We all used to discuss the regular risks associated with mutual fund investment. But recently due to one company’s stock and debenture, the mutual fund industry experienced few unknown Mutual Fund risks. Let us see what they are and how to be careful.
The trouble started with an auto ancillary industry company called Amtek Auto. One month back the stock price was around Rs.170 and it is now at around Rs.28. A fall of around 80% within a month. The reasons are as below.
- The company has under loss and June quarter results reported a loss of more than Rs.150 Cr.
- The company is finding it difficult to pay the interest on loans of around Rs.7, 800 Cr. Per quarter they need around Rs.200 Cr. to pay as an interest towards this loan, i.e. around 25% of its sales.
- CARE rating suspending the company for rating stating the reason as a company not provided the information.
- The stock has been taken off from Future and Options segment of the market.
Which Mutual Fund Companies hold Amtek Auto?
Five of India’s Top mutual fund companies holding the stock in their portfolio under the different fund categories. They are HDFC MF, Kotak MF, UTI MF, ICICI Prudential MF, and IDFC MF. Basically, the major chunk is from Arbitrage Funds of these MF companies. The total holdings of these mutual fund companies is around Rs.100 Cr. When we consider the AUM of funds, then this may seem less. But the question is why fund managers silent on company’s financial health and why they hold?
The detailed holding is explained in the Business Standard’s article of dated September 1, 2015.
This is the history about the company and equity holding of mutual fund companies. Now let us concentrate to this post. Recently JP Morgan Mutual Fund Company has been in the news because of Amtek Auto.
Two JP Morgan Mutual Fund’s debt schemes, Short Term Income Fund’s and JP Morgan India Treasury Fund together hold around the combined exposure of Rs 200 crore in Amtek Auto’s debt papers. When the debentures of this company were issued in earlier this year, then CARE rated this as AA- (double A negative). Both these funds holding around 10.25% of Amtek Auto debenture.
Why NAV falls due to fall in credit rating? As per Live Mint “When a bond’s credit rating drops, its price, too, gets marked down as an adjustment, according to the formula that debt funds are mandated to use to value underlying securities. In other words, this is a mark to market loss. Amtek Auto has not yet defaulted on the principal payment to JP Morgan AMC.”.
Due to fall in bond price and panic of defaulting, the redemption started in these two funds. The result is NAV of two of its debt mutual funds, JP Morgan Short Term Income Fund and JP Morgan India Treasury Fund fell by -3.38% and – 1.73% on August 27th, 2015.
To limit this sudden redemption and further fall of NAV, JP Morgan restricted the redemption from each of the two schemes to 1% of the total number of units outstanding on any business day. Means 1% of units in each scheme will be available for redemption, on a first-come-first-served basis.
But instead of default by Amtek Auto, the company may tell JP Morgan to roll over the debentures. Then the issue may calm down as of now. However, this is not a long-term or permanent solution. At the same time, if the Amtek Auto defaults, then you may see another such fall in NAVs of both funds. This means a permanent loss of equal to the % of holdings by these two funds in Amtek Auto Debenture. So the EXIT is the best option.
Now let us understand what risks this whole scenario brings to us–
- Liquidity Risk-When we say Mutual Fund investment, we always used to hear that it is a liquid asset. But what if because of such situations you are not able to liquidate your holdings? JP Morgan Mutual Fund restricted the redemption from each of the two schemes to 1% of the total number of units outstanding on any business day. It is as if the situation where banks restrict money withdrawal from an ATM during a banking crisis. According to rule, for any mutual fund company to take such decisions, the board of directors and trustee of a company must agree to it. Also, it must inform to SEBI for such action. But I feel there is no such process followed. Once there is an approval from all these three (board of directors, Trustee and SEBI), then only mutual fund company can impose such rule. In this case, no such rules followed. Is it to protect investors money or collapse of their own fund?
- Biased Risk-It sounds strange to you, but if you go with this news item of Times Of India, it allowed 3 large companies to exit from the schemes but not allowed for other 5 biggest companies. So the mutual fund company biased towards few companies to liquidate and come out of troubled funds. But what about the retail investors? Will they get such special treatments?
- Dynamic nature of Credit Rating Risk-See the ratings of the debenture when it was launched to the current status. CARE rated it an AA- (double A negative). CRISIL AA (+ve or -ve) means “Instruments with this rating are considered to have high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk.” But now rating agency suspended it’s rating. So what retail investors can learn? Never be in the wrong belief that ratings remain constant. They are dynamic in nature and risk is always there.
- Fund Manager’s Risk-Look at these two funds. One is short term fund and another is ultra short term debt fund. We invest in such funds to avoid any volatility. We consider them as safe funds due to their holding nature of high-rated securities. In such a situation, why the Fund Manager hold Amtek Auto? Doesn’t he know the finances of the company? Who will bear the cost for his fault? Initially, the fund was invested around 15% in AA rated securities as were mandated. But later it increased the exposure to 30%. This is purely against the mandate provided during the launch of the fund. Usually, fund managers indulge in such track to create good returns against the peers or index. The result is devastating.
- Regulatory Risk-We all say with proud that mutual fund is the well-regulated industry. If so, then why SEBI not pushed the alarm button to the JP Morgan Mutual Fund when it increased its holding in low-rated bonds to more than the mandated holding? Now forget about that too, why SEBI not acting when without any such rules, JM Mutual Fund restricted the redemption limit? Also, why SEBI closed its eyes when JP Morgan Mutual Fund allowed redemption only to few big investors but forget retail investors?
What can we learn from this episode?
Check your fund holdings. It is hard for retail investors to understand the debt holdings. But not that much difficult also. If your debt funds holding any such low rated funds, then it is better to switch off. Because you have enough volatility from equity portfolio. Otherwise, if your fund holding such low rated bonds, then selects a fund which is low modified duration fund.