller lenders are willing to accept lower collateral too.

Three, sharp intra-day falls of 20-30 per cent have become quite common for stocks buffeted by negative news as seen in the case of Yes Bank, DHFL or Zee Entertainment. Such instant value erosion prompts a bunch of lenders to liquidate their stock of pledged shares, putting further pressure on the collateral value.

But such sharp erosion in the collateral value has wedged mutual funds with promoter loans between a rock and a hard place. In cases such as the Essel/Zee or ADAG group where promoters have expressed their inability to bring in more collateral after recent stock price falls, mutual funds have been unable to enforce their contracts by selling the pledged shares.

Given the lack of depth in the market, concerted selling of pledged shares by lenders can decimate value for everyone. This has prompted fund houses to cobble together ‘standstill’ arrangements with the promoters of the Zee and ADAG groups, giving them more time to come good.

If the promoter eventually fails to come good on his promise in such cases, the fund may be forced to liquidate its collateral at a distress price and write down the bond’s value in its NAV.

What can happen

So what does this mean for investors in debt funds? Investors need to be aware that this crisis, unlike the NBFC liquidity crisis, hurts only those debt schemes which have promoter loan exposures in their portfolio and have moreover seen sudden and steep erosion in the prices of the underlying stock.

As of now, of the key promoter names doing the rounds, only the ADAG group is in real debt distress. The DHFL group has been honouring its payments, while the Essel/Zee group is on a good fundamental footing.

Ballpark estimates put individual scheme exposures to the troubled promoter bonds at 1 to 8 per cent of respective scheme NAVs. So in the worst-case scenario, investors in the affected schemes may end up sacrificing the whole or a part of one year’s returns to this crisis.

Shielding retail

Now that the pitfalls of promoter lending by mutual funds are out in the open, what can be done to prevent retail investors from being singed by these risks?

One suggestion is that SEBI can completely ban promoter funding structures in debt schemes. While this is easily done, one needs to remember that not all investors in debt funds are risk-averse and willing to settle for moderate returns. A blanket ban on promoter funding will not just choke off a lucrative return avenue for debt funds, but also a critical source of capital for the more credit-worthy promoters.

Others suggest that SEBI should mandate more elaborate disclosures for debt schemes owning promoter-backed bonds.

But expecting retail investors to identify obscure promoter entities in portfolios and assess their loan covenants is quite unrealistic.

A good solution would be for SEBI to insist that mutual fund houses restrict promoter lending against shares to specially demarcated credit-risk schemes. While laying down rules for re-categorisation of debt mutual funds in 2017, SEBI had required fund houses to classify debt funds based on the duration risks they took on. But the industry continues to take on credit risk across a wide variety of funds, including liquid and short-term funds that are often sold to retail investors as FD substitutes.

Before hard-selling debt funds to retail folk, SEBI must require all fund houses to offer specially labelled retail debt schemes that stick to extremely low-risk strategies on both duration and credit.

These retail schemes should be managed separately from institutional ones, with a bar on inter-scheme transfers between the two.

There is also a crying need to replace the bland ‘Riskometer’ for debt funds with a clear statement on the probability of capital losses from credit or duration risks.

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